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MS-291: Engineering Economy

(3 Credit Hours)

So for .
1. Introduction

What is Economics? Economics for Engineers ?

What is Engineering Economy ? Performing Engineering Economy
Study ?
Some Basic Concepts Utility & Various cost concept, Time value of
money (TVM), Interest rate and Rate of Returns, Cash Flow, Economic
Equivalence, Minimum Attractive Rate of Return, Cost of Capital and
MARR, Simple and compound interest rates

2. Various Type of Factors

Factors Single payment Factors
P/F, F/P
Uniform Series Factors
P/A, A/P, F/A, A/F
Gradient Series Factors
Arithmetic Gradient and Geometric Gradient

3. Dealing with Shifted Series

Shifted uniform series

Shifted series and single cash flows
Shifted gradients

This is basically
three
Foundational
Pillars we need
for using various
engineering
economy criteria
for decision
making

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Chapter 4
Nominal and Effective
Interest Rates
MS291: Engineering Economy

Content of the Chapter

Interest Rate: important terminologies

Nominal and Effective Rate of Interest
Effective Annual Interest Rate
Converting Nominal rate into Effective Rate
Calculating Effective Interest rates
Equivalence Relations: PP and CP
Continuous Compounding
Varying Interest Rates

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Lets start with a

Simple Example

15% per year

Compounded daily

How much
you going to
pay after 1
year ?

But ..is Due amount

after a year is really
$1150 ? Lets do
check!!!

Paid $1000 from credit card

1000+150 = $1150 ?

Rate is 15% per year but compounding is daily so the rate at per day is 0.15/365 =
0.000411 per day or 0.0411% per day
Days

Amount ($)

1000

Interest earned

Total due ($)

Amount x r =0.411

1000.411

1000.411

0.411169

1000. 82269

1000. 82269

0.411169

1001.233507

--------

------

------

1161.338553

0.47731

1161.815863

365

1161.815863 . But
this is around 16.81%
rate rather than
15% stated
If compounding
period is less than a
year . We face
such situation!!!

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Interest rate is same for

each period
1161.815863 . But this is
around 16.81% rate rather
than 15% stated
Nominal Interest Rate (15%)

denoted by (r)
does not include any consideration of
the compounding of
interest(frequency)
It is given as: r = interest rate per
period x number of compounding
periods

But interest due is

increasing in every
period

Effective Interest Rate (16.81%)

Denoted by (i)
take accounts of the effect of the
compounding period
commonly express on an annual
basis (however any time maybe
used)

Previous Learning

Our learning so for is based one interest rate thats

compounded annually

Interest rates on loans, mortgages, bonds & stocks are

commonly based upon interest rates compounded more
frequently than annually

When amount is compounded more than once annually,

distinction need to be made between nominal and
effective rate of interests

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Interest Rate:
important terminologies
New time-based definitions to understand and remember
Interest period (t) period of time over which interest is expressed.
For example, 1% per month.
Compounding period (CP) The time unit over which interest is charged or earned.
For example,10% per year, here CP is a year.
Compounding frequency (m) Number of times compounding occurs within the
interest period t.
For example, at i = 10% per year, compounded monthly, interest would be
compounded 12 times during the one year interest period.

Examples of interest rate

Statements
Annual interest rate of 8% compounded monthly
interest period (t) = 1 year
compounding period (CP) = 1 month
compounding frequency (m) = 12
Annual interest rate of 6% compounded weekly
interest period (t) = 1 year
compounding period (CP) = 1 Week
compounding frequency (m) = 52

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IMPORTANT: Compounding
Period and Interest Rate
Some times, Compounding period is not mentioned in
Interest statement
For example, an interest rate of 1.5% per month
..It means that interest is compounded each
month; i.e., Compounding Period is 1 month.
REMEMBER: If the Compounding Period is not
mentioned it is understood to be the same as the time
period mentioned with the interest rate.

Calculating Effective
Interest Rate
Effective interest rate per compounding
period can be calculated as follows:
=

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Example:
Three different bank loan rates for electric
generation equipment are listed below.
Determine the effective rate on the basis of the
compounding period for each rate
(a) 9% per year, compounded quarterly
(b) 9% per year, compounded monthly
(c) 4.5% per 6 months, compounded weekly

Example: Calculating
Effective Interest rates per CP
a. 9% per year, compounded quarterly.
b. 9% per year, compounded monthly.
c. 4.5% per 6 months, compounded weekly.

