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IE 353
Engineering Economy
Chapter 4: The Time Value of Money

Department of Industrial Engineering

Dr. Rula Allaf

Learning Objectives
 Understand the concept of “time value of money”
 Distinguish between simple and compound interest
 Understand the concept of “equivalence” of cash
flows
 Solve problems using Single Payment Compound
Interest Formulas
 Solve problems using Uniform Series Compound
Interest Formulas
 Apply arithmetic and geometric gradients in
modeling economic analysis
 Understand nominal and effective interest rates
 Apply continuous compounding
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Money has a time value.

 Question: Would you rather
• Receive $1000 today or
• Receive $1000 1 year from today?
 Answer:----------
 Why?
• Earning power of money
• Purchasing power of money
• Money is a valuable asset
Because money is more valuable today than in the future,
we need to describe cash receipts and disbursements at
the time they occur.
3

Simple interest
Interest is computed only on the original sum
(the original principal), and not on accrued
interest

When the total interest earned or charged is

linearly proportional to:
– principal amount lent or borrowed (P)
 the initial amount of the loan (principal),
– number of interest periods (e.g., years) (n),
and
– interest rate per interest period (i ),
 the interest and interest rate are said to be
simple.
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Computation of simple interest

Total interest earned = P  i  n

where P = Principal
i = Simple annual interest rate
n = Number of years

F  P  P in
where F = Amount due at the end of n periods (years)

Example 4-1
If $5,000 were loaned for five years at a
simple interest rate of 8% per year, the
interest earned would be:
Total interest earned = P  i  n  $5,000  0.08  5
 $2,000
So, the total amount repaid at the end of
five years would be the original amount
($5,000) plus the interest ($2,000):

Amount due at end of loan =F  P  P  i  n  $7,000

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Compound Interest

 Interest is computed on the unpaid

balance, which includes the principal and
any unpaid interest from the preceding
period
 Charging interest on unpaid interest
(compounding)
 Common practice for interest calculation,
unless specifically stated otherwise

Compound Interest / Equivalence

Example 4-2 : Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay principal and interest in one payment at end of 5
years
Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5
Subtotal

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Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay principal and interest in one payment at end of 5
years
Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $0.00 $0.00 $0.00
2 $5,400.00 $432.00 $5,832.00 $0.00 $0.00 $0.00
3 $5,832.00 $466.56 $6,298.56 $0.00 $0.00 $0.00
4 $6,298.56 $503.88 $6,802.44 $0.00 $0.00 $0.00
5 $6,802.44 $544.20 $7,346.64 $2,346.64 $5,000.00 $7,346.64

Subtotal $2,346.64 $5,000.00 $7,346.64

Repaying a Debt
repay 1/n th of the principal plus interest due

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay $1000 principal plus interest due

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5

Subtotal
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Repaying a Debt
repay 1/n th of the principal plus interest due

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay $1000 principal plus interest due

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $1,000.00 $1,400.00
2 $4,000.00 $320.00 $4,320.00 $320.00 $1,000.00 $1,320.00
3 $3,000.00 $240.00 $3,240.00 $240.00 $1,000.00 $1,240.00
4 $2,000.00 $160.00 $2,160.00 $160.00 $1,000.00 $1,160.00
5 $1,000.00 $80.00 $1,080.00 $80.00 $1,000.00 $1,080.00

Subtotal $1,200.00 $5,000.00 $6,200.00

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Repaying a Debt

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay interest due at end of each year and principal at end
of 5 years

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5
Subtotal
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Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay interest due at end of each year and principal at end of
5 years
Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
2 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
3 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
4 $5,000.00 $400.00 $5,400.00 $400.00 $0.00 $400.00
5 $5,000.00 $400.00 $5,400.00 $400.00 $5,000.00 $5,400.00

Subtotal $2,000.00 $5,000.00 $7,000.00

13

Repaying a Debt

 Repay of a loan of $5000 in 5 yrs at interest rate of 8%

 Pay in 5 equal end-of-year payments of $1252.28

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of Year Interest Year Payment Payment Payment
1
2
3
4
5
Subtotal

