Professional Documents
Culture Documents
Hugh Miller
Colorado School of Mines
Mining Engineering Department
Fall 2013
Basics
Notation
Significant Digits
Maximum of 4 significant figures unless the first digit is a 1, in which case a
maximum of 5 sig figs can be used
In general, omit cents (fractions of a dollar)
Year-End Convention
Use the method most easy for you (visualize problem setup)
Concept of Interest
If you won the lotto, would you rather get $1 Million now or
$50,000 for 25 years?
What about automobile and home financing? What type of
financing makes more economic sense for your particular
situation?
Interest: Money paid for the use of borrowed money.
Simple Interest
Simple Interest is also known as the Nominal Rate of Interest
Suppose you invested $1,000 for one year at 6% simple rate; at the end
of one year the investment would yield:
$1,000 + $1,000(0.06) = $1,060
This means that each year interest gives $60
How much will you earn (including principal) after 3 years?
$1,000 + $1,000(0.06) + $1,000(0.06) + $1,000(0.06) = $1,180
Note that for each year, the interest earned is only calculated over $1,000.
Does this mean that you could draw the $60 earned at the end of each year?
Terms
In most situations, the percentage is not paid at the end of the period, where the interest
earned is instead added to the original amount (principal). In this case, interest earned from
previous periods is part of the basis for calculating the new interest payment.
This adding up defines the concept of Compounded Interest
Now assume you invested $1,000 for two years at 6% compounded annually;
At the end of one year the investment would yield:
$1,000 + $1,000 ( 0.06 ) = $1,060
or
$1,000 ( 1 + 0.06 )
Since interest is compounded annually, at the end of the second year the investment
would be worth:
Factorizing:
$1,000 ( 1 + 0.06 ) ( 1 + 0.06 ) = $1,000 ( 1 + 0.06 )2 = $1,124
How much this investment would yield at the end of year 3?
Receipts
A2
Cash Flow
A1
A3
A4
A5
A6
Time
Disbursements
Interest Formulas
The compound interest relationship may generally be expressed as:
F = P (1+r)n
Where
(1)
Interest Formulas
r = Nominal rate of interest
i = Effective interest rate per period
Future Value
Example:
Given
n=
P=
i=
Find F
Future Value
Example:
Given
n =
P =
r =
Find F
6 years
$ 1,500
6.0 %
F = (1,500)(1+0.06)6
F = $ 2,128
Future Value
Example:
F = P (F/P,i,n)
F = 1500 (F/P, 6%, 6)
F = 1500 (
)=
Future Value
Example:
F = P (F/P,i,n)
F = 1500 (F/P, 6%, 6)
F = 1500 (1.4185) = $2,128
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:
P = F / (1+r)n
(2)
Example: If you will need $25,000 to buy a new truck in 3 years, how much
should you invest now at an interest rate of 10% compounded
annually?
(P/F,i,n)
Given
F =
n =
i
=
Find P
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:
P = F / (1+r)n
(2)
Example: If you will need $25,000 to buy a new truck in 3 years, how much
should you invest now at an interest rate of 10% compounded
annually?
Given
F =
n =
i
=
Find P
$25,000
3 years
10.0%
P = F / (1+r)n
P = (25,000) /(1 + 0.10)3
= $18,783
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:
P = F / (1+r)n
(2)
Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 10% compounded annually?
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:
P = F / (1+r)n
(2)
Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 10% compounded annually?
Present Value
Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 9.5% compounded annually?
Method #1: Direct Calculation: Straight forward - Plug and Crank
Method #2: Tables: Interpolation
Engineering Economics
EIT Review
Uniform Series & Effective Interest
Annuities
Uniform series are known as equal annual
payments made to an interest bearing account
for a specified number of periods to obtain a
future amount.
Cash Flow
A1
A2
A3
A4
A5
A6
Time
Annuities Formula
The future value (F) of a series of payments (A) made during (n)
periods to an account that yields (i) interest:
F = A [ (1+i)n 1 ]
i
(5)
Applications?
Example:
What is the future value of a series payments of $10,000 each, for 5
years, if deposited into a savings account yielding 6% nominal interest
compounded yearly?
Visualize the Cash Flow Diagram then Select the Equation
F = A [ (1+i)n 1 ] =
i
Example:
What is the future value of a series payments of $10,000 each, for 5
years, if deposited in a savings account yielding 6% nominal interest
compounded yearly?
Draw the cash flow diagram.
F = A [ (1+i)n 1 ] = 10,000 [ (1+0.06)5 1 ] = 10,000 [ 1.3382 1 ]
i
0.06 0.06
= $ 56,370
Checking with Factor Values:
F = A (F/A,i,n)
= 10,000 (F/A, 6%, 5)
= 10,000 ( 5.6371 )
= $ 56,370
Sinking Fund
We can also get the corresponding value of an annuity (A) during (n) periods
to an account that yields (i) interest to be able to get the future value (F) :
Solving for A:
A = i F / [ (1+i)n 1 ]
(6)
Notation: A = F (A/F,i,n)
Applications?
Example:
How much money would you have to save annually in order to buy a car in 4
years which has a projected value of $18,000? The savings account offers
4.0% yearly interest.
A=
Sinking Fund
Example:
How much money do we have to save annually to buy a car 4 years from
now that has an estimated cost of $18,000? The savings account offers
4.0 % yearly interest.
