Engineering Economic Analysis

Professor Dr. Pradeep K Jha

Department of Mechanical and Industrial Engineering
Indian Institute of Technology Roorkee
Lecture 3
Interest Formulas: Simple and Compound Interest, Cash Flow Diagrams
Welcome to the lecture on interest and cash flow diagrams.

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So far we have studied about interest and interest rates. In engineering economic analysis,
different engineering alternatives are evaluated. These alternatives estimate amount and
timing of future receipts and disbursements. So what we have seen that something a lender is
investing and he is getting a return on it from the borrower. It means there are proposals and
from there you have different types of receipts and disbursements.

Receipts means something somebody is getting and disbursement means something

somebody is paying. So in this lecture we will study about the effect of time and interest rate
because it has to be given a importance. Effect of time as well as interest rate has bearing on
the amount which has ultimately to be paid by the borrower.

So basically we are dealing with monetary transactions. Some amount is taken by the
borrower and he has to pay the amount itself after certain amount of time. So in that both
interest rate as well as time plays an important role, ultimately what he has to pay.

Interest may be charged in different way over time by the lender. So basically the lender is
charging the interest in a different way to the borrower. So we will see how it is.
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Again, the rental rate for a sum of money is usually expressed as certain percent of the sum to
be paid for its use for a period of one year. We have already discussed about interest rate, it is
nothing but the amount you get. If X amount is being given by the lender, then after one year
he will get X + Y, then Y is the interest. So Y will be certain fraction of X and that will be
interest rate.

Interest rates are also quoted for periods other than one year, known as interest period. So
normally this period can be one year or even different. Usually it is taken as one year and
then that way we call it as annual interest rate.

Simple and compound interest of approaches will be studied for determining the effect of
time value of money. So in this lecture we will also study the simple interest and compound
interest. There are two types of interests and how they affect the amount which is to be paid
by the borrower that will be studied in this lecture.
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So first of all let us study what this simple interest. We all know that simple interest, it is the
interest owed upon repayment of a loan and that is basically proportional to the length of time
the principal sum has been borrowed.

So suppose a person is lending certain amount and if he is lending for four years, then he will
get certain interest. And if he is lending the same amount for eight years, he will get the
interest double of that amount. So basically that is linearly varying, in that case it is known as
the simple interest.

Simple interest calculation, as we know interest I will be P (P is the principal amount)

multiplied by n (n is the number of interest period) and i (i is the interest rate).
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Suppose a person is lending Rs. 10,000 as P to a borrower and if he is lending it for 1 year, so
n is 1 year and if the interest rate for the one year is 16%, in that case the interest amount can
be calculated by the formula. So I will be equal to P x n x i. So P is 10000 multiplied by n
that is one year because our interest period is also one year and then interest rate is 16%, so
that a 0.16. In that case simple interest comes out to be 1600.

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Now the thing is, the term this one indicates that as the length of time will increase, this
interest amount will go on increasing. If n becomes 2 years, this amount comes out to be
3200. So this way the simple interest amount will be varying as the time is increased.
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This simple interest loan may be made for any period of time. Interest and principal become
due only at the end of the time period. So one of the characteristic of this simple interest is
that, the person or the borrower who has taken the money from the lender, he has not to pay
the interest amount in the middle period, he has to pay the accumulated interests.

Every year whatever it is accumulating, at the end of the period plus the principal sum. So
this is one of the characteristic of the simple interest.

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Then now we come to compound interest. Now, what is compound interest? When a loan is
made for several interest periods, interest is calculated and payable at the end of each interest
period. Basically there may be conditioned by the lender that you should pay the interest at
the end of every year otherwise the lender may say that this interest amount may be
compounded or it will be added to the principal amount which is owed at the beginning of the
year again.

It means that the interest amount which is generated every year, it will go on increasing, so
that is known as the compounding of the interest.

At the end of the year, one may pay the interest when it is due or may allow the interest
accumulate until the loan is due. So there are two cases, if a person has paid certain amount
or a lender has given certain amount to a borrower, he may tell the borrower to pay the
interest every or he may say the borrower not to pay but the interest every year will be added
to the amount owed every year.

So every year amount owed will be increasing and correspondingly the interest accrued also
will be going on increasing. If the borrower does not pay the interest earned at the end of
each period and is charged interest on the total amount owed. So basically in that case,
interest is charged on total amount owed that is principal + interest. This is known as
compounding of the interest.