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Repaying a Debt
 Repay of a loan of $5000 in 5 yrs at interest rate of 8%
 Pay in 5 equal end-of-year payments of $1252.28

Balance at
the Balance at
Beginning the end of Interest Principal Total
Yr of year Interest year Payment Payment Payment
1 $5,000.00 $400.00 $5,400.00 $400.00 $852.28 $1,252.28
2 $4,147.72 $331.82 $4,479.54 $331.82 $920.46 $1,252.28
3 $3,227.25 $258.18 $3,485.43 $258.18 $994.10 $1,252.28
4 $2,233.15 $178.65 $2,411.80 $178.65 $1,073.63 $1,252.28
5 $1,159.52 $92.76 $1,252.28 $92.76 $1,159.52 $1,252.28

Subtotal $1,261.41 $5,000.00 $6,261.41

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Question ?

 If you were given the choice between the

4 alternative repayment plans, which one
would you choose?

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Equivalence
 If a firm believes 8% was reasonable, it would
have no preference about whether it received
$5000 now or was paid by any of the 4
repayment plans
 The 4 repayment plans are equivalent to one
another and to $5000 now at 8% interest (in
spite of the different repayment structure and
the total payment amount)
 They have equal comparable equivalent
values; in this case “the present” value
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Use of Equivalence in
Engineering Economic Studies

 Using the concept of equivalence, one can

convert different types of cash flows at different
points of time to an equivalent value at a
common reference point
 Equivalence need not be a single sum; it could be
a series of payments or receipts
 Equivalence is dependent on interest rate; two
series of payments may be equivalent at one
interest rate, but not equivalent at another
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Cash Flow Diagrams (CFD)

 CFD summarize costs & benefits occur over time
 CFD illustrates the size, sign, and timing of individual
cash flows
 Components of CFD
◦ A segmented time-based horizontal line, divided into time units
◦ A vertical arrow representing a cash flow is added at the time it
occurs
◦ Cash flows are assumed to occur at the end of the period
◦ Arrow pointing down for costs and up for benefits
$100 $100
$50
Period 1

0 1 2 3 4 5
End of period 4 is also beginning of
Today “time 0”
period 5
$100
$150 $150 19

Drawing a Cash Flow Diagram

 CFD shows when all cash flows occur
 In a CFD, the end of period t is the same time as the beginning of
period t+1
 Rent, lease, and insurance payments are usually treated as beginning-
of-period cash flows
 O&M, salvage, revenues, and overhauls are assumed to be end-of-
period cash flows
 The choice of time 0 is arbitrary
 Perspective in assigning the sign of cash flow
 Show individual concurrent cash flows
 First cost: expenses to build or to buy and install
Operations and maintenance (O&M): annual expense, such as
Categories of


Cash Flows

electricity, labor, and minor repairs

 Salvage value: receipt at project termination for sale or transfer of the
equipment
 Revenues: annual receipts due to sale of products or services
 Overhaul: major capital expenditure that occurs during the asset’s life
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Computing Cash Flows: Example 4-3

Cash flows of 2 payment options

To purchase a new $30,000 machine,

• Pay the full price now minus a 3% discount or
• Pay $5000 now; $8000 at the end of year 1;
and $6000 at the end of each of the next 4
years

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Example 4-3
Cash flows of 2 payment options
Pay in full Pay in 5 years
End of End of
Year Cash Flow Year Cash Flow
Table of cash

0 (now) -$29,100 0 (now) -$5,000

flows

1 0 1 -8,000
2 0 2 -6,000
3 0 3 -6,000
4 0 4 -6,000
5 0 5 -6,000
cash flow
diagrams

0 1 2 3 4 5 0 1 2 3 4 5
$5,000
$29,100 $8,000 $6,000
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Cash Flow Tables

