Engineering Economics

21S3101

INTEREST AND EQUIVALENCE (Part 3)

Engineering Management
Del Institute of Technology
 Nominal and Effective Interest

• Nominal interest rate per year, r, is the annual interest rate without
considering the effect of any compounding.

• Effective interest rate per year, ia , is the annual interest rate taking into
account the effect of any compounding during the year.

Equation :
m
 r
Effective annual interest rate i a  1    1
 m
Where,
r = nominal interest rate per year
m = number of compounding subperiods per year
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 Nominal and Effective Interest
• Substituting the effective interest rate per compounding subperiod, i = (r/m),

Effective annual interest rate

m Where,
i a  (1  i )  1 i = effective interest rate per compounding subperiod
m = number of compounding subperiods per year

Example :
If a savings bank pays 1% interest every 3 months, what are the nominal and
effective interest rates per year?

Nominal interest rate per year r  4  1%  4%

4
 0.04 
Effective annual interest rate i a  1    1  4.06%
 4 
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 Continuous Compounding
• Single Payment Interest Factors: Continuous Compounding

• The single payment compound amount formula :

F  P (1  i ) n P  F (1  i )  n
• If substituting the effective interest rate per compounding subperiod,
i = (r/m),
r mn r  mn
F  P (1  ) P  F (1  )
m m
• To find compound amount and present worth for continuous
compounding and a single payment,
Compound amount F  P (e) rn  PF / P, r , n 
Present worth P  F (e)  rn  F P / F , r , n
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 Continuous Compounding

 er 1 
• Continuous compounding A  F  rn   F A / F , r , n
sinking fund :  e  1

• Continuous compounding  e rn (e r  1) 
capital recovery : A  P rn   PA / P, r , n
 e 1 

 e rn  1
  AF / A, r , n 
• Continuous compounding
F  A r
series compound amount :
 e 1 
 e rn  1 
• Continuous compounding P  A rn r   AP / A, r , n
series present worth :  e (e  1) 
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 Continuous Compounding
Example :
If you were to deposit $5000 in a bank
that pays 5% nominal interest,
compounded continuously, how much
would be in the account at the end of 5
years?
Solution :
F  5.000  e 0.055  6.420
or

F  PF / P, r , n

F  5.000  1,2840  6.420

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 Arithmetic Gradient

• An arithmetic gradient series is a cash flow series that either

increases or decreases by a constant amount each period.

• The amount of change is called the gradient.

• Equation Arithmetic Gradient Present Worth Factor :

 1  i n  in  1
P  G 
 i 1  i 
2 n


P  G P / G , i, n 
*Where G is Gradient 21S3101
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 Arithmetic Gradient

0 1 2 3 n -1 n

(n-1)G
(n-2)G

2G
A A A A A G
+
0 1 2 3 n-1 n 0 1 2 3 n-1 n
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 Arithmetic Gradient

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 Arithmetic Gradient

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 Arithmetic Gradient
Example :
Andrew has purchased a new car. He wishes to set aside enough
money in a bank account to pay the maintenance for the first 5 years.
It has been estimated that the maintenance cost of a car is as follows:
Year Maintenance Cost
1 $ 100
2 $ 150
3 $ 200
4 $ 250
5 $ 300

Assume the maintenance costs occur at the end of each year and that
the bank pays 5% interest. How much should Andrew deposit in the
bank now? 21S3101
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 Arithmetic Gradient
Solution : 300
250
200
150
100

0 1 2 3 4 5

Uniform Series
Present Worth
P = Arithmetic Gradient
Present Worth
200
150
100
100 100 100 100 100 50
0
0
1 2 3 4 5 + 0
1 2 3 4 5
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P P Engineering Economics

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 Arithmetic Gradient
Solution :

 1  i   1
n  1  i n  in  1
Pa  A Pg  G  
n 
 i 1  i 
n
 i 1  i  
2


 1  0.05  1  5 
Pg  50 
1  0. 05 5
 (0.05)(5)  1
Pa  100 5

0.05 1  0.05
5
 0.051  0.05 
2
 

Pa  433 Pg  412 Andrew should deposit

$845 in the bank now
P  Pa  Pg
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P  433  412  845 Engineering Economics

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 Arithmetic Gradient
Alternate Solution :

Pa  AP / A, i, n  Pg  G P / G, i, n 
Pa  1004.329   433 Pg  50(8.237)  412
21S3101
P  Pa  Pg P  433  412  845 Engineering Economics

