Engineering Economy & Accounting

ECOACC013
10202004
I NTEREST
J .M.Martinez, J r.
School of EE-ECE-CoE
Mapa Institute of Technology
Simple I nt erest
Discount
Compound I nt erest
2
TI ME VALUE OF MONEY
The change in t he amount of money over a
given t ime period
The most import ant concept in engineering
economy.
I t ref ers t o t he f act t hat a peso on hand t oday is
wort h more t han a peso promised at some t ime
in t he f ut ure.
You could earn int erest while you wait ed; so a
peso t oday would grow t o more t han a peso
lat er.
Golden Rule: MONEY MAKES MONEY!
Suggested Reading: Rich Dad, Poor Dad by Robert T. Kiyosaki
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I NTEREST
manif est at ion of t he t ime value of money.
sum of money paid f or t he use of anot her
amount of money called t he pr i nci pal or
capi t al .
reward f or t hrif t ; t hat is, payment of f ered
t o people t o encourage t hem t o save and
t o make t heir savings available t o ot hers.
dif f erence bet ween t he f ut ur e wor t h and
t he pr esent wor t h of t he borrowed/ lend.
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I NTEREST
P F I =
P
i
... .......... ..........
=
where:
I= I nt erest
F= Fut ure Wort h
P= Present Wort h
I NTEREST RATE
Interest paid/earned per unit time
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5
00 . 700 == I
EXAMPLE 1:
A st udent of Mapa I nst it ut e of Technology borrows
..10,000.00 on November 1 and must repay a t ot al
of . 10,700.00 exact ly 1 year lat er. Det ermine t he
int erest rat e paid.
Sol ut i on: The int erest paid is
00 . 700 000 , 10 700 , 10 = = I
per year
% 100
000 , 10
700
= i
% 7 = i
t he int erest rat e is
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I NTEREST I S EVI L & SI NFUL!
Regarded wit h disfavor in early t imes. Ari st ot le
t hought it evi l !
During t he Mi ddl e Ages and before, t he payment
and receiving of int erest was quest ioned on moral
grounds.
The posit ion of t he Christ ian church, as defined by
t he I t alian t heologian Thomas Aqui nas, condoned
int erest on loans for business purposes, because t he
money was used t o produce new wealt h, but
adj udged it si nf ul t o pay or receive int erest on loans
made for purchase of consumer goods.
USURY-a payment of interest, by a borrower to a lender
for the use of money, in excess of the amount fixed by law.
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MODERN PERSPECTI VE
Under modern capit alism, t he payment of int erest for all t ypes
of loans is considered pr oper and even desi r abl e because
int erest charges serve as a means t o allocat e t he limit ed f unds
available for loan t o proj ect s in which t hey will be most
profit able and most product ive.
Consumers are prot ect ed from cont ract ing loans at excessi ve
i nt er est r at es. The current , or market , rat e of int erest is
det ermined primarily by t he relat ion bet ween t he suppl y of
money and t he demands of bor r ower s.
When t he supply of money available for invest ment increases
fast er t han t he requirement s of borrowers, int erest rat es t end t o
fall. Conversely, int erest rat es generally rise when t he demand
for invest ment funds grows fast er t han t he available supply of
funds t o meet t hat demand.
Business execut ives will not borrow money at an int erest rat e
t hat exceeds t he ret urn t hey expect t he use of t he money t o
yield.
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VARI ATI ON I N THE
I NTEREST RATES
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9
SI MPLE I NTEREST
int erest on a loan or principal t hat is based
only on t he original amount of t he loan
int erest earned only on t he original principal
amount invest ed.
Pin I =
where:
I= int erest
P= principal/ present wort h
i= int erest rat e per period
n= period
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SI MPLE I NTEREST I S LI NEAR
OVER A PERI OD OF TI ME
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TWO TYPES OF
SI MPLE I NTEREST
1. Ordi nary Si mpl e I nt erest
Based on one bankers year. A bankers year
is composed of 12 mont hs of 30 days each
which is equivalent t o a t ot al of 360 days in
a year.
360
d
n =
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TWO TYPES OF SI MPLE I NTEREST
366
d
n =
2. Exact Si mpl e I nt erest
Based on t he exact number of days in a given
year. The number of days in a mont h is based on
t he act ual number of days each mont h cont ains
in our Gregori an cal endar. A normal year has
365 days while a leap year has 366 days.
365
d
n =
f or normal
year
f or leap
year
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LEAP YEAR
A noncent ury year is a leap year if it is
di vi si bl e by 4 (1992,1784,1524, et c.).