Cash flow tables are essential to modeling

engineering economy problems in a spreadsheet

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Drawing Cash Flow Diagrams

with Spreadsheet
Stacked bar chart
0 1 2 3 4 5 6
$20,000
Capital $10,000
$-
Year Costs O&M Overhaul $(10,000)
Cash Flows

$(20,000)
0 $(80,000) $(30,000)
$(40,000)
1 $(12,000)
$(50,000)
2 $(12,000) $(60,000)
$(70,000)
3 $(12,000) $(25,000) $(80,000)
$(90,000)
4 $(12,000)
Year
5 $(12,000)
Capital Costs O&M Overhaul
6 $10,000 $(12,000)

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Interest Formulas
Notation used for compound interest calculations
• i = effective interest rate per interest period (stated as a decimal)
• n = number of interest periods (usually periods when cash flows
occur)
• P = present sum of money; equivalent value of one or more cash
flows at the present reference point in time
• F = future sum of money; equivalent value of one or more cash
flows at a future reference point in time
• A = end-of-period cash flows in a uniform series continuing for a
certain number of periods, starting at the end of the first period
and continuing through the last

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Single Payment Compound Interest Formulas

F
Notation:
i = effective interest rate per interest
period
0 1 2 n-1 n n = number of interest periods
P = a present sum of money
F = a future sum of money ( F is an
i% amount, n periods from the present,
that is equivalent to P with interest
P rate i)

1) Single Payment Compound Amount Formula

F  P(1  i)n
F  P(F/P, i%, n)
Single Payment Compound Amount Factor:
Functional Find F, given P, at i, over n
notation
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Single Payment
Compound Interest Formulas

2) Single Payment Present Worth Formula

P  F(1  i)-n
P  F(P/F, i%, n)
single payment present worth factor:
Find P, given F, at i, over n

27

Problems involving unknown n or i

◦ We may know P, F, and i and want to find n
F  P(1  i) n 
F F
 (1  i) n  log( )  log(1  i) n  n log(1  i ) 
P P
log( F P )
n
log(1  i )
◦ We may know P, F, and n and want to find i
F
F  P(1  i) n   (1  i) n 
P
1n 1n
F F F
   n   1 i  i    1
P P P
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Compounding Frequency Considerations

 It is customary to assume that the stated

interest rate is for one-year period (annual)
also a nominal interest rate, r

 When the number of compounding periods

per year, m ≠1, the actual or effective interest
rate per compounding period, ieff, is given by
r
ieff  ia, annual effective
iq, quarterly effective
m im, monthly effective
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Rounding
 The answer should be rounded off; the
answer can only be as accurate as the
input information on which it is based.

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Example 4-4 Single Payment Compound

Interest Formulas
$500 were deposited in a saving account (pays 6%,
compounded quarterly) for 3 years. How much
accumulates in the account at the end of the 3
years?

31

Example 4-4 Single Payment Compound

Interest Formulas
$500 were deposited in a saving account (pays 6%,
compounded quarterly) for 3 years. How much
accumulates in the account at the end of the 3 years?

iq = 6%/4 = 1.5%
F=?
n = 3 x 4 = 12 quarters
F = P(1+i)n = P(F/P, i%, n)
0 1 2 11 12 = 500(1+0.015)12
iq=1.5% = 500(F/P,1.5%,12)
P=500 = 500(1.196) = $598.00

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Example 4-5 Single Payment Compound

Interest Formulas

Year Cash Flow • Solve for P.

0 +P
1 0 • Solve for the present amount
2 0 that is equivalent to 2 future
3 -400 payments shown.
4 0
• What present amount you can
5 -600
borrow today that you pay in 2
future payments as shown
P=?

0 1 2 3 4 5
i=12%
400 600
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Example 4-5 Single Payment Compound

Interest Formulas
Solve for P
Year Cash Flow
0 +P
P = 400(P/F,12%,3) +
1 0 600(P/F,12%,5)
2 0 = 400(0.7118) +
3 -400 600(0.5674)
4 0 = 625.16
5 -600

P=?

