Interest and Interest Rate

Interest the manifestation of the time

value of money
EGR 312 - 02

Fee that one pays to use someone elses money

Difference between an ending amount of money and a
beginning amount of money

Interest = amount owed now principal

Interest, I ($) = amount owed now original amount
A)

$1000 placed in bank account one year ago is now worth $1025.
Interest earned is _____.

B)

$10,000 borrowed last year from Sharkys Easy Money, and you
now owe $12,000. Interest owed is ______.
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Interest and Interest Rate

Interest accrued per period
Interest rate, i (%)
100%
Principal

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Interest paid over a specific time period is called an interest rate.

What is the interest rate in example A? Example B?

Rate of Return

Interest accrued per period, I

Rate of Return(%)
100%
Principal

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Rate of Return (ROR) interest earned over a specific time period,

expressed as a percentage of the original amount (principal).

Borrowers perspective interest rate paid

Investors perspective rate of return (ROR) or return on investment
(ROI).

Interest rate

Rate of return

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Interest paid
Interest
earned

Engineering Economy

Inflation
Appreciation

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Other factors that act the same way as interest:

Depreciation

Equivalence

Example: (assuming 5%/year interest rate)

$1000 today is equivalent to ________ a year from now.

EGR 312 - 02

Economic equivalence different sums of money at different times

can be equal in economic value because of the time value of
money and interest rates.

$1000 a year from now is equivalent to ______ today.

What is the interest rate if an investment of $500 is equivalent to

$545 a year from now?

Simple vs Compound Interest

interest = (principal)(number of periods)(interest rate)
= Pni
Example: you invest $500 in an insurance policy that pays 8% simple
interest. How much is the policy worth in 3 years?

EGR 312 - 02

Simple Interest interest is calculated using the principal only.

Principal Interest
Year 0) $500
Year 1) $500
$ 40
Year 2) $500
$ 40
Year 3) $500
$ 40
$ 120
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Simple vs Compound Interest

interest = (principal + all accrued interest)(interest rate)

EGR 312 - 02

Compound Interest interest is calculated using both

the principal and interest earned.

Example: you invest $500 in an insurance policy that pays 8%

compound interest. How much is the policy worth in 3 years?
Principal Interest
Total
Year 0) $500
Year 1) $500
Year 2) $540
Year 3) $583.20
$129.85

$500(1.08)1
$500(1.08)2
$500(1.08)3
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Historical Perspective In 1626, Manhattan Island was purchased

from a native tribe for $24. If that tribe had invested the $24 in an
investment paying 8% annually, what would it be worth today?
$24(1.08)(2014-1626) = $24(1.08)(387) = $24(9.3x1012)
or $223.17 trillion

EGR 312 - 02

Power of Compound Interest

However, if the tribe invested in an investment that paid simple

interest:
$24 + $24(.08)(388) = $768.96

Symbols and Terminology

F value or amount of money at some future time, also referred to as

future worth (FW) or future value (FV).

EGR 312 - 02

P value or amount of money at time 0, also referred to as present

worth (PW), present value (PV), net present value (NPV), or
discounted cash flow (DCF).

A a series of consecutive, equal, end-of-period amount of money, also

referred to as annual worth (AW) or equivalent uniform annual worth
(EUAW). Does not have to be annual payouts, could be monthly,
weekly, etc.
n number of periods: years, months, days,
i interest rate or rate of return per time period
t time, stated in periods

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Example: To diligently plan for my retirement, I should invest $2K in

an IRA each year. If I start next year and continue until I retire, I will
be making that investment for about 15 years. I hope to obtain a
rate of return of 6%.
A = $2000
i = 6% or .06 annually
n = 15
F = ? the value of the investment when I retire

EGR 312 - 02

Symbols and Terminology

11

The Minimum Attractive Rate of Return is a minimum level set by a

Corporation when deciding on whether to pursue or not to pursue
projects.