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Class Practice:
2 minute
For nominal interest rate of 18% per year
calculate the effective interest rate
i. If compounding period is yearly 18%
ii. If compounding period is semi-annually
iii. If compounding period is quarterly 4.5%
iv. If compounding period is monthly 1.5%
v. If compounding period is weekly 0.346%
vi. If compounding period is daily 0.0493 %

9%

Effective Annual Interest

Rates
When we talk about Annual we consider year as the
interest period t , and the compounding period CP can be
any time unit less than 1 year
Nominal rates are converted into Effective Annual Interest Rates (EAIR)
via the equation:

where

= (1 + ) 1

= (1 +

ia = effective annual interest rate

i = effective rate for one compounding period (r/m)
m = number times interest is compounded per year

) 1

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Example
For a nominal interest rate of 12% per year, determine the nominal and effective
rates per year for
(a) quarterly, and
ia = (1 + i)m 1
(b) monthly compounding
Solution:
(a) Nominal r per year = 12% per year

where
ia = effective annual interest rate
i = effective rate for one compounding
period (r/m)
m = number times interest is compounded
per year

Nominal r per quarter = 12/4 = 3.0% per quarter

Effective i per year = (1 + 0.03)4 1 = 12.55% per year
(b) Nominal r per month = 12/12 = 1.0% per month
Effective I per year = (1 + 0.01)12 1 = 12.68% per year

15% per year

Compounded daily

Effective I per year = (1 + 0.15/365)365 1 = 16.81% per year

Class Practice:
3 minutes
For nominal interest rate of 18% per
year determine, nominal and
effective interest rates per year .
i. If compounding period is yearly
ii. If compounding period is semiannually
iii. If compounding period is
quarterly
iv. If compounding period is
monthly
v. If compounding period is
weekly

= (1 +

) 1

= (1 + ) 1

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r = 18% per year,

compounded CP-ly

Economic Equivalence:
From Chapter 1

Different sums of money at different times may be equal

in economic value at a given rate
$110
Rate of return = 10% per year
Year

1
$100 now

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year
Economic Equivalence: Combination of interest rate (rate of return) and
time value of money to determine different amounts of money at different
points in time that are economically equivalent ..
Compounding/Discounting (F/P, P/F, F/A, P/G etc.)

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Equivalence Relations: Payment

Period(PP) & Compounding
Period(CP)

The payment period (PP) is the length of

time between cash flows (inflows or
outflows)

E.g., r = nominal 8% per year, compounded semi-annually

CP
6 months

PP
1 month

CP
6 months

10

11

12

Months

PP = CP, PP >CP, or PP<CP

Equivalence Relations: Payment

Period(PP) and Compounding Period

It is common that the lengths of the payment period and the

compounding period (CP) do not coincide

To do correct calculation of Economic Equivalence

Interest rate must coincide with compounding period

It is important to determine if PP = CP, PP >CP, or PP<CP

Length of Time

PP = CP

Involves Single
Amount
(P and F Only)

P/F , F/P

PP > CP
PP < CP

P/F, F/P

Involves Gradient
Series (A, G, or g)

P/A, P/G, P/g

F/A etc.
P/A, P/G, F/A etc.

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Case I:
When PP>CP for Single Amount
for P/F or F/P
Determine the future value of $100 after 2 years at credit
card stated interest rate of 15% per year, compounded
monthly.
F=?
Solution:
P = $100, r = 15%, m = 12
EIR /month = 15/12 = 1.25%
n = 2 years or 24 months

F = P(F/P, i, n)
F = 100(F/P, 0.0125, 24)
F = 100(1.3474)

i = (1 + r/m)m 1
= (1+0.15/12)12 1
= 16.076%

F = P(F/P, i, n)

F = P(F/P, 0.0125, 24)

F = 100(1.3474)

Alternative Method

F = P(F/P, 16.076%, 2)
F = 100(1.3456)
F = $134.56

Interpolation
needed

The results are slightly different because of the rounding off

16.076% to 16.0%

F = $134.74

Case I:
When PP>CP for Single
Amount for P/F or F/P
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)

i = r/M
Step 3: Determine the total number of payment
periods (n)
Step 4: Use the SPPWF or SPCAF with i and N above

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Case II: When PP >CP

for Series for P/A or F/A

For series cash flows, first step is to determine relationship

between PP and CP
Determine if PP CP, or if PP < CP
When PP CP, the only procedure (2 steps) that can be
used is as follows:
First, find effective i per PP
Example: if PP is in quarters, must find effective i/quarter

Second, determine n, the number of A values involved

Example: quarterly payments for 6 years yields n = 46 = 24

You can use then the standard P = A(P/A, i , n) or F = A(F/A, i, n)

etc.

Example: PP >CP for

Series for P/A or F/A
For the 7 years, Excelon
Energy has paid $500
every 6 months for a
software maintenance
contract. What is the
equivalent total amount
after the last payment, if
these funds are taken
from a pool that has been
returning 8% per year,
compounded quarterly?

