Chapter 4 More Interest Formulas

Faculty of Applied Engineering and
Urban Planning
Civil Engineering Department
Engineering Economy
Chapter 4
More Interest Formulas
Lecture 7-8
Week 4
2nd Semester 20015/2016
Chapter 4: More Interest Formulas
Uniform Series
Arithmetic Gradient
Geometric Gradient
Nominal and Effective Interest
Continuous Compounding
University Of Palestine
Eng. Islam Falouji 2
Uniform Series
Uniform Series
In Chapter 3 we dealt with single payments:
F = P (1+i)n F = P (F/P,i%,n)
P = F (1+i)-n P = F (P/F,i%,n)
Uniform Series
Quite often we have to deal with uniform
(equidistant and equal-valued) cash flows
during a period of time:
Deriving Uniform Series
Formula
We want an expression for the present worth P of a stream
of equal, end-of-period cash flows.
Write a present worth value for each period individually,

and add them.
Formula
Formula
Formula
Uniform Series
Example 4-1: You deposit $500 in a bank at the end of
each year for five years. The bank pays 5% interest,
compounded annually. At the end of five years,
immediately following your fifth deposit, how much will
you have in this account?
Uniform Series
Example 4-2:How much money do you put in bank every
month to have $1,000 at the end of the year. Assume you
will put the same amount in the bank each month and the
bank pays ½ % interest monthly?
Solution:
A = 1000 (A/F, ½%,12) = 1000 (0.0811) = $81.10/month1
Uniform Series
Example 4-3: Suppose on January 1 you deposit $5,000 in a bank
paying 8% interest, compounded annually. You want to withdraw all the
money in five equal end-of year sums, beginning December 31stof the
first year.
Solution:
Given: P = $5000 n = 5 i= 8% A = unknown
A = P (A/P,8%,5) = P{[i(1 + i)n]/[(1+i)n–1]}
= 5000 (0.2504564545) = $1,252.28
The withdrawal amount is about $1,252
Note: This is the source of the $1,252 in Plan C from Chapter 31
Uniform Series
Examples 4-4 & 4-5:
An investor holds a time payment purchase contract on some
machine tools. The contract calls for the payment of $140 at the
end of each month for a five-year period. The first payment is due
in one month. He offers to sell you the contract for $6,800 cash
today. If you otherwise can make 1% per month on your money,
would you accept or reject the investor’s offer?
Solution:
Given: A =$140, n=60, i=1%
P = A (P/A,i,n) = 140 (P/A,1%,60) = 140 (44.955) = $6,293.70
This is less than the required $6,800 => Reject offer
Uniform Series
Example 4-6:
Compute the value of the following cash flows at at the end of
year 5 given i= 15%.
The Sinking Fund Factor diagram is based on the assumption

the withdrawal coincides with the last deposit. This does not
happen in this example. he end of year 5 given i= 15%.
Uniform Series
Uniform Series
Second Approach: Compute the future values of each
deposit then add them.
F = F1+ F2+ F3
= 100(F/P,15%,4) + 100(F/P,15%,3) + 100(F/P,15%,2)
= 100 (1.749) + 100 (1.521) + 100 (1.322) = $459.20
Uniform Series
Example 4-7: For diagram below and given i= 15%, find
value of P?
This diagram is not in a standard form
Approach 1:Compute the present value of each flow then

add them:
P = P1+ P2+ P3
= 20 (P/F,15%,2) + 30 (P/F,15%,3) + 20 (P/F,15%,4)
= 20 (0.7561) + 30 (0.6575) + 20 (0.5718) = $46.28
Uniform Series
Approach 2: Compute the future value, F, of the flows at the end
of year 4. Then compute the present value of the future value, F.
Approach 3:Compute the present values of the flows at the end

of year 1, P1. Then compute P, the present value of P1.
Approach 4: How about this one:
P = 20 (P/A,15%,3) (P/F,15%,1) + 10 (P/F,15%,3)

