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After studying chapter 2, students should be able to:

1)
2)

3)
4)
5)

Know the symbols used in engineering economy


analysis.
Explain the meaning of equivalence in
engineering economy.
Calculate growth rate and rate of return.
Apply simple interest and compounded interest.
Explain nominal and effective growth rate in
engineering economy analyses.

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Simple growth.
Compounded growth.
Nominal growth rate.
Effective growth rate.
Factors involved.
Time value of money.

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Unit time is the unit year that occur at each year end.

Basic symbols,
i)
P
Present value / present worth at time 0. It is a single value occuring
only once.
ii)
F
A single value that occur in the future, that is, at any year end
except time/year 0.
iii) A
A uniform annual value that occur in series for more than 1 year,
starting at end of year 1.

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iv) G
G is a set of values that increase uniformly (gradient series) that starts at
year 1 with the value 0.

v)
e
e is a set of values that increase geometrically or exponentially in a series
of years. This series starts with an initial value D and then increases by a
specific percentage of the previous value.
vi) i
A growth rate that occur for each year and is in the form of percentage.
vii) n
It is period of the analyses usually in unit year.

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Example 2.1
Ali planned to borrow RM30,000 now and will payback this loan in a single payment at
the end of the third year. How much will he has to pay at 12% growth rate? Determine
the symbols used in Engineering Economy in this case.

Solution:
P = RM30,000
i = 12%
n = 3 years
F=?

Example 2.2
Refering to example 2.1 how much will the cumulative value of the loan if growth rate is
12% and payment will be made every year for 3 years. Determine the symbols used in
Engineering Economy in this case.
Solution:
P = RM30,000
i = 12%
n = 3 years
A=?

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Principle
The initial or basic value of an investment or loan
Growth
Represents time value of money of the principle

Growth = Future value Initial value

Growth Rate

Growth Rate (%) =

Growth in a unit time


Initial value

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x 100%

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Example 2.3
Ahmad made a bank loan of RM20,000 now and is required to
pay back RM21,000 one year from now. What is the growth value
and growth rate of this loan?
Solution:
Growth = RM21,000 RM20,000 = RM1,000
Growth rate = 1,000 x 100%
20,000
= 5%

Exercise:
Borrow RM50,000 now
Pay RM 65,000 one year from now
Growth?
Growth rate?
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A value that is equal to another, due to time value of money.

Example
Ali deposited RM1,000 in a bank now at the rate of 5% a year. A
year later his savings become RM1,050. Thus a growth of
RM50 occurred over the one year period.
This shows that the value of RM1,000 now is equivalent to
RM1,050 one year from now at growth rate of 5%.

RM1000
Now

Equivalent
i = 5%

RM1050
After 1 year

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Simple growth is calculated based only on the


principle value.

Growth = Principle x Unit time x Growth rate

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Example 2.4
A company provides loan facility for workers with a pay back
scheme based on simple growth. Determine the amount
owed by a worker if he borrowed RM2,000 for 5 years at the
growth rate of 10% per year.
Solution:

Growth each year = RM2,000 x 10% = RM200


Total growth for 5 years = RM200 x 5 = RM1,000
Or RM 2000 x 10% x 5 = RM1,000
Therefore, the accumulated amount he owes in 5 years;
= RM2,000 + RM1,000
= RM3,000
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Compound growth; growth for each period is based


on the principle value and the total growth from
previous years.
Growth = (Principle + Total growth) x Growth rate

Example 2.5
A client borrowed RM2,000 from a bank with a
compounded growth rate of 10% a year. Determine
the total amount that he owes over a 5 year period.