0 1 2 3 4 5
i=12% 400 600
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Uniform Series Compound Interest Formulas

Uniform (equal) series of receipts or payments; future
costs or benefits estimated to be the same or uniform for
each period of time
Examples:
• Automobile loans, mortgage payments, insurance
premium, rents, and other periodic payments

Notation:
A = an end-of-period cash flow in a uniform series, (Annuity),
starting at period 1 and continuing for n periods
A A A A

0 1 2 n-1 n
i%
35

Uniform Series Compound Interest Formulas

A A A A

0 1 2 n-1 n
i%

1) Uniform Series Compound Amount Formula

F
 (1  i)  1 
n
F  A   A( F A , i %, n)
 i 
2) Uniform Series Sinking Fund formula
 i 
A  F   F ( A F , i %, n)
 (1  i) n
 1  36

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Example 4-6 Uniform Series

Compound Interest Formulas

Jim wants to save money at the end of each

month to pay for some equipment of $1000
at the end of the year. If bank pays 6%
interest, compounded monthly, how much
Jim has to deposit every month?

37

Example 4-6 Uniform Series

Compound Interest Formulas
Jim wants to save money at the end of each month to pay
for some equipment of $1000 at the end of the year. If
bank pays 6% interest, compounded monthly, how much Jim
has to deposit every month?
1000
0 1 2 3 4 5 9 10 11 12

A A A A A A A A A=?
imo  6% 12  0.5%
Same basis
• What if start at end
of period 2?
A  F ( A F , i %, n)  1000( A / F ,0.5%,12) • What if missing one/
 1000(0.0811)  $81.10 more payment? He
cannot pay in June38

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Example 4-6 What if missing one/ more payment?

e.g., He cannot pay in June

1000
0 1 2 3 4 5 6 7 8 9 10 11 12

A A A A A A A A A A A=?

imo  6% 12  0.5%

 A(F/A, 0.5%, 12)-A(F/P,0.5%,6)=1000

 or,
 A(F/A,0.5%, 5)(F/P,0.5%,7)+A(F/A,0.5%,6)=1000

39

Uniform Series Compound Interest Formulas

P

0 1 2 n-1 n

A A i% A A
3) Uniform Series Capital Recovery Formula
 i (1  i ) n 
A  P   P ( A P , i %, n)
 (1  i) n
 1 

4) Uniform Series Present Worth Formula

 (1  i) n  1 
P  A n 
 A( P A , i %, n)
 i (1  i )  40

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Example 4-7 Uniform Series

Compound Interest Formulas

Should you spend $6800 to buy a contract

that pays $140 at the end of each month
for 5 years if you otherwise can make 1%
per month on your money?

NOTE: 1% per month  compounding period: month

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Example 4-7: Solution #1

Should you spend $6800 to buy a contract that pays $140 at
the end of each month for 5 years if the desired return is
1% per month? A=140

n=60 i=1%

P=?
P  A( P A , i %, n)
 140( P A ,1%,60)  140(44.955)  $6293.70

The contract is only worth $6293.70, so reject the offer.

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Example 4-7: Solution #2

A=?

n=60 i=1%

P=6800

A  P ( A P , i, n)
 6800( A P ,1%, 60)  6800(0.0222)  $150.96
The $6800 investment would generate $150.96
monthly at 1% per month, so reject the offer.

43

Example 4-7: Solution #3

A=140

n=60 i=?
P=6800
6800  140( P A , i %, 60) ( P A , i %, 60)  48.571

Solve for i,
Exact solution
From the compound interest tables,
(P/A, i%, 60) = 51.726 when i = 0.5%
(P/A, i%, 60) = 48.174 when i = 0.75%
By linear interpolation, rate of return would be 0.72% <1%,
so reject the offer 44

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Example 4-8 Uniform Series

Compound Interest Formulas
What amount, P, needs to be deposited in a saving
account that pays 15% interest, to support 3 later
withdraws?

Year Cash Flow 30

20 20
0 -P
1 0 0 1 2 3 4
2 +20
3 +30 i=15%
4 +20 P=?