A cent ury year is a leap year if it is di vi si bl e
by 400. So 1600 and 2000 are leap years
but 1700,1800, and 1900 are not .
Leap year is so named because the extra day causes
any date after February in a leap year to leap over
one day in the week and to occur two days later in the
week than it did in the previous year, rather than just
one day later as in a normal year.
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HI STORY OF MODERN
CALENDAR
The ancient Babyl oni ans had a lunisolar calendar of
12 lunar mont hs of 30 days each, and t hey added
ext ra mont hs when necessary t o keep t he calendar in
line wit h t he seasons of t he year. (360 days)
The ancient Egypt i ans were t he first t o replace t he
lunar calendar wit h a calendar based on t he solar
year. They measured t he solar year as 365 days,
divided int o 12 mont hs of 30 days each, wit h 5 ext ra
days at t he end. About 238 B.C. King Pt olemy I I I
ordered t hat an ext ra day be added t o every fourt h
year, similar t o t he modern leap year. (365 days)
The ast ronomical year has a mean lengt h of 365.2422
solar days, or 365 days, 5 hr, 48 min, 46 sec
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HI STORY OF MODERN CALENDAR
I n 45 B.C. Julius Caesar, upon t he advice of t he Greek
ast ronomer Sosigenes, decided t o use a purely solar
calendar. This calendar, known as t he Jul i an cal endar ,
fixed t he normal year at 365 days, and t he leap year,
every fourt h year, at 366 days. ( 365.25 days)
The Julian year was 11 mi n and 14 sec l onger t han t he
solar year. This discrepancy accumulat ed unt il by 1582 t he
vernal equinox occurred 10 days early and church holidays
did not occur in t he appropriat e seasons. To make t he
vernal equinox occur on March 21, as it had in A.D. 325,
t he year of t he First Council of Nicaea, Pope Gregory XI I I
issued a decree dropping 10 days from t he calendar. To
prevent furt her displacement he inst it ut ed a calendar,
known as t he Gr egor i an cal endar , t hat provided t hat
cent ury years divisible evenly by 400 should be leap years
and t hat all ot her cent ury years should be common years.
Thus, 1600 was a leap year, but 1700 and 1800 were
common years. (365.2425 days)
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EXAMPLE 2:
Ordinary Simple I nt erest
Det ermine t he ordinary simple int erest on 10,000
f or 9 mont hs and 10 days if t he rat e of int erest is
12%.
Sol ut i on: Based on a bankers year,
280 10 ) 30 ( 9 = + = d
The ordinary simple int erest is
|
.
|

\
|
= =
360
280
) 12 . 0 )( 00 . 000 , 10 ( Pin I
33 . 933 = I
days
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EXAMPLE 3:
Ordinary & Exact Simple I nt erest
Det ermine t he ordinary and exact simple int erest on
_5,000 for t he period from January 15 t o June 20, 1993,
if t he rat e of simple int erest is 14%.
Sol ut i on: The t ot al number of days is,
days
January- 16
February- 28
March- 31
April- 30
May- 31
June- 20
Tot al - 156
(excluding January 15)
(including June 20)
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1993 is a normal year
(365 days). The exact
simple int erest is
Pin I =
33 . 303 = I
EXAMPLE 3:
Ordinary & Exact Simple I nt erest
Sol ut i on:
The ordinary simple
int erest based on bankers
year of 360 days is
|
.
|

\
|
=
360
156
) 14 . 0 )( 00 . 000 , 5 ( I
Pin I =
18 . 299 = I
|
.
|

\
|
=
365
156
) 14 . 0 )( 00 . 000 , 5 ( I
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EXAMPLE 4:
Ordinary & Exact Simple I nt erest
Det ermine t he exact and
ordinary simple int erest s
on _1,200 for t he period
from January 16 t o
November 26, 1992, if
t he rat e of int erest is
24%.