= 20 (2.283) (0.8696)+ 10 (0.6575) = $46.28
Other approaches will also work.
Arithmetic Gradient Series
Sometimes cash flows increase/decrease by a uniform fixed
amount G every subsequent period.
Write a future worth value for each period individually, and

add them
F = G(1+i)n-2 + 2G(1+i)n-3+ … + (n-2)G(1+i)1+ (n-1)G(1+i)0
= G [(1+i)n-2 + 2(1+i)n-3+ … + (n-2)(1+i)1+ n-1]
 Arithmetic Gradient Present Worth -(P/G, i%, n):
 Arithmetic Gradient Future Worth -(F/G, i%, n):
 Arithmetic Gradient Uniform Series -(A/G, i%, n):
Example 4-8: Suppose you buy a car. You wish to set up
enough money in a bank account to pay for standard
maintenance on the car for the first five years. You estimate the
maintenance cost increases by G = $30 each year. The
maintenance cost for year 1 is estimated as $120. i= 5%.
Thus, estimated costs by year are $120, $150, $180, $210, $240.
Example 4-9: Maintenance costs of a machine start at $100
and go up by $100 each year for 4 years. What is the
equivalent uniform annual maintenance cost for the
machinery if i= 6%.
Solution:
This is not in the standard form:
Because year-one cash flow is not zero
We need to reformulate the problem

Example 4-10: With i= 10%, n = 4, find an equivalent uniform
payment A for the following CFD
This is a problem with decreasing costs instead of increasing

costs.
Solution:
The cash flow can be rewritten as the DIFFERENCE of the

following two diagrams: (1) the standard form we need for
arithmetic gradient, and (2) a series of uniform payments.
Example 4-11: Find P for the following CFD with i= 10%.
Solution:
 This is not in the standard form for the arithmetic gradient.
 If we insert a “present value” J at the end of year 2, the diagram from that
point on is in standard form.
J = 50 (P/G,10%,4) = 50 (4.378) = 218.90

P = J (P/F,10%,2) = 218.90 (0.8264) = $180.9
Geometric Gradient Series
Instead of constant amount of increase, sometimes cash flows increase by
a uniform rate of increase g (constant percentage amount) every
subsequent period.
At the end of year i, i= 1, ..., n;

we incur a cost Ai= A(1+g)i-1
Write a future worth value for each period individually, and add them up
P= A(1+i)-1+A(1+g)1(1+i)-2+A(1+g)2(1+i)-3+…
+A(1+g)n-2(1+i)-n+1+A(1+g)n-1(1+i)-n
Example: Suppose you have a vehicle. The first year maintenance cost is
estimated to be $100. The rate of increase in each subsequent year is 10%. You
want to know the present worth of the cost of the first five years of
maintenance, given i= 8%.
Solution: Repeated Present-Worth (Step-by-Step) Approach:
Nominal and Effective Interest Rates
Multiple Compounding
The time standard for interest computations is One Year.
Many banks compound interest multiple times during the year.
◦ E.g.: 12% per year, compounded monthly (1% interest is paid monthly)
◦ E.g.: 8% per year, compounded semi-annually (4% interest is paid twice a
year or once every 6 months)
Compounding is not less important than interest. You have to know all
the info to make a good decision.
You need to pay attention to the following terms:
◦ Time Period –The period over which the interest is expressed (always stated).
 E.g.: “6% per year”
◦ Compounding Period (sub-period)–The shortest time unit over which interest

is charged or earned.
 E.g.: If interest is “6% per year, compounded monthly”, compounding period is one month
◦ Compounding Frequency –The number of times (m) that compounding

occurs within time period.
 Compounding semi-annually: m = 2; Compounding quarterly: m = 4
 Compounding monthly: m = 12; Compounding weekly: m Of
University = Palestine
52; daily = 365
Nominal and Effective Interest Rate
Two types of interest are typically quoted:
1. Nominal interest rate, r, is an annual interest rate without considering the
effect of (sub-period) compounding.
2. Effective interest rate, i, is the actual rate that applies for a stated period of
time which takes into account the effect of (sub-period) compounding.
 The effective rate is commonly expressed on an annual basis denoted
as “ia”.
Sometimes one interest rate is quoted, sometimes another is quoted. If

you confuse the two you can make a bad decision.
Effective interest is the “real” interest rate over a period of time; nominal
rate is just given for simplicity (per year)
All interest formulas use the effective interest rate to properly account
for the time value of money. Eng. Islam Falouji 36
To get effective rate per compounding period, i:
To get effective rate per year, ia:
Example: Given an interest rate of 12% per year, compounded quarterly:

