Pamantasan ng Lungsod ngMaynila

College of Engineering and Technology

Engineering Economics
Chapter 2
Interest

Prepared by:
Engr. Jenalyn Macarilay
Electronics Engineering Department
 To develop and apply
mathematical models
describing real life cash
flows and time value of
money

LEARNING To formulate and apply

interest factors to real
OUTCOMES life engineering problems

To describe the concept of

equivalence and calculate
present and future worth of
cash flows using nominal and
effective interest rates and
continuous compounding
 oThe “time value” of money is the
most important concept in
TIME engineering economy

VALUE OF oAll firms make use of investment

of funds
MONEY
oInvestments are expected to
earn a return

oMoney possesses a “time value”

 EQUIVALENCE
Different sums of money at different times may be
equal in economic value
$106 one
year from now

0 1
Interest rate = 6% per year

$100 now

$100 now is said to be equivalent to $106 one year from now,

if the $100 is invested at the interest rate of 6% per year.
 • t = time, usually in periods
such as years or months

• P = value or amount of
money at a time t designated
as present or time 0

• F = value or amount of
money at some future time,
such as at t = n periods in the
future

• A = series of consecutive,
equal, end-of-period amounts
of money
• n = number of interest
periods; years, months
• i = interest rate or rate of
SYMBOLS AND return per time period;
percent per year or month

NOTATIONS • I= amount earned from

borrowed money
 • Cash Inflows (CI)–
Revenues (R), receipts,
incomes, savings
generated by projects
CASH Depict the timing
and amount of
and activities that
flow in. Plus sign used

FLOW expenses (negative,

downward) and
• Cash Outflows (CO)
– Disbursements (D),

DIAGRAMS revenues ( positive,

upward)for
costs,expenses, taxes
caused by projects
and activities that
engineering flow out. Minus sign
projects. used
• Net Cash Flow (NCF)
for each time period:

NCF = CI-C0 = R – D
 CASH FLOW DIAGRAMS
What a typical cash flow diagram might look like

Draw a time line

Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow
 • The manifestation of the time
value of money
INTEREST • the amount of money paid for
the use of borrowed capital or
RATE AND the income produced by money,
which has been loaned.
RATE OF • Difference between an
ending amount of money
RETURN and a beginning amount
of money
𝑰𝑰 = 𝑭𝑭 − 𝑷𝑷
 Interest earned over a
period of time is expressed
as a percentage of the
INTEREST original amount

RATE AND o Borrower’s

Perspective – interest
RATE OF rate paid
RETURN o Lender or Investor’s
Perspective – rate of
return earned
 Interest Interest
paid earned

Interest rate Rate of return

 Simple Interest

SIMPLE AND o Calculated using the

principal only, ignoring
COMPOUND any interest that had
been accrued in
INTEREST preceding period

𝑰𝑰 = 𝑷𝑷𝑷𝑷𝑷𝑷

𝑭𝑭 = 𝑷𝑷 + 𝑰𝑰
 SIMPLE INTEREST

Ordinary Simple Interest

• Under ordinary simple interest, it is assumed that

each month contains 30 days and consequently,
each year has 360 days

Exact Simple Interest

• Under exact simple interest, the exact days per

month is used. There are 365 days per year on
ordinary year and 366 days every fourth year called
leap year
 SIMPLE INTEREST
Sample Problem
$100,000 lent for 3 years at simple i = 10% per year.
What is repayment after 3 years?

Given: P=$100,000
n=3 years
i=10% CA
Solution:
𝑰𝑰=𝑷𝑷𝒊𝒊𝒏𝒏
I= 100,000(3)(0.10) = $30,000
Total due = $100,000 + $30,000

Ans. $130,000
 Example 1:

A loan of P50,000 is made

for a period of 13 months from
SIMPLE April 1 to April 30 of the
following year, at a simple
INTEREST interest rate of 20%. What
future amount is due at the end
of the loan period?

Ans. P60, 833.33

 Example 2:

What is the principal

amount if the amount of interest
SIMPLE at the end of 2 ½ year is 450 for
INTEREST a simple interest rate of 6% per
annum?

Ans. P3, 000

 Example 3:

What will be the future

worth of money after 12
SIMPLE months, if the sum of P25,000 is
INTEREST invested today at simple interest
rate of 1% per month?

Ans: P28,000
 Example 4:

Determine the exact

simple interest of P25000 for the
period from Dec 27, 2001 to
SIMPLE March 23, 2003, if the rate of
INTEREST interest is 10%?

Ans. P3, 095.8

 Example 5:

Determine the exact

simple interest of 25000 for the
period from Dec 27, 2001 to
SIMPLE March 23, 2004, if the rate of
INTEREST interest is 10%?
 Compound Interest
o The interest for an
SIMPLE AND interest period is
calculated on the
COMPOUND principal plus total
amount of interest
INTEREST accumulated in previous
period.
o “ the interest on top of
interest”.
 The quantity 1 + 𝑖𝑖 𝑛𝑛 is
commonly called the single
SIMPLE AND payment compound
amount factor
COMPOUND
INTEREST 𝑭𝑭 = 𝑷𝑷 𝟏𝟏 + 𝒊𝒊 𝒏𝒏
 COMPOUND INTEREST

Sample Problem

$100,000 lent for 3 years at i = 10% per year compounded.

