Engineering Economics

Lecturer: Muhammad Ali Abdullah Mirza

Simple Vs Compound Interest

• Simple interest: Interest is earned only on the original

principal

• Compound interest: Interest is earned on principal and on

interest received
Commonly used Symbols

T = time, usually in periods such as years or months

PV = value or amount of money at a time t designated as present or

time 0

FV = value or amount of money at some future time, such as at t = n

periods in the future

A = series of consecutive, equal, end-of-period amounts of money

n = number of interest periods; years, months

r = interest rate or rate of return per time period; percent per year or
month
Simple Interest

Simple interest: Simple interest is calculated using principal

only.

Interest = (principal)(number of periods)(interest rate)

I = Pni
Simple Interest Example

Suppose $100,000 lent for 3 years at simple i = 10% per year.

What is repayment after 3 years?

Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

Compound Interest

Compound Interest is based on principal plus all accrued interest.

That is, interest compounds over time.

Interest = (principal + all accrued interest) (interest rate)

Compound Interest Example

Suppose $100,000 lent for 3 years at i = 10% per year compounded.

What is repayment after 3 years?
Interest, year 1: I1 = 100,000(0.10) = $10,000
Total due, year 1: T1= 100,000 + 10,000 = $110,000

Interest, year 2: I2 = 110,000(0.10) = $11,000

Total due, year 2: T2= 110,000 + 11,000 = $121,000

Interest, year 3: I3 = 121,000(0.10) = $12,100

Total due, year 3: T3=121,000 + 12,100 = $133,100

Compounded: $133,100 Simple: $130,000

Effects of Compounding
Compound Interest Example:1

• Suppose you invest the $1,000 at 5% per annum for 5

years. How much would you have?
▪ FV = 1,000(1.05)5 = 1,276.28

• The effect of compounding is small for a small number of

periods, but increases as the number of periods increases.
(Simple interest would have a future value of $1,250, for a
difference of $26.28.)
Compound Interest Example:2

• Suppose you had a relative, who deposited $10 for you at

5.5% interest 200 years ago. How much would the investment
be worth today?
▪ FV = ?

• What is the effect of compounding?

– Simple interest = ?
– Compounding = ?
Compound Interest Example:2
Solution

• Future Value in 200 years:

▪ FV = 10(1.055)200 = $447,189.84

• Compounding effect:
▪ Simple interest = 10(200)(0.055) = $110
▪ Compounding = 447,189.84 – (10 + 110)
▪ Compounding added $447,069.84 to the value of the
investment !
Class Activity:1
• Suppose you have $500 to invest and you believe that you can earn
8% per year over the next 15 years.
– How much would you have at the end of 15 years using
compound interest?
– How much would you have using simple interest?
Present Values
• How much do I have to invest today to have some amount in the
future?

– FV = PV(1 + r)t
– Rearrange to solve for PV = FV
(1 + r)t
• When we talk about discounting, we mean finding the
present value of some future amount.

• When we talk about the “value” of something, we are talking

about the present value unless we specifically indicate that we
want the future value.
Present Values – One Period Example

• Suppose you need $10,000 in one year for the down payment on a
new car. If you can earn 7% annually, how much do you need to
invest today?
▪ PV = 10,000 / (1.07)1 = 9,345.79

• $9,345.79 is the present value. This means that investing this

amount for 1 year at 7% will result in your having a future value of
$10,000.
Present Values – Multiple Periods
Example

• Your parents set up a trust fund for you 10 years ago that is now
worth $19,671.51. If the fund earned 7% per year, how much
did your parents invest?

• 10 years ago, your parents set up a trust fund for you of exactly
$10,000:

▪ PV = 19,671.51 / (1.07)10 = 10,000

Relationship b/w Present Value
and Interest Rate
• For a given interest rate – the longer the time period, the
lower the present value.
▪ What is the present value of $500 to be received in 5 years?
In 10 years? The discount rate is 10%:
▪ 5 years: PV = 500 / (1.1)5 = 310.46
▪ 10 years: PV = 500 / (1.1)10 = 192.77
Relationship b/w Present Value and
Time Period
• For a given time period – the higher the interest rate
(= discount rate), the smaller the present value.

▪ What is the present value of $500 received in 5 years if

the interest rate is 10%? 15%?
▪ Rate = 10%: PV = 500 / (1.1)5 = 310.46
▪ Rate = 15%; PV = 500 / (1.15)5 = 248.59
Effects of Discounting
Class Activity:2

Suppose you need $15,000 in 3 years. If you can earn

6% annually, how much do you need to invest today?
The Basic Present Value Equation

• PV = FV
(1 + r)t

• There are four variables in this equation

– PV, FV, r and t

➔ If we know any three, we can solve for the fourth.

Discount Rate
• Often we will want to know what the implied interest rate is in
an investment.

