ENGINEERING ECONOMICS

LECTURE - 06 ASST PROF. ENGR

ALI SALMAN
alisalman@
ceme.nust.edu.pk
DEPARTMENT
DEPARTMENT
OF
OF
ENGINEERING
ENGINEERING MANAGEMENT
MANAGEMENT
NUST
NUSTCOLLEGE
COLLEGEOF
OFEE&&ME
ME
ALI SALMAN 1
 Interest and Interest Rate

Interest
is the rental amount charged by financial
institutions for the use of money.

Interest Rate
or the rate of capital growth, is the rate of
gain received from an investment.

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Usually this rate of gain is stated on a per year
basis, and it represents the percentage gain realized
on the money committed to the undertaking.

Thus, an 11% interest rate indicates that for every

dollar of money used, an additional $0.11 must be
returned as payment for the use of money.

The interest rate is determined by mutual

agreement between the borrower and the lender
and is known as the market rate.

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In one aspect, interest is an amount of money
received as a result of investing funds either
by lending it or by using it in the purchase of
materials, labor or facilities. Interest received
in this connection is gain or profit.

In another aspect, interest is an amount of

money paid out as a result of borrowing
funds. Interest paid in this connection is a
cost.

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 The Time Value of Money
Because money can earn at a certain interest rate
through its investment for a period of time, one
thousand rupees received at some future date is not
worth as much as in hand at present. This
relationship between interest and time leads to the
concept of the time value of money.
One thousand rupees in hand now is worth more
than one thousand rupees received n years from
now. Why?
Because having one thousand now provides the
opportunity for investing that for n years more than
the one thousand to be received at that time.
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Since money has earning power, this opportunity
will earn a return, so that after n years the original
one thousand plus its interest will be greater than
the one thousand received at that time. Thus, the
fact that money has a time value means that equal
amounts at different points in time have different
value as long as the interest rate that can be earned
exceeds zero. This relationship between money and
time is illustrated in fig.

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It is also true that money has time value
because the purchasing power of a thousand
changes through time.
During periods of inflation the amount of
goods that can be bought for a particular
amount of money decreases as the time of
purchase occurs further out in the future.
Therefore, when considering the time value
of money it is important to recognize both the
earning power of money and the purchasing
power of money.
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 The Earning Power of Money
Funds borrowed for the prospect of gain are
commonly exchanged for goods, services, or
instruments of production. This leads to the
consideration of the earning power of money that
may make it profitable to borrow.
Consider the example of Mr. ABC who manually digs
ditches for underground cable. For this he is paid
$0.40 per foot and averages 200 feet per day.
Weather conditions limit this kind of work to 180
days per year. Thus he has an income of $80 per
day worked or $14,400 per year.
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An advertisement brings to his attention a
power ditcher that can be purchased for
$8000. Mr. ABC buys the ditcher after
borrowing $8000 at 14% interest. The
machine will dig an average of 800 feet per
day. By reducing the price to $0.30 per foot he
can get sufficient work to keep the machine
busy when the weather will permit.
Estimated operating and maintenance costs
for the ditching machine are $40 per working
day. At the end of year the machine is
worthless because it is worn out. A summary
of the venture follows:
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• Receipts
• Amount of Loan $8000
• Payment for ditches dug 43200
51200
• Disbursements
• Purchase of Ditcher $8000
• Operating and maintenance 7200
• Interest on loan 1120
• Repayment of loan 8000
24320
• Receipts less Disbursements $26880
An increase in net earnings for the year over the
previous year of $26880-$14400=$12480 is enjoyed by Mr.
ABC.
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This example is an illustration of what is
known as the “earning power of money.”

It was an instrument of production, the power

ditcher, that enables Mr. ABC to increase his
earnings. Borrowed money made it possible
for the instrument of production to be
employed.

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 The Purchasing Power of Money
As prices increase or decrease, the amount of
goods or services that can be purchased for a fixed
amount of money decreases or increases
accordingly.
Prices for goods and services are driven upward or
downward because of numerous factors at work
within the economy.
For example, increases in productivity and in the
availability of goods tend to reduce prices, while
government policies tend to increase prices. When
all such effects are taken together , the most
common result has been that prices increase.
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 Simple and Compound Interest
Interest Periods Interest is usually charged on
amount for a period of one year. Interest rates are
quoted for periods other than one year, known as
interest periods.
Simple Interest: Under simple interest, the interest
owed upon repayment of a loan is proportional to the
length of time the principal sum has been borrowed.
The interest earned may be found in the following
manner. Let I represents the interest earned, P the
principal amount, n the number of interest periods,
and i the interest rate. Then,
I = Pni
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Suppose that Rs1000 is borrowed at a simple
interest rate of 12% per annum. At the end of one
year, the interest owed would be
I = 1000(1)(0.12) = Rs120
The principal plus the interest would be Rs1120 and
would be due at the end of one year.
A simple-interest loan can be made for any period of
time.
Interest and principal become due only at the end of
the time period.
When it is necessary to calculate the interest due for
a fraction of year, it is common to represent that
fraction as the ratio of the number of days in the loan
to the total days in a year. 14
For example, on a loan of Rs1000 at an
interest rate of 12% per annum, for a period
March 1 to May 20, the interest due on May
20 along with the principal sum of Rs1000
would be

0.12(1000) (81 / 365) = Rs26.63

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When a loan is made for several interest periods,
interest is calculated and payable at the end of each
interest period.

