B.

Maddah ENMG 602 Introduction Financial Eng’g 01/04/09

The Basic Theory of Interest (Chapter 2, Luenberger)

• Interest concept: Review

¾ Recall that interest is the manifestation of time value of
money.
¾ Under a compound interest rule, an investment earns interest
on interest. Specifically, P dollars invested for n years at an
interest rate of r per year will have a total value of
F = P (1 + r ) n .
¾ An amount F received n years from now is equivalent to
having P = F/(1 + r)n now, where P is called the present
value or the discounted value of F.
¾ The future value, n years from now, of an amount P one has
today is F = P(1 + r)n.
¾ The present value of a cash flow stream x = (x0, x1, …, xn) is

PV = x0 + + + + = ∑
x1 x2 xn n xj
1 + r (1 + r ) 2 (1 + r ) n j =0 (1 + r ) j
… .

¾ The future value stream x = (x0, x1, …, xn) is

FV = x0 (1 + r ) + x1 (1 + r ) n −1
+ … + xn = ∑ x j (1 + r ) n − j .
n
n

j =0

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• Simple interest
¾ Under a simple interest rule, P dollars invested for n years at
a rate of r per year will accumulate interest of Pr every year.
¾ Then, the total value of the investment after n years is
F = P(1 + nr) .
¾ Note that the investment value grows linearly with time.

• The seven-ten rule and the rule of 72

¾ Money invested at 10% (7%) per year, under compounding,
doubles in approximately 7 (10) years.
¾ More generally, money invested at an interest rate of i % per
year will double in approximately 72/i years.
¾ For example, money invested at 12% doubles in
approximately 72/12 = 6 years.

• Compounding at intervals less than 1 year

¾ Interest may be compounded more frequently than one year.
E.g., every quarter, every month, or even every day.
¾ In these situations, it is common to quote the interest rate on
a yearly basis and then to apply the appropriate proportion of
the interest rate over the compounding period.
¾ For example, a nominal interest rate of 8% per year
compounded quarterly means that the effective interest rate
per quarter is 8% / 4 = 2%.

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 ¾ However, the effective interest rate per year is (1 + 0.08/4)4 −
1 = 0.0824, i.e., 8.24% .
¾ Generally, if the nominal interest rate is r per year and
interest is compounded at m equally spaced epochs per year,
then the effective interest rate per period is r/m and an
amount P invested for k periods grows to
F = P(1 + r/m)k .
¾ The effective interest rate per year, r’, is found by noting that
the future value of an amount P after one year is
P (1 + r ′) = P (1 + r / m ) m .
¾ Then,
r ′ = (1 + r / m) m − 1 .

• Continuous compounding
¾ If the compounding period length becomes very small, i.e.,
m → ∞, the effective interest rate per year is
r ′ = lim (1 + r / m) m − 1 = e r − 1 .
m →∞

¾ If an amount P is invested for t years under a continuous

compounding of r per year then, letting k = mt with m → ∞,
implies that the value of the investment after t years is
F = lim P (1 + r / m) k = lim P (1 + r / m) mt = Pe rt .
m →∞ m →∞

¾ Note that P is growing exponentially.

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• Example: $1 invested at a nominal rate of 8%
year m=1 m=2 m=4 m = 12 m=∞
1 1.080 1.082 1.082 1.083 1.083
2 1.166 1.170 1.172 1.173 1.174
3 1.260 1.265 1.268 1.270 1.271
4 1.360 1.369 1.373 1.376 1.377
5 1.469 1.480 1.486 1.490 1.492
6 1.587 1.601 1.608 1.614 1.616
7 1.714 1.732 1.741 1.747 1.751
8 1.851 1.873 1.885 1.892 1.896
9 1.999 2.026 2.040 2.050 2.054
10 2.159 2.191 2.208 2.220 2.226

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8
Fann( n)

Fsemi( n) 6
Fcont ( n)
4

0
0 5 10 15 20 25 30
n

• Constant ideal bank

¾ This is a bank that charges the same interest rate for
borrowing and lending with no transaction fees.
¾ Moreover, the interest rate is the same regardless of the
length of time the money is held.

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 ¾ In this chapter, we assume that we have a constant ideal bank
situation. We relax this assumption later.

• Main theorem on present value

The cash flow streams x = (x0, x1, …, xn) and y = (y0, y1, …, yn) are
equivalent for a constant ideal bank with interest rate r if and only
if the present value of the two streams are equal.

• Internal rate of return

¾ For an investment involving one single payment P and
returning F at a future time the rate of return is
r=F/P−1.
¾ Alternatively, r is given by the solution to
−P + F / (1+r) = 0 .
¾ That is, r is the solution to the equation PV(r) = 0 .
¾ With more sophisticated cash flow streams involving several
payments and receipts, solving the same equation, PV(r) = 0,
defines the internal rate of return (IRR) of the stream.
¾ Formally, the IRR of a cash flow stream x = (x0, x1, …, xn) is
a number r satisfying the equation

x0 + + + + = 0.
x1 x2 xn
1 + r (1 + r ) 2 (1 + r ) n
…

¾ Defining c = 1/(1+r) (that is r = 1/c −1) then the IRR can be

obtained by solving the polynomial equation
x0 + x1c + x2 c n + … + xn c n = 0 . (1)

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 ¾ The IRR is an important measure especially that it has the
nice property of not depending on the prevailing external
market interest rate.
¾ One issue with the IRR is that equation (1) may have
multiple solutions. In this case, it becomes unclear which
solution is the true IRR of the cash flow stream at hand.
¾ Fortunately, for one of the most common forms of
investments, involving an initial payment followed by many
receipts1, (1) has a unique > 0 root which gives a true IRR.
¾ The following theorem proves this.