The interest owed in previous year becomes part of the total amount owed for this year. So
basically, if you have certain amount and at the certain interest rate at the end of first year,
you will have certain interest generated. This interest is added to the principal amount and
this principal amount + interest generated during the first year becomes the principal amount
at the beginning of the second year.

And in the second year, the interest will be a percentage of this summed amount. So now we
have discussed about the two types of compounding. In one case the interest is paid annually
and in another case, we don’t pay the interest annually, so interest is allowed to compound.
Let us see by an example, these two cases.
(Refer Slide Time: 8.47)

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Let us assume that amount of Rs. 10,000 is borrowed by a borrower or a lender has given to a
borrower. Time n is 4 years and annual interest rate i is 20%. Now let us see how this
compounding of interest is done for the two cases.

So since we have taken four years, the year will be 1, 2, 3, 4. Now amount owed at the
beginning of the year that we can take as A. Similarly, interest to be paid of year that will be
taken as B, amount owed at the end of year we can take it as C and amount paid by borrower
at end of year that we can take as D.
Now we have taken Rs. 10,000, so in the beginning of the first year, you have Rs. 10,000
which is owed by the borrower. Now borrower is paying interest on this amount and this this
interest amount will be 20% of this amount and this comes out to be 2000. So ultimately the
amount which is owing at the end of first year will be 10,000+2000 and that will be 12,000.

Out of this 12,000, 10,000 the principal sum and 2000 is the interest. The condition is that we
are talking about the case when he is paying the interest annually. So basically out of this, the
interest amount 2000 he has paid. So once he has paid 2000 interest, in that case now he owes
an amount of 12,000-2000, so again it is left out to be 10,000.

So in the beginning of the second year he owes an amount of 10,000. Again he has to pay in
the second year, interest amount of 20% of this sum. Again this comes out to be 2000. So
again the total sum comes out to be 12,000 and he is paying annually the interest charged, so
2000 again he pays back. Third year again, it remains out to be 10,000, he has 2000 interest,
so amount owed at the end of the third year is 12,000, he has paid 2000.

In the fourth year, he has 10,000, 2000 is the interest, so it comes out to be 12,000 and in the
fourth year end he has to pay the complete amount that is the amount he owes towards end of
the period, so it is 12,000. So ultimately he is paying 2000 and the end of first, second and
third year and he is paying 12,000 at the end of four years.

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Now let us see the second case where he is not paying the interest and interest is getting
compounded. So in that case if you look at, so this is a case where he is paying the interest
annually. Now if he is not paying the interest annually, interest is accumulated and that’s how
the interest amount goes on increasing every year. In that case, A, B, C and D, these amounts
will be how much, that we have to see.

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So in this first case he has Rs. 10,000, Rs. 2000 is the interest generated, total amount owed
at the end of first year is 12,000 but he is not paying anything. So in the beginning of the
second year, the amount which he is owing is 12,000. This interest is compounded. Now this
interest what he has to pay in the second year will be interest rate multiplied by this sum. So
he will be 20% of 12,000 and he will be paying 2400, so this is the interest generated.

The total amount owed at the end of the second year will be 14400 and still he is not paying
anything towards the end of the second period. So after the end of second year and in the
beginning of the third year, now the principal sum comes out to be 14400. On 14,400, now he
has to pay the interest at the rate of 20%. So that comes out to be 2880. So, it will be 17280
and still he has not paid the interest.

So ultimately in the end of the third year or at the beginning of the fourth year, the amount he
owes is 17,280. On this he will be paying the 20% as the interest charge, so it will be 3456
and this comes out to be 20736. So, ultimately at the end of the fourth year he has to pay the
full amount and this amount comes out to be 20736.

So there are two ways by which he can pay the amount and both are cases of compounding
but in one case he has not paid. He has not paid the interest also at the end of the period. In
another case, he is paying the interest, so ultimately he is only paying 12,000, whereas in this
case, he is paying 20,736.
So what we see that this case where the interest is compounded every year and it becomes a
part of the total sum, this is a case of compound interest.

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So we will discuss about the cash flow diagrams. As the name indicates, there is flow of cash
or monetary transactions that is known as cash flow. It is actual inflow or receipts and
outflow that is disbursement at different points in time that occur over the life of an
investment. So for a particular investment, during the course of time, you have sometimes
certain money either coming or sometimes the money is going out.