A = i F / [ (1+i)n 1 ]
A = (0.04 x 18,000) / [ (1.04)4 -1 ] = 720 / 0.170 = $4,239
A = F (A/F,i,n)
A = (18,000)(A/F,4.0,4) = (18,000)(0.2355) = $4,239
(7)
Notation: P = A (P/A,i,n)
Applications?
Example:
What is the present value of a series of royalty payments of $50,000
each for 8 years if nominal interest is 8%?
P=
(8)
Notation: A = P (A/P,i,n)
Example:
If an investment opportunity is offered today for $5 Million, how much must it yield
at the end of every year for 10 years to justify the investment if we want to get a
12% interest?
A=
i P (1+i)n
(1+i)n -1
= 0.12 x 5 (1+0.12)10 =
(1.12)10 - 1
= 0.8849 Million
0.6 [ 3.1058 ]
2.1058
Engineering Economics
EIT Review
Varying Compounding Periods
Effective Interest
A, i, n
Receipts
A1
A2
A3
A4
A1 + A2 + A3 = $1000
A4 + A5 = $600
A5
Time
Time
A1 = A2 = A3 = A4 = A5 = $600
A2 A3
Time
A1 = A2 = A3 = $400
Time
A1 = A2 = A3 = $1000
Time
A4 = A5 = $600
Receipts
A1
A2
A3
A4
A5
Time
Compounding Frequency
Compounding Frequency
Example: If a student borrows $1,000 from a finance
company which charges interest at a compound
2% per month:
rate of
The effective interest rate is the rate compounded once a year which is
equivalent to the nominal interest rate compounded x times a year
The effective interest rate is always greater than or equal to the nominal
interest rate
The greater the frequency of compounding the greater the difference between
effective and nominal rates. But it has a limit Continuous Compounding.
Frequency
Periods/year
Annual
1
Semiannual
Quarterly
Monthly
12
Weekly
52
Daily
365
Continuously
Nominal Rate
12%
2
4
12.00%
12%
12%
12%
12%
12%
Effective Rate
12.36%
12.55%
12.68%
12.73%
12.75%
12%
12.75%
Compounding Frequency
i P (1+i)n
(1+i)n -1
Example: Approach #1
An engineer deposits $1,000 in a savings account at the end of each year. If
the bank pays interest at the rate of 6% per year, compounded quarterly, how
much money will have accumulated in the account after 5 years?
Effective Interest Rate: i = (6%/4) = 1.5% per quarter
F = P (F/P,i,mn)
F = $1000(F/P,1.5%,16) + $1000(F/P,1.5%,12) + $1000(F/P,1.5%,8) +
$1000(F/P,1.5%,4) + $1000(F/P,1.5%,0)
Using formulas or tables: F = $5,652
Example: Approach #2
An engineer deposits $1,000 in a savings account at the end of each year. If
the bank pays interest at the rate of 6% per year, compounded quarterly, how
much money will have accumulated in the account after 5 years?
When this occurs, some payments may not have been deposited for an
entire interest period. Such payments do not earn any interest during that
period.
Consider all deposits that were made during the interest period to have been
made at the end of the interest period (i.e., no interest earned during the period)
Consider all withdrawals that were made during the interest period to have been
made at the beginning of the interest period (i.e., earning no interest)
Then proceed as though the interest periods and the payment periods coincide.
Quarter #1:
Quarter #2:
Quarter #3:
Quarter #4:
Jan. 1 March 31
April 1 June 30
July 1 Sept. 30
Oct. 1 Dec. 31
Deposit
Withdrawal
$175
$1,200
$1,800
$65
$115
$50
$250
$1,600
$800
$350
$2,300
$750
Effective Date
Jan. 1st (beginning 1st Q)
Mar. 31th (end of 1st Q)
April 1st (beginning 2nd Q)
June 30 (end of 2nd Q)
June 30 (end of 2nd Q)
April 1st (beginning 2nd Q)
April 1st (beginning 2nd Q)
Sept. 30 (end of 3rd Q)
July 1st (beginning 3rd Q)
Oct. 1 (beginning 4th Q)
Dec. 31 (end of 4th Q)
Oct. 1 (beginning 4th Q)
Continuous Compounding
Continuous Compounding
Example: An investment institution is selling long-term
savings certificates that pay interest at the rate of 7 %
per year, compounded continuously. What is the actual
annual yield of these certificates?
i = er 1 = e0.075 1 = 0.0779 (7.79%)
Continuous Compounding
Discrete payments:
If interest is compounded continuously but payments are
made annually, the following equations can be used:
F/P = ern
P/F = e-rn
Where:
Gradient Series
Thus far, most of the course discussion has focused on uniformseries problems
A Uniform Gradient Series (G) exists when cash flows either increase or
decrease by a fixed amount in successive periods.
AT = (A1) + (A2)
A2 = G [(1/i) (n/i)(A/F,i,n)]
where:
Therefore:
AT = (A1) + G(A/G,i,n))
Want to Find: P
Given: A1, G, i, and n
$18000
$8000
$7000
$6000
$5000
T=0
14
15
P = A (1 + j)-1 K =[(1
1 + j)/(1 + i)]-K
For i = j:
P = (n x A ) / (1 + i)
For i j:
P = A [1(1-j)n (1+i)-n] / (i - j)
Nomenclature:
P = A (P/A,i,j,n)