Compound Interest It is common practice to express the rates on the same time

- includes interest on the interest earned in the previous basis as the compounding period
period
- when interest is compounded more than once each year, Effective Interest Rate per Compounding Period
the terms nominal and effective must be considered

Nominal Rate, r
- can be stated for any time period NOTE: Changing the basic time period t does not alter the
 2% per month is equal to: compounding period, month in the previous example.
 2% x 12 months = 24% per year Whenever time period = compounding period, stated
 2% x 3 months = 6% per quarter nominal rate is an effective rate. Therefore, icp is the
 2% x 0.231 month = 0.462% per week effective rate per CP too.

Effective Interest Rate Effective Annual Interest Rate

- actual rate that applies for a stated period of time - time period t is year, and the compounding period can be
- actual amount of interest that will accumulate in a stated any time unit less than a year
period of time - effective interest rate at any point during the year includes
- accounts the compounding of interest during the time the interest rate of all previous compounding periods during
period of the corresponding nominal rate the year
- commonly expressed on an annual basis as the effective
rate, ia, but any time basis can be used

Effective Rate
- has the compounding frequency attached to the nominal
rate statement (4% per year, compounded monthly)

If compounding frequency is not stated, it is assumed to be

the same as the time period of r, i.e. compounding 1 time
during the time period *r: nominal interest rate per year
m: compounding occurs within the time period t (1 year).
All the interest formulas, factors, tabulated values must have icp: effective interest rate per compounding period (r/m)
the effective interest rate to properly account for the time ia: effective interest rate per year
value of money.

Therefore, we should know how to calculate the effective

interest rate value for any nominal or effective rate
statement

Annual Percentage Rate (APR) and Annual Percentage Yield

(APY)
- can be used as instead of nominal and effective interest
rates in practice
- APY ≥ APR

Three Time-Based Units

When the effective interest rates are calculated using the
- associated with an interest rate statement
formula for ia, the resulting rates are usually not integer.
 Time Period
Therefore, the engineering economy factors cannot be
- period over which the interest is expressed
obtained directly from the interest factor tables
- it is the t in the statement of r% per time period t
- 1% per month
Alternatives to Find the Factor Value
1. Use factor formula with ia rate substituted for i
 Compounding Period
2. Linearly interpolate between tabulated rates
- shortest time period over which interest is charged or
earned
- 8% per year compounded monthly
- CP is month

 Compounding Frequency
- number of times that m compounding occurs within Where a, b, c, and d are differences between the
the time period t indicated numbers in the tables.
- If the compounding period (CP) and the time period t
are the same, the compounding frequency is 1
- 1% per month compounded monthly
Payment Period  Determine the effective interest rate over the time
- the frequency of payments or receipts period t of the nominal rate, and set n equal to the
- most of the time the compounding period and payment number of time periods between P and F.
period are not the same
- to evaluate cash flows occurring more frequently than Uniform or Gradient Series Cash Flows
annually, effective interest rate over the payment period - determine the effective interest rate over the frequency of
must be calculated. the cash flows
 Find the effective i per payment period
 Determine n as the total number of payment periods
*r: nominal interest rate per payment period
m: number of compounding periods per payment period Timing of the cash flow transactions between compounding
points introduces the question of how inter-period
Effective Continuous Interest Rate compounding is handled.
- time periods on i and r are the same
No Inter-Period Policy
Allowing more and more frequent compounding, increases - handles inter-period compounding
the number of compounding periods per time period, m. As - deposits are assumed to be at the end of the CP (- cash
m approaches infinity, the effective interest rate must be flows)
written in a new form. First recall the definition of natural - withdrawals are assumed to be at the beginning of the CP
logarithm: - cash flows are forced into PP=CP situation

FROM WEEK 3-4 PDF

Nominal Interest Rate, r
- an interest rate that does not account for compounding
- also defined as a stated interest rate
- works according to the simple interest and does not take
into account the compounding periods

r = interest rate per time period x number of periods

=ixm

Effective Interest Rate, i

- rate wherein the compounding of interest is considered
- caters the compounding periods during a payment plan
- compare the annual interest between loans with different
In most of the equivalence computations, the frequency of compounding periods like week, month, year etc
cash flows does not equal the frequency of interest - effective rates are commonly expressed on an annual basis
compounding. To correctly perform any equivalence as an effective annual rate; however, any time basis may be
computation, it is essential that the compounding period and used
payment period be placed on the same time basis, and the  An interest rate of “1.5% per month” means that
interest rate be adjusted accordingly interest is compounded each month; that is ,
compounding period (CP) is 1 month

Annual Percentage Rate

- annual interest rate for credit cards, loans, and house
mortgages
- same as the nominal rate
 An APR of 15% is the same as a nominal 15% per year or
a nominal 1.25% on a monthly basis.

