INTEREST

Interest is cost of borrowed money or the earnings of money loaned. Interest rate is
defined as the amount of money earned by, or paid on, a unit of principal in a unit of time,
expressed as a fraction or percentage a year. Principal refers to original amount or the remaining
anpaid amount of the ican.

Simple Interest
l = PiN

i (the tnterest rate)

P (Principal)

N (Number of time units or interest period)

l (simple interest)

The principall must be repaid eventually, therefore, the entire amount of principal plus
simple interest due after N interest period is

F = P + l = P (l + iN)

F (Total amount of principal and accumulated interest at time N.

Compound Interest

Compound interest is the interest earned on accumulated. The compound amount earned
after any discrate number of interest periods can be determined and the result at table page 280.

(F/ P , i, N) = (l + i)N ……………. (7-4)

Can also written as :

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

The factor value easily calculated from eq. 7.4

Figure 7.1 Page 281 shows a comparison among total amounts earned at different times for cases
using simple interest, discreate annuay compounded interest and continue ously compounded
interest.
Nominal and Effective Interest Rate

The effective interest rate ieff is the rate which when compounded once per year, gives
the same amount of money at the end of 1 year, as does the nominal rate r cpmpounded m times
per year. The interest rate per period is r/m , and dthe amount at the end of year.

𝒓
F = ( 1 + 𝒎) m

The amount given by compounding at the effective rate ieff at the end 1 year is

F= (1 + ieff)

These two values of F must be the same, given the devinition of nominal and effective interest,
before :

𝒓
1 + ieff = ( 1 + 𝒎)m

The effective annual interest rate can be determined from this relation as

𝒓
ieff = ( 1 + 𝒎)m -1

Thus, if r = 0,06 and m = 2 (twce on annual basis), then :

𝟎,𝟎𝟔 2
ieff = (1 + ) – 1 = 0, 0609
𝟐

Continious Interest

The cocept of continuous interst is that the cost or income due to interest flows regularly
and this is just a reasonable an assumpstion for most cases as the concept of tnterst accumulating
only at discrete intervals. For N years eq can be written as :

𝒎
𝒓 ( 𝒓 )(𝒓𝑵)
F = P 𝐥𝐢𝐦 (𝟏 + )
𝒎→∞ 𝒎

The effective interest rate can be expessed in terms of the continuous nominal rate as

F = Pe1N = P (1+ieff)N
Cost Of Capital

In the premliminary design of a project, unless more specific information is available,

one of the following two methods is usually employed to account for interest cost :

1. No interest cost are included. This assumes that all the necessary capital comes from
internal corporate funds, and comparisons to alternative investments must be on the same
basis.
2. Interest is charged on the total capital investment, or a predertemined fractiom thereof, at
a set interest rate, usually equivalent to rates charges for bank loans.

Income Tax Effect

The effect of income taxes on the cost capital is very important. In determining income
taxes, interest on loans and bounds can be considered as a cost, whle the returm of both preferred
and common stock cannot be included as a cost. If the incremental annual income tax rate is
35%, evey $1 spent for interest loans or bonds has a true cost after taxes of only $o,65. Thus
after income taxes are taken into consideration, a bond issued at an annual interest rate of 5%
actually has an interest rate of only (5)(65/100) = 3,25%. On the other hand, dividends on
preferred stock has an annual dividend rate of 8%, the equivalent rate before incoming taxes is
12,3% and after income taxes it is 8 %.

A comparison of representative interest and divinded rates for divided types of externally
financed capital is presented in Table 7.1 Page 287.

The choice of capital source to be used to fund a project usually made at the highest
corporate level based upon corporate circumstances and policies.

1. Federal Income Taxes

Because the federal coiporate income tax rate is as high as 39 percent of net profit, it is an
extremely important component in corporate planning The actual federal marginal, or
incremental, coiporate income tax rates, as of September 2000, are shown in Table 7-2, and they
range from 15 to 39 percent of taxable income.

Table 7-2 U.S. corporate incremental income tax rates

Average corporate income tax rates are shown in Table 7-3. Clearly the tax rate is quite
dependent on taxable income. To estimate corporate income tax for a new project, the actual
incremental, or marginal, tax rate associated with the taxable income added to corporate earnings
should be used, if known.

