Chapter 3

Interest and Equivalence

Copyright Oxford University Press 2011

Chapter Outline

Time Value of Money

Interest Calculations
Cash Flow Equivalence
Single Payment Compound Interest
Formulas
Nominal and Effective Interest Rates

Copyright Oxford University Press 2011

Learning Objectives
Understand the concept of time value of
money
Distinguish between simple and
compound interest
Understand the concept of equivalence
of cash flows
Solve problems using Single Payment
Compound Interest Formulas
Copyright Oxford University Press 2011

Vignette: A Prescription for Success

A pharmaceutical company
manufactured a prescription drug.
Current process resulted in significant
scrap and tablet press downtime.
Modification to the 3 presses cost
$90,000.
Impact of the modifications:

Each batch finished in 16 hrs (24 hrs)

Product yield increased to 96.6% (92.4%)
Production was reduced to 2 shifts (3)
240 batches processed in one year
First year savings of $10 million
Copyright Oxford University Press 2011

Vignette: A Prescription for Success

One year of production had a value of $240 million. What
is the value of one batch of product?
How many batches needed to break even on the initial
$27,000 investment? (assume 4.2% yield improvement)
If the first year savings is considered to be a single endof-year cash flow, and the entire $90,000 investment is
considered to occur at time 0, what is the present value of
the project? (Assume interest rate of 15%)
If one batch is produced per day, how often are the
savings actually compounded?

Copyright Oxford University Press 2011

Computing Cash Flows

Question: Would you rather
Receive $1000 today; or
Receive $1000 10 years from today?

Answer: Of course today!

Why?
I could invest $1000 today to make more money
I could buy a lot of stuff today with $1000
Who knows what will happen in 10 years

Copyright Oxford University Press 2011

Computing Cash Flows

Because money is more valuable today than in
the future, we need to describe cash receipts
and disbursements at time they occur.

Copyright Oxford University Press 2011

Example 3-1
Cash flows of 2 payment options
To purchase a new $30,000 machine,
Pay the full price now minus a 3% discount; or
Pay $5000 now; $8000 at the end of year 1;
and $6000 at the end of each of the next 4
years

Copyright Oxford University Press 2011

Example 3-1
Cash flows of 2 payment options
Pay in 5 years

Pay in full

End of
Year

Cash Flow

End of
Year

Cash Flow

0 (now)

-$29,100

0 (now)

-$5,000

-8,000

-6,000

-6,000

-6,000

-6,000

0
$5,000

$29,100

$8,000

Copyright Oxford University Press 2011

Example 3-2
Cash flow for repayment of a loan
To repay a loan of $1,000 at 8% interest in 2 years
Repay half of $1000 plus interest at the end of each year
$1000

Yr Interest Balance Repayment

0
1000

Cash
Flow
1000

1
2

-580
-540

80
40

500
0

500
500

$580

Copyright Oxford University Press 2011

$540

Time Value of Money

Money has purchasing power

Money has earning power
Money is a valuable asset
People are willing to pay some charges
(interests) to have money available for their use

Copyright Oxford University Press 2011

Simple Interest
Interest is computed only on the original sum, and
not on accrued interest
Total interest earned =

P in

(Eq. 3-1)

Where P = Principal
i = Simple annual interest rate
n = Number of years

F P P in
Where F = Amount due at the end of n years

Copyright Oxford University Press 2011

(Eq. 3-2)

Example 3-3
Simple Interest Calculation
Loan of $5000 for 5 yrs at simple interest rate of 8%
Total interest earned = $5000(8%)(5) = $2000
Amount due at end of loan = $5000 + 2000 = $7000

Copyright Oxford University Press 2011

Compound Interest
Interest is computed on the unpaid balance,
which includes the principal and any unpaid
interest from the preceding period
Common practice for interest calculation, unless
specifically stated otherwise

Copyright Oxford University Press 2011

Example 3-4
Compound Interest Calculation
Loan of $5000 for 5 yrs at interest rate of 8%

Year

Balance at the
Beginning of the year

Interest

Balance at the end

of the year

$5,000.00

$400.00

$5,400.00

$5,400.00

$432.00

$5,832.00

$5,832.00

$466.56

$6,298.56

$6,298.56

$503.88

$6,802.44

$6,802.44

$544.20

$7,346.64

Copyright Oxford University Press 2011

Repaying a Debt
Plan #1: Constant Principal
Repay of a loan of $5000 in 5 yrs at interest rate of 8%
Plan #1: Constant principal payment plus interest due

