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Chapter 3: 
Interest and Equivalence

BSEN 206. Engineering Economy



Jeffrey C. Woldstad, Ph.D., P.E.

University of Nebraska

Time Value of Money

- The most important concept in this class is that the value

of money changes over time and that you must take

time into account when comparing economic alternatives.

- Would you rather have $1000 today or $1000 ten years

from now?

- Money must be thought of as an asset.

If you have money,

other people are willing to pay for the use (or rent) of it.
If you do not have any money, you must be will to pay for
the use of other peoples money.

- The amount paid for the use of money is called interest.

- The interest required to borrow money depends on both
the market value and how likely other people judge you
are to return the money you borrowed.

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Simple Interest

- Simple interest is interest that is computed only

on the original sum, not on accrued interest.

- For a loan of P (present amount) at a simple

annual interest rate of i (expressed as a decimal)

borrowed for n years, the amount of interest
owed would be:

Total interest earned = P * i * n

- At the end of n years, the total amount that would

need to be returned F (future amount) would be

F = P + (P * i * n) = P * (1 +(i*n))

3

Problem 1

If we borrowed $10,000 (to pay to attend school) at
8% simple annual interest for 10 years, how much
would we need to pay back at the end on this
period?

(A) $10,000

(B) $14,000

(C) $18,000

(D) $22,000

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Problem 2

If we borrowed $20,000 (to buy a car) at 6%
simple annual interest for 4 years, how much
would we need to pay back at the end on this
period?

(A) $20,000

(B) $24,200

(C) $24,800

(D) $28,400

5

Problem 3

If we borrowed $200,000 (to buy a house) at 4%
simple annual interest for 30 years, how much
would we need to pay back at the end on this
period?

(A) $200,000

(B) $240,000

(C) $320,000

(D) $440,000

6

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Compound Interest

- Most people who lend money think about

both the interest to be paid and the
repayment of the loan in specific time
intervals notice that even for simple
interest, the rate is specified as an annual
rate.

- If we associate loan interest and repayment

with a particular interval, then if makes
sense to calculate the interest owed at the
end of each period.

7

EXAMPLE

- $10,000 borrowed for 10 years at an annual

interest rate of 8%

YEAR+

PRINCIPLE (P)

INEREST OWED

AMOUNT DUE

$10,000

$10,000*0.08*1= $800

$10,800

$10,800

$10,800*0.08*1= $864

$11,664

$11,664

$11,664*0.08*1= $933

$12,597

$12,597

$12,597*0.08*1= $1008

$13,605

$13,605

$13,605*0.08*1= $1088

$14,693

$14,693

$14,693*0.08*1= $1175

$15,869

$15,869

$15,869*0.08*1= $1269

$17,138

$17,138

$17,138*0.08*1= $1371

$18,509

$18,509

$18,509*0.08*1= $1481

$19,990

10

$19,990

$19,990*0.08*1= $1599

$21,589

Compared to a simple interest loan - $10,000*(1+(0.08*10)) = $18,000

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Compound Interest

- Requiring interest to be paid on the interest
accrued is call compounding interest.

- Calculating the amount due for a loan based on a

compounded interest rate, requires that the
compounding period be known.

- In practice, almost all loans are based on a

compounded interest rate when making

calculations you should assume a compounded
rate unless it is clearly specified as being a simple
interest rate.

9

Repayment EXAMPLE

Loan of $5000 for 5 yrs at interest rate of 8%

Year
1
2
3
4
5

Balance at the
Beginning of the
year
$5,000.00
$5,400.00
$5,832.00
$6,298.56
$6,802.44

Interest
$400.00
$432.00
$466.56
$503.88
$544.20

Balance at the
end of the year
$5,400.00
$5,832.00
$6,298.56
$6,802.44
$7,346.64

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EXAMPLE: Repay of a loan of $5000 in 5 yrs at

interest rate of 8%


Plan #1: Constant principal payment plus interest due

Yr

Balance at
the
Beginning
of year

1
2

Interest

Balance at
the end of
year

Interest
Payment

Principal
Payment

Total
Payment

$5,000.00

$400.00

$5,400.00

$400.00

$1,000.00

$1,400.00

$4,000.00

$320.00

$4,320.00

$320.00

$1,000.00

$1,320.00

$3,000.00

$240.00

$3,240.00

$240.00

$1,000.00

$1,240.00

4
5

$2,000.00
$1,000.00

$160.00
$80.00

$2,160.00
$1,080.00

$160.00
$80.00

$1,000.00
$1,000.00

$1,160.00
$1,080.00

$1,200.00

$5,000.00

$6,200.00

Subtotal

11

EXAMPLE: Repay of a loan of $5000 in 5 yrs at

interest rate of 8%


Plan #2: Annual interest payment and principal payment at end of 5 yrs

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

Interest
Payment

Principal
Payment

Total
Payment

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$0.00

$400.00

$5,000.00

$400.00

$5,400.00

$400.00

$5,000.00

$5,400.00

$2,000.00

$5,000.00

$7,000.00

Subtotal

12

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EXAMPLE: Repay of a loan of $5000 in 5 yrs at