• Main theorem on internal rate of return

Suppose the cash flow stream x = (x1, x2, …, xn) has x0 < 0 and
xk ≥ 0 for k = 1, 2, …, n, with at least one xj > 0, j ∈{1, 2, …, n}.
Then, there is a unique root to the equation
x0 + x1c + x2 c n + … + xn c n = 0 .

∑x > 0, then the corresponding internal rate of

n

Furthermore if
k =0
k

return r = 1/c −1 is positive.

Proof. Define f (c ) = x0 + x1c + x2 c + … + xn c . Then,
n n

f(0) = x0 < 0 and f(∞) = ∞. This implies that the equation f(c) = 0
has at least one positive root. It can also be seen that f(c) is strictly
increasing in c. This proves the first part of the theorem. To prove

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This is called a “conventional” cash flow stream.

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the second part note that f (1) = x0 + x1 + … + xn = ∑ xk . This implies
n

k =0

∑x > 0 then f(1) > 0, and the unique root of f(c) is less
n

that if
k =0
k

than 1. Hence, the corresponding r = 1/c −1 > 0. █

• Evaluation criteria
¾ Several criteria are used in comparing cash flow streams.
¾ The objective of the comparison is selecting the stream which
is most desirable from an economic perspective.
¾ The two most important criteria are based on present value
and internal rate of return.

• Net present value

¾ Under net present value (NPV) criteria, alternatives are
ranked based on their present value (the larger the better).
¾ The prefix “net” indicates that present values of costs and
payments are considered.
¾ To be worthy of consideration a cash flow stream must have
a NPV > 0.
¾ All present values are evaluated with an interest rate based on
the firm’s cost of capital.
Check my ENMG 400 Engineering Economy notes, here, for discussion on
how to set the cost of capital. Typically, firms use a minimum attractive
rate return (for interest) above the cost capital when doing economic
feasibility analysis.

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• IRR criteria
¾ Under IRR criteria, alternatives are ranked based on their
internal rate of return (the larger the better).
¾ To be worthy of consideration a cash flow stream must have
an IRR greater than the interest rate (determined based on
the firm cost of capital).

• Discussion of criteria
¾ NPV and IRR criteria do not always give the same answer
especially if alternatives have different life spans.
¾ In certain situations, e.g., if cash flows occur in repetitive
cycles, then the two criteria can lead to similar conclusions.
¾ The advantages of NPV criteria are ease of computation and
“linearity” (meaning that the NPV of sum of cash flows
streams is equal to the sum of the streams NPVs).
¾ The main disadvantage of NPV criteria is that it requires the
estimation of an “external” interest rate based on cost of
capital which is not always easy to do.
¾ The main advantage of IRR criteria is that IRR depends only
on the cash flow stream under consideration (and not on
external factors such as the market interest rate).
¾ The main disadvantages of IRR criteria are difficulty of
computation and the ambiguity associated with several
possible roots of the IRR equation.

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• Which criteria to use?
¾ It is widely agreed that NPV is the best criterion (if applied
prudently).
¾ But NPV is not “the whole story.”

• Comparing alternatives that repeat indefinitely with NPV

¾ Consider two alternatives that are composed of cycles of cash
flows that repeat indefinitely.
¾ The two alternatives can be compared in two different ways
(i) Repeat the cycles of alternatives until they terminate at
the same time (i.e., evaluate the two alternatives over the
least common multiplier of cycles).
(ii) Evaluate the NPV of each alternative directly over the
infinite horizon based on a recursive equation.

• Taxes and depreciation

¾ Taxes can complicate a cash flow analysis.
¾ One situation where tax considerations have important
implications is that involving property depreciation.
¾ The annual depreciation amount is exempt from tax, which
reduces tax on net revenues.

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• Inflation
¾ Inflation is characterized by an increase in general prices
with time. That is, purchasing power declines with time.
¾ Inflation can be quantified with an inflation rate f .
¾ $1 today has the same purchasing power as (1+f)n dollars n
years from now.
¾ That is, (1+f)n dollars n years from now are worth 1 constant
dollar or one real dollar today.
¾ If the real interest rate is r0, then the nominal market interest
rate, r, is such that 1 + r = (1+r0)(1+f), or equivalently,
r = r0 + f + r0f .
¾ The real interest rate can be concluded from the nominal rate,
r− f
r0 =
1+ f
.

• Present value of a uniform stream of cash flows

¾ Consider a cash flow stream extending from year 1 to n such
that the net cash flow at the end of years 1, 2, …, n is A.
¾ Then, at an annual interest rate of r, the PV of this stream is
⎛ 1 ⎞
1− ⎜ ⎟
n

∑⎜ ⎟ =
n −1
⎛ 1 ⎞ ⎝ 1+ r ⎠
PV = + +…+ =
j
A A A A A
1 + r (1 + r ) 2 (1 + r ) n 1 + r j =0 ⎝ 1 + r ⎠ 1 + r ⎛ 1 ⎞
1− ⎜ ⎟
⎝ 1+ r ⎠
⎡ (1 + r ) n − 1 ⎤ A ⎡ 1 ⎤
= A⎢ n ⎥
= ⎢1 − n ⎥
⎣ + ⎦ ⎣ + ⎦
.
r (1 r ) r (1 r )

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