Engineering Economic Analysis 9th Edition Minggu 2 INTEREST AND EQUIVALENCE (Chapter 3)

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Economic Decision Components

Where economic decisions are immediate we need to consider:
amount of expenditure taxes

Where economic decisions occur over a considerable period of time we also need to consider:
interest inflation

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Computing Cash Flows

Cash flows have:

Costs (disbursements) > a negative number Benefits (receipts) > a positive number Example 3-1
End of Year 0 1 2 Cash flow $ (1,000.00) $ 580.00 $ 580.00

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Time Value of Money Money has value

Money can be leased or rented The payment is called interest If you put $100 in a bank at 9% interest for one time period you will receive back your original $100 plus $9

Original amount to be returned = $100 Interest to be returned = $100 x .09 = $9

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 4

Simple Interest

Interest that is computed only on the original sum or principal Total interest earned = I = P x i x n
Where
P present sum of money i interest rate n number of periods (years)

I = $100 x .09/period x 2 periods = $18

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Future Value of a Loan with Simple Interest Amount of money due at the end of a loan
F = P + P i n or F = P (1 + i n ) Where
F = future value

F = $100 (1 + .09 x 2) = $118 Would you accept payment with simple interest terms? Would a bank?
Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 6

Compound Interest

Interest that is computed on the original unpaid debt and the unpaid interest Total interest earned = In = P (1+i)n - P
Where
P present sum of money i interest rate n number of periods (years)

I2 = $100 x (1+.09)2 - $100 = $18.81

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Future Value of a Loan with Compound Interest Amount of money due at the end of a loan
F = P(1+i)1(1+i)2..(1+i)n or F = P (1 + i)n Where
F = future value

F = $100 (1 + .09)2 = $118.81 Would you be more likely to accept payment with compound interest terms? Would a bank?
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Comparison of Simple and Compound Interest Over Time

If you loaned a friend money for short period of time the difference between simple and compound interest is negligible. If you loaned a friend money for a long period of time the difference between simple and compound interest may amount to a considerable difference.

Simple and compound interest Single payment Principal = Interest = 100.00 9.00%

Short or long? When is the $ difference significant? You pick the time period.

Simple Compound Period amount factor amount factor Find Fs Given P Find F Given P n Fs/P F/P 0 100.000 100.000 1 109.000 109.000 2 118.000 118.810 3 127.000 129.503 4 136.000 141.158 5 145.000 153.862 6 154.000 167.710 7 163.000 182.804 8 172.000 199.256 9 181.000 217.189 10 190.000 236.736 11 199.000 258.043 12 208.000 281.266 13 217.000 306.580 14 226.000 334.173 15 235.000 364.248 16 244.000 397.031 17 253.000 432.763 Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 9 18 262.000 471.712 19 271.000 514.166 20 280.000 560.441

Check the table to see the difference over time.

Four Ways to Repay a Debt

Plan

1 2 3 4

Repay Repay Interest Principal Equal annual Interest on installments unpaid balance End of loan Interest on unpaid balance Equal annual installments End of loan Compound and pay at end of loan

Interest Earned Declines Constant Declines at increasing rate Compounds at increasing rate until end of loan
1 0

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Loan Repayment Four Options

Loan Repayment Option Calculator

This calculator is partially complete. If you complete the calculator you can earn 10 bonus points for your team.

$5,000 Principal 10.00% Interest rate (enter as .1 for 10%) 10 Years Plan 1 Enter 1 through 4 Principal payment Equal annual installments Interest payment EOY on unpaid principal
Amount owed at the beginning of the year Interest owed for that year Total owed at the end of year Total end of year payment

Years

Principal payment

1 2 3 4 5 6 7 8 9 10

5,000 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500

500 450 400 350 300 250 200 150 100 50 2,750 500 500 500 500 500 2,500 500 450 400 350 300 2,000 500 550 605 666 732 3,053