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Solution:
Growth for year 1 = RM2,000 x 10% = RM200
Total accumulated debt at end of year 1
= RM2,000 + RM200 = RM2,200
Growth for year 2 = RM2,200 x 10% = RM220
Total accumulated debt at end of year 2
= RM2,200 + RM220 = RM2,420
Growth for year 3 = RM2,420 x 10% = RM242
Total accumulated debt at end of year 3
= RM2,420 + RM242 = RM2662
Growth for year 4 = RM2,662 x 10% = RM266.2
Total accumulated debt at end of year 4
= RM2,662 + RM266.2 = RM2,928.2
Growth for year 5 = RM2,928.2 x 10% = RM292.82
Total accumulated debt at end of year 5
= RM2,928.2 + RM292.82 = RM3,221.02

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Conclusion:
With simple growth, the debt became RM3,000 (in 5 years)

With compounded growth, the debt became RM3,221.02 (in 5 years)


A difference of RM221.02

The method of calculating growth rate has an impact on the value


accumulated at the end of each year.

Growth this year

(Principle + growth last year) growth rate

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A graphical representation of cash flow on a


time scale.

Cash Flow, RM

Time

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Note:

Suppose to be 1G, 2G,


3G, 4G

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Example 2.6
A man borrowed RM5,000 now at the growth rate of 12% per
year, how much must he pay at year 5. Construct the cash
flow diagram for this problem.

Solution:

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Example 2.7
Azman invest RM2,000 every year for 6 years. He wants to
know the amount of return in his investment accumulated
after 6 years if growth rate is 10% a year. Construct the cash
flow diagram for this problem.
Solution:

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Single payment

And

Factor
And

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

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known

known

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Example 2.8
Ah Chong saves RM20,000 in a bank that promises a yearly growth
rate of 12%. How much money will be accumulated after 10 years?
Solution:
F = 20,000 (F/P, 12%, 10)
Refering to the table of
compounded growth rate,
at i = 12% and at 10 year,
F/P = 3.1058
Therefore,
F = 20,000 (3.1058)
= RM62,116
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Annual worth

Thus the factor is written as,

And

Similarly, with F value

And

And

Thus the factor is written as,

And

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Example 2.9
How much money should be invested now to gain a return of
RM500 a year for 10 years with growth rate of 12% a year?
Solution:

P = 500 (P/A, 12%, 10)


From the table, P/A = 5.6502)
Thus,
P = 500 (5.6502)
= RM2825.10

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Example 2.10
If you invest RM1,000 per year starting at the end of the first
year, how much return will be accumulated at the end of the
8th year if annual growth rate is 10%?
Solution:
F = 1,000 (F/A, 10%, 8)
From the table F/A = 11.4358

Thus,
F = 1,000 (11.4358)
= RM11,435.80

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Uniform increase or gradient series.

And

Thus the factor is written as,

And

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Example 2.11
Rent for a business premise is RM500 for the first year and
increases at a constant rate of RM100 each year for 5 years.
If the annual growth rate is 8%, determine the equivalent
value of;

a) P
b) A
Solution:

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a) P
P = 500 (P/A, 8%, 5) + 100 (P/G, 8%, 5)
From the Table, P/A = 3.9927 dan P/G = 7.3724,
Therefore,
P = 500 (3.9927) + 100 (7.3724) = RM2733.59

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b) A
A = 500 + 100 (A/G, 8%, 5)
From the Table, A/G = 1.8465,
therefore,
A = 500 + 100 (1.8465)= RM684.65
5

0
500
100

684.65

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Geometrical increase or Exponential series


No minus sign in the formulae

For i e

And

For i = e

e represents yearly incremental rate of


cost or income based on percentage
instead of fixed amount

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Example 2.12
Maintenance cost of a machine is RM990 in the first year and
increases at the rate of 10% a year until year 6. Calculate
present value P if the rate of return (growth rate) is;
a) 15% per year
b) 10% per year
Solution:
Where,

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a) For the case of i e


-5925.29
0.1-0.15

b) For the case of i = e

-5400
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What is capitalised
project?
and

When n =
P/A = 1/i
A = Pi
P = A/i

A project which has a


very long service life
(n) such as highway,
bridge, airport etc
Case like this, n is
assumed infinity
Usually, it has yearly
maintenance cost,
recurring cost (eg.
every 5 years) and
non-recurring cost
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6,000
n=

P=?

