Interest Formulas
Interest Formulas
Interest rate can be classified into simple interest rate and compound interest rate.
✔ In simple interest, the interest is calculated, based on the initial deposit for
every interest period. In this case, calculation of interest on interest is not
applicable.
▪
✔ In compound interest, the interest for the current period is computed based
on the amount (principal plus interest up to the end of the previous period)
at the beginning of the current period.
The notations which are used in various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly,
quarterly, semiannually or annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after
period to/from the amount of deposit A1 at the end of period
1
Time Value of Money - .
It represents the growth of capital per unit period. The period may be a month, a
quarter, semiannual or a year.
An interest rate 15% compounded annually means that for every hundred
rupees invested now, an amount of Rs. 15 will be added to the account at the end
of the first year. So, the total amount at the end of the first year will be Rs. 115.
1
At the end of the second year, again 15% of Rs. 115, i.e. Rs. 17.25 will be
added to the account.
Hence the total amount at the end of the second year will be Rs. 132.25. The
process will continue thus till the specified number of years.
If an investor invests a sum of Rs. 100 in a fixed deposit for five years with an
interest rate of 15% compounded annually, the accumulated amount at the end of
every year will be as shown in Table
Compound Amounts
(amount of deposit = Rs. 100.00)
Year end Interest Compound amount
(Rs.) (Rs.)
0 100.00
1 15.00 115.00
2 17.25 132.25
3 19.84 152.09
4 22.81 174.90
5 26.24 201.14
The formula to find the future worth in the third column is
F = P (1 + i)n
where
P = principal amount invested at time 0, F = future amount,
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i = interest rate compounded annually, n = period of deposit.
The maturity value at the end of the fifth year is Rs. 201.14. This
means that the amount Rs. 201.14 at the end of the fifth year is equivalent
to Rs. 100.00 at time 0 (i.e. at present). This is diagrammatically shown in
Fig. 3.1. This explanation assumes that the inflation is at zero percentage.
Single-Payment Compound Amount –
Here, the objective is to find the single future sum (F) of the initial payment (P)
made at time 0 after n periods at an interest rate i compounded every
Cash flow diagram of single-payment compound amount.
The formula to obtain the single-payment compound amount is
F = P(1 + i)n = P(F/P, i, n)
where
(F/P, i, n) is called as single-payment compound amount factor.
Single-Payment Present Worth Amount –
Here, the objective is to find the present worth amount (P) of a single future sum
(F) which will be received after n periods at an interest rate of i compounded at the
end of every interest period.
Cash flow diagram of single-payment present worth amount.
3
The formula to obtain the present worth is
Where
(P/F, i, n) is termed as single-payment present worth factor.
Equal-Payment Series Sinking Fund
In this type of investment mode, the objective is to find the equivalent amount
(A) that should be deposited at the end of every interest period for n interest
periods to realize a future sum (F) at the end of the nth interest period at an
interest rate of i.
A = equal amount to be deposited at the end of each interest
period
n = No. of interest periods
i = rate of interest
F = single future amount at the end of the nth period
The formula to get F is
Where
(A/F, i, n) is called as equal-payment series sinking fund factor.
4
Equal-Payment Series Present Worth Amount
The objective of this mode of investment is to find the present worth of an equal
payment made at the end of every interest period for n interest periods at an
interest rate of i compounded at the end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.8. Here,
P = present worth
A = annual equivalent payment i = interest rate
n = No. of interest periods
The formula to compute P is
Where
(P/A, i, n) is called equal-payment series present worth factor
Equal-Payment Series capital recovery
The objective of this mode of investment is to find the annual equivalent amount
(A) which is to be recovered at the end of every interest period for n interest
periods for a loan (P) which is sanctioned now at an interest
Cash flow diagram of equal-payment series capital recovery
amount.
P = present worth (loan amount)
A = annual equivalent payment (recovery amount)
i = interest rate
n = No. of interest periods
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The formula to compute P is as follows:
Where,
(A/P, i, n) is called equal-payment series capital recovery factor.
Uniform Gradient series annual equivalent
The objective of this mode of investment is to find the annual equivalent amount of
a series with an amount A1 at the end of the first year and with an equal increment
(G) at the end of each of the following n – 1 years with an interest
rate i compounded annually.
The corresponding cash flow diagram is shown in Fig
Cash flow diagram of uniform gradient series annual equivalent
amount.
The formula to compute A under this situation is
● here Where
(A/G, i, n) is called uniform gradient series factor
Effective Interest Rate
Let i be the nominal interest rate compounded annually. But, in practice, the
compounding may occur less than a year. For example, compounding may be
monthly, quarterly, or semi-annually. Compounding monthly means that the
interest is computed at the end of every month. There are 12 interest periods in a
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year if the interest is compounded monthly. Under such situations, the formula to
compute the
effective interest rate, which is compounded annually, is Effective interest
rate,
R = 1 + i/C C 1
where,
i = the nominal interest rate
C = the number of interest periods in a year.
CASH FLOW
Introduction
In this method of comparison, the cash flows of each alternative will be
reduced to time zero by assuming an interest rate i. Then, depending on the type
of decision, the best alternative will be selected by comparing the present worth
amounts of the alternatives.
The sign of various amounts at different points in time in a cash flow
diagram is to be decided based on the type of the decision problem.
In a cost dominated cash flow diagram, the costs (outflows) will be assigned
with positive sign and the profit, revenue, salvage value (all inflows), etc. will
be assigned with negative sign.
In a revenue/profit-dominated cash flow diagram, the profit, revenue, salvage
value (all inflows to an organization) will be assigned with positive sign. The
costs (outflows) will be assigned with negative sign.
In case the decision is to select the alternative with the minimum cost, then
the alternative with the least present worth amount will be selected. On the
other hand, if the decision is to select the alternative with the maximum profit,
then the alternative with the maximum present worth will be selected.
BASES FOR COMPARISON OF ALTERNATIVES
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In most of the practical decision environments, executives will be forced to
select the best alternative from a set of competing alternatives.
Let us assume that an organization has a huge sum of money for potential
investment and there are three different projects whose initial outlay and annual
revenues during their lives are known. The executive has to select the best
alternative among these three competing projects.
There are several bases for comparing the worthiness of the projects. These
bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
[Link] WORTH METHOD
✔ In this method of comparison, the cash flows of each alternative will be
reduced to time zero by assuming an interest rate i.
▪
✔ Then, depending on the type of decision, the best alternative will be
selected by comparing the present worth amounts of the alternatives.
▪
In a cost dominated cash flow diagram, the costs (outflows) will be
assigned with positive sign and the profit, revenue, salvage value (all
inflows), etc. will be assigned with negative sign.
✔ In a