5,500 4,950 4,400 3,850 3,300 2,750 2,200 1,650 1,100 550

500 500 500 500 500 500 500 500 500 500 5,000 0 0 0 0 5,000 5,000 314 345 380 418 459 1,915 -500 -550 -605 -666 7,321 5,000

1,000 950 900 850 800 750 700 650 600 550 7,750 500 500 500 500 5,500 7,500 814 814 814 814 814 4,069 0 0 0 0 8,053 1 8,053

1 2 3 4 5

5,000 5,000 5,000 5,000 5,000

5,500 5,500 5,500 5,500 5,500

1 2 3 4 5

5,000 4,500 4,000 3,500 3,000

5,500 4,950 4,400 3,850 3,300

1 2 3 4 5

5,000 5,500 6,050 6,655 7,321

5,500 6,050 6,655 7,321 8,053

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Equivalence (1)
When an organization is indifferent as to whether it has a present sum of money now or the assurance of some other sum of money (or series of sums of money) in the future, we say that the present sum of money is equivalent to the future sum or series of sums.

Each of the plans on the previous slide is equivalent because each repays $5000 at the same 10% interest rate.
Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 1 2

Equivalence (2)
Example : Four plans for repayment of $5000 in five years at 8% interest : - Plan 1 : At end of each year pay $1000 principle plus interest due.
(1) Year (2) Amount owed at beginning of year 5000 4000 3000 (3) Interest owed for that year (4) Total owed at end of year (5) Principle payment (6) Total end of year payment

[8% x (2)]
1 2 3 400 320 240

[(2) + (3)}
5400 4320 3240 1000 1000 1000 1400 1320 1240

4
5 Total

2000
1000

160
80 1200

2160
1080

1000
1000 5000

1160
1080 6200
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Equivalence (3)
- Plan 2: Pay Interest due at end of each year and principal at end of five years
(1) (2) Amount owed at beginning of year (3) Interest owed for that year [8% x (2)] 1 2 3 4 5 Total 5000 5000 5000 5000 5000 400 400 400 400 400 2000 (4) Total owed at end of year [(2) + (3)} 5400 5400 5400 5400 5400 0 0 0 0 5000 5000 400 400 400 400 5400 7000
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(5) Principl e payment

(6) Total end of year payment

Year

Equivalence (4)
- Plan 3 : Pay in five equal end-of-year payments.
(1) Year (2) (3) (4) (5) (6)

Amount owed at beginning of year

Interest owed for that year

[8% x (2)]

Total owed at end of year

[(2) + (3)}

Principl e payment

Total end of year payment

5000
4148 3227 2233 1159

400
331 258 178 93 1260

5400
4479 3485 2411 1252

852
921 994 1074 1159 5000

1252
1252 1252 1252 1252 6260
15

2
3 4 5 Total

Equivalence (5)
- Plan 4 : Pay interest and principal at the end of periods.
(1) Year (2) (3) (4) (5) (6)

Amount owed at beginning of year

Interest owed for that year

[8% x (2)]

Total owed at end of year

[(2) + (3)}

Principl e payment

Total end of year payment

5000
5400 5832 6299 6803

400
432 467 504 544 2347

5400
5832 6299 6803 7347

0
0 0 0 5000 5000

0
0 0 0 7347 7347
16

2
3 4 5 Total

Equivalence (6)
ratio = total interest paid /total amount owed at the beginning of year.
Plan Total Interest paid Total amount owed at the beginning of year ratio

1 2
3 4

$ 1200 2000
1260 2347

$ 15000 25000
15767 29334

0,08 0,08
0,08 0,08

From our calculations, we more easily see why the repayment plans require the payment of different total sums of money, yet are actually equivalent to each other.
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Given the choice of these two plans which would you choose?
Year 1 2 3 4 Plan 1 $1400 1320 1240 1160 Plan 2 $400 400 400 400

5 Total

1080 $6200

5400 $7000

To make a choice the cash flows must be altered so a comparison may be made.
Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 1 8

Technique of Equivalence

Determine a single equivalent value at a point in time for plan 1. Determine a single equivalent value at a point in time for plan 2.
Both at the same interest rate.