45

Example 4-8: Solution #1

30 30
20 20 20 20

0 1 2 3 4= 0 1 2 3 4+ 0 1 2 3 4 +0 1 2 3 4
P1 P2 P3

P  P1  P2  P3
 20(P F,15%,2)  30(P F,15%,3)  20(P F,15%,4)
 20(0.7561)  30(0.6575)  20(0.5718)
 $46.28
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Example 4-8: Solution #2

30 F2
2030 20
F F1 20F
20 3

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4 + 0 1 2 3 4

F  F1  F2  F3  20(F P,15%,2)  30(F P,15%,1)  20

 20(1.322)  30(1.150)  20  $80.94

203020 F
P  F(P F,15%,4)
0 1 2 3 4 = 0 1 2 3 4
 80.94(0.57 18)
P P  $46.28

47

Example 4-8: Solution #3

Deferred annuity: starting after period 1
30 30
20 20 20 20 202020 10
0 1 2 3 4 1 2 3 4 = 1 2 3 4 + 1 2 3 4

P12
P P1 P1 P11

P  P1(P F,15%,1)
 20(P A,15%,3)  10(P F,15%,2)(P F,15%,1)
 20(2.283)  10(0.7561)(0.8696)
 $46.28
Deferred annuities are uniform series that do not begin until some time in the future
48

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Example 4-9: Analyzing a Loan

Maria has a 30-year monthly payment mortgage of

$100,000 at 7.5% compounded monthly. She just
made her 12th payment. What is her remaining
balance after this 12th payment

49

Example 4-9: Analyzing a Loan

A

0 1 2 3 12 360

P=100000
Balance Due?
Monthly Payment
A  100000(A/P,0.625%,360)  $699.21

Balance at the end of 12 months == 348 months remaining

Balance348  699.21(P/A, 0.625%, 348)  $99,077.53
Or,
Balance = 100,000(F/P, 0.625%,12)-699.21(F/A,0.625%,12)
=100,000 (1.0776) – 699.21(12.4212)=$99074.97
NOTE: she paid (699.21x12), but her balance decreased by
50
925.03, she was mainly paying interest !

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Relationships Between Compound

Interest Factors
Single Payment
Uniform Series
1
(F/P, i%, n) 
(P/F, i%, n) n
(P/A, i%, n)   (P/F, i%, t)
Uniform Series t 1

n 1

 (F/P, i%, t)
1
(A/P, i%, n)  (F/A, i%, n)  1 
(P/A, i%, n) t 1

(F/A, i%, n) 
1 (A/P, i%, n)  (A/F, i%, n)  i
(A/F, i%, n)
(F/A, i%, n)  (P/A, i%, n)(F/P, i%, n)
51

Interest Tables Interpolation

Factor values can be obtained in one of three ways:
1.Using the formulas
2.Interpolating between the tabulated values on both
sides of the unlisted desired value
3.Using a software which has the economy factors
programmed into it

 linear interpolation is
acceptable and is considered
sufficient as long as the
values of i or n are not too
distant from each other.
52

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Problems involving unknown n or i

 It is more challenging to solve for n or i, for
instance:
◦ We may know P, A, and i and want to find n
◦ We may know P, A, and n and want to find i

 These problems present special challenges

that are best handled on a spreadsheet.

53

Example 4-10: Finding n

ACM company borrowed $100,000 from a local bank,
which charges them an interest rate of 7% per year. If
ACM pays the bank $8,000 per year, how many years will
it take to pay off the loan?
P  A(P/A, i%, n )  $100,000  $8000(P/A, 7%, n)

So, (P/A, 7%, n )  $100,000 / $8000  12.5 

1.07 n  1
0.07(1.07) n
This can be solved by using the interest tables and
interpolation: n = 30.74 years
Year, n (P/A, 7%,n)
30 12.409
n 12.5
31 12.532
54

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Example 4-10: Finding n

P  A(P/A, i%, n )  $100,000  $8000(P/A, 7%, n)
By interpolation: n = 30.74 years, so actually, the loan
will be paid by 31 years, however, the 31st payment will
be less than 8000.
Find the value of that payment (call it A31)

8000(P/A,7%,30)+A31(P/F,7%,31)=100,000

Solve for A31

55

Example 4-11: Finding i

Jill invested $1,000 each year for five years in a local
company and sold her investment after five years for
$8,000. What annual rate of return did Jill earn?