Annual Percentage Yield

- annual rate of return for investments, certificates of deposit
and saving accounts
- same as an effective rate

*effective rate is always greater than or equal to the nominal

Single-Amount Cash Flows rate, and similarly APY ≥ APR
- ways to determine i, n, P/F, and F/P factors
 Determine the effective interest rate over the Interest Period
compounding period CP, and set n equal to the number - period of time over which the interest is expressed
of compounding periods between P and F. - this is the t in the statement r% per time period t
 1% per month ; t = 1 month
- time unit of 1 year is commonly used ; assume if not stated
Compounding Period Capitalized-Worth Method
- shortest time unit over which interest is charged or earned - variation of PW method which involves determining the PW
- defined by the compounding term in the interest rate of all revenues or expenses over an infinite length of time
statement - if only expenses are considered, results obtained by this
 8% per year, compounded monthly ; CP = 1 month method are sometimes referred to as capitalized cost
- if CP is not stated, assume to be the same as the interest - a convenient basis for comparing mutually exclusive
period alternatives when the period of needed service is indefinitely
long
Compounding Frequency
- number of times that compounding occurs within the Future Worth Method
interest period t. - based on the equivalent worth of all cash inflows and
- if the compounding period CP and the time period t are the outflows at the end of the planning horizon(study period) at
same, the compounding frequency is 1. an interest rate that is generally the MARR
 1% per month, compounded monthly ; m = 1 times per - FW of a project is equivalent to its PW
month
Annual Worth Method
Continuous Compounding - equal annual series of amounts, for a stated study period,
- present when the duration of CP, the compounding period, that is equivalent to the cash inflows and outflows at an
becomes infinitely small and m, the number of times interest interest rate that is generally the MARR
is compounded per period, becomes infinite
- businesses with large numbers of cash flows each day Capital Recovery Amount
consider the interest to be continuously compounded for all - equivalent uniform annual cost of the capital invested
transactions. - it is an annual amount that covers the following two items:
 Loss in value of the asset
Minimum Attractive Rate of Return  Interest on invested capital (i.e., at the MARR)
- reasonable rate of return established for the evaluation and
selection of alternatives Internal Rate of Return Method
- a project is not economically viable unless it is expected to - most widely used rate-of-return method for performing
return at least the MARR engineering economic analyses
- referred to as the hurdle rate, cutoff rate, benchmark rate, - sometimes called by several other names, such as the
and minimum acceptable rate of return investor’s method, the discounted cash-flow method, and the
- interest rate at which a firm can always earn or borrow profitability index
money - solves for the interest rate that equates the equivalent
- generally dictated by management and is the rate at which worth of an alternative’s cash inflows (receipts or savings) to
PW analysis should be conducted the equivalent worth of cash outflows (expenditures,
- policy issue resolved by the top management of an including investment costs)
organization in view of numerous considerations
Investment-Balance Diagram
MARR Considerations - shows how much of the original investment in an
 The amount of money available for investment, and the alternative is still to be recovered as a function of time
source and cost of these funds (i.e., equity funds or - downward arrows represent annual returns, (Rk - Ek) for 1 ≤
borrowed funds). k ≤ N, against the unrecovered investment, and the dashed
 The number of good projects available for investment lines indicate the opportunity cost of interest, or profit, on
and their purpose (i.e., whether they sustain present the beginning-of-year investment balance
operations and are essential, or whether they expand
on present operations and are elective).
 The amount of perceived risk associated with
investment opportunities available to the firm and the
estimated cost of administering projects over short
planning horizons versus long planning horizons.
 The type of organization involved (i.e., government,
public utility, or private industry).

Present Worth Method

- based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the
present
- all cash inflows and outflows are discounted to the present
point in time at an interest rate that is generally the MARR.
External Rate of Return Method FROM CHAPTER IV DEPRECIATION
- rate of return per year for a cash flow series Depreciation
- considers the situations: - decrease in the value of a property, such as machinery,
 the rate of investment for a positive net cash flow equipment, building or other structure, due to the passage of
generated by the project during a year time
 the interest rate (independent of or external to the - due to many reasons, from deterioration and obsolescence
project. e.g., a bank loan rate) that the project to impending retirement
must pay to continue operation, when the project - depends upon the physical and economic life of the
produces a negative net cash flow, that is, a loss in equipment and its first cost
a year
Physical Life
Payback Analysis - length of time during which it is capable of performing the
- another use of the present worth technique function for which it was designed and manufactured
- determine the amount of time, usually expressed in years,
required to recover the first cost of an asset or project Economic Life
- length of time during which it will operate at a satisfactory
Payback Period unit
- payback or payout period
- estimated time for the revenues, savings, and any other Basis (or Cost Basis)
monetary benefits to completely recover the initial - cost of acquiring an asset (purchase price) including normal
investment plus a stated rate of return i costs of making the asset serviceable
- referred to as unadjusted cost
Discounted Payback
- i > 0% Adjusted (Cost) Basis
- time value of money is considered in that some return - changes to the original cost basis of a property caused by
 10% per year must be realized in addition to recovering various types of improvements or casualty losses
the initial investment
Value
Net Cash Flow Equation - present worth (PW) of all the future profits that are to be
 NCF = cash inflows - cash outflows received though ownership of a particular property
- The terminology is P for the initial investment in the asset,
project, contract, etc., and NCF for the estimated annual net Market Value (MV)
cash flow - what will be paid by a willing buyer to a willing seller for a
property where each has equal advantage and is under no
Salvage Value compulsion to buy or sell
- salvage values and additional revenues to the government,
when they are estimated, are subtracted from costs in the Salvage or Residual Value (SV)
denominator - price that can be obtained from the sale of the property
after it has been used
Disbenefits - best estimate of an asset‟s net market value at the end of
- considered in different ways depending upon the model its useful life
used - if used in depreciation calculations, it is referred to as
- most commonly, disbenefits are subtracted from benefits estimated salvage (ES), representing an asset‟s terminal
and placed in the numerator value