Judge the relative attractiveness of the two alternatives from the comparable equivalent values.
Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 1 9

Repayment Plans Establish the Interest Rate

Equivalence Calculator

1. Principal outstanding over time 2. Amount repaid over time

$5,000 8.00% 5 Plan 1 Principal payment Equal annual installments Interest payment EOY on unpaid principal
Year s Interest owed for that year Total owed at the end of year

Amount owed at the beginning of the year

1 2 3 4 5 Totals

5,000 4,000 3,000 2,000 1,000

400 320 240 160 80 1,200

5,400 4,320 3,240 2,160 1,080

Interest paid over time Total owed over time

1,200 15,000

8.00%

As an example:

If F = P (1 + i)n Then i=(F/P)1/n-1

$4,876.63 9.00% 5 Plan 1 Principal payment Equal annual installments Interest payment EOY on unpaid principal
Year s Interest owed for that year Total owed at the end of year

Amount owed at the beginning of the year

1 2 3 4 5 Totals

4,877 3,901 2,926 1,951 975

439 351 263 176 88 1,317

5,316 4,252 3,189 2,126 1,063

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

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Application of Equivalence Calculations

Comparing alternatives
Interest rate Year 0 1 2 3 4 5 6 7 8 9 10 P A F A $600 $115 $115 $115 $115 $115 $115 $115 $115 $115 $115 $1,306.63 $212.65 $3,389.05 10.00% Alternative B C -$600 -$850 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 -$115 -$80 ($1,306.63) ($1,341.57) ($212.65) ($218.33) D $850 $80 $80 $80 $80 $80 $80 $80 $80 $80 $80 $1,341.57 $218.33 $3,479.68 Present worth Annual worth Future worth
2 1

Pick an alternative. Which would you choose?

Change the interest rate. What happens at 8%,15%,3%?

($3,389.05) ($3,479.68)

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

Interest Formulas

To understand equivalence, the underlying interest formulas must be analyzed. Notation:

I = Interest rate per interest period n = Number of interest periods P = Present sum of money (Present worth) F = Future sum of money (Future worth)

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

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Single Payment Compound Interest

Year 1 2

Beginning balance
P P(1+i)

Interest for period

iP iP(1+i)

Ending balance
P(1+i) P(1+i)2

3
n

P(1+i)2
P(1+i)n-1

iP(1+i)2
iP(1+i)n-1

P(1+i)3
P(1+i)n

P at time 0 increases to P(1+i)n at the end of time n. Or a Future sum = present sum (1+i)n
Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc. 2 3

Notation for Calculating a Future Value Formula: F=P(1+i)n is the

single payment compound amount factor.

Functional notation: F=P(F/P,i,n) F=5000(F/P,6%,10) F =P(F/P) which is dimensionally correct.

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

2 4

Notation for Calculating a Present Value P=F(1/1+i)n=F(1+i)-n is the

single payment present worth factor.

Functional notation: P=F(P/F,i,n) P=5000(P/F,6%,10)

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

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Single Payment Formulas (2)

The single payment compoud amount formula function notation is

F = P(F/P,i,n)
example : If $500 were deposited in a bank savings account, how much would be in the account 3 years hence if the bank paid 6% interest compounded annualy?
F=?

F = 500 (F/P,6%,3) = 500 (1,191) = $ 595,5

P = 500

n=3 i = 0,06
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Single Payment Formulas (3)

2. Present Equivalent Values If we take F = P(1+i)n and solve for P

PF

1 i

F 1 i

This is the single payment present worth formula. The equation :

P F 1 i

In our notation becomes

P = F(P/F,i,n)
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Single Payment Formulas (4)

example : 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 sould the investor be willing to pay now for this property ?
F = 10.000

P=?

n=6 i = 0,08

P = 10.000 (P/F,8%,6) = 10.000 (0,6302) = $6.302

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MENCARI F DIKETAHUI P
Rumus F = P (1+i)n Dengan Excel F =FV(i%,n,,-P) Dengan tabel F = P(F/P,i,n) Contoh: Bila sejumlah $500 didepositokan di bank, berapakah jumlahnya 3 tahun yang akan datang kalau bunga bank 6% per tahun?
F=?