Table 7-3 U.S. corporate average income tax rates

2. Taxable Income

Income taxes are paid on a corporatewide basis. The taxable income of a corporation is the total
gross profit. Gross profit, or gross earnings, equals total revenue minus total product cost (TPC).
Total revenue is income from all sources, primarily product sales, but including sales of assets
and supplies, royalties, and other revenues. In the assessment of the performance of a particular
unit or process within a corporation, the revenues and costs associated with that process are
determined and used in the evaluation. In addition, there are expenses incurred at levels above
that of the individual operating units, at the plant, division, or corporate level. These include such
items as safety, payroll, restaurant, recreation, control laboratories, waste disposal, administrative
costs, donations, advertising, and research and development.
3. Capital Gain Tax

A capital gains tax is levied on profits made from the sale of capital assets, such as land,
buildings, and equipment. The profit on the sale of land equals the selling price less the
acquisition price, costs of selling, and costs of improvements. The capital gain on an item held
for 1 year or more before sale is known as a longterm capital gain. The capital gain on items held
for less than 1 year is designated as a short-term capital gain. Under current income tax laws, the
tax rate on a long-term capital gain is 20 percent, while that on a short-term capital gain is equal
to the incremental income tax rate. Normally, a 35% rate can be used for estimates.

4. Losses

The tax laws also make provisions for losses as well. Losses within a company may be used to
offset gains within the company in the same year, thereby reducing the taxable income. In such
cases, the question arises as to whether the losses should be used to reduce overall corporate
income taxes or whether these reductions should be used as a negative income tax in the
evaluation of the process. Even though it may be realistic to do so, it is unwise to use this
argument for justifying the economic viability of a project.

5. State Taxes

If state income tax is to be included in an economic analysis, the state in which the project is to
take place and the corporate taxation policies of that state must be determined and factored into
the analysis. Some analysts choose to add a number to the federal income tax rate to reflect the
possibility of state taxes. There are other state taxes as well, for example, workers' compensation
taxes.

6. Nonincome Taxes

In addition to income taxes, property and excise taxes may be levied by federal, state, or local
governments. Property taxes are referred to as direct since they must be paid directly by the
particular business and cannot be passed on as such to the consumer. Excise taxes are levied by
federal and state governments. Federal excise taxes include charges for import customs duties,
transfer of stocks and bonds, and a large number of similar items. Taxes of this type are often
referred to as indirect since they can be passed on to the consumer.
FIXED CHARGES

The first three of these charges (depreciation, property taxes, and insurance) are costs related to
the capital investment in a project.

1. DEPRECIATION

Depreciation is an unusual charge in that it is paid into the corporate treasury. The concept of
depreciation is based upon the fact that physical facilities deteriorate and decline in usefulness
with time, thus, the value of a facility decreases. Physical depreciation is the term given to the
measure of the decrease in value of a facility due to changes in the physical aspects of a property.
Wear and tear, corrosion, accidents, and deterioration due to age or the elements are all causes of
physical depreciation.

Depreciation due to all other causes is known as functional depreciation. One common type of
functional depreciation is obsolescence. This is caused by technological advances which make an
existing property obsolete. Other causes of functional depreciation could be:

 Decrease in demand for the service rendered by the property

 Shifts in population
 Changes in requirements of public authority
 Inadequacy or insufficient capacity
 Abandonment of the enterprise
a. Depreciation and Income Tax

Depreciation is a charge to the revenue resulting from an investment in real property. It is

entirely reasonable that invested principal should be recovered by the investor and that project
revenues be charged to pay that principal. In the case of other investments, such as savings
accounts, the original investment is available in addition to any return that has been earned, and
thus a recovery of invested capital is to be expected in plant investments as well. Depreciation is
more than an artifact, however, because of the effect it has on the amount of income tax that
corporation must pay. It has been shown that depreciation adds to the corporate treasury as
indicated by the following relationship: Aj = (Sj- Coj)(1 - ф) + фdj
b. Depreciable Investments

In general, all property with a limited useful life of more than 1 year that is used in a trade or
business, or held for the production of income, is depreciable. Physical facilities, including such
costs as design and engineering, shipping, and field erection, are depreciable. In project
terminology, the fixed-capital investment, not including land, is depreciable. The total amount of
depreciation that may be charged is equal to the amount of the original investment in a property
no more and no less. Depreciation does not inflate or deflate.

c. Current Value

The current value of an asset is the value of the asset in its condition at the time of valuation.
Book value is the difference between the original cost of a property and all the depreciation
charged up to a time. The method of determining depreciation may be different for purposes of
obtaining the book value than that which is used for income tax puiposes, depending on
corporate policy. The price that could be obtained for an asset if it were sold on the open market
is designated the market value.

d. Salvage Value

Salvage value is the net amount of money obtainable from the sale of used property over and
above any charges involved in removal and sale. The term salvage value impliesthat the property
can be of further service. If the property is not useful, it can often be sold for material recovery.
Income obtainable from this type of disposal is known as scrap value.

e. Recovery Period

The period over which the use of a property is economically feasible is known as the service life
of the property. The period over which depreciation is charged is the recovery period, and this is
established by tax codes. Recovery periods for some chemical- and process-industries related
depreciation are shown in Table 7-4.

Table 7-4Recovery periods for selected chemical-industry-related asset classest