There are a number of loan repayment plans. These

range from paying the interest when it is due to
accumulating the interest until the loan is due.

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 For example, the payments on a 4-year loan of
Rs1000 at 16% interest per annum, payable
when due, would be calculated as shown.

Yr Amount owed Interest to Amount Amount to be

at beginning be paid at owed at paid by the
of yr end of yr end of yr borrower at
Rs Rs Rs end of yr-Rs
1 1000 160 1160 160
2 1000 160 1160 160
3 1000 160 1160 160
4 1000 160 1160 1160

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 If the borrower does not pay the interest earned at
the end of each period and is charged interest on the
total amount owed (principal plus interest), the
interest is said to be compounded.

The interest owed in the previous year becomes part

of the total amount owed for this year. This year’s
interest charge includes interest that has been
earned on previous interest charges.

For example, a loan of Rs 1000 at 16% interest

compounded annually for a 4-year period will
produce the results shown.
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Year Amount Interest (Rs) Amount Amount
(Rs) owed to be added (Rs) owed at (Rs) paid
at to loan at end end of year by
beginning of year (B) (A+B) borrower
of year (A) at end of
year
1 1000.00 1000 X 0.16 1000(1.16)= 00.00
=160.00 1160

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Year Amount Interest (Rs) Amount Amount
(Rs) owed to be added (Rs) owed at (Rs) paid
at to loan at end end of year by
beginning of year (B) (A+B) borrower
of year (A) at end of
year
1 1000.00 1000 X 0.16 1000(1.16)= 00.00
=160.00 1160
2 1160.00 1160 x 0.16 1000(1.16)2= 00.00
=185.60 1345.60

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Year Amount Interest (Rs) Amount Amount
(Rs) owed to be added (Rs) owed at (Rs) paid
at to loan at end end of year by
beginning of year (B) (A+B) borrower
of year (A) at end of
year
1 1000.00 1000 X 0.16 1000(1.16)= 00.00
=160.00 1160
2 1160.00 1160 x 0.16 1000(1.16)2= 00.00
=185.60 1345.60
3 1345.60 1345x 0.16 1000(1.16)3= 00.00
=215.30 1560.90

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Year Amount Interest (Rs) Amount Amount
(Rs) owed to be added (Rs) owed at (Rs) paid
at to loan at end end of year by
beginning of year (B) (A+B) borrower
of year (A) at end of
year
1 1000.00 1000 X 0.16 1000(1.16)= 00.00
=160.00 1160
2 1160.00 1160 x 0.16 1000(1.16)2= 00.00
=185.60 1345.60
3 1345.60 1345x 0.16 1000(1.16)3= 00.00
=215.30 1560.90
4 1560.90 1560.90x 0.16 1000(1.16)4= 1810.64
=249.75 1810.64

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 Describing Cash Flows Over Time
Cash flow is the actual inflow (receipts) and outflow
(disbursements) at different points in time that occur
over the life of an investment.

Cash flow diagram will provide the information

necessary for analyzing an investment proposal.

A cash flow diagram represents receipts received

during a period of time by an upward arrow (an
increase in cash) located at the period’s end.

The arrow’s height may be proportional to the

magnitude of the receipts during that period.
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Similarly, disbursements during a period are
represented by a downward arrow (a decrease
in cash).
These arrows are then placed on a time scale
that spans all time periods covered by the
proposed investment.

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 Note: Since there are two parties to every
transaction, it is important to note that the
cash flow directions in cash flow diagrams
depend upon the point of view taken.

Net Cash Flow

When an investment alternative has both
receipts and disbursements occurring
simultaneously, a net cash flow may be
calculated.
Net cash flow is the arithmetic sum of the
receipts (+) and the disbursements (-) that occur
at the same point in time.
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 Compounding Frequency
Considerations
The loan agreements may require that the
interest be paid more frequently, such as each
half year, each quarter or each month.

Such agreements result in interest periods of

one half-year, one quarter year, or one twelfth
year, and the compounding of interest twice,
four times, or twelve times a year,
respectively.

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• Every year – once a year (at the end):
– (Annually)
• Every 6 months – 2 times a year:
– (Semi-annually)
• Every quarter – 4 times a year:
– (Quarterly)
• Every month – 12 times a year:
– (Monthly)
• Every day – 365 times a year:
– (Daily)
• Continuous – infinite number of compounding
periods in a year! 27
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