Sol ut i on: The t ot al
number of days is,
days
January- 15
February- 29
March- 31
April- 30
May- 31
June- 30
July- 31
August- 31
Sept ember- 30
Oct ober- 31
November- 26
Tot al - 315
(excluding Jan 15)
(including Nov 26)
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1992 is a leap year (366
days). The exact simple
int erest is
Pin I =
00 . 252 = I
EXAMPLE 4:
Ordinary & Exact Simple I nt erest
Sol ut i on:
The ordinary simple
int erest based on bankers
year of 360 days is
|
.
|

\
|
=
360
315
) 24 . 0 )( 00 . 200 , 1 ( I
Pin I =
87 . 247 = I
|
.
|

\
|
=
366
315
) 24 . 0 )( 00 . 200 , 1 ( I
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EXAMPLE 5:
Ordinary & Exact Simple I nt erest
Det ermine t he exact and ordinary simple int erest s on
_6,000 for t he period from November 18 1991 t o
March 25, 1992, if t he rat e of int erest is 20%.
Sol ut i on:
days
January 31
February. 29
March.. 25
Tot al 85
November 12
December 31
Tot al .. 43
The t ot al number of
days for 1991 is,
The t ot al number of
days for 1992 is,
days
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1991 is a normal year (365
days) while 1992 is a leap
year (366 days). The exact
simple int erest is
Pin I =
67 . 426 = I
EXAMPLE 5:
Ordinary & Exact Simple I nt erest
Sol ut i on:
The ordinary simple
int erest based on bankers
year of 360 days is
|
.
|

\
|
+
=
360
85 43
) 20 . 0 )( 00 . 000 , 6 ( I
Pin I =
06 . 420 = I
|
.
|

\
|
+ =
366
85
365
43
) 20 . 0 )( 00 . 000 , 6 ( I
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FUTURE WORTH
si nce
I P F + =
Pin P F + =
) 1 ( in P F + =
t hen
EXAMPLE 6: A loan of 5,000 is made f or a period of
15 mont hs, at a simple int erest rat e of 15%, what
f ut ure amount is due at t he end of t he loan period
Sol ut i on:

|
.
|

\
|
+ = + =
12
15
15 . 0 1 5000 ) 1 ( in P F
50 . 937 , 5 = F
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24
DI SCOUNT
dif f erence bet ween t he f ut ure wort h and t he
present wort h but t he int erest is deduct ed in t he
present .
EXAMPLE 7: A man borrows 10,000 f rom a
lending company but t he int erest is t o be deduct ed
f rom t he loan at t he t ime t he money is borrowed.
The man only get s 8,500 in cash. Det ermine how
much is discount ed f rom his loan?
Sol ut i on:
00 . 500 , 1 = D 500 , 8 000 , 10 = = P F D
P F D =
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25
RATE OF DI SCOUNT
discount on one unit of principal per unit of t ime.
F
D
d =
in t erms of act ual int erest rat e
i
i
d
+
=
1
EXAMPLE 8: I n Example 7, det ermine t he rat e of
discount and t he act ual int erest rat e.
Sol ut i on:
% 15
000 , 10
500 , 1
= = d
% 65 . 17
15 . 0 1
15 . 0
1
=

=
d
d
i
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COMPOUND I NTEREST
int erest earned on bot h t he init ial principal and
t he int erest reinvest ed f rom prior periods.
int erest earned by t he principal is not paid at t he
end of each int erest period, but is considered as
added t o t he principal, and t heref ore will also
earn int erest f or t he succeeding periods.
more f requent ly used in commercial pract ice
t han simple int erest , more especially if it is a
longer period which spans f or more t han a year.
int erest on t op of int erest .
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COMPOUND I NTEREST
Peri od Pri nci pal I nt erest Tot al Amount
1 P Pi P(1+i)
2 P(1+i) P(1+i)i P(1+i)
2
3 P(1+i)
2
P(1+i)
2
i P(1+i)
3
.
.
.
.
.
.

.
.
.

.
.
.
n P(1+i)
n-1
P(1+i)
n-1
i P(1+i)
n

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COMPOUND I NTEREST I S GEOMETRI C
OVER A PERI OD OF TI ME
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29
single payment compound amount fact or (SPCAF)
EXAMPLE 9: The amount of 20,000 was deposit ed in a
bank earning an int erest of 6.5% per annum. Det ermine
t he t ot al amount at t he end of 7 years if t he principal an
int erest were not wit hdrawn during t his period.
FUTURE WORTH
) %, , / ( n i P F
n
i P F ) 1 ( + =
Sol ut i on:
7
) 065 . 0 1 ( 000 , 20 ) 1 ( + = + =
n
i P F
73 . 079 , 31 = F
10202004 jmmart inezjr
= +
n
i) 1 (
30
single payment present wort h f act or (SPPWF)
EXAMPLE 10: Find t he present wort h of a f ut ure
payment of 80,000 t o be made in 6 years wit h an
int erest of 12% annually.
PRESENT WORTH
) %, , / ( n i F P
n
i F P

