ENG 3000 Summer 2018

Module 3: Interest
Reference:
Newnan, D., Jones, J., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Can. ed.). Oxford University Press.

Learning Objectives
• Define concept of time value of money
• Distinguish between simple and compound interest
• Explain equivalence of cash flows
• Solve problems using single payment and uniform series compound interest formulas

Time Value of Money

• What would you rather have?
– $1000.00 now or $1000.00 5 years from now?
• Amount of goods and services purchased with same amount of money normally
decreases over time because of “inflation”
• Actual “value” of money changes at some rate over time
– Rate typically expressed as percentage per period of time
–
• Amount can be used now instead of sometime later
• People willing to pay charge to use money now
– Charge = interest
• Simple Interest
– Interest applied ONLY to original sum
– Never calculated on accrued interest

• Where: P = present sum, i = interest rate/period, n = # of time periods

– Total money after n periods (F):

• Or F=P(1+in), where: F = future sum

• Compound interest
– Interest calculated on accumulated amount and not simply original amount
– “Interest on top of interest”
– Normally used; simple interest not used unless stated otherwise

Equivalence
• Implies that sum of money in one time period may have same “value” to different sum in another
time period with respect to interest rate

• Example:
– $1000 now is equivalent to:
• $1100 one year from now at 10% per year
• $1050 one year from now at 5% per year
• $1210 two years from now at 10% per year
• $1102 two years from now at 5% per year

• Equivalence is dependent on interest rate!

• Equivalence is useful when:

– Cash flows (+ve and/or –ve) over n time periods need to be compared
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– Alternative projects with multiple cash flows over ‘n’ time periods need to be compared

Single Payment Compound Interest Formulas

• Notation:
– i = interest rate per period
– n = number of interest periods
– P = present sum of money
– F = future sum of money

• If n is in years:
– Future amount at end of year one would be:
• F = P(1+i)
– After two years, future amount at end of year two would be additional interest on year one’s
total:
• F = P(1+i) + iP(1+i) = P(1+i)(1+i) = P(1+i) 2

• Generalizing: F = P(1+i)n
• Above formula is “Single payment compound amount formula”, written as: F = P(F/P, i, n)
– Notation in brackets reads as: “Future sum ‘F’, given present sum ‘P’ at interest rate ‘i’
per interest period for ‘n' periods”, or “F, given P at i, over n”

• Suppose you want to find equivalent value now for future value:
– F = P(1+i)n
– Rearranging: P = F/(1+i)n = F(1+i)-n
– Notation becomes: P = F(P/F, i, n)

Uniform Series Compound Interest Formulas

• Uniform series (A)
– End-of-period cash receipt or disbursement in uniform series, continuing for n periods,
entire series equivalent to P or F at interest rate i

• Uniform series (A)

– In general case:
• F = A(1+i)n-1+…+A(1+i)2 +A(1+i) +A (1)

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– Multiplying by (1+i):
• (1+i)F = A(1+i)n+…+A(1+i)3 +A(1+i)2 +A(1+i) (2)

– Factoring out A and subtracting (1) from (2):

(1+i)F = A[(1+i)n+…+(1+i)3 +(1+i)2 +(1+i)]
--- F = A[(1+i)n-1+…+(1+i)2 +(1+i) +1]

= iF = A[(1+i)n – 1]

– Rearranging this equation:

 (1  i) n  1
F  A 
 i 
– Notation is: F = A(F/A, i%, n)

– Solving for A:
 i 
A  F 
 (1  i)  1
n

– Notation is: A = F(A/F, i%, n)

– Taking sinking fund formula and substituting single payment compound formula for F
yields:

 i 
A  P(1  i) n  
 (1  i)  1
n

– Therefore:

 i(1  i ) n 
A  P 
 (1  i )  1
n

– Notation: A = P(A/P, i%, n)

– Solving capital recovery formula for P:

 (1  i ) n  1
P  A n 
 i(1  i ) 
– Notation: P = A(P/A, i%, n)

Nominal and Effective Interest

• Nominal Interest Rate (r) ‘in name only’:
– Interest rate without consideration of compounding (not used in analysis)

• Effective Interest Rate (i):

– Interest rate that takes compounding into consideration (used in analysis)

• Example: 12% per year compounded monthly

– Nominal interest rate:
• r =12%/year compounded monthly

– Effective monthly rate (i):

• i = r/m where m = number of compounding periods per year
• i = 0.12/12 = 1% per month effective!
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– Effective Yearly Rate (ia):

• ia = (1+r/m)m – 1 = (1+i)m – 1
• ia = (1+0.12/12)12 – 1 = 12.68%/year effective!