F  A(F/A, i%, n )  $8,000  $1,000(F/A, i %, 5)

So, (F/A, i%, 5)  $8,000 / $1,000  8 

1  i 5  1
i
Again, this can be solved using the interest tables and
interpolation: i = 23.65%
i% (F/A, i%, 5)
20% 7.442
i% 8.000
25% 8.207
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More complicated cases

 Find i%

1000(F/A,i%,5)+500(F/A,i%,2)(F/P,i%,3)=8000

i% (F/A, i%, 5) (F/A,i%,2) (F/P,i%,3) F

There are specific spreadsheet functions to

find n and i.

One Excel function used to solve for n is

NPER (rate, pmt, pv, fv), which will compute the
number of payments of magnitude pmt required to pay
off a present amount (pv) [or future value (fv)] at a
fixed interest rate (rate).

One Excel function used to solve for i is

RATE (nper, pmt, pv, fv), which returns a fixed interest
rate for an annuity of pmt that lasts for nper periods to
either its present value (pv) or future value (fv).

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A Uniformly Increasing Series

Arithmetic Gradient Series G is the change
from period to
period
A+4G
A+3G
A+2G 4G
A+G 2G
3G
A A A A A A G
0
0 1 2 3 4 5 = 0 1 2 3 4 5 + 0 1 2 3 4 5

Uniform Arithmetic
Series Gradient
Series

Examples: P  A( P A,i,n)  G( P G,i,n)

• Operating and maintenance costs
• Salary packages
59

Arithmetic Gradient
The arithmetic gradient is a series of increasing cash flows,
where the period-by-period change in cash flows is a
constant amount, G

Notation:
G = a fixed amount increment or decrement per time
period
End of Cash
Period Flows
(n-1)G
(n-2)G 1 0
2G
2 G
G
0
3 2G
0 1 2 3 n-1 n : :
i% n (n-1)G
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Arithmetic Gradient
Compound Interest Formulas
Arithmetic Gradient Present Worth Formula
 (1  i ) n  i  n  1 
P  G   G ( P G , i %, n)
 i 2
(1  i) n


Arithmetic Gradient Uniform Series Formula

 (1  i) n  i  n  1 
A  G 
 i (1  i )  i 
n

1 n 
 G    G ( A G , i %, n)
 i (1  i ) n
 1 
61

Example 4-12 Application of Arithmetic

Gradient Interest Factors

Revenues from a new product will decline as

competitors enter the market. At an interest rate of 10%,
what is an equivalent uniform series?

Year Cash Flow A

24000
1 24000 18000
12000
2 18000 6000
3 12000
0 1 2 3 4 0 1 2 3 4
4 6000
i=10%
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Example 4-12 Application of Arithmetic

Gradient Interest Factors
24000 A=24000
18000
12000
6000

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4

6000
12000
Year Cash Flow 18000

1 24000
2 18000
A  24000  6000( A G,10%,4)
3 12000  24000  6000(1.381)
4 6000  $15,714
63

Example 4-13 Application of Arithmetic

Gradient Interest Factors
 A car warranty is 3 years. Upon expiration, annual
maintenance starts at $150 and then climbs $25 per year
until the car is sold at the end of year 7. Use a 10%
interest rate and find the present worth of these expense.