+ = ) 1 (
Sol ut i on:
6
) 12 . 0 1 ( 000 , 80 ) 1 (

+ = + =
n
i F P
49 . 530 , 40 = P
10202004 jmmart inezjr
= +
n
i) 1 (
31
EXAMPLE 11:
A loan of 50,000 is t o be
paid in 3 years at t he
amount of 65,000.
What is t he int erest rat e
per annum.
1
000 , 50
000 , 65
3
1
|
.
|

\
|
= i
1
1

|
.
|

\
|
=
n
P
F
i
% 14 . 9 = i
Sol ut i on:
10202004 jmmart inezjr
EXAMPLE 12:
How long will it t ake t he
money t o double it self if
invest ed at 5%
compounded annually?
n
i P F ) 1 ( + =
years n 2 . 14 =
Sol ut i on:
) 05 . 0 1 ln(
2
ln
) 1 ln(
ln
+
=
+
=
P
P
i
P
F
n
32
NOMI NAL RATE (r)
basic annual rat e of int erest .
a nominal rat e of int erest of 24% compounded
mont hl y means t hat t here are 12 i nt erest
peri ods each year, t he rat e per period being
24%/ 12= 2% .
m
r
i =
where:
i= int erest per period
r= nominal rat e of int erest
m= number of period per year
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COMPOUNDI NG PERI ODS
Peri od Number of Peri ods Per Year
i = r / m,
( r=24%)
Annually 1
24%
Semiannually 2
12%
Quarterly 4
6%
Bimonthly 6
4%
Monthly 12
2%
Semimonthly 24
1%
Weekly 52
0.4615%
Daily 365
0.0658%
Hourly 8,760
0.0027%
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EXAMPLE 13:
Find t he compound amount
if 10,000 is invest ed at
24% compounded quart erly
for 2 years.
n
i P F ) 1 ( + =
48 . 938 , 15 = F
Sol ut i on:
10202004 jmmart inezjr
EXAMPLE 14:
An amount of 2,000
becomes 3,500 aft er 5
years compounded mont hly.
Find t he nominal int erest .
mn
m
r
P F ) 1 ( + =
% 24 . 11 = r
Sol ut i on:

|
.
|

\
|
= 1
1
mn
P
F
m r
) 2 ( 4
)
4
24 . 0
1 ( 000 , 10 + = F
mn
m
r
P F ) 1 ( + =

|
.
|

\
|
= 1
000 , 2
500 , 3
) 12 (
) 5 )( 12 (
1
r
35
Let
F
1
= fut ure amount of money if invest ed at an annual
int erest i
eff
for 1 year.
F
2
= fut ure amount of money if invest ed at a nominal rat e
of r for 1 year.
EFFECTI VE RATE
act ual or t he exact rat e of int erest on t he principal
during a one-year period
m
F F =
1
) 1 (
) 1 (
1 ) 1 (
m
eff
m
r
P i P
|
.
|

\
|
+ = +
1 1
|
.
|

\
|
+ =
m
eff
m
r
i
10202004 jmmart inezjr
36
EFFECTI VE RATES FOR r= 24% USI NG
DI FFERENT COMPOUNDI NG PERI ODS
Per i od m i = r / m i
ef f
Annually 1 24% 24.00%
Semiannually 2 12% 25.44%
Quarterly 4 6% 26.25%
Bimonthly 6 4% 26.53%
Monthly 12 2% 26.82%
Semimonthly 24 1% 26.97%
Weekly 52 0.4615% 27.05%
Daily 365 0.0658% 27.11%
Hourly 8,760 0.0027% 27.12%
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EXAMPLE 15:
Which of t hese gives t he lowest effect ive rat e of int erest ?
(a)12.35% compounded annually (b)11.90% compounded
semiannually (c)12.20% compounded quart erly
(d)11.60% compounded mont hly Ans: ( d)
1
2
119 . 0
1
2

|
.
|

\
|
+ =
eff
i
1
4
122 . 0
1
4

|
.
|

\
|
+ =
eff
i
1
12
116 . 0
1
12

|
.
|

\
|
+ =
eff
i
( a) if compounded annually
( d)
( c)
( b)
% 25 . 12 =
eff
i
% 77 . 12 =
eff
i
% 24 . 12 =
eff
i
% 35 . 12 =
eff
i
r i
eff
=
Sol ut i on:
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EXAMPLE 16:
What nominal rat e, compounded semiannually, yields t he
same amount as 16% compounded quart erly?
To yield t he same amount , t heir effect ive rat es
must be equal
% 32 . 16
2
= r
4 2
2
4
4
2
2
) 4 ( ) 2 (
4
16 . 0
1
2
1
1
4
1 1
2
1
|
.
|