Solution:

CP = Quarter

PP = 6 months

r = 8 % per year or 4% per 6 months &

m=2/ quarter
Because in

PP > CP
Effective rate (i) per 6 months = (1+r/m)m -1
i= (1+0.04/2)2 1 => 4.04%

each PP
amount get
compounded
twice

Since, total time is 7 years and PP is 6 months

we have total 7x2=14 payments

F = A(F/A, i, n)

F = 500(F/A, 0.0404, 14)

F = 500(18.3422) => $9171.09

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Case III: Economic

Equivalence when PP< CP
If a person deposits money each month into a savings account where
interest is compounded quarterly, do all the monthly deposits earn
interest before the next quarterly compounding time?
If a person's credit card payment is due with interest on the 15th of the
month, and if the full payment is made on the 1st, does the financial
institution reduce the interest owed, based on early payment? Anyone ?
The Usual answers are NO!!!! Some time possible for big
cooperation's
CP: 3 months = 1 quarter

10

11

12

Months

PP
1 month

Case III: Economic

Equivalence when PP< CP
Two policies:
1. Inter-period cash flows
earn no interest (most
common)
positive cash flows are
moved to beginning of the
interest period (no
interest earned) in which
they occur and negative
cash flows are moved to
the end of the interest
period (no interest paid)

2. inter-period cash flows

earn compound interest

cash flows are not

moved and equivalent
P, F, and A values are
determined using the
effective interest rate
per payment period

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Example 4.11: Example: Clean

Air Now (CAN) Company
Last year AllStar Venture Capital agreed to invest funds in Clean
Air Now (CAN), a start-up company in Las Vegas that is an
outgrowth of research conducted in mechanical engineering at
the University of NevadaLas Vegas. The product is a new
filtration system used in the process of carbon capture and
sequestration (CCS) for coal-fired power plants. The venture
fund manager generated the cash flow diagram in Figure in
$1000 units from AllStars perspective. Included are payments
(outflows) to CAN made over the first year and receipts (inflows)
from CAN to AllStar. The receipts were unexpected this first
year; however, the product has great promise, and advance
orders have come from eastern U.S. plants anxious to become
zero-emission coal-fueled plants. The interest rate is 12% per
year, compounded quarterly, and AllStar uses the no-inter
period-interest policy. How much is AllStar in the red at the end
of the year?

Example 4.11: Example: Clean Air

Now (CAN) Company
The venture fund manager generated the cash flow diagram in $1000
units from AllStars perspective as given below. Included are payments
(outflows) to CAN made over the first year and receipts (inflows)
from CAN to AllStar. The receipts were unexpected this first year;
however, the product has great promise, and advance orders have
come from eastern U.S. plants anxious to become zero-emission coalfueled plants. The interest rate is 12% per year, compounded quarterly,
and AllStar uses the no-inter period-interest policy. How much is
AllStar in the red at the end of the year?

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Example: Clean Air Now

(CAN) Company

Given cash flows

Positive Cash flows (inflows) at the start

of CP period

Negative Cash flows (outflows) at the

end of CP period

Example: Clean Air Now (CAN)

Company

Solution:
Effective rate per quarter = 12/4 = 3%
Now
F = 1000[-150(F/P, 3%, 4)-200(F/P, 3%, 3) +(180-175 )(F/P, 3%, 2)+ 165(F/P, 3%, 1)-50]
F = $ (-262111) Investment after one year

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Case III: Economic

Equivalence when PP< CP
If a person deposits money each month into a savings account where
interest is compounded quarterly, do all the monthly deposits earn
interest before the next quarterly compounding time?
If a person's credit card payment is due with interest on the 15th of the
month, and if the full payment is made on the 1st, does the financial
institution reduce the interest owed, based on early payment? Anyone ?
The Usual answers are NO!!!! Some time possible for big
cooperation's
CP: 3 months = 1 quarter

10

11

12

Months

PP
1 month

Case III: Economic

Equivalence when PP< CP
Two policies:
1. Inter-period cash flows
earn no interest (most
common)
positive cash flows are
moved to beginning of the
interest period (no
interest earned) in which
they occur and negative
cash flows are moved to
the end of the interest
period (no interest paid)

2. inter-period cash flows

earn compound interest

cash flows are not

moved and equivalent
P, F, and A values are
determined using the
effective interest rate
per payment period

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Example 4.11: Example: Clean

Air Now (CAN) Company
Last year AllStar Venture Capital agreed to invest funds in Clean
Air Now (CAN), a start-up company in Las Vegas that is an
outgrowth of research conducted in mechanical engineering at
the University of NevadaLas Vegas. The product is a new
filtration system used in the process of carbon capture and
sequestration (CCS) for coal-fired power plants. The venture
fund manager generated the cash flow diagram in Figure in
$1000 units from AllStars perspective. Included are
payments (outflows) to CAN made over the first year and
receipts (inflows) from CAN to AllStar. The receipts were
unexpected this first year; however, the product has great
promise, and advance orders have come from eastern U.S.
plants anxious to become zero-emission coal-fueled plants. The
interest rate is 12% per year, compounded quarterly, and AllStar
uses the no-inter period-interest policy. How much is AllStar in
the red at the end of the year?