F = 500 (F/P,6%,3) = 500 (1,191) = $ 595,5

F = FV(6%,3,,-500) = ????

P = 500

n=3 i = 0,06
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MENCARI P DIKETAHUI F
Rumus P F 1 i Dengan Excel P =PV(i%,n,,-F) Dengan tabel P = F(P/F,i,n)
Contoh: Seorang investor dapat membeli tanah yang nilainya akan menjadi $ 10.000 dalam 6 tahun mendatang. Bila nilai tanah naik sebesar 8% setiap tahun, berapakah harga yang harus dibayar investor ini saat sekarang?
F = 10.000

P=?

n=6 i = 0,08

P = 10.000 (P/F,8%,6) Dengan Excel: = 10.000 (0,6302) P=PV(8%,6,,-10000) = ???? = $6.302 30

Compound Interest Factors

Examples F=P(F/P,i,n) P=F(P/F,i,n)

F=$5000 i=0.10 n=5 P=? F=P(1+i)n=$5000(1+0.10)5 =$5000(1.611)=$8055 F=P(F/P,10,5)=$5000(1.611) =$8055 P=F(P/F,10,5)=$8055(.62092) =$5000

10.00%

Single Amount Factor Compound Amount Factor Present Worth Factor P/F $1.00 $8,052.55 0.90909 $7,320.50 0.82645 $6,655.00 0.75131 $6,050.00 0.68301 $5,500.00 0.62092 $5,000.00 0.56447 $4,545.45 0.51316 $4,132.23 0.46651 $3,756.57 0.42410 $3,415.07 0.38554 $3,104.61 0.35049 $2,822.37 0.31863 $2,565.79 0.28966 $2,332.54 0.26333 $2,120.49 0.23939 $1,927.72 0.21763 $1,752.47 0.19784 $1,593.15 0.17986 $1,448.32 0.16351 $1,316.66 0.14864 $1,196.96 0.09230 $743.22 0.05731 $461.48 0.02209 $177.92 0.00852 $68.60 0.00328 $26.45 0.00105 $8.43 0.00007 $0.58

n 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 25 30 40 50 60 72 100

F/P $1.00 $5,000.00 1.100 $5,500.00 1.210 $6,050.00 1.331 $6,655.00 1.464 $7,320.50 1.611 $8,052.55 1.772 $8,857.81 1.949 $9,743.59 2.144 $10,717.94 2.358 $11,789.74 2.594 $12,968.71 2.853 $14,265.58 3.138 $15,692.14 3.452 $17,261.36 3.797 $18,987.49 4.177 $20,886.24 4.595 $22,974.86 5.054 $25,272.35 5.560 $27,799.59 6.116 $30,579.55 6.727 $33,637.50 10.835 $54,173.53 17.449 $87,247.01 45.259 $226,296.28 117.391 $586,954.26 304.482 $1,522,408.20 955.594 $4,777,969.09 13,780.612 $68,903,061.70

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.

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18% Compounded Monthly

18% interest: Assume a yearly rate if not stated

Compounded monthly: Indicates 12 periods/year [18%/year] / [12months/year] = 1.5% / month
Effective vs Nominal Interest Comparator
Nominal Interest rate Effective Interest rate Number of years 9.00% 9.42% 1.00
@

365 per year

Periods/year

Single Amount Factor Compound Amount Factor F/P i 9.00% 0.02% n 1.00 365 $1.00 1.090 1.094 $500.00 $545.00 $547.08 Present Worth Factor P/F $1.00 0.99975 0.91394 $547.08 $501.91 $500.00
3 2

Engineering Economic Analysis - Ninth Edition Newnan/Eschenbach/Lavelle Copyright 2004 by Oxford Unversity Press, Inc.