Benefit/Cost Ratio Useful Life

- if the B/C value is exactly or very near 1.0, noneconomic - referred to as depreciable life
factors will help make the decision - expected period of time that a property will be used in a
trade or business or to produce income
- is not how long the property will last but how long the
owner expects to productively use it

Book Value (BV)

In the above equation, disbenefits are subtracted from - worth of a property as shown on the accounting records of
benefits, not added to costs. The B/C value could change a company
considerably if disbenefits are regarded as costs. - original cost of the property less all amounts that have been
charged as depreciation expense
Modified Benefit/Cost Ratio
- includes all the estimates associated with the project, once Scrap Value
operational - amount the property would sell if disposed off as a junk
Depreciable Property - annual depreciation charges, different each year,
- property for which depreciation is allowed under federal, decrease from year to year, greatest during the 1st year
state or municipal income tax laws and regulations. and least in the last year of life of the property
- property can never depreciate to zero value
Property is depreciable if it meets the following
requirements:
 It must be used in business or held to produce income.
 It must have a determinable useful life, and the life
must be longer than one year.
 It must be something that wears out, decays, gets used
up, becomes obsolete or loses value from natural
causes.
 It is not inventory, stock in trade, or investment
property
3. Sum-of-theYears-Digits (SYD) Method
- provides very rapid depreciation during the early years
Examples of Depreciable Assets
of life of the property, and therefore enables faster
 Cars
recovery of capital
 Computers
- basic assumption for this method is that the value of
 Office Furniture
the property decreases at a decreasing rate
 Machines
 Buildings
To Compute:
 Significant additions or improvements (as opposed to
 List the digits corresponding to the number for each
repairs) to these kinds of property
permissible year of life in reverse order
 Determine the sum of these digits
Requirements of a Depreciation Method
 For any year, the depreciation factor is the number
It should be simple
from the reversed-order listing for that year


It should recover capital

divided by sum of the digits.


Ensure that the book value will be reasonably close to

The depreciation deduction for any year is the


the market value at any time
product of the SYD depreciation factor that year
The method must be acceptable by the BIR
and the difference between the cost basis (B) and


the SVN.
Depreciation Method
1. Straight-Line (SL) Method
In general, the annual cost of depreciation for any year k,
- simplest and most widely used
when N equals the depreciable life of an asset, is
- assumes that the loss in value is directly proportional
to the age of the property
- depreciation base is evenly allocated over the lifetime
of the asset, resulting in equal annual depreciation The book value at the end of the year k is
- does not need annuity tables.
- does not take into account the interest or profit
earned on the accumulated depreciation fund. Likewise cumulative depreciation through the kth year is simply
O and M cost are disregarded

4. Sinking Fund Method

- depreciates an asset as if the firm were to make a
series of equal deposits whose value at the end of the
asset‟s useful life just equaled the cost of replacing the
asset
- assumed that a sinking fund is established in which
funds will accumulate for replacement purposes and will
bear interest
2. Declining Balance (DB) Method -total depreciation which has occurred up to any given
- called the constant percentage method or the time is assumed to equal the amount in the sinking fund
Matheson formula at that time
- assumed that the annual cost of depreciation is a fixed
percentage of the BV at the beginning of the year
- ratio of the depreciation is a fixed percentage of the
BV at the beginning of the year is constant throughout
the life of the asset and is designated by R (0 ≤ R ≤ 1)
- R = 2/N when a 200% declining balance is being used
 The amount in the sinking fund at the end of year k (k =
1,2….N) is the accumulated depreciation through k, thus:

The depreciation in year k, which includes interest

earned at that time, is given as:

The book value, BV, as usual is defined as :

5. Units-of-Production Method
- results in the cost basis (minus final SV) being allocated
equally over the estimated number of units produced
during the useful life of the asset