Nominal rate = 12%
Effective (Actual) rate = 12%/4 = 3% per quarter
Effective rate per year = [1+(0.12/4)]4-1= 0.1255=12.55%
Investing $1 at 3% per quarter is equivalent to investing $1 at 12.55%
annually
Example: A bank pays 1.5% interest every three months. What
are the nominal and effective interest rates per year?
Solution:
Nominal interest rate per year is
r = 4 *1.5% = 6% a year
Effective interest rate per year:

ia= (1 + r/m)m–1 = (1.015)4–1 = 0.06136
6.14% a year
Example: $10K is borrowed for 2 years at an interest rate of 24% per
year compounded quarterly. If the same sum of money could be
borrowed for the same period at the same interest rate of 24% per year
compounded annually, how much could be saved in interest charges?
Interestcharges for quarterly compounding:

$10,000(1+24%/4)2x4-$10,000 = $5938.48
Interestcharges for annually compounding:

$10,000(1+24%)2-$10,000 = $5376.00
Savings:
$5938.48 -$5376 = $562.48
Example 4-15: A loan shark lends money on the following
terms. “If I give you $50 on Monday, then you give back $60
the following Monday.”
1.What is the nominal rate, r ?
The loan shark charges i= 20% a week:

60 = 50 (1+i) » i= 0.2 [Note we have solved 60 = 50(F/P,i,1)
for i]
We know m = 52, so r = 52 *i= 10.4, or 1,040% a year
2.What is the effective rate, ia?

ia= (1 + r/m)m–1 = (1+10.4/52)52–1 ≈13,104
This means about 1,310,400 % a yearUniversity
(can Ofyou believe this!!)
Palestine
Words of Warning: When all various compounding periods in a problem
match, it makes calculations much simpler. When they do not match, life
is more complicated.
Example 4-16: You deposit $5,000 in a bank paying 8% nominal

interest, compounded quarterly. You want to withdraw the money in five
equal yearly sums, beginning Dec. 31 of the first year. How much
should you withdraw each year? Note effective interest is i= 2% = r/4 =
8%/4 quarterly, and there are 20 periods.
Note: The withdrawal periods and the compounding periods are not the same. If we want to
use the formula
A = P (A/P,i,n)
then we must find a way to put the problem into an equivalent form where all the periods are
the same.
Solution 1: Suppose we withdraw an amount A quarterly. (We don’t, but suppose we do.).
We compute
A = P (A/P,i,n) = 5000 (A/P,2%,20) = 5000 (0.0612) = $306
Now consider the following:
Consider a one-year period:
This is now in a standard form that repeats every year.

W = A(F/A,i,n) = 306 (F/A,2%,4) = 306 (4.122) = $1,260
You should withdraw $1,260 at the end of each year.
Solution 2: (Probably the easiest way)
ia= (1 + r/m)m–1 = (1 + i)m–1 = (1.02)4–1 = 0.0824

