MODULE#2

TOPIC : 3
INTEREST
RATE AND
ECONOMIC
EQUIVALENCE
ENGR JOSEPH B. CANAPI
Interest Rate and Economic Equivalence:
LEARNING OBJECTIVES:

After completing MODULE , Students should be able understand the concepts :

v The time value of money.
v The difference between simple interest and the compound interest.
v The meaning of economic equivalence and why we need it in economic analysis.
v How to compare two different money series by means of the concept of economic equivalence.
v The interest operation and the types of interest formulas used to facilitate the calculation of economic
equivalence.

MODULE COVERAGE:
v Interest : The Cost of Money
v Economic Equivalence
v Formulas fo Equivalence calculations
v Uncoventional Equivalence calculations
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING

v SINGLE PAYMENTS or SINGLE CASH FLOWS

The factor is frequently called the Single

The factor is frequently called the
Payment Compound Amount
Single Payment Present
Factor
Worth Factor
Factor Notation: Factor Notation:
(F/P, i, N) which is read as “Find F, Given P, i, and N.” (P/F, i, N) which is read as “Find P, Given F, i, and N.”

The interest rate i and the P/F factor are also referred to as
the discount rate and discounting factor, respectively
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING

v Nominal rate of interest v Effective rate of interest

The nominal rate of interest specifies the rate of interest and Effective rate of interest is the actual or exact rate of
a number of interest periods in one year. interest on the principal during one year.
NOTE: It is always expressed on an annual basis.

where: i = rate of interest per interest period Example 1:

r = nominal interest rate Consider, one unit of principal for one unit a time
m = number of compounding periods per year invested in a nominal interest of 12% compounded
monthly,
n = Tm
P= 1.00 , N= 12 months
where: n = no. of interest per periods
T = no. of years ER = ( 1+ 12/12) exp 12 - 1 = 0.1268 or 12.68%
m = number of compounding periods per year In other words, paying 1% interest per month for 12
months is equivalent to paying 12.68% interest just
If the nominal rate of interest is 10% compounded quarterly, one time each year.
then i= 10%/4= 2.5%, the rate of interest per interest period.
F = P(1 + 0.01)12 = P( F/P, i, N) = 1.1268
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING

Example 2:
F4 = P(1 + ni ) = P2000 [1 + (4) (0.08) ]= P 2,640
A P2,000 loan was originally made 8% simple interest for 4
years. At the end of this period the loan was extended for 3
F7 = F4 (1 + �)� = P(F/P, i, N)= 2,640 (1.3401)
years, without the interest being paid, but the new interest rate
= P2,640(1 + 10/2)3(2) = P3,537.86
was made 10% compounded semi- annually. How much should
the borrower pay at the end of the 7 years?
Example 3:
Solution:
Wilson Technology, a growing machine shop, wishes to
set aside money now to invest over the next four years
in automating its customer service department. The
company can earn 10% on a lump sum deposited now,
and it wishes to withdraw the money in the following
increments:
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING

Example 3:
Ø Year 1: $25,000, to purchase a computer and database
software designed for customer service use;
Ø Year 2: $3,000, to purchase additional hardware to
accommodate anticipated growth in use of the system;
Ø Year 3: No expenses; and
Ø Year 4: $5,000, to purchase software upgrades.
How much money must be deposited now to cover the
anticipated payments over the next 4 years?
STRATEGY:
calculate the equivalent present value of each single
cash flow and to sum the present values to find P.

P = $25K (P/F, 10%,1) + $3K(P/F, 10%, 2)+ $5K(P/F,10%,4)

= $25k ( 0.9091) + $3K(0.8264) + $5K( 0.6830)
= $28,622
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING
Equal Payment Series or UNIFORM SERIES (ANNUITIES)
An annuity is a series of equal payments made at equal
intervals of time. Financial activities like installment or, expressed alternatively,
payments, monthly rentals, life-insurance premium,
monthly retirement benefits, are familiar examples of
annuity.
Multiplying Eq. (3.8) by (1 + i) results in

Subtracting Eq. (3.8) from Eq. (3.9) to eliminate common

terms :

Solving for F:

