Chapter 3

Interest rate and economic

equivalence

Contemporary Engineering Economics, 5th 1

edition, 2010
3.1) Interest: the cost of money
3.2) Economic equivalence
3.3) Development of formulas for equivalence
calculations
3.4) Unconventional equivalence calculations

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3.1) Interest: the cost of money

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 Chapter Opening Story Take a Lump Sum or
Annual Installments

Mr. Robert Harris won a lottery.

He had two options:

Option 1: Take a cash payment of $167M.
Option 2: Take an annuity payment of $10.57M a year for 26
years.

Mr. Harris took Option 1.

How do we compare these two payment options?

What can we say about Mr. Harris decision?

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 What do we need to know?

To make such comparisons (the lottery decision

problem), we must be able to compare the value of
money at different points in time.

To do this, we need to develop a method for reducing a

sequence of benefits and costs to a single point in time.
Then, we will make our comparisons on that basis.

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 3.1.1 - Time Value of Money

Money has a time value because it

can earn more money over time
(earning power).
Money has a time value because its
purchasing power changes over time
(inflation).
Time value of money is measured in
terms of market interest rate which
reflects both earning and purchasing
power in the financial market.

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3.1.2 - The Interest Rate
Interest is the cost of moneya cost to the borrower and
an earning to the lender.
Elements of transactions involving interest:
Principal: initial amount of Money in transactions
including debt or investment
Interest rate: cost or price of money
Interest period: determines how frequently interest is
calculated
Total number of interest periods
A plan for receipts or disbursements
A future amount of money

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 3.1.2 - The Interest Rate
P = A sum of money at a time chosen as time zero =
Present value = Present worth
Interest rate = i
Total number of interest periods = N
F = a future sum of money at the end of the analysis
period
An = a discrete payment or receipt ocurring at the end of
some interest period n
A = an end-of-period payment or receipt in a uniform
series that continues for N periods. A1=A2==AN=A
Vn = an equivalent sum of money at the end of a specified
period n that considers the effect of the time value of
money. V0 = P, VN = F
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 End-of-Period Convention

Convention: Any cash

flows occurring during the
interest period are summed
to a single amount and
placed at the end of the
interest period.
Logic: This convention
allows financial institutions
to make interest
calculations easier.

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 3.1.3 - Methods of Calculating Interest

Simple interest: the practice of charging an interest

rate only to an initial sum (principal amount).
Compound interest: the practice of charging an
interest rate to an initial sum and to any previously
accumulated interest that has not been withdrawn.
Note: Unless otherwise mentioned, all interest
rates used in engineering economic analyses are
compound interest rates.

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3.2) Economic equivalence

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 What is Economic Equivalence?

Economic equivalence exists between cash flows that

have the same economic effect and could therefore be
traded for one another.

Even though the amounts and timing of the cash flows

may differ, the appropriate interest rate makes them
equal in economic sense.

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 Equivalence
Equivalence from Personal Alternate Way of Defining
Financing Point of View Equivalence

If you deposit P dollars today F dollars at the end of period N

for N periods at i, you will have is equal to a single sum P
F dollars at the end of period dollars now, if your earning
N. power is measured in terms of
F
interest rate i.
P

F P(1 i) N
0
0 N
N
F

P F (1 i) N
P
0 N
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 3.2.2 Equivalence calculations: general
principles

Principle 1: equivalence calculations made to

compare alternatives require a common time basis

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Principle 2: Equivalence depends on the interest rate

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Example 3.5

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Principle 3: Equivalence calculations may require
the conversion of multiple payment cash flows to a
single cash flow

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Principle 4: Equivalence is maintained regardless
of the point of view

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3.3) Development of formulas
for equivalence calculations

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Types of Common Cash Flows in
Engineering Economics

Single cash flow

Equal (uniform) payment series at regular intervals
Linear gradient series
Geometric gradient series
Irregular (random) payment series

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3.3.2) Single cash flow formulas

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Example 3.7

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Example 3.8

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 $ 40

$ 20

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Rule of 72

Approximating Number of Years Required to Double

how long it will an Initial Investment at Various
take for a sum of Interest Rates
money to double

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N
interest rate (%)
72

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3.6 years
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Problem

Compare the interest earned by $4000 for 6 years at 10%

simple interest with that earned by the same amount for 6
years compounded annually.

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