CEECONO Lecture 5

Lecture 5
INTEREST AND MONEY-TIME RELATIONSHIPS

SIMPLE INTEREST & COMPOUND INTEREST
Simple Interest
• When simple interest is applicable, the total interest,

I, earned or paid may be computed using the formula
above
Example:
If $1,000 were loaned for three years at a simple interest rate
of 10% per year, the interest earned would be
Simple Interest
• Example continued…
• The total amount owed at the end of three years would be:
Compound Interest
• Whenever the interest charge for any interest period (a year, for
example) is based on the remaining principal amount plus any
accumulated interest charges up to the beginning of that period, the
interest is said to be compound.
Compound Interest
• The effect of compounding of interest can be seen in the following table for
$1,000 loaned for three periods at an interest rate of 10% compounded
each period:
• The difference with simple and compound interest is due to the effect of
compounding, which is essentially the calculation of interest on previously
earned interest.
Simple vs Compound Interest
Compound Interest
• This difference would be much greater for larger amounts of money,
higher interest rates, or greater numbers of interest periods.
• Compound interest is much more common in practice than simple
interest.
The Concept of Equivalence
• Alternatives should be compared when they produce similar results,
serve the same purpose, or accomplish the same function.
• How can alternatives for providing the same service or accomplishing
the same function be compared when interest is involved over
extended periods of time?
• We should consider the comparison of alternative options, or
proposals, by reducing them to an equivalent basis that is dependent
on:
• interest rate
• the amount of money involved
• the timing of the monetary receipts or expenses.
Example
• Suppose you have a $17,000 balance on your credit card and tell
yourself that it has got to stop. So you decide to repay the $17,000
debt in four months. An unpaid credit card balance at the beginning
of a month will be charged interest at the rate of 1% by your credit
card company. For this situation, we have selected three plans to
repay the $17,000 principal plus interest owed.
Example
Notation and Cash-Flow Diagrams
• The following notation is utilized in formulas for compound interest
calculations:
Some Notes
• Cash ﬂows are important in engineering economy because they form
the basis for evaluating alternatives.
• The usefulness of a cash-ﬂow diagram for economic analysis
problems is analogous to that of the free-body diagram for mechanics
problems.
Cash Flow Diagrams
1. The horizontal line is a time scale, with progression of time moving from left to
right.
2. The arrows signify cash flows and are placed at the end of the period.
Downward arrows represent expenses, and upward arrows represent receipts.
3. The cash-flow diagram is dependent on the point of view. (credit card company
vs borrower)
Cash Flow Diagramming
• An investment of $10,000 can be made by a corporation which is expected to produce
uniform annual revenue of $5,310 for five years and then have a market (recovery) value
of $2,000 at the end of year (EOY) five. Annual expenses will be $3,000 at the end of
each year for operating and maintaining the project. Draw a cash-flow diagram for the
five-year life of the project. Use the corporation’s viewpoint.
Cash Flow Diagramming
• An investment of $10,000 can be made by a corporation which is expected to produce
uniform annual revenue of $5,310 for five years and then have a market (recovery) value
of $2,000 at the end of year (EOY) five. Annual expenses will be $3,000 at the end of
each year for operating and maintaining the project. Draw a cash-flow diagram for the
five-year life of the project. Use the corporation’s viewpoint.
$2,000
$5,310 $5,310 $5,310 $5,310 $5,310
0 1 2 3 4 5
$3,000 $3,000 $3,000 $3,000 $3,000
$10,000
End of Year
Present and Future Worth
• Finding F when Given P
• The quantity (1 + i)N is commonly called the single payment

compound amount factor.
• We shall use the functional symbol (F/P, i %,N) for (1 + i)N.
• Hence,
• where the factor in parentheses is read “find F given P at i %

interest per period for N interest periods.”
• Finding P when Given F
• The quantity (1 + i)−N is called the single payment present worth factor.
• Where (P / F, i %, N) is:
• Finding the Interest Rate Given P, F, and N
• Finding N when Given P, F, and i

• Example 1
Suppose that you borrow $8,000 now, promising to repay the loan
principal plus accumulated interest in four years at i = 10% per year.
How much would you repay at the end of four years?
• Example 1
Suppose that you borrow $8,000 now, promising to repay the loan
principal plus accumulated interest in four years at i = 10% per year.
How much would you repay at the end of four years?
(F/P, 10%, 4) = (1 + 0.10)4

= 1.4641
• Example 2
An investor (owner) has an option to purchase a tract of land that will
be worth $10,000 in six years. If the value of the land increases at 8%
each year, how much should the investor be willing to pay now for this
property?
• Example 2
An investor (owner) has an option to purchase a tract of land that will
be worth $10,000 in six years. If the value of the land increases at 8%
each year, how much should the investor be willing to pay now for this
property?
• Example 3
The average price of gasoline in 2005 was $2.31 per gallon. In 1993, the
average price was $1.07. What was the average annual rate of increase
in the price of gasoline over this 12-year period?
• Example 3
The average price of gasoline in 2005 was $2.31 per gallon. In 1993, the
average price was $1.07. What was the average annual rate of increase
in the price of gasoline over this 12-year period?
With respect to the year 1993, the year 2005 is in the future.
Thus, P = $1.07, F = $2.31, N = 12
• Example 4
In Example 3, the average price of gasoline was given as $2.31 in 2005.
We computed the average annual rate of increase in the price of
gasoline to be 6.62%. If we assume that the price of gasoline will
continue to inflate at this rate, how long will it be before we are paying
$5.00 per gallon?
• Example 4
In Example 3, the average price of gasoline was given as $2.31 in 2005.
We computed the average annual rate of increase in the price of
gasoline to be 6.62%. If we assume that the price of gasoline will
continue to inflate at this rate, how long will it be before we are paying
$5.00 per gallon?
We have P = $2.31, F = $5.00, i = 6.62% per year.
https://www.youtube.com/watch?v=9yj6CtMUsYU&t=48s
Lecture 5
INTEREST AND MONEY-TIME RELATIONSHIPS
SIMPLE INTEREST & COMPOUND INTEREST

CEECONO Lecture 5

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Lecture 5

INTEREST AND MONEY-TIME RELATIONSHIPS

• When simple interest is applicable, the total interest,

$5,310 $5,310 $5,310 $5,310 $5,310

$3,000 $3,000 $3,000 $3,000 $3,000

• The quantity (1 + i)N is commonly called the single payment

• where the factor in parentheses is read “find F given P at i %

• Finding N when Given P, F, and i

(F/P, 10%, 4) = (1 + 0.10)4

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