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 Arithmetic Gradient

• Equation Arithmetic Gradient Uniform Series Factor :

 1  i n  in  1 1 n 
A  G  A  G  
 i 1  i   1 
n
 i 1  i n
 1 

A  G  A / G , i, n 
Example : Year Maintenance Cost
• On a certain piece of machinery, it is
1 $ 100
estimated that the maintenance 2 $ 150
expense will be as follows: 3 $ 200
4 $ 250
What is the equivalent uniform annual 5 $ 300
maintenance cost for the machinery if 21S3101
5% interest is used? Engineering Economics

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 Arithmetic Gradient
Solution :
0 1 2 3 4 5

100
150
200
250
300

=
0 1 2 3 4 5 0 1 2 3 4 5

+ 0
100 100 100 100 100 50
100
150
200
A0  100 A1  ... ?
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 Arithmetic Gradient
Solution :

 1 5 
A1  50   
 0 .05 1  0.05  1
5

A1  95

A  A0  A1
A  100  95  195

The equivalent uniform annual maintenance cost is $195

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 Arithmetic Gradient
Alternate Solution :

A1  501.902  95 A0  100
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A  100  95  195 Engineering Economics

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 Geometric Gradient
• A geometric gradient series is a series of cash flows that increase or
decrease by a constant percentage each period.

• Some terminologies :
g = constant rate of change, in decimal form, by which cash flow
values
in one period to the next. Can be + or -.
A1 = initial cash flow in year 1 of the geometric series
Pg = present worth of the entire geometric gradientn-1series, including the
A1(1+g)

initial amount A1
A1(1+g)n-2

A1(1+g)2
A1 A1(1+g)1
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0 1 2 3 n-1 n
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 Geometric Gradient

• If the maintenance costs for an automobile are $100 the first year and they
increase at a uniform rate, g, of 10% per year, the cash flow for the first 5
years would be as follows:

Year Cash Flow

1 100.00 = $ 100.00
2 100.00 + 10%(100.00) = 100(1 + 0.10)1 = $ 110.00
3 110.00 + 10%(110.00) = 100(1 + 0.10)2 = $ 121.00
4 121.00 + 10%(121.00) = 100(1 + 0.10)3 = $ 133.10
5 133.10 + 10%(133.10) = 100(1 + 0.10)4 = $ 146.41

0 1 2 3 4 5

100
110
121
133.1 21S3101
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 Geometric Gradient

• Equation geometric series present worth factor , i≠g:

1  (1  g ) n (1  i )  n 
P  A1  
 i  g 
P  A1 P / A, g , i, n 

Example :

The first-year maintenance cost for a new car is estimated to be $100, and it
increases at a uniform rate of 10% per year. Using an 8% interest rate,
calculate the present worth (PW) of the cost of the first 5 years of
maintenance.
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 Geometric Gradient
Solution : 1  (1  0.1) 5 (1  0.08) 5 
P  100  
 0.08  0.1 

P  480.43
The present worth of cost of maintenance for the first 5 years is $480,43.

• Equation geometric series present worth factor , i=g:


P  A1 n(1  i ) 1 
P  A1 ( P / A, g , i, n) or P  A1 ( P / A, i, i, n)
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 Practice

1. A student is buying a new car. The car’s price is $16,500, the sales tax is 8%,
and the title, license, and registration fee is $450 to be paid in cash. The dealer
offers to finance 90% of the car’s price for 48 months at a nominal interest rate
of 9% per year, compounded monthly.
a. How much cash is paid when the car is pur- chased?
b. How much is the monthly payment?
2. It is estimated that the maintenance cost on a new car will be $400 the first
year. Each subsequent year, this cost is expected to increase by $100. How
much would you need to set aside when you bought a new car to pay all future
maintenance costs if you planned to keep the vehicle for 7 years? Assume
interest is 5% per annum.

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 Practice

3. The council members of a small town have decided that the earth levee
that protects the town flooding should be rebuilt and strengthened. The
town engi- neer estimates that the cost of the work at the end of the first
year will be $85,000. He estimates that in subsequent years the annual
repair costs will decline by $10,000, making the second-year cost $75,000;
the third-year $65,000, and so forth. The council members want to know
what the equivalent present cost is for the first 5 years of repair work if
interest is 4%.

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 Handbook

• Donald G. Newnan et al., Engineering Economic Analysis

Eleventh Edition, Oxford University Press: New York, 2012.

• Chan S. Park, Fundamentals of Engineering Economics,

Pearson Education Limited: Edinburgh Gate, 2013.

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