P = A/i = 6000/0.06
= 100,000

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Non recurring cost


Eg. Overhaul cost ,
investment cost where it
occurs 10 years from
now. It happens only once
It is considered as single
payment, F
Use P/F factor to find
capitalised cost at year 0

Recurring cost
Eg. Major rework cost of
RM 50,000 every 15
years. Meaning, this cost
recurs every 15 years
until infinity
Consider this recurring
cost in one cycle only for
the whole project life.
Treat this as a single
payment, F
Use A/F factor to find
annual operating cost
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A suspension bridge has a first cost of RM 30 million with annual


inspection and yearly maintenance cost of RM10,000. The cost of
purchasing of land (right-off-way) is expected to be RM 500,000.
In addition, the concrete deck would have to be resurfaced every
10 years at a cost of RM 100,000. Determine the total budgetary
cost for the whole project now if the interest rate is 6% per year.
0

10

20

10,000
500,000

30,000,000

100,000

100,000

Recurring cost
Non-Recurring cost
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P1 = 30,000,000 + 500,000 = 30,500,000


Annual recurring operating cost, A1 = 10,000
Annual equivalent of resurface cost (consider only 1 cycle),
A2 = 100,000 (A/F, 6, 10)

P2 = capitalized cost of recurring costs = (A1 + A2)/i


Total capitalized cost of suspension bridge = P1 + P2

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Conventional cases
Cash flow (A, F)
starts at first year
and P always at
year 0

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Unconventional cases
Cash flow (A, F, G)
starts at
somewhere in the
middle

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Example 2.14
Abdullah bought a piece of land with a down payment of
RM15,000 and a yearly payment of RM1,000 for 6 years. Due
to financial problems he wishes to delay the yearly payment
and start paying 3 years from now. What is the present value
of the land if growth rate is 10% per year?.
Solution:
0

2
0

3
1

8
6

A
P

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P = 1,000 (P/A, 10%, 6)


= 1,000 (4.3553)
= RM4,355.30
P = 4,355.30 (P/F, 10%, 2)
= 4,355.30 (0.8264)
= RM3,599.22
Therefore, total P value is,
P = 15,000 + 3,599.22
= RM18,599.22
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Example 2.15
The transaction for the purchase of a fix asset is shown in the
following table;
Year

Annual payment (RM)

1-3

1,000

4-7

3,000

8-10

2,000

Determine the present worth for this purchase if growth rate


is 12% per year.
0

Solution:

10
1,000
2,000
3,000
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P1 = 1,000 (P/A, 12%, 3)


= 1,000 (2.4018)
= RM2,401.80

10
1,000
2,000

P2 = 3,000 (P/A, 12%, 4) (P/F, 12%, 3)


= 3,000 (3.0373) (0.7118)
= RM6,485.85
P3 = 2,000 (P/A, 12%, 3) (P/F, 12%, 7)
= 2,000 (2.4018) (0.4523)
= RM2,172.67
Thus,

3,000

10

PTotal = P1 + P2 + P3
= 2,401.80 + 6,485.85 + 2,172.67
= RM11,060.32

42
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Solution 2.16
Income/return from a machine is shown in the cash flow
diagram below. Calculate P.
Solution:

Thus

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Example 2.17
Based on the following information, calculate;
i. Present worth of project
ii. Projects value at year 7
iii. Balance/remaining value of project at year 7

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Solution :
i.
Present value of project , P
P = - 170,000 8,000 (P/A, 10%, 12) +10,000 (P/G, 10%, 12)
= - 170,000 8,000 (6.8137) + 10,000 (29.9012)
= - 170,000 54,509.60 + 299,012
= RM74,502.40
ii.

iii.

