Lecture#08

Engineering Economics
By Lec. Junaid Arshad
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INTEREST PERIODS
Interest is usually charged on amount for a period of one year. Interest rates are also quoted for periods other than one year, known as interest periods.

SIMPLE INTEREST
The total interest earned or charged is linearly proportional to the initial amount of the loan (principal), the interest rate and the number of interest periods for which the principal is committed. Let I represents the interest earned, P the principal amount, n the interest period, and i the interest rate. Then, I = Pni

Suppose that $1000 is borrowed at a simple interest rate of 12% per annum. At the end of one year, the interest owed would be I = $1000(1)(0.12) = $120 The principal plus the interest would be $1120 and would be due at the end of one year. Suppose that $1000 is borrowed at a simple interest rate of 12% per annum. At the end of two year, the interest owed would be I = $1000(2)(0.12) = $240
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When it is necessary to calculate the interest due for a fraction of year, it is common to represent that fraction as the ratio of the number of days in the loan to the total days in a year. For example, on a loan of $1000 at an interest rate of 12% per annum, for a period March 1 to May 20, the interest due on May 20 along with the principal sum of $1000 would be 0.12($1000) (81 / 365) = $26.63

COMPOUND INTEREST

When a loan is made for several interest periods, interest is calculated and payable at the end of each interest period. . If the borrower does not pay the interest at the end of each period and charged interest on the total amount owed (principal plus interest), the interest is said to be compunded. There are a number of loan repayment plans. These range from paying the interest when it is due to accumulating the interest until the loan is due
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For example, the payments on a 4-year loan of $1000 at 16% interest per annum, payable when due, would be calculated as shown.
Year Amount owed at beginning of yr $1000 $1000 $1000 Interest to be paid at end of year Amount owed at end of year $1160 $1160 $1160 Amount to be paid by the borrower at end of year $160 $160 $160

1 2 3

$160 $160 $160

$1000

$160

$1160

$1640(1000+ 640) 7

If the borrower does not pay the interest earned at the end of each period and is charged interest on the total amount owed (principal plus interest), the interest is said to be compounded. The interest owed in the previous year becomes part of the total amount owed for this year. This years interest charge includes interest that has been earned on previous interest charges.

For example, a loan of $1000 at 16% interest compounded annually for a 4-year period will produce the results shown.
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Year

Amount ($) Interest ($) to Amount ($) Amount ($) owed at be added to owed at end paid by beginning loan at end of of year borrower of year (A) year (B) at end of (A+B) year

1
2 3 4

1000.00
1160.00 1345.60 1560.90

1000 X 0.16 =160.00

1160 x 0.16 =185.60 1345x 0.16 =215.30

1000(1.16)=1 1160
1000(1.16)2= 1345.60 1000(1.16)3= 1560.90

00.00
00.00 00.00 1810.64

1590.90x 1000(1.16)4= 0.16=249.75 1810.64 (160+185.60+ 215.30+249.7 5=810.65)

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