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

Interest
Payment

Principal
Payment

Total
Payment

$5,000.00

$400.00

$5,400.00

$400.00

$1,000.00

$1,400.00

$4,000.00

$320.00

$4,320.00

$320.00

$1,000.00

$1,320.00

$3,000.00

$240.00

$3,240.00

$240.00

$1,000.00

$1,240.00

$2,000.00

$160.00

$2,160.00

$160.00

$1,000.00

$1,160.00

$1,000.00

$80.00

$1,080.00

$80.00

$1,000.00

$1,080.00

$1,200.00

$5,000.00

$6,200.00

Subtotal

Copyright Oxford University Press 2011

Repaying a Debt
Plan #2: Interest Only

Repay of a loan of $5000 in 5 yrs at interest rate of 8%

Plan #2: Annual interest payment and principal payment at end of 5 yrs

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$5,000.00

$5,400.00

$2,000.00

$5,000.00

$7,000.00

Subtotal

Interest
Payment

Principal
Payment

Copyright Oxford University Press 2011

Total
Payment

Repaying a Debt
Plan #3: Constant Payment
Repay of a loan of $5000 in 5 yrs at interest rate of 8%
Plan #3: Constant annual payments

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

$5,000.00

$400.00

$5,400.00

$400.00

$852.28

$1,252.28

$4,147.72

$331.82

$4,479.54

$331.82

$920.46

$1,252.28

$3,227.25

$258.18

$3,485.43

$258.18

$994.10

$1,252.28

$2,233.15

$178.65

$2,411.80

$178.65

$1,073.63

$1,252.28

$1,159.52

$92.76

$1,252.28

$92.76

$1,159.52

$1,252.28

$1,261.41

$5,000.00

$6,261.41

Subtotal

Interest
Payment

Principal
Payment

Copyright Oxford University Press 2011

Total
Payment

Repaying a Debt
Plan #4: All at Maturity
Repay of a loan of $5000 in 5 yrs at interest rate of 8%
Plan #4: All payment at end of 5 years

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

$5,000.00

$400.00

$5,400.00

$0.00

$0.00

$0.00

$5,400.00

$432.00

$5,832.00

$0.00

$0.00

$0.00

$5,832.00

$466.56

$6,298.56

$0.00

$0.00

$0.00

$6,298.56

$503.88

$6,802.44

$0.00

$0.00

$0.00

$6,802.44

$544.20

$7,346.64

$2,346.64

$5,000.00

$7,346.64

$2,346.64

$5,000.00

$7,346.64

Subtotal

Interest
Payment

Principal
Payment

Copyright Oxford University Press 2011

Total
Payment

A Closer Look at the 4 Repayment

Differences:
Repayment structure (repayment amounts at various
points in time)
Total payment amount

Similarities:
All interest charges were calculated at 8%
They all achieved the same purpose of repaying the
loan within 5 years

Copyright Oxford University Press 2011

Equivalence
If a firm believes 8% was reasonable, it would
have no preference about whether it received
$5000 now or was paid by any of the 4
repayment plans.
The 4 repayment plans are equivalent to one
another and to $5000 now at 8% interest

Copyright Oxford University Press 2011

Use of Equivalence in
Engineering Economic Studies
Using the concept of equivalence, one can
convert different types of cash flows at different
points of time to an equivalent value at a
common reference point
Equivalence is dependent on interest rate

Copyright Oxford University Press 2011

Single Payment
Compound Interest Formulas
Notation:
i = interest rate per compounding period
n = number of compounding periods
P = a present sum of money
F = a future sum of money

Single Payment Compound Amount Formula

F P(1 i)

(Eq. 3-3)

F P(F/P, i, n)

(Eq. 3-4)

Find F, given P, at i, over n

Copyright Oxford University Press 2011

Example 3-5 Single Payment

Compound Interest Formulas
$500 were deposited in a saving account (pays 6%
compounded annually) for 3 years
F=?