So when the money is coming there is inflow of money that is known as receipts. And
similarly, at whichever time you are giving the amount to someone that is known as a
disbursement. And this is known as cash flow, so cash is basically flowing either it is coming
in or it is going out.

It depends upon the point of view taken. So you have basically two persons, one is lender and
one is borrower and if we take the viewpoint of the two, it will be different. For the lender, if
he is lending some amount at a particular time, he is losing at that amount of time but at a
future time he will be gaining it but for the borrower viewpoint, at the initial time he’s
gaining something and he has to pay it in the end.

So basically whatever due is taken, it means that if for one case if it is positive, for another
that amount same will be same but it will be negative. Net cash flow at any time Ft, at any
time t that is Ft is arithmetic sum of receipts and disbursements that occurs at same point in
time.
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So if at any time if you have a cash flow, you have time, 1, 2, 3, 4, so you may have cash
flow like this, so these are known as receipts, these are receipts and these are disbursements.
So from the viewpoint of either lender or borrower, if the money is shown as positive amount
it is receipts and if it is a negative amount, it is the disbursement.

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And if at any point of time, suppose you have both receipt as well as disbursement, in that
case, the net amount will be A-B and this is known as net cash flow. So that is known as net
cash flow and if it is positive, it is known as net receipt. And if it is negative, then it is known
as net disbursement. So this way you have cash flows occurring over the span of time.
Then cash flow diagrams are nothing but the graphical representation of the flow of cash. The
diagram which we have drawn here, this is nothing but a cash flow diagram.

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Similar to body diagram or the circuit diagram what we use. Basically it shows you that at
what point of time what was the flow of cash, what was the receipt and what was the
disbursement, so that is a cash flow diagram.

Cash flow can occur at any point of time during the year. So basically during the year it can
occur at any point of time but we will have certain assumptions that we will discuss later
when we will try to calculate the amount of compound interest or so. So basically, any cash
flow either it can happen sometimes during the third quarter, during the second month or
during the sixth month. So, to avoid any complexity it is assumed that the payment is made at
the end of the year and that is why this end of year convention is normally used. So, all cash
to transactions are placed at end of interest period.
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Now types of cash flows. As we will see different types of cash flows. Now, there are
different types of cash flows under that we have single cash flow, let us see what it means.

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So, a single cash flow means, the cash flow diagram having only once the receipt and only
once the disbursement. So you can have the cash flow diagrams as a receipt and certain
disbursement at the end of year i.e. A and B. So this type of cash flows is known as single
cash flow, where you have single receipt and single disbursement.

Example is that somebody a borrower has borrowed certain amount and what he will pay at
the end of certain period, that is an example of single cash flow.
(Refer Slide Time: 23:46)

Next is equal uniform cash flow, now in this case many a times what we see is that the
payment is made equally at the end of the year. So that is known as equal uniform cash flow
and the cash flow diagram for such flows are like this.

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This starts from 0. So what is happening, the borrower will be paying certain amount at the
end of every year. So basically he has got certain amount from the lender but he will be
paying a uniform amount to the lender for the rest of the periods. So this is an example of
equal uniform cash flow.

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Then we have example of linear gradient series. Under this what happens that, the amount
which is paid by the borrower, they have a linear gradient. It increases by a certain fixed
amount. So what you can see is, if he has taken certain amount, so he will pay as B, B+D, B
+ 2D, B + 3D and B + 4D. So, what we see in this cash flow diagram is that the borrower has
received amount A and he is paying B amount at the end of first year and in the subsequent
years, he is maintaining a gradient of D. A linear gradient of D is maintained, so every year
he is paying amount of D extra, so in the second year B + D, third year B + 2D like that. So
this is an example of linear gradient series.

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Similarly, the next is geometric gradient series. Under this series, this linear amount will be
changing to a geometric factor. So basically in this case like that. So, basically if you have a
gradient factor, it will go on increasing in a geometric series. So, this is an example of
geometric gradient series factors.

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And the last is irregular series, it is nothing but the there is no pattern. In irregular series,
there is no pattern. So basically you can have any amount being borrowed and it is paid and
that does not follow any rule. So such as the cash flow diagrams represent a type of irregular
series where no rules are applied. You will have to find the equivalent value by using suitable
methods.

So these are the different kind of cash flows. Thank you.

Keywords:

Simple interest
Compound interest
Receipts and disbursements
Cash flow diagram
Type of cash flow diagram