*Note: that is 0.68% higher than nominal at 12% per year compounded monthly

Example 1
Problem
You have agreed to lend a friend $5,000 for five years at a simple interest rate of 8%. How much interest
will you receive from the loan? How much will your friend pay you at the end of the five years?

Solution

Example 2
Problem
You have agreed to lend a friend $5,000 for five years at a compound interest rate of 8%. How much interest
will you receive from the loan? How much will your friend pay you at the end of the five years?

Solution

Example 3
Problem
How much would $3000.00 deposited in a bank account at 7% interest, compounded annually be after
four years?

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Solution
– F = P(F/P, 7%, 4)
– F = 3000(1+0.07)4
– F = $3932.39

Example 4
Problem
How much would $500.00 deposited in a bank account at 6% interest, compounded quarterly be after three
years?

Solution

Example 5
Problem
If you want to have $3000.00 in the bank after four years at 7% per year interest, compounded annually,
what would you have to deposit now?

Solution
– P = F(P/F, 7%, 4)
– P = 3000(1+0.07)-4
– P = $2288.69

Example 6
Problem
Consider the following situation where the borrowing of P is repaid in two payments:

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Assume a 12% interest rate, what would be the value of P?

Solution

Example 7
Problem
You deposit $500 in a credit union at the end of each year for five years. The credit union pays 5% interest,
compounded annually. Immediately after the fifth deposit, how much do you have in your account?

Solution

Example 8
Problem
Jim Hayes wants to buy some electronic equipment for $1,000. He decided to save a uniform amount at
the end of each month so that he would have the required $1,000 at the end of one year. The local credit
union pays 6% interest, compounded monthly. How much would Jim have to deposit each month?

Solution
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Example 9
Problem
An energy-efficient machine costs $5,000 and has a life of five years. If the interest rate is 8%, how much
will it have to save every year in order for the initial capital amount to be recovered?

Solution

Example 10
Problem
You are interested in financing a new machine tool by paying $140 at the end of each month for a five-year
period. The first payment is due in one month. A different seller offers you the same tool for $6,800 cash
today. If you can make 1% per month on your money, would you accept or reject the seller’s offer?

Solution

We would be paying more if we accepted the seller’s offer, therefore reject it.

Example 11
Problem
Suppose the $6,800 cash for the machine tool in the previous example is equivalent to the monthly financing
option. What monthly rate of return would be assumed in this case?

Solution

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We know the value of the uniform series present worth factor but not the interest rate i. We need to look
through several compound interest tables to find the values closest to 48.571 and compute the rate of return
by interpolation.

Since a/b = c/d, a = b(c/d),

Example 12
Problem
Using a 15% interest rate, compute the value of P deposited into a savings accounts with the following
three withdrawals.

Solution

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Example 13
Problem
If a savings bank pays 1.5% interest every three months, what are the nominal and effective interest rates
per year?

Solution

Example 14
Problem
A loan shark lends money on the following term: “If I give you $50 on Monday, you owe me $60 on the
following Monday”
a- What nominal interest rate per year (r) is the loan shark charging?
b- What effective interest rate per year (ia) is he charging?
c- If the loan shark started with $50 and was able to keep it, as well as the money he received, out in loans
at all times, how much money would he have at the end of one year?

Solution

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Example 15
Problem
On January 1st, a woman deposits $5,000 in a credit union that pays 8% nominal annual interest,
compounded quarterly. She wishes to withdraw all the money in five equal yearly sums, beginning
December 31st of the first year. How much should she withdraw each year?

Solution

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