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1.0 Interest and Equivalence Part I

The document provides examples and explanations of key concepts related to interest and time value of money, including: 1) It distinguishes between simple and compound interest, with simple interest calculated only on the original amount and compound interest calculated on the accumulating balance over time. 2) It gives examples of calculating simple and compound interest on loans over multiple years. 3) It introduces the concept of equivalence, where present and future cash flows can be considered equal in value based on interest rates. 4) It provides a numerical example comparing two payment plans for a purchase to demonstrate equivalence between present and future cash flows.

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48 views

1.0 Interest and Equivalence Part I

The document provides examples and explanations of key concepts related to interest and time value of money, including: 1) It distinguishes between simple and compound interest, with simple interest calculated only on the original amount and compound interest calculated on the accumulating balance over time. 2) It gives examples of calculating simple and compound interest on loans over multiple years. 3) It introduces the concept of equivalence, where present and future cash flows can be considered equal in value based on interest rates. 4) It provides a numerical example comparing two payment plans for a purchase to demonstrate equivalence between present and future cash flows.

Uploaded by

Celestialbear
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Interest and

Equivalence
Part I

Prepared by:
Hazel A. Caparas, MSIE, PIE, AAE
Learning Objectives:
At the end of this module, the student
should be able to:
• Define and provide examples of the
time value of money
• Distinguish between simple and
compound interest and use
compound interest in engineering
economic analysis
• Explain equivalence of cash flows
• Solve problems using the single
payment compound interest formulas
Receipts

Disbursement

Cash Flows
Example 1
The manager has decided to purchase
new $30,000 mixing machine. The
machine may be paid for in one of two
ways:
1. Pay the full price now minus a 3%
discount
2. Pay $5000 now; at the end of one
year, pay $8000; at the end of each of
the next four years, pay $6000.
List the alternatives in the form of a table
of cash flows.
Solution Example 1
End of Year Pay in Full Now Pay Over 5 Years
0 (now) -$29,000 -$5,000
1 0 -8,000
2 0 -6,000
3 0 -6,000
4 0 -6,000
5 0 -6,000

0 1 2 3 4 5

0 1 2 3 4 5
$29,100

$5000
$6000 $6000 $6000 $6000

$8000
Example 2
A man borrowed $1,000 from a bank at
8% interest. He agreed to repay the loan
in two end-of-year payments. At the
end of each year, he will pay half of the
$1,000 principal amount plus the interest
that is due. Compute the borrower’s
cash flow.
Solution Example 2

End of Year Cash Flow


0 (now) +$1000
1 -580
2 -540

$1000

0 1 2

$540
$580
Time Value of Money

Money can be rented in roughly the


same way one rents an apartment; only
with money, the charge is called
interest.
The importance of interest is
demonstrated by banks and saving
institutions continuously offering the pay
for the use of people’s money to pay
interest.
Simple Interest
Interest that is computed only on the
original sum, not on accrued interest.

I = Pin
F=P+I
F = P (1 + in)
Where:
I = interest
P = principal
F = future worth
i = interest rate
Ordinary Simple Interest

I = Pin

Where:
n = (d/360)
d is the number of days invested
(borrowed)
Exact Simple Interest

I = Pin

Where:
n = (d/365)
for ordinary year

n = (d/366)
for leap year

d is the number of days invested


(borrowed)
Example 3:
You have agreed to loan a friend $5000
for 5 years at a simple interest rate of 8%
per year. How much interest will you
receive from the loan? How much will
your friend pay you at the end of 5
years?
Solution Example 3:

Total interest earned


Pin = ($5000)(0.08)(5) = $2000

Amount due at end of loan


P + Pin = 5000 + 2000 = $7000
Compound Interest

For loan, any interest owed but not paid


at the end of the year is added to the
balance due.
Then the next year’s interest is
calculated on the unpaid balance due
which includes the unpaid interest from
the preceding period.
In this way, compound interest can be
simplified as interest on top of interest.
Example 4:

Original loan amount = $5000


Loan term = 5 years
Interest rate charged = 8% per year
compound interest
Solution Example 4:

Year Total Principal (P) on Interest (I) owed at the end Total amount due at the end
which interest is calculated of year n from year n’s of year n, new total
in year n unpaid total principal principal for year n+1
1 $5000 $5000 x 0.08 = 400 $5000 + 400 = 5400
2 5400 5400 x 0.08 = 432 5400 + 432 = 5832
3 5832 5832 x 0.08 = 467 5832 + 467 = 6299
4 6299 6299 x 0.08 = 504 6299 + 504 = 6803
5 6803 6803 x 0.08 = 544 6803 + 544 = 7347
Equivalence

When we are indifferent as to whether


we have a quantity of money now or
the assurance of some other sum of
money in the future or series of future
sums of money we say that the present
sum of money is equivalent to the future
sum or series of future sums.
Equivalence
Year Plan 1 Plan 2
1 -$1400 -$400
2 -1320 -400
3 -1240 -400
4 -1160 -400
5 -1080 -5400
End

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