Overall project worth at year 7, F7


F7 = 74,502.40 (F/P, 10%, 7)
= 74,502.40 (1.9487)
= RM145,182.82

P7

G = 10,000

70,000
7

A = 8,000

12

Remaining/ Balance of project value at year 7, P7


F8 = (8 1) (10,000) = RM70,000
Thus,
P7 = 70,000 (P/A, 10%, 5) + 10,000 (P/G, 10%, 5)
8,000 (P/A, 10%, 5)
= 70,000 (3.7908) + 10,000 (6.8618)
8,000 (3.7908)
= 265,356 + 68618 30,326.40
= RM303,647.60

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Example 2.18
Data on a machine is as follows;
a. Expected market price after 10 years is RM30,000.
b. Revenue from the sales of product is RM12,000 per year.
c. Material and maintenance costs from year 1 to year 5 is RM5,000
per year.
d. Cost for machine overhaul is RM10,000 at year 5.
e. The maintenance cost from year 6 to year 10 is ;
Year

Value (RM)

5,000

6,000

7,000

8,000

10

9,000

Calculate P if i = 10% per year.


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Solution:

P = 12,000 (P/A, 10%, 10) + 30,000 (P/F, 10%, 10)


5,000 (P/A, 10%, 10) - 10,000 (P/F, 10%, 5)
1,000 (P/G, 10%, 5) (P/F, 10%, 5)
= 12,000 (6.1446) + 30,000 (0.3855) 5,000 (6.1446)
- 10,000 (0.6209) 1,000 (6.8618) (0.6209)
= 73,735.20 + 11,565 30,723 6,209 4,260.49
= RM44,107.71

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47

Compute the
Future worth in year
10
Present value
Equivalent annual
amount
Assume i = 12%

3000

700
200

150

10

300
800

1200
1400
1600

IS

1300

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Case for unconventional growth rate.


F = (1 + iyear) = (1 + imonth)n
Thus,

(1 + iyear) = (1 + imonth)n
imonth

iyear = (1 + imonth)n -1
18
month

If imonth = 1%,

iyear

= (1 + 0.01)12 1
= 12.68%
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Consider the following


statements:
Invest now RM1000 at interest
rates:
1. 12% per year compounded
annually
2. 12% per year compounded
semiannually
3. 12% per year compounded
quarterly
Calculate what will happen to the
amount of money after 1 year
investment?

F=?

CASE 1

1 year

12 months

P=1000
F = P(1 + i)n
= 1000 (1 + 0.12)1
= 1120

Compounded annually means


interest charged yearly
Compounded semiannually
means interest will be charged
2x a year (every 6 months)
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Interest is charged twice on the


investment i.e first at 6 months
and the second time at the end of
year 1

1st time charging:


F6mth = 1000 (1 + 0.06) = 1060
2nd time charging:
F12mth = 1060 (1 + 0.06) = 1123.6

iyear = (1 + 0.06)2 1 = 12.36%

What is the real or effective interest


rate? 12% or 12.36%

CASE 2

F=?

1 year

0
0

12

P=1000

Effective interest rate, ieff


= {(1123.6 1000)/1000}x100
= 12.36%
When compounding more than
once per year, the interest rate
becomes more than what is
stated!
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Interest is charged 4x on the


investment i.e every 3 months

1st time charging:

CASE 3

1 year

0
0

F3mth = 1000 (1 + 0.03) = 1030

F=?

12

P=1000

2nd

time charging:
F6mth = 1030 (1 + 0.03) = 1060.9

Effective interest rate, ieff

3rd time

= {(
1000)/1000}x100
= _____%

4th time

What is the real or effective


interest rate? 12%?

iyear = (1 + 0.03)4 1 = 12.55%

If we know the eff interest rate


= 12.55%,
F = 1000 (1 + 0.1255)1
= 1125.50
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i = 12% per year


compounded quarterly

0
months

3
months

6
months

9
months

12
months

Nominal

3%

6%

9%

12%

Effective

3%

6.09%

9.27%

12.55%

Interest compounded every 3 months, 4x per year


Nominal interest rate/quarter = 12/3 = 3%

Effective interest rate/period, ieff/period = (1 + iN/period/m)m 1


Adjust interest rate to align with payment period
m is no of compounding periods
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Effective interest rate/period,

1.

ieff/period = (1 + iN/period/m)m 1

2.