Expected ROR
for a new or risky
proposal

MARR
ROR on safe
Investment (e.g
money market)

EGR 312 - 02

Minimum Attractive Rate of Return

(MARR)

Is MARR
constant from
year to year?
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 Cash Inflows Revenues (R), receipts,

incomes, savings generated by projects and
activities that flow in. Plus sign used
Cash Outflows Disbursements (D), costs,
expenses, taxes caused by projects and
activities that flow out. Minus sign used

EGR 312 - 02

Cash Flows: Terms

Net Cash Flow (NCF) for each time period:

NCF = cash inflows cash outflows

=RD
End-of-period assumption:
Funds flow at the end of a given interest period

13

Cash Flows: Estimating

Cash inflow: Income = $150,000 per
month

EGR 312 - 02

Point estimate A single-value estimate of a cash

flow element of an alternative

Range estimate Min and max values that

estimate the cash flow

Cash outflow: Cost is between $2.5 M

and $3.2 M
Point estimates are commonly used; however,
range estimates with probabilities attached
provide a better understanding of variability of
economic parameters used to make decisions

14

Cash Flow Diagrams

Estimates of cash flows typically follow the end-of-period convention

(cash flows are assumed to occur simultaneously at the end of an
interest period).

EGR 312 - 02

Cash flow diagrams are a way to graphically represent the inflows and
outflows of cash over time.

When several receipts and disbursements occur within an interest

period, the net cash flow might be shown.
Net cash flow = receipts disbursements
= cash inflows cash outflows

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Example 1: Rental property

$70K Purchase price with 20% down ($14K)
Monthly expenses (utilities, maintenance, insurance, etc..) = $200
Monthly P&I = $345 (starts in two months)
Rental income = $750 (starting in 5 months)
Expect to sell in a few years at a net profit of $50K
(will need to spend two months prior to selling preparing the
property)

EGR 312 - 02

Cash Flow Diagrams

16

Example 2: An electrical engineer wants to deposit an amount of P

now such that she can withdraw an equal annual amount of A1 =
$2000 per year for the first 5 years, starting 1 year after the
deposit, and a different annual withdrawal of A2 = $3000 per year
for the following 3 years. How would the cash flow diagram appear
if i = 8.5% per year?

EGR 312 - 02

Cash Flow Diagrams

17

Cash Flow Diagrams

End of
year

Incom
e

Cost

Net Cash
Flow

-7

$0

$2500

-6

750

100

-5

750

125

-4

750

150

-3

750

175

-2

750

200

-1

750

225

750

250

750+1
50

275

EGR 312 - 02

Example 3: Plot observed cash flows over last 8 years and

estimated sale next year for $150. Show present worth (P)
arrow at present time, t = 0

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Cash Flow Diagrams

Net Cash
Flow
$-2500

EGR 312 - 02

Example: Plot observed cash flows over last 8 years and

estimated sale next year for $150. Show present worth (P)
arrow at present time, t = 0

650
625
600
575
550
525
500
625

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 Problem:
Identify the following as cash inflows or outflows
to commercial air carriers:
Fuel Cost:
Pension Plan:
Contribution:
Fares:
Maintenance:
Landing fees:

EGR 312 - 02

Your Turn

20

 Draw Cash flow diagram for the following

problem:
A mechanical device will cost $25,000 when
purchased. Maintenance will cost $1500 per year.
The device will generate revenues of $6000 per
year for 5 years. The salvage value is $7500.

EGR 312 - 02

Your Turn

Work with a partner and agree on one version of

your cfds. Be prepared to draw these on the
board.
21

Rule of 72: Estimating Doubling Time and

Interest Rate
To estimate how many years, n (periods) to double your money:
estimated n = 72/i

EGR 312 - 02

The rule of 72 helps estimate how long is will take for an investment, using
compound interest, to double in value.

To estimate the interest rate required to double your money in n periods:

estimated i = 72/n

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Rule of 72: Estimating Doubling Time

and Interest Rate
If you invested $1000 today in a CD paying 5% annually, how long will
it be until the CD is worth $2000?

EGR 312 - 02

Example:

If you wanted the $1000 to double in 10 years, what interest rate must
you earn?

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