Year Cash Flow 0 1 2 3 4 5 6 7

4 150
5 175 150 175
200 225
6 200
P
7 225
i=10%

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Example 4-13 Application of Arithmetic

Gradient Interest Factors

0 1 2 3 4 5 6 7 = 0 1 2 3 4 5 6 7 + 0 1 2 3 4 5 6 7

25 50
75
150 175
200 225 A=150

P P3

P3  150(P A,10%,4)  25(P G,10%,4)

Year Cash Flow
 150(3.170)  25(4.378)
4 150
5 175  $584.95
6 200 P0  P3 (P F,10%,3)  584.95(0.7513)
7 225
 $439.47
65

Geometric Gradient
The geometric gradient is a series of increasing or
decreasing cash flows, where the period-by-period
change in cash flows is a uniform rate or
percentage, g.
Notation:
g = a constant rate (+ or -) per period, that is, the
geometric gradient
A1 = cash flow at period 1
A1(1+g)n-1
A1(1+g)n-2 g% of An-1
A1(1+g)2
A1 A1(1+g)
g% of A1

0 1 2 3 n-1 n
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Geometric Gradient
Compound Interest Formulas

Geometric Gradient Present Worth Formula

1  (1  g ) n (1  i )  n 
P  A1    A1 (P/A, g , i, n) where i  g
 i  g 

n  A1
P  A1 (P/A, g , i, n) where i  g
(1  i )

67

Example 4-14 Application of Geometric

Gradient Interest Factors

Using 8% interest rate, calculate the Present Worth

of maintenance cost of the first 5 years where the
first year’s cost is estimated at $100, and it
increases at a constant rate of 10% per year.

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Example 4-14 Application of Geometric

Gradient Interest Factors
Using 8% interest rate, calculate the Present Worth of maintenance
cost of the first 5 years where the first year’s cost is estimated at $100,
and it increases at a constant rate of 10% per year.

0 1 2 3 4 5

100(1+0.1)4
100

g=10%

P i=8%

1  (1  g ) n (1  i ) n 
P  A1  
 ig 
1  (1  10%) 5 (1  8%) 5 
 100    $480.42
 8%  10% 
69

Interest Rates that Vary with Time

 Interest rates often change with time (e.g., a
variable rate mortgage).
 We often must resort to moving cash flows
one period at a time, reflecting the interest
rate for that single period.
◦ The present equivalent of a cash flow occurring at
the end of period n can be computed with the
equation below, where ik is the interest rate for
the kth period.
Fn
P

n
(1  ik )1
k 1

If F3 = $2,500 and i1=8%, i2=10%, and i3=11%, then

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Nominal and Effective Interest Rates

Often, the time between successive compounding, or the
interest period, is less than one year (e.g., daily,
monthly, quarterly).
Notation:
r = Nominal interest rate per year without considering
the effect of any compounding
Annual Percentage Rate (APR)
ieff = Effective interest rate per compounding period
ia = Effective annual interest rate taking into account the
effect of compounding
Annual Percentage Yield (APY)
m = Number of compounding periods per year
r r m
i eff  i a  (1  )  1  (1  ieff ) m  1
m m
71

Nominal and Effective Interest

Nominal

Effective Annual Rate when compounded

Rate

Semi-
Yearly annually Quarterly Monthly Daily Continuously
1% 1% 1.0025% 1.0038% 1.0046% 1.0050% 1.0050%
2% 2% 2.0100% 2.0151% 2.0184% 2.0201% 2.0201%
3% 3% 3.0225% 3.0339% 3.0416% 3.0453% 3.0455%
4% 4% 4.0400% 4.0604% 4.0742% 4.0808% 4.0811%
5% 5% 5.0625% 5.0945% 5.1162% 5.1267% 5.1271%
6% 6% 6.0900% 6.1364% 6.1678% 6.1831% 6.1837%
8% 8% 8.1600% 8.2432% 8.3000% 8.3278% 8.3287%
10% 10% 10.2500% 10.3813% 10.4713% 10.5156% 10.5171%
15% 15% 15.5625% 15.8650% 16.0755% 16.1798% 16.1834%
25% 25% 26.5625% 27.4429% 28.0732% 28.3916% 28.4025%

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Nominal and Effective Interest Rates

Often, the time between successive cash flows is a multiple c
of the compounding, or the interest period, and less
than one year (e.g., daily, monthly, quarterly).
Notation:
r = Nominal interest rate per year without considering
the effect of any compounding
ieff = Effective interest rate per compounding period
ip = Effective interest rate taking in the period of study
taking into account the effect of compounding
m = Number of compounding periods per year
c = Number of compounding periods per period
of study

r r c
i eff  i p  (1  )  1  (1  ieff ) c  1
m m
73

Example 4-15: Finding effective interest

rates.
For an 18% nominal rate, compounded quarterly,
the effective annual interest is.

