Interest

Chapter 3
Supplemental Reading, Chapter 3
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023
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 ‘compound interest
formulas’
Time Value of Money

• What would you rather have?

• $1000 now or $1000, five years from now?
• A dollar received today is not equivalent to a dollar at sometime
in the future!
• Money has earning power: INTEREST
• Money can be rented, like a car. Instead of rent, you pay
INTEREST
• Time Value of Money: Willingness of banks, business
and people to pay interest to you to use your money
 Time Value of Money
• 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
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 and how much will your friend pay
you at the end of the five years?
Time Value of Money

• Compound interest
➢Interest calculated on accumulated amount and not
simply original amount

• “Interest on top of interest”

• Normally used in calculations
• Note: Simple interest is not used unless stated
otherwise
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?
 Example 2
Solution:

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 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
 Equivalence

• 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
• Example:
➢$2500 deposited at 12% compounded annually for two
years will be equivalent to $3136
 Equivalence
• Your firm receives $5000 today with the interest rate of 8%.
Which repay alternative would you choose?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 Source: ”Newnan, D.,
Whittaker, J., Eschenbach, T.,
and Lavelle, J. (2014).
Engineering Economic
Analysis (3rd Canadian
edition). Oxford University
Press: Page 78
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) if n=1
• After two years, future amount at end of year two would be
additional interest on year one’s total:
• F = P(1+i) + i P(1+i) = P(1+i)(1+i) = P(1+i)2
 Single Payment Compound Interest Formulas

F = future sum of money

• Generalizing: F = P(1+i)n P = present sum of money
i = interest rate per period
n = number of interest periods

or the compound interest tables method:

F = P(F/P, i, n)

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 3
Problem:
How much would $3000.00 deposited in a bank account
at 7% interest, compounded annually be after four years?
Example 3
Problem:
How much would $3000.00 deposited in a bank account
at 7% interest, compounded annually be after four years?
Example 3
Problem:
How much would $3000.00 deposited in a bank account
at 7% interest, compounded annually be after four years?

Solution:
• F = P(1+i)n
• F = 3000 (1+0.07)4
• F = $3932.39
• F = P(F/P, i, n)
• F = P(F/P, 7%, 4)
Example 3 F = P(F/P, 7%, 4)
F = P(1+i)n
F = 3000 (1+0.07) 4
F = 3000(1.311) F = $3932.39
F = $3933
 Example 4
Problem:
How much would $500.00 deposited in a bank account at 6%
interest, compounded quarterly be after three years?
 Example 4
Problem:
How much would $500.00 deposited in a bank account at 6%
interest, compounded quarterly be after three years?

6% : 4 = 1.5%

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 4

500 x 1.196 = $598

 Single Payment Compound Interest Formulas

• Suppose you want to find equivalent value now (present

time) for a given future value:
• F = P(1+i)n
➢ After rearranging: P = F/(1+i)n = F(1+i)-n
➢ Notation becomes: P = F(P/F, i, n)
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 5
Solution:
P = F(P/F, 7%, 4) P = F(P/F, 7%, 4)
P = 3000(0.7629) P = 3000(1+0.07)-4
P = $2288.7 P = $2288.69
 Example 6

Problem
Consider the following situation
where the borrowing of P is
repaid in two payments.

Assume a 12% interest rate,

what would be the value of P?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 6

Solution:
 Example 6
Solution:
 Uniform Series, Compound Interest
Formulas

• Uniform series (A)

P
➢End-of-period cash
receipts or disbursements
in uniform series
▪ Continuing for n periods
▪ Entire series equivalent to
(a single transaction of) P
or F at interest rate i

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Uniform Series Compound Interest
Formulas
• Uniform series (A)
➢In general case:
• F = A(1+i)n-1+…+A(1+i)2 +A(1+i) +A (1)

➢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]
= i.F = A[(1+i)n – 1]
 Uniform Series Compound Interest Formulas

• Uniform series (A)

➢Rearranging previous slide
 (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)

Uniform Series Compound Interest Formulas

Sinking Fund Payment

• Any account that is established for accumulating

funds to meet future obligations or debts is called
a sinking fund.
• ‘A’: The sinking fund payment is defined to be the amount that
must be deposited into an account periodically to have a given
future amount.
 i 
A = F 
• Sinking Fund Formula:  (1 + i ) n
− 1 
uniform series
sinking fund factor
Uniform Series Compound Interest Formulas
 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?
 Example 7
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?
 6% : 12 = 0.5%

Example 8
Solution:
Uniform Series Compound Interest Formulas

• Uniform series (A)  i 

A = F 
 (1 + i ) n
− 1 
➢Taking sinking fund formula and substituting single
payment compound formula for F yields:
 i 
A = P(1 + i) 
n

 (1 + i) − 1
n

➢Therefore:
➢ Capital Recovery Formula  i (1 + i ) n

A = P 
 (1 + i ) n
− 1 
➢Notation: A = P(A/P, i%, n)
uniform series capital
recovery factor
Uniform Series Compound Interest Formulas

• Uniform series (A)

➢Solving capital recovery formula for P:

 (1 + i) n − 1
P = A n 
 i(1 + i) 
Uniform series
present-worth factor

➢Notation: P = A(P/A, i%, n)

A A A A
• The term in brackets is called the
Uniform series present-worth factor (USPWF),
0 1 2 3 4
or P/A factor.