8.24%
Now use:
W = P(A/P,8.24%,5) = P {[i(1+i)n]/[(1+i)n –1]}

= 5000(0.252) = $1,260 per year
Continuous Compounding
Continuous compounding can sometimes be used to simplify
computations, and for theoretical purposes.
The previous equation illustrates that er-1 is a good
approximation of (1 + r/m)m for large m (i.e., ∞).
• This means there are continuous compounding versions of the
formulas we have seen earlier.
Summary:
F = P ernis analogous to F
= P (F/P,r,n): (F/P,r,n)∞= ern
P = F e-rnis analogous to P
= F (P/F,r,n): (P/F,r,n)∞= e-rn
Summary: Notation
i: effective interest rate per interest period (stated as a decimal)
n: number of interest periods
P: present sum of money
F: future sum of money: an amount, n interest periods from the
present, that is equivalent to P with interest rate i
A: end-of-period cash receipt or disbursement amount in a uniform
series, continuing for n periods, the entire series equivalent to P or
F at interest rate i.
G: arithmetic gradient: uniform period-by-period increase or
decrease in cash receipts or disbursements
g: geometric gradient: uniform rate of cash flow increase or
decrease from period to period
r: nominal interest rate per interest period (usually one year)
ia: effective interest rate per year (annum)
m: number of compounding sub-periods per period Eng. Islam Falouji 48
Summary: Formulas
Single Payment formulas:
Compound amount: F = P (1+i)n= P (F/P,i,n)
Present worth: P = F (1+i)-n = F (P/F,i,n)
Uniform Series Formulas:
Compound Amount: F = A{[(1+i)n–1]/i} = A (F/A,i,n)
Sinking Fund: A = F {i/[(1+i)n–1]} = F (A/F,i,n)
Capital Recovery: A = P {[i(1+i)n]/[(1+i)n–1] = P (A/P,i,n)
Present Worth: P= A{[(1+i)n–1]/[i(1+i)n]} = A (P/A,i,n)
Arithmetic Gradient Formulas:
Present Worth: P= G {[(1+i)n–in –1]/[i2(1+i)n]} = G(P/G,i,n)
Uniform Series: A= G {[(1+i)n–in –1]/[i(1+i)n–i]} = G (A/G,i,n)
Geometric Gradient Formulas:
If i≠g, P = A {[1 –(1+g)n(1+i)-n]/(i-g)}= A (P/A,g,i,n)
If i= g,P= A [n (1+i)-1] = A (P/A,g,i,n)
Summary: Formulas
Nominal interest rate per year, r : the annual interest rate
without considering the effect of any compounding
Effective interest rate per year, i a:

ia= (1 + r/m)m–1 = (1+i)m–1 with i=r/m
Continuous compounding, ∞:
r: one-period interest rate, n: number of periods

(P/F,r,n)∞ = e-r n
(F/P,r,n)∞ = ern
Next Class
Read Chapter 4 of textbook

Try to do some of the problems at end of
Chapter 4
Be ready for Midterm Exam 1

Chapter 4 More Interest Formulas

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Faculty of Applied Engineering and

Civil Engineering Department

Write a present worth value for each period individually,

The Sinking Fund Factor diagram is based on the assumption

This diagram is not in a standard form

Approach 1:Compute the present value of each flow then

Approach 3:Compute the present values of the flows at the end

Approach 4: How about this one:

P = 20 (P/A,15%,3) (P/F,15%,1) + 10 (P/F,15%,3)

Other approaches will also work.

Write a future worth value for each period individually, and

 Arithmetic Gradient Future Worth -(F/G, i%, n):

 Arithmetic Gradient Uniform Series -(A/G, i%, n):

This is not in the standard form:

Because year-one cash flow is not zero

We need to reformulate the problem

This is a problem with decreasing costs instead of increasing

The cash flow can be rewritten as the DIFFERENCE of the

J = 50 (P/G,10%,4) = 50 (4.378) = 218.90

At the end of year i, i= 1, ..., n;

Solution: Repeated Present-Worth (Step-by-Step) Approach:

◦ Compounding Period (sub-period)–The shortest time unit over which interest

◦ Compounding Frequency –The number of times (m) that compounding

Sometimes one interest rate is quoted, sometimes another is quoted. If

To get effective rate per year, ia:

Example: Given an interest rate of 12% per year, compounded quarterly:

Effective interest rate per year:

Interestcharges for quarterly compounding:

Interestcharges for annually compounding:

$5938.48 -$5376 = $562.48

The loan shark charges i= 20% a week:

2.What is the effective rate, ia?

Example 4-16: You deposit $5,000 in a bank paying 8% nominal

Consider a one-year period:

This is now in a standard form that repeats every year.

ia= (1 + r/m)m–1 = (1 + i)m–1 = (1.02)4–1 = 0.0824

W = P(A/P,8.24%,5) = P {[i(1+i)n]/[(1+i)n –1]}

Effective interest rate per year, i a:

r: one-period interest rate, n: number of periods

Read Chapter 4 of textbook

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