Equal payment series compound-amount

factor, or the uniform series compound-amount factor
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING

Solving for A from Eq. of Uniform series, we obtain

The term within the brackets is called the equal

payment series sinking-fund factor, or sinking-fund
factor The portion within the brackets is called the
A sinking fund is an interest-bearing account into equal payment series capital recovery factor, or simply
which a fixed sum is deposited each interest capital recovery factor,which is designated (A/P, i, N).
period; it is commonly established for the purpose
of replacing fixed assets or retiring
corporate bonds.(pay off debt or bond) Capital Recovery represents the return of your initially
Example, a company issuing $1M of bonds that are invested capital over the lifespan of an investment.
to mature in 10 years.. given this it creates sinking Example , if company purchases a printing press for $20K
fund and deposits yearly to ensure bonds are all The company cannot determine any profits until recovers
bought back by their maturity date. the $20k.
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING
Solving for P from Eq. of Capital Recovery, we obtain SOLUTION:
F= A (F/A, i, N)
= $3,000 ( F/A, 7%, 10)
= $3,000 (13.8164
The bracketed term is referred to as the equal = $41,449.20
payment series present-worth factor

Example 4:
Suppose you make an annual contribution of $3,000 to
your savings account at the end of each year for 10 years.
If the account earns 7% interest annually, how much can
be withdrawn at the end of 10 years
Each payment has been shifted to one year earlier;

F10 = $41,449.20(1.07) = $44,350.64.

 INTEREST FORMULAS FOR DISCRETE COMPOUNDING
Example 5: Example 7:
What interest rate, compounded annually, will make a To help you reach a $5,000 goal five years from now, your father
uniform series investment (at the end of each year) of offers to give you $500 now. You plan to get a part-time job and
$1,000 equivalent to a future sum of $7,442? The make five additional deposits, one at the end of each year. (The
investment period is 5 years. first deposit is made at the end of the first year.) If all your
money is deposited in a bank that pays 7% interest, how large
SOLUTION:
must your annual deposit be?
F = A(F/A,i,n) ⇒ 7, 442 = 1, 000(F/A,i,5 (F/A,i,5) = 7.442 SOLUTION:
n = 5 yields i = 20%
Example 6:
Determine the present equivalent value of P5,000 paid
every 3 months for period of seven years and the rate
of interest is 12% compounded quarterly.
Required: The present value, P
i= 12%/4= 3% ; n = 7 (4) =28
P = A ( P/A, i, n)= 5,000 ( P/A, 3%, 28)
= 5,000 (18.7641) = P93,820.5
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING
Example 7:
SOLUTION:
Given: Cash flow as shown in CFD, with i=7%/Yr. and
N= 5 Years
Find: A.

A = ( $5,000- Fx ) ( A/F, 7%, 5)

= [ $5,000-$500( F/P, 7%,5)] ( A/F, 7%, 5)
SOLUTION:
= [$5,000- $500 (1.4016)] (0.1739)
= $ 747.55 Given: P= $250,000, i=8%/Yr. and N= 6 Years
Find: A.
Example 8:
A= $250,000 ( A/P, 8% , 6)
BioGen Company, a small biotechnology firm, has
= $250,000 (0.2163)
borrowed $250,000 to purchase laboratory
= $54,075
equipment for gene splicing. The loan carries an
interest rate of 8% per year and is to be repaid in
equal installments over the next six years. Compute
the amount of the annual installment
 INTEREST FORMULAS FOR DISCRETE COMPOUNDING
Example 9:
In Example 8 , suppose that BioGen wants to negotiate
with the bank to defer the first loan repayment until the
end of year 2 (but still desires to make six equal
install_x0002_ments at 8% interest). If the bank wishes
to earn the same profit, what should be the
annual installment, also known as deferred annuity
or deffered loan repayment
SOLUTION:
Given: P= $250,000, i=8%/Yr. and N= 6 Years
but the first payment occurs at the end Year 2.
Find: A.

P’ = $250,000 ( F/P, 8%,1)

= $270,000 A’ =$270,000 ( A/P, 8%, 6)
= $ 58,401
By deferring the first payment for one year, BioGen needs
to make additional payments of $4,326 in each year