• Rearrange the basic PV equation and solve for r:

▪ FV = PV(1 + r)t
▪ FV / PV = (1 + r)t
▪ (FV/PV) 1/t = 1 + r
▪ r = (FV / PV)1/t – 1
Discount Rate Example:1

• You are looking at an investment that will pay $1,200

in 5 years if you invest $1,000 today. What is the
implied rate of interest?

▪ r = (1,200 / 1,000)1/5 – 1 = 0.03714 = 3.714%

Discount Rate Example:2

• Suppose you are offered an investment that will allow you

to double your money in 6 years. You have $10,000 to
invest. What is the implied rate of interest?

▪ r = (20,000 / 10,000)1/6 – 1
▪ r = 21/6 – 1
▪ r = 0.122462 = 12.25%
Finding the Number of Periods
• Finding the number of periods is important when you want to know how
long it takes until an investment grows to a certain amount.
• Start with basic equation and solve for t (remember the logarithm
function)
▪ FV = PV(1 + r)t
▪ (1 + r)t = FV / PV
▪ ln (1 + r)t = ln (FV / PV)
▪ t × ln (1 + r) = ln (FV / PV)

ln (FV / PV)
▪ t=
ln (1 + r)
Number of Periods Example:1
• You want to purchase a new car and you are willing to pay
$20,000. If you can invest at 10% per year and you currently
have $15,000, how long will it be before you have enough
money to pay cash for the car?

• If you invest 15,000 at 10% per year for app. 3 years you will
have 20,000 to buy the car.

▪ t = ln(20,000 / 15,000) / ln(1.1) = 3.02 years

Class Activity:3

• Suppose you want to buy some new furniture for your family
room. You currently have $500 and the furniture you want
costs $600. If you can earn 6%, how long will you have to wait
if you don’t add any additional money?
 Annuities and Perpetuities
• Annuity – finite series of equal payments that occur at regular
intervals
– If the first payment occurs at the end of the period, it
is called an ordinary annuity
– If the first payment occurs at the beginning of the period, it
is called an annuity due

• Perpetuity – infinite series of equal payments

Annuities and Perpetuities Basic
Formulas
Present Values of Annuity Example:1

• After carefully going over your budget, you have determined

you can afford to pay $632 per month towards a new sports
car. You call up your local bank and find out that the going
rate is 1 percent per month for 48 months.

• How much can you borrow?

Present Values of Annuity Example:1
Solution
Present Values of Annuity Example:2

• Suppose you win $10 million in a lottery. The money is paid in

equal annual installments of $333,333.33 over 30 years.

• If the appropriate discount rate is 5%, how much is it actually

worth today?
Present Values of Annuity Example:2
Solution
Future Values of Annuity
Finding the Annuity Payments

Suppose you want to borrow $20,000 for a new car. You can
borrow at 8% per year, compounded monthly (8/12 = 0.667%
per month).If you take a 4-year loan, what is your monthly
payment?
Finding the Annuity Payments
Solution
Number of Payments for Annuity

Suppose you borrow $2,000 at 5% and you are going to make

annual payments of $734.42. How long before you pay off the
loan?
Number of Payments for Annuity
Solution

• It will take you three years to pay back the loan:

▪ 2,000 = 734.42(1 – 1/1.05t) / 0.05

▪ 0.136161869 = 1 –1/1.05t
▪ 1/1.05t = 0.863838131
▪ 1.157624287 = 1.05t
▪ t = ln(1.157624287) / ln(1.05) = 3 years
Finding the Rate of Annuity Example

Suppose you borrow $10,000 from your parents to buy a

car. You agree to pay $207.58 per month for 60 months.
What is the monthly interest rate?

▪ PV = 10,000
▪ C = 207.58
▪ t = 60
▪ r=?
Finding the Rate of Annuity Example
Solution
• Trial and Error Process
– Choose an interest rate and compute the PV of the
payments based on this rate
– Compare the computed PV with the actual loan amount
– If the computed PV > loan amount, then the interest
rate is too low
– If the computed PV < loan amount, then the interest
rate is too high
– Adjust the rate and repeat the process until the
computed PV and the loan amount are equal
Finding the Rate of Annuity Example
Solution
Perpetuity

• A special case of an annuity is a perpetuity

• The stream of payments continue forever, i.e. a perpetuity

has an infinite number of equal cash flows.

• The Perpetuity Formula is

▪ PV = C/r

• The formula is used for almost all equity investments and

for business valuation.
Perpetuity Example

You are considering to buy preferred stock that pays a quarterly

dividend of $1.50. If your desired return is 3% per quarter, how
much would you be willing to pay?
• The Perpetuity Formula:

▪ PV = C / r
▪ PV = 1.50 / 0.03 = 50

• The“fair price” for this security shouldbe $50

Thank You