F = P(1+i)n = 500(1+0.06)3
= $595.50

1
i=6%

P=500

Or
F = P(F/P, i, n) = 500(F/P, 6%, 3)
= 500(1.191) = $595.50
Copyright Oxford University Press 2011

Single Payment
Compound Interest Formulas
Notation:
i = interest rate per compounding period
n = number of compounding periods
P = a present sum of money
F = a future sum of money

Single Payment Present Worth Formula

P F(1 i)

-n

P F(P/F, i, n)
Find P, given F, at i, over n
Copyright Oxford University Press 2011

(Eq. 3-5)
(Eq. 3-6)

Example 3-6 Single Payment

Compound Interest Formulas
Wish to have $800 at the end of 4 years, how much
should be deposited in an account that pays 5% annually?
F=800

P = F(1+i)-n = 800(1+0.05)-4
= $658.16

2
i=5%

P=?

Or
P = F(P/F, i, n) = 800(P/F, 5%, 4)
= 800(0.8227) = $658.16

Copyright Oxford University Press 2011

Example 3-7 Single Payment

Compound Interest Formulas
$500 were deposited in a saving account (pays 6%,
compounded quarterly) for 3 years
F=?

i = 6%/4 = 1.5%
n = 3 x 4 = 12 quarters

2
i=1.5%

P=500

11

12

F = P(1+i)n = P(F/P, i, n)
= 500(1+0.015)12 = 500(F/P,1.5%,12)
= 500(1.196) = $598.00

Copyright Oxford University Press 2011

Nominal and Effective Interest

Rates
Notation:
r = Nominal interest rate per year without considering
the effect of any compounding
i = Effective interest rate per compounding period
ia = Effective annual interest rate taking into account
the effect of compounding
m = Number of compounding periods per year

r m
m
ia (1 ) 1 (1 i) 1
m
r
For Continuous Compounding
ia e 1
r
i
m

Copyright Oxford University Press 2011

(3-7)
(3-8)

(3-9)

Nominal and Effective Interest

(Table 3-3)
Nominal
Rate

Effective Annual Rate when compounded

Yearly

Semiannually

Quarterly

Monthly

Daily

Continuously

1%

1%

1.0025%

1.0038%

1.0046%

1.0050%

1.0050%

2%

2%

2.0100%

2.0151%

2.0184%

2.0201%

2.0201%

3%

3%

3.0225%

3.0339%

3.0416%

3.0453%

3.0455%

4%

4%

4.0400%

4.0604%

4.0742%

4.0808%

4.0811%

5%

5%

5.0625%

5.0945%

5.1162%

5.1267%

5.1271%

6%

6%

6.0900%

6.1364%

6.1678%

6.1831%

6.1837%

8%

8%

8.1600%

8.2432%

8.3000%

8.3278%

8.3287%

10%

10%

10.2500%

10.3813%

10.4713% 10.5156%

10.5171%

15%

15%

15.5625%

15.8650%

16.0755% 16.1798%

16.1834%

25%

25%

26.5625%

27.4429%

28.0732% 28.3916%

28.4025%

Copyright Oxford University Press 2011

Example 3-10 Application of

Nominal and Effective Interest Rates
If I give you $50, you owe me $60 on the following
Monday.
a) Weekly interest rate = ($60-50)/50 = 20%
Nominal annual rate = 20% * 52 = 1040%
b) Effective annual rate

ia (1 i)m 1 (1 20%)52 1 1310400 %

c) End-of-the-year balance

F P(1 i)n 50(1 20%)52 $655,200

Copyright Oxford University Press 2011

Continuous Compounding
Interest Formulas
Single Payment Compound Amount

F PF/P, r, n P(e )
rn

(3-15)

Single Payment Present Worth

P FP/F, r, n F(e rn )

Copyright Oxford University Press 2011

(3-16)

Example 3-11 Application of

Continuous Compounding
How much would be in the account for $2000
deposit in a bank that pays 5% nominal interest,
compounding continuously for 2 years?
F P(er n ) 2000e( 0.05 )( 2 ) $2210.40
Or

i er 1 5.1271%
F P(1 i)2 2000(1.051 271)2 $2210.34

Copyright Oxford University Press 2011

Example 3-13 Application of

Continuous Compounding
How long will it take for money to double at 10%
nominal interest, compounding continuously?
F P(er n ) e( 0.10 )(n ) 2
(0.10)n ln 2 0.693
n 6.93 years
Or

i er 1 10.5171%
F 1(1 i)n 2
n 6.93

(1.105171) n 2

Copyright Oxford University Press 2011