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Economics (Simple and Compound Interest#2)

Simple and compound interest are important concepts in engineering economy. Simple interest is calculated on the principal only, while compound interest is calculated on the principal plus all accrued interest over multiple periods. Key terms include principal (P), future value (F), annual worth (A), interest rate (i), and number of periods (n). Computer programs use these terms to calculate present value, future value, payment amounts, number of periods, and interest rates. The minimum attractive rate of return (MARR) is an important criterion for evaluating project alternatives in engineering economy studies.

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4K views

Economics (Simple and Compound Interest#2)

Simple and compound interest are important concepts in engineering economy. Simple interest is calculated on the principal only, while compound interest is calculated on the principal plus all accrued interest over multiple periods. Key terms include principal (P), future value (F), annual worth (A), interest rate (i), and number of periods (n). Computer programs use these terms to calculate present value, future value, payment amounts, number of periods, and interest rates. The minimum attractive rate of return (MARR) is an important criterion for evaluating project alternatives in engineering economy studies.

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Simple and

Compound Interest
Economic Equivalence
 The time value of money and the interest
rate help develop the concept of economic
equivalence.
 $100 today = $106 after one year, if the
interest rate is 6%
 $100 today = $94.34 before one year, of
the interest rate is 6%
Simple and Compound Interest
 The terms interest period, and interest rate
are useful in calculating equivalent sums
of money for one interest period in the
past and one period in the future.
 But for more than one interest period, the
terms simple and compound interest
become important.
Simple Interest
 Simple interest is calculated using the principal only.
 Interest = (Principal) (number of periods) (interest rate)
where the interest rate in this case is in decimals
Example 1.7
Compound Interest
 The interest accrued for each interest period is calculated on the principal plus the
total amount of interest accumulated in all previous periods.
 Compound interest mean interest on top of interest.
 Interest=(Principal + all accrued interest) (interest rate)

 Total due after a number of years =


Principal (1+interest rate) numberofyears
Interest rate in
this case is in
decimals
Example 1.8
 If an engineer borrows $1000 from the company credit union at 5%
per year compound interest, compute the total amount due after 3
years.
Terminology

and Symbols
P = Value or amount of money at a time designated as the present or
time 0. P is also referred to as present worth (PW).
 F = value or amount of money at some future time. F is also referred
to as future worth (FW).
 A = series of consecutive, equal, end-of-period amount of money. A is
also called the annual worth (AW)
 n, N= number of interest periods; years, months, days.i = interest rate
or rate of return per time period; percent per year, percent per month.
 t = time, stated in periods; years, months, days
Terminology
 The symbol P and F represents one-time occurrence.
 A occurs with the same value one each interest period for a
specified number of periods.
 It should be clear that a present value P represents a single
sum of money at some time prior to a future value F or prior
to the first occurrence of an equivalent series amount A.
 A always represents a uniform value, i.e. same amount
each period.
 Interest rate “i” is assumed to be compound rate, unless
specifically stated as simple interest.
Example 1.10
A new college graduate has a job with Boeing Aerospace. He plans to borrow $10,000 now to help in
buying a car. He has arranged to repay the entire principal plus 8% per year interest after 5 year.
Identify the engineering economy symbols involved and their values for the total owed after 5 year.

Solution:
P = $10,000

i = 8% per year

n = 5 years

F=?
Example 1.11
Assume you borrow $2000 now at 7% per year for 10
years and must repay the loan in equal yearly
payments. Determine the symbols involved and their
values?

Solution:
P = $2000

i = 7% per year

n = 10 years

A = ? Per year for 5 years


Example 1.13
You plan to make a lump-sum deposit of $5000 now into an investment account that pays 6% per year,
and you plan to withdraw an equal end-of-year amount of $1000 for 5 years, starting next year. At the
end of the sixth year, you plan to close your account by withdrawing the remaining money. Define the
engineering economy symbols involved?

Solution:
Time is expressed in years
P = $ 5000
A = $1000 per year for 5 years
F = ? At the end of year 6
i = 6% per year
n = 5 years for A series and 6 for the F
value
Example 1.14
Last year Smith’s father offered to put enough money into a saving account to
generate $1000 this year to help pay Smith’s expenses at college. Identify the
engineering economy symbols.

Solution:
Time is in years
P=?
i = 6% per year
n = 1 year
F = P + interest = ? + $1000
Introduction to solution by computer
 To find present value P:
 PV(i%,n,A,F)
 To find future value F:
 FV(i%,n,A,P)
 To find the equal, periodic value A:
 PMT(i%,n,P,F)
 To find the number of periods n:
 NPER(i%,A,P,F)

 To find the compound interest rate i:


 RATE(n,A,P,F)

 Note that the values of P,F,A should be entered by


taking in view the borrower and lender. Means if P,A
are +ive then F should be –ive in the case of Lender
and vice versa.
Minimum Attractive Rate of Return
 Engineering alternatives are evaluated upon the basis that
reasonable ROR can be expected.
 Therefore some reasonable rate must be established for the
selection criteria phase of the engineering economy study.
 The reasonable rate is called Minimum Attractive Rate of
Return (MARR) and is higher then the rate expected from a
bank or some safe investment that involves minimal
investment risk.
 MARR is also referred to as the hurdle rate for
projects; i.e. to be considered financially viable the
expected ROR must meet or exceed the MARR or
hurdle rate.
 MARR is not a value calculated like ROR. It is
established by (financial) management and used as
a criterion against which an alternative’s ROR is
measured, when making the accept/reject decision.
 ROR ≥ MARR > Cost of capital

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