Adjust interest rate to align with payment


period, where m is no of compounding
periods

How many compounding per


year are there?
1. m = 1
2. m = 2
3. m = 4

3.

12% per year compounded


annually
12% per year compounded
semiannually
12% per year compounded
quarterly

eff/year

= (1 + 0.12/1)1 -1 = 0.12

eff/year

= (1 + 0.12/2)2 -1 = 0.1236

eff/year

= (1 + 0.12/4)4 -1 = 0.1255

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Adjust interest rate to align with payment period


means..adjust interest position so that effective interest on
the payment can be charged according to the no of
compounding period.
Three conditions available (for single payment only):
PP > CP
PP = CP
PP < CP

PP = CP

PP > CP

1 yr

Any CP less than 1 year

1 yr

PP < CP

Eg. CP = 3
months,
Payment in
6 months

1 yr

Any CP coincide with


payment within 1 year

Any payment made within


1 year but less than CP

Eg. Payment at 6
months, CP = 6
months

Eg. Payment every 3


months, CP = 6 months
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Case 1, PP>CP
Method 1: Use iN for a period that follow
compounding period. Eg. Compounded
semiannually (twice a year), i nominal must be
per 6 months. No of periods = 2xn where 2 is no
of compounding per year and n is no of years
Or Method 2: use ieff for 1 year period. Calculate
ieff with formula ieff/period = (1 + iN/period/m)m 1
where m is no of compounding periods within a
year

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Case 2, PP=CP
ieff per compounding period is equal to iN for the
payment. Eg. 12% per year compounded
semiannually and payment also at 6 months. In
this case ieff/6mth = iN/6mth = 6%.
Follow calculation using 1st method in case 1

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Case 3, PP<CP

Two choices will occur. Inter-period payment before


compounding period will be charged simple interest or
without charging any interest.
Interest = (M/N)*simple interest. This interest amount will
be added to the payment (if any) at the CP. Only payment at
CP will get compounding interest
Eg. CP=6, Payment at month 3 . It is assumed that the
payment made at month 6, no interest given to payments
made from month 3-5. In withdrawal case, it is assumed
the withdrawal occurs at previous compounding period. Eg.
Withdraw at month 5 is assumed withdrew at month 0.

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Special notes for cases involving series (A, G or


e) when PP CP

Use method 2 in CASE 1 to solve the problem

Determine the total no of payment periods and use


that number as n
Find the effective ieff per payment period
Calculate P or F using std notation formula

IS

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Example 2.19
For a growth rate of 12% a year compounded every 3 months,
determine;
a. Nominal and effective growth rate for 3 months.
b. Nominal and effective growth rate for 6 months.
c. Nominal and effective growth rate for 1 year.
d. Nominal and effective growth rate for 1 month.

Solution:
In (a) growth is compounded every 3 months, that is, 4 times a
year (4 period) that growth is calculated.

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a) Nominal growth rate = iN3m = 12%/4 = 3 %


Effective growth rate = iE3m = 3%
In this case both rates are equal because both occur at the same period.
b) Nominal growth rate = iN6m = 12%/2 = 6 %
For effective growth rate; 1+iE6m = (1+0.03)2
Therefore, iE6m = 0.0609 (6.09%)
Growth is compounded twice a year.
c) Nominal growth rate per year = 3% x 4 = 12%
For effective growth rate; 1+iEyear = (1+0.03)4
Therefore, iEyear = 0.1255 (12.55%)
Growth is compounded each year.
d) There is no effective growth for period less than the compounded period. (No growth is
generated in this period).

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Example 2.20
An individual saves RM1,000 now, RM3,000 four years from
now and RM1,500 six years from now. At a growth rate of
12% a year compounded twice a year, how much money is
accumulated in his account at year 10.