interest rate of 8%


Plan #3: Constant annual payments

Yr

Balance at
the
Beginning
of year

Interest

Balance at
the end of
year

Interest
Payment

Principal
Payment

Total
Payment

$5,000.00

$400.00

$5,400.00

$400.00

$852.28

$1,252.28

$4,147.72

$331.82

$4,479.54

$331.82

$920.46

$1,252.28

$3,227.25

$258.18

$3,485.43

$258.18

$994.10

$1,252.28

$2,233.15

$178.65

$2,411.80

$178.65

$1,073.63

$1,252.28

$1,159.52

$92.76

$1,252.28

$92.76

$1,159.52

$1,252.28

$1,261.41

$5,000.00

$6,261.41

Subtotal

13

EXAMPLE: Repay of a loan of $5000 in 5 yrs at

interest rate of 8%


Plan #4: All payment at end of 5 years

Yr
1

Balance at
the
Beginning
of year

Interest
$5,000.00
$400.00

Balance at
the end of
year

Interest
Payment

Principal
Payment

Total
Payment

$5,400.00

$0.00

$0.00

$0.00

$5,400.00

$432.00

$5,832.00

$0.00

$0.00

$0.00

$5,832.00

$466.56

$6,298.56

$0.00

$0.00

$0.00

$6,298.56

$503.88

$6,802.44

$0.00

$0.00

$0.00

$6,802.44

$544.20

$7,346.64

$2,346.64

$5,000.00

$7,346.64

$2,346.64

$5,000.00

$7,346.64

Subtotal

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Equivalence

- Note that if you believe an 8% annual interest rate
is correct, you would not care which of these
plans was used to repay the loan.

- 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 is dependent on interest rate

15

Single Payment Compound Interest Formula

Year

Amount at the
Beginning of
+ Interest for
Period

Interest Period

= Amount at End of Interest

Period

1
2

P
P(1+i)

+ iP
+ i P(1+i)

= P+ iP = P(1+i)
= P(1+i) + i P(1+i) = P(1+i)(1+i)
= P(1+i)2

P(1+i) 2

+ i P(1+i)2

= P(1+i)2 + i P(1+i)2 = P(1+i)2(1+i)

= P(1+i)3

P(1+i)n-1

+ i P(1+i)n-1

= P(1+i)n-1 + i P(1+i)n-1 = P(1+i)n-1(1+i)

= P(1+i)n

16

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Single Payment Compound Interest Formula

Notation:


i = interest rate per compounding period


n = number of compounding periods


P = a present sum of money


F = a future sum of money

Single Payment Compound Amount Formula

F = P(1+ i)n

F = P(F/P, i, n)
Find F, given P, at i, over n

17

Compound Interest Table 6.0%

18

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Problems 4 & 5

$500 (P) is deposited in a saving account that pays 6%
compounded annually for 3 years what is the future
amount F?

F=?

2
i=6%

(A) $590

(B) $595

(C) $600

(D) $610

P=500

Is this the same as if we borrowed $500 for 3 years at 6%

interest? (A) YES; (B) NO

19

Problem 6

You wish to have $800 (F) at the end of 4 years, how much
should be deposited (P) in an account that pays 4% annually?

(A) $684

(B) $712

(C) $756

(D) $800

F=800

i=4%

P=?

20

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Single Payment Present Worth Formula

Notation:


i = interest rate per compounding period


n = number of compounding periods


P = a present sum of money


F = a future sum of money

Single Payment Present Worth Formula

P = F(1+ i)n

P = F(P/F, i, n)
Find F, given P, at i, over n

21

Compound Interest Table 4.0%

22

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Problem 7

$500 (P) is deposited in a saving account that pays
6%, compounded quarterly for 3 years, what is the
future amount F?

(A) $598

(B) $604

(C) $610

(D) $648

i = 6%/4 = 1.5%
n = 3 x 4 = 12 quarters
F = P(1+i)n = P(F/P, i, n)
= 500(1+0.015)12 = 500(F/P,1.5%,12)

F=?

= 500(1.196) = $598.00
1

11

12

i=1.5%
P=500
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Nominal and Effective Interest Rate

- Because compounding charges interest on the

interest, it should be clear that the more

compounding periods used, the more interest that
can be collected.

- Consider $1000 borrowed for 1 years at a 6%

nominal annual interest.