\
|
+ =
|
.
|

\
|
+

|
.
|

\
|
+ =
|
.
|

\
|
+
=
r
r r
i i
eff eff
Sol ut i on:
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39
For a given nominal rat e, increasing t he number of int erest
periods per year, increases t he effect ive rat e of int erest . As m
approaches infinit y, t he effect ive int erest rat e approaches a
cert ain value
CONTI NUOUS COMPOUNDI NG
x
x
x
y
|
.
|

\
|
+ =

1
1
lim
max
718 . 2
max
= = e y
rn
Pe F =
mn
m
r
P F
|
.
|

\
|
+ = 1
r
m
x =


x
m
xrn
x
P F
|
.
|

\
|
+ =
1
1
let
as
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40
PLOT OF _____
x y
100 2.71818
1,000
10,000
:
.
:
.

e
x
x
x y
|
.
|

\
|
+ =
1
1 ) (
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41
EXAMPLE 17:
A nominal int erest of 3% compounded
cont inuously is given on t he account . What is t he
accumulat ed amount f or 10,000 af t er 10 years?
What is equivalent ef f ect ive rat e?
) 10 )( 03 . 0 (
) 000 , 10 ( e F =
rn
Pe F =
59 . 498 , 13 = F
( )
n
eff
rn
i P Pe + = 1
( )
eff
r
i e + = 1
Sol ut i on:
t he equivalent rat e
of int erest is
1 1
03 . 0
= = e e i
r
eff
% 04 . 3 =
eff
i
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42
CASH FLOW DI AGRAM
graphical represent at ion of payment (s)
as a f unct ion of t ime.
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0 1 2 3 4 5 6 7 8 9 n
P
F
Present Wort h
Fut ure Wort h
43
EXAMPLE 18:
A st udent plans t o deposit 1,500 in t he bank now and
anot her 3,000 for t he next 2 years. I f he plans t o wit hdraw
---5,000 t hree years from aft er his last deposit . What will be
t he amount of money left in t he bank aft er one year of his
wit hdrawal considering an annual int erest rat e of 10%?
10202004 jmmart inezjr
0 1 2 3 4 5 6
1,500
F
1
F
2
3,000
5,000
F
3
Sol ut i on:
44
EXAMPLE 18:
00 . 500 , 5 30 . 392 , 4 34 . 657 , 2
) 10 . 0 1 ( 000 , 5
) 10 . 0 1 ( 000 , 3 ) 10 . 0 1 ( 500 , 1
) 1 ( ) 1 ( ) 1 (
1
4 6
3 2 1
3 2 1
3 2 1
+ =
+
+ + + =
+ + + + =
+ =
F
F
i P i P i P F
F F F F
n n n
64 . 549 , 1 = F
Let F= amount remaining in t he bank
45
0 1 2 3
EXAMPLE 19:
Deposit s of 3,000 each were made af t er t he
f irst , second, and t hird year . What is t he present
wort h of t hese deposit s if t he int erest rat e is 8%
annually?
10202004 jmmart inezjr
3,000
Sol ut i on:
3,000 3,000
P
29 . 731 , 7
) 08 . 0 1 ( 000 , 3
) 08 . 0 1 ( 000 , 3
) 08 . 0 1 ( 000 , 3
3
2
1
3 2 1
=
+ +
+ +
+ =
+ + =

P
P
P P P P
46
0 1 2 3 4 5 6 7 8 9 n-1 n
EXAMPLE 20:
How long will it t ake t o make a million dollars if
deposit s of $1,000 were made mont hly? The
int erest rat e is 25% compounded mont hly.
10202004 jmmart inezjr
1,000
Sol ut i on:
1,000 1,000
1,000,000
1,000 1,000 1,000 1,000 1,000 1,000 1,000 1,000
47
48
REFERENCES:
Engi neeri ng Economy, Tiong J.R.
Engi neeri ng Economy, 3
rd
ed., Arreola M.
Grol i er Encycl opedi a of Knowl edge
1995, I nt ernat ional Ed.
Mi crosof t Encart a Ref erence Li brary
2003
Encycl opedi a Bri t anni ca 2002
Engi neeri ng Economy, 5
t h
ed. Blank L. and
Tarquin A.
jmmart inezjr 10202004