For a 7% nominal rate, compounded monthly, the

effective annual interest is.

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Example 4-16 Application of Nominal and

Effective Interest Rates
“If I give you $50 on Monday, you owe me $60 on
the following Monday.”
a) Effective weekly interest rate =
Nominal annual rate =
b) Effective annual rate

c) If you took the $50 for 1 year, how much do you

owe me at the end of the year?

75

Example 4-16 Application of Nominal and

Effective Interest Rates
“If I give you $50 on Monday, you owe me $60 on
the following Monday.”
a) Effective weekly interest rate = ($60-50)/50 = 20%;
F=P(1+ieff)1
Nominal annual rate = 20% * 52 weeks = 1040%
b) Effective annual rate
r m
i a  (1  )  1  (1  20%) 52  1  1310363%
m
c) End-of-the-year balance
F  P(1  i eff ) n  50(1  20%) 52  $655,231.5
F  P(1  i a ) n  50(1  1310363%)1  $655,231.5
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Example
What is the future equivalent of quarterly
payments made for 3 years? If the nominal
interest rate is 10% compounded monthly.

Continuous Compounding

 Interest is typically compounded at the end of

discrete periods.
 In most companies cash is always flowing, and
should be immediately put to use.
 We can allow compounding to occur
continuously throughout the period.
 The effect of this compared to discrete
compounding is small in most cases.

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Continuous Compounding
Interest Formulas
For Continuous Compounding, the duration of the compounding
period decreases to an infinitely small duration, m 
r m
lim (1  )  lim(1  x) r / x  e r Substituting in the
m  m x 0
compound interest
(1+i a )  e r thus i a  e r  1 formulae ….

Single Payment Compound Amount

F  PF/P, r, n  P(ern )
Single Payment Present Worth
P  FP/F, r, n  F(e rn )
79

Continuous Compounding
Interest Formulas

Continuous Compounding Sinking Fund

 er  1 
A F , r, n   r n 
 e  1
Continuous Compounding Capital Recovery

 er n (er  1) 
A P , r, n   r n 
 e 1 

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Continuous Compounding
Interest Formulas

Continuous Compounding Uniform Series

Compound Amount

 er n  1
F A , r, n   r 
 e 1
Continuous Compounding Uniform Series Present
Worth
 er n  1 
P A , r, n   r n r 
 e (e  1) 
81

Example 4-17: Application of Continuous

Compounding
How long will it take for money to double at 10%
nominal interest, compounding continuously?

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Example 4-17: Application of Continuous

Compounding
How long will it take for money to double at 10%
nominal interest, compounding continuously?
F
F  P (e r n )   e ( 0.10)( n )  2
P
(0.10)n  ln 2  0.693
n  6.93 years
Or
i a  e r  1  10.5171%
F
F  P(1  i a ) n   (1.105171) n  2
P
n  6.93
83

Example 4-18: Application of Continuous

Compounding
$500 were deposited in a credit union (pays 5%
compounded continuously) at the end of each year
for 5 years, how much do you have after the 5th
deposit?

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Example 4-18: Application of Continuous

Compounding
$500 were deposited in a credit union (pays 5%
compounded continuously) at the end of each year
for 5 years, how much do you have after the 5th
deposit?
 er n  1  e(0.05)5  1
F  AF A , r, n  A  r   500  (0.05)   $2769.84
 e  1   e  1 
Or
i a  e r  1  5.1271%
F  500(F/A, 5.1271%, 5)  500(5.5397)  2769.84

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