Number of
compounding periods

Amount owed after

10 years

Effective interest rate

1 (annually)

F= (1000)(1+0.06)1 = $1060.00

6.000 %

4 (quarterly)

F= (1000)(1+0.015)4 = $1061.36

6.136 %

12 (monthly)

F= (1000)(1+0.005)12 = $1061.67

6.167%

24 (bi-monthy)

F= (1000)(1+0.0025)24 = $1061.75

6.175 %

365 (daily)

F= (1000)(1+0.00016)365 = $1061.83

6.183 %

24

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Nominal and Effective Interest Rate

- The Nominal Interest Rate per year (r) is

the annual interest rate without considering
compounding this is also called the Annual
Percentage Rate (APR).

- The Effective Interest Rate per year (i ) is

a

the annual interest rate considering compounding.

It increases as the number of compounding
periods m increases.

m

! r$
ia = #1+ & 1
" m%
25

Problem 8

You borrow money for a car at a nominal (APR) interest
rate of 8%. This interest in compounded monthly what
is the effective interest rate.

(A) 8.0%

(B) 8.3%

(C) 8.4%

(D) 8.8%

m

12

! r$
! 0.08 $
ia = #1+ & 1 = #1+
& 1 = 0.0830 = 8.3%
" m%
"
12 %
26

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EXAMPLE

If I give you $50 today, you owe me $60 on the a week
from today.

a) Weekly interest rate = ($60-50)/50 = 20%


Nominal annual rate = 20% * 52 = 1040%

b) Effective annual rate

ia = (1 + i)m 1 = (1 + 20%)52 1 = 1310400 %

c) End-of-the-year balance

F = P(1 + i)n = 50(1 + 20%)52 = $655,200

27

Continuous Compounding

- Notice that as the number of compounding periods

increases, the effective interest rate increases, but at

a slower and slower rate.

- By using calculus you can show that as the number of

periods goes to infinity, the effective annual interest
rate converges to:

ia = er 1

- The single payment compound amount formula for n

years at a nominal annual interest rate r then is:

F = P ( e rn ) = P[F / P, r, n]
28

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Continuous Compounding

Nominal
Rate

Effective Annual Rate when compounded

Yearly

Semiannually

Quarterly

Monthly

Daily

Continuously

1%
2%

1%
2%

1.0025%
2.0100%

1.0038%
2.0151%

1.0046%
2.0184%

1.0050%
2.0201%

1.0050%
2.0201%

3%

3%

3.0225%

3.0339%

3.0416%

3.0453%

3.0455%

4%
5%

4%
5%

4.0400%
5.0625%

4.0604%
5.0945%

4.0742%
5.1162%

4.0808%
5.1267%

4.0811%
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%

29

Problems 9-11 (3.6 &3.10)

3-6. How long will it take for an
investment to double at 4% simple
interest per year?

3-10. How long will it take for an
investment to double at 4%
compounded annually?

(A) 15.0 years

(B) 17.3 years

(C) 17.7 years

(D) 25.0 years

How long will it take for an investment

to double at 4% compounded
continuously?

30

15

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Compound Interest Table 4.0%

31

Problem 12 (3-27)

3-27. In 1995 an anonymous private collector
purchased a painting by Picasso entitled Angel Frenandez
de Soto for $29,152,000. The painting was done in 1903
and was valued then at 
$600. If the painting was 
(A) 8.3%

owned by the same family
(B) 12.4%

until its sale in 1995, what 
(C) 22.2%

rate of return did they 
(D) 110%

receive on the $600 
investment.

F=P*(1+i)^(n) => 29152000 = 600*(1+i)^92 => 48586.67 = (1+i)^92 => LOG(48586.67) =
92*LOG(1+i) => LOG(1+i) = 0.05094 => 1+i = 10^0.05094 = 1.124 => i = 12.4%

32

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EXAMPLE

- 3-32. Sally is buying a car that costs $12,000.

She
will pay $2000 immediately and the remaining
$10,000 in four annual end-of-year principle
payments of $2500 each. In addition to the
$2500, she must pay 15% interest on the unpaid
balance of the loan each year. Prepare a cash flow
diagram to represent this situation.

$12,000

TOTAL PAYMENTS - $15,750

i=15%

0

$2000

$1500

$2500

$4000

$1125

$2500

$3625

$750

$2500

$3250

$375

$2500

$2875

33

Problem 13 (3-61)

3-61. A friend was left $50,000 by his uncle. He has
decided to put it into a savings account for the next
year or so. He finds there are various interest rates at
savings institutions:

(A) 4.375% compounded annually, 
(B) 4.25% compounded quarterly, and 
(C) 4.125% compounded continuously.

Which interest rate should he choose to get the highest
return?

Case 1 4.375% compounded annually is the nominal rate

Case 2 4.25% compounded quarterly - Ia = (1+(r/m))^m -1 = (1+(0.0425/4))^4 -1 =
(1.010625)^4 1 = 1.043182 -1 = 0.043182 = 4.318%

Case 3 4.125% compounded continuously - Ia = e^r -1 = e^(0.04125) 1 = 1.0142113 1 =
0.042113 = 4.211%

34

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