Example 4.11: Example: Clean Air

Now (CAN) Company
The venture fund manager generated the cash flow diagram in $1000
units from AllStars perspective as given below. Included are payments
(outflows) to CAN made over the first year and receipts (inflows)
from CAN to AllStar. The receipts were unexpected this first year;
however, the product has great promise, and advance orders have
come from eastern U.S. plants anxious to become zero-emission coalfueled plants. The interest rate is 12% per year, compounded quarterly,
and AllStar uses the no-inter period-interest policy. How much is
AllStar in the red at the end of the year?

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Example: Clean Air Now

(CAN) Company

Given cash flows

Positive Cash flows (inflows) at the start

of CP period

Negative Cash flows (outflows) at the

end of CP period

Example: Clean Air Now (CAN)

Company
12% per year, compounded quarterly

Solution:
Effective rate per quarter = 12/4 = 3%
Now
F = 1000[-150(F/P, 3%, 4)-200(F/P, 3%, 3) +(180-175 )(F/P, 3%, 2)+ 165(F/P, 3%, 1)-50]
F = $ (-262111) Investment after one year

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Continuous Compounding
If we allow compounding to occur more and more frequently, the
compounding period becomes shorter and shorter and m , the
number of compounding periods per payment period, increases.
Continuous compounding is present when the duration of the
compounding period (CP), becomes infinitely small and, the
number of times interest is compounded per period (m), becomes
infinite.
Businesses with large numbers of cash flows each day consider
the interest to be continuously compounded for all transactions.
As m approaches infinity, the effective interest rate
i = (1 + r/m)m 1 must be written and use as; i = er 1

Example: Continuous
Compounding
Example: If a person deposits $500 into an account every 3 months
at an interest rate of 6% per year, compounded continuously, how
much will be in the account at the end of 5 years?
Solution:

Payment Period: PP = 3 months

Nominal rate per three months: r = 6%/4 = 1.50%
Effective rate per 3 months: i = e0.015 1 = 1.51%
F = 500(F/A,1.51%,20) = $11,573
Practice:
Example 4.12 & 4.13

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Varying Interest Rates

Interest rate does not remain constant full life time of a

project

In order to do incorporate varying interest rates in our

calculations, normally, engineering studies do consider
average values that do care of these variations.

But sometimes variation can be large and having significant

effects on Present or future values calculated via using
average values

Mathematically, varying interest rates can be

accommodated in engineering studies

Example: Varying Interest Rates

Given below the cash flow calculate the Present value.
$70,000
i=7%

$35,000

i=7%
i=9%

$25,000
i=10%

Year
0

P=?

P = 70,000(P/A, 7%, 2) + 35,000 (P/F, 9%, 1) (P/F, 7%, 2)

+ 25000(P/F, 10%, 1) (P/F, 9%, 1) (P/F, 7%, 2)
= 70,000 (1.8080) + 35,000 (0.9174)(0.8734) + 25,000(0.9091)(0.8734)(0.0.9174)
= $172,816

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Varying Interest Rates

When interest rates vary over time, use the interest
rates associated with their respective time periods to
find P
The general formula for varying interest rate is given as:
P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + ..
+ Fn (P/F, i1, 1)(P/F, i2, 1) (P/F, in, 1)

For single F or P only the last term of the equation can

be used.
For uniform series replace F with A

Example: Varying Interest Rates

Calculate (a) the Present value (b) the uniform Annual
worth A of the following Cash flow series
P=?
i=10%

i=14%

Year

0
$100 $100 $100 $100 $100
$160 $160

$160

P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + ..

+ Fn (P/F, i1, 1)(P/F, i2, 1) (P/F, in, 1)

P = 100(P/A, 10%, 5) + 160 (P/A, 14%, 3) (P/F, 10%, 5)

= 100(3.7908) + 160(2.3216)(0.6209)
= $609.72

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Problem 4.57: Varying Interest

Rates
(b) Calculate the uniform Annual worth
A of the following Cash flow series
P = 609.72
i=10%

1 2 3

i=14%

4 5

Year

Year
A=?

P = 100(P/A, 10%, 5) + 150 (P/A, 14%, 3) (P/F, 10%, 5)

= 100(3.7908) + 160(2.3216)(0.6209)
= $609.72

609.72 = A(3.7908) + A(2.3216)(0.6209)

A = 609.72 / 5.2323
A = $ 116.53 per year

THANK YOU

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