Solution:
iN = 12% compounded twice yearly
(year)

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Note:

i = 12% per year


compounded semiannually

Single Payment
Case: PP > CP

3000

1500

10 year

PP = 1 year,
CP = 6 months

1000

Use i effective for 1 year period:


ieff/yr =

iN / yr
1
m

- 1 = (1 + 0.12/2)2 - 1= 12.36%

F = 1000(F/P, 12.36, 10) + 3000(F/P, 12.36, 6) + 1500(F/P, 12.36, 4)

Or use i nominal for 6 month periods because interest


compounded semiannually :
F = 1000(F/P, 6%, 10x2) + 3000(F/P, 6%, 6x2) + 1500(F/P, 6%, 4x2)
0

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If a women deposits RM 500 every 6 months for 8 years, how much


money will she have in her account after she makes her last
deposit? Assume that the growth rate is 20% per year compounded
quarterly.
F=?
0

A = 500
0

Which case? A series, PP>CP


Step:
1. Determine how many
payments? 8 x 2 = 16. So,
n = 16
2. Calculate ieff/6month , iN per
period = 10% (follow PP),
m = 2 (2x compounding
within 6 months)
3. Calculate F using ieff/6month n
= 16,
iS

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Method 1: Based on the compounded period


iN6month = iE6month = 12%/2 = 6%
In this case, 2 compounded period per year of 6% per period, with a total of 20
compounded period in10 years.

Method 2: Based on the annual effective growth


In this case, the effective annual growth is used.
(1+iE6month ) = (1 + 0.06)2
iE6month = 0.1236 (12.36%)
In this case, the effective annual growth of 12.36% is used.

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Cash flow series

Interest rate

What to find,
what is given

Standard notation

$500 semiannually
for 5 years

16% per year,


compounded
semiannually

Find P, given A

P= 500(P/A,8%,10)

$75 monthly for 3


years

24% per year,


compounded
monthly

Find F, given A

F= 75(F/A,2%,36)

$180 quarterly for


15 years

5% per quarter

Find F, given A

F= 180(F/A,5%,60)

$25 per month


increase for 4
years

1% per month

Find P, given G

P= 25(P/G,1%,48)

$5000 per quarter


for 6 years

1% per month

Find A, given P

A= 5000(A/P,3.03%,24)

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In single payment, if
PP > CP use iN and mn or ieff
PP = CP use iN & mn

In series A, G or e
PP > CP use ieff
PP = CP use iN & mn

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Example 2.21
Calculate the nominal and effective growth if growth is
compounded every month.
Solution :
iNyear = ?
iEyear= ?

1,300 (1 + imonth)4 = 1500


(1 + imonth) = (1.1585)1/4
imonth = 0.0364 (3.64%)

Thus, imonth = 12 x 3.64% = 43.68%


4
months

Thus,

(1 + iEmonth) = (1 + imonth)12
(1 + imonth) = (1 + 0.0364)12
(1 + imonth) = 1.5362
imonth = 0.5362 (53.62%)

(For a period of 1 year, growth is compounded 12


times)

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Time value of money.


Cash Flow Diagram.
Factors in analyses.
Compounded period less than 1 year.
Transformation involved.
Consideration for method of growth.

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A company that specializes in odor


control made deposits of $10000
at the end of year 2, $25000 at the
end of year 3, and $30000 at the
end of year 5. Determine the future
worth (in year 6) of the deposits at
an interest rate of
i. 16% per year compounded
quarterly.
ii. 6 % per six months
compounded monthly
iii. 1 % per month compounded
semiannually

10,000
25,000
20,000

30,000

1/2

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For the past 7 years, a quality


manager has paid $500 every 6
months for the software
maintenance contract of a LAN.
What is the equivalent amount
after the last payment, if these
funds are taken from a pool that
has been returning 20% per year,
compounded quarterly?
PP = 6 months, CP = 3 months
PP CP, Case 1 with A series

Align ieff to the payment period,


i.e. ieff/6 months , iN/6 months = 10%

A = $500
Effective i% per 6 months
= (1 + 0.10/2)2 1 = 10.25%
F = 500(F/A, 10.25%, 14)
= 14,244.50
What is the minimum revenue
per year should the company
generate in order to recover
the maintenance cost?
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