What is repayment after 3 years?

Given: P=$100,000
n=3 years
i=10% CA
 COMPOUND INTEREST
Sample Problem

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000
Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100

Ans: $133,100
 Example 1:
What rate of interest
compounded annually must be
received if an investment of
COMPOUND 5400 made now will result in a
receipt of 7200 in 5 years?
INTEREST
Ans. 5.92%
 Example 2:

What amount will be

accumulated by P4100 in 10
COMPOUND years at 6% compounded
INTEREST annually?

Ans. P7342.48
 Example 3:

How long it will take for the

COMPOUND money to triple itself if invested
at 8% compounded annually?
INTEREST
Ans. 14.27 years
 Nominal Rate
RATES OF
INTEREST
Effective Rate
 specifies the rate of 𝒓𝒓
interest and a number 𝒊𝒊 =
of interest period in 𝒎𝒎
one year.
Nominal Where:
Rate Of Note:
• m = 1 = compounded
i= rate of interest /
interest period
annually (CA)
Interest • m = 2 = compounded
semi-annually (CSA)
r = nominal interest
period
• m = 4= compounded m= number of
quarterly (CQ) compounding periods
• m = 12 = compounded
monthly (CM)
 𝒊𝒊𝒆𝒆𝒆𝒆𝒆𝒆 = 𝑭𝑭 − 𝟏𝟏
𝒊𝒊𝒆𝒆𝒆𝒆𝒆𝒆 = ( 𝟏𝟏 + 𝒊𝒊)𝒎𝒎 − 𝟏𝟏
Effective Where:
the actual or exact
Rate Of rate of interest on 𝒊𝒊𝒆𝒆𝒆𝒆𝒆𝒆 = effective rate
F = future worth rate
the principal
Interest during one year i = rate of interest/
interest period
m = number of
compounding periods
 Example 1:

What effective annual

interest rate corresponds
to the following situations:
RATES OF a. Nominal interest rate of
10% compounded semi-
INTEREST annually
b. Nominal interest rate of
6% compounded monthly
c. Nominal interest rate of
8% compounded quarterly

Ans. 10.25%; 6.17%; 8.24%

 Example 2:

If 1000 becomes 5734

after 15 years, when invested at
an unknown rate of interest
compounded semi-annually,
RATES OF determine the unknown nominal
INTEREST rate and corresponding effective
rate.

Ans. i=12.36% ; r=12%

 Example 3:

What is the equivalent

nominal rate compounded
RATES OF monthly of 15% nominal rate
INTEREST compounded semi-annually?
 The interest continuously accumulates

CONTINOUS 𝑭𝑭 = 𝑷𝑷𝒆𝒆𝒊𝒊𝒊𝒊
COMPOUNDING 𝒓𝒓
𝒊𝒊𝒆𝒆𝒆𝒆𝒆𝒆 = 𝒆𝒆 − 𝟏𝟏
𝒎𝒎

INTEREST • Where:
F = future worth
i = rate of interest/ interest period
n = number of compounding periods
 Example 1:

Philip invested 100 on

bank. The bank offers 5%
interest compounded
CONTINUOUS continuously in a savings
COMPOUNDING account. Determine
(a) how long will it require for
INTEREST him to earn $5
(b) the equivalent simple
interest rate for 1 year bank?

Ans. 0.9758 year; 5.127%

 EQUATION OF
VALUE
obtained by setting the sum of
values on a certain comparison
or local date of one set of
obligations equal to the sum of
the values on the same date of
another set of obligations
 Example 1:

Jay wishes his son, Jayson to

receive 1000000 twenty years from
now. What amount should he invest
EQUATION now, if it will earn interest of 12%
compounded annually during the
OF VALUE first 5 years and 10% compounded
monthly for the remaining years.

Ans. P5 = P224, 521.34; P0 = P127, 399.44

 Example 2:

Find the present worth of

a future payment of P300,000 to
EQUATION be made in 10 years with an
interest rate of 10%
OF VALUE compounded annually. What will
be the amount if it will be paid
on the 15th year?

Ans. P115, 662.99; P483,153.01

 DISCRETE
PAYMENTS

oThe solution in discrete

payments or number of
transactions occurring
at different periods is
taking each transaction
to the base year and
equating each value.
 Example 1:
Acosta holdings borrowed
P9000 from smith corporation
on January 1, 1998 and P12000
on January 1, 2000. Acosta
holdings made a partial payment
DISCRETE of P7000 on January 1, 2001. It
was agreed that the balance of
PAYMENTS the loan would be amortized by
two payments. One on January
1, 2002 and one January 1,
2003. The second being 50%
larger than the first. If the
interest rate is 12%, what is the
amount of each payment?
Ans. P9137.18; P13 705.77
 Example 2:

A machine worth P50,000 is

expected to last for 3 years.
DISCRETE During its operation, a
maintenance cost of P1,000 is
PAYMENTS needed after the 1st year of
operation and P2,000 at the end
of the 2nd year. What present
amount is required to operate
the machine, if money is worth
16% compounded quarterly?

Ans. P52, 316.18

REFERENCES
oEngineering Economy, Blank
and Tarquin, 7th Edition,
McGraw-Hill, 2012
oEngineering Economy,
Hipolito Sta. Maria
oVarious online materials
THANK YOU!!!