P
Uniform Series Compound Interest Formulas
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?
Example 9
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?
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?
Example 10
 Example 10
Solution:
Example 11
Problem:
Suppose you decided to pay the $6,800 for the time-
payment purchase contract in the previous example and
that one-time payment is equivalent to paying $140 at the
end of each month for a five-year period.

What monthly rate of return would we obtain on the

investment?
Example 11
 Example 12
Problem:
Using a 15% interest rate, compute the value of P deposited
into a savings accounts with the following three withdrawals.

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 Example 12
Problem:
Using a 15% interest rate, compute the value of P deposited
into a savings accounts with the following three withdrawals.
 Nominal and Effective Interest
• Nominal Interest Rate (r) ‘in name only’:
• Interest rate without consideration of compounding
(not used in analysis)
• Nominal Interest Rate per interest period = r

• Effective Interest Rate (i):

• Interest rate that takes compounding into consideration
(used in analysis)
• Effective interest rate per compounding sub-period = i
• Effective interest rate per interest period = ia

• Rule of thumb:
• Compounding sub-period < interest period
• Always use the effective interest rate in engineering economic
analysis (unless otherwise stated)
• Nominal interest rates need to be converted to effective interest rate
before they can be used in engineering economic analysis
 Nominal and Effective Interest
• Example:
12% per year compounded monthly:

• Nominal interest rate (r):

r =12% per year compounded monthly

• Effective monthly rate (i): i = r/m

Where:
➢ r = nominal interest rate per interest period
➢ m = number of compounding sub-periods per interest period

i = r/m = 0.12/12 = 0.01 or 1% effective interest rate per compounding

sub-period
Nominal and Effective Interest

• Effective Yearly Rate (ia):

ia = (1+0.12/12)12 – 1 = 12.68% per year effective!

*Note: that is 0.68% higher than nominal at 12% per year compounded
monthly
 Interest Compounding Use interest
Interest rate example Interest rate type
period sub-period rate as is

i = 12% per year, compounded yearly Year Year Effective (ia = i) YES

i= 12% per year Year Year Effective (ia = i) YES

i= 12% Year Year Effective (ia = i) YES

i= 12% per year, compounded quarterly Year Quarter Nominal ( r ) NO

i= 12%, compounded quarterly Year Quarter Nominal ( r ) NO

i= 3%, per quarter, compounded yearly DOES NOT EXIST!

Example 13
Consider the situation of a person depositing $100 in a
bank account that pays 5% Interest, compounded semi-
annually.

How much would be in the savings account at the end of

one year?

How much is the effective interest rate?

• Solution:
Example 14
Problem
If a savings bank account pays 1.5% interest every three
months, what are the nominal and effective interest rates
per year?
Example 14
Example 15
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- How much money would the loan shark have at the end of one
year?
 Example 15
Solution
 Example 15
Solution
 Example 15
Solution
Example 16
Problem
On January 1st, a lady 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?
Example 16
Solution
Example 16
Solution
Example 16
Solution
 Arithmetic Gradient
• A series of "n" transactions
uniformly spaced but
differing from one period to
the next by a constant.
• The change or "gradient"
from one period to the next
is denoted "G"

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
 Arithmetic Gradient

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Arithmetic Gradient
 Example 17
Problem:
A man has purchased a new car. He wishes to set aside enough
money in a bank account to pay the maintenance on the car for the
first five years. It has been estimated that the maintenance cost of
a car is as follows:

Assume the maintenance costs occur at the end of each year and
that the bank pays 5% interest. How much should the car owner
deposit in the bank now?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 17
Example 17
Solution:
Note that value of n in the gradient factor is 5 not 4. In
deriving the gradient factor, the cash flow in the first period
is zero followed by (n-1) terms containing G. Here, there
are four terms containing G, and it’s a five year period
gradient.
 Example 18
Problem:
On a certain piece of machinery, it is estimated that the
maintenance expense will be as follows:

What is the equivalent uniform annual maintenance cost for

the machinery if 6% interest is used?

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.
Example 18
Example 19
Problem:
Which one is better? $3000 today or this CFD if rate of return is 10%.
 Interest
Chapter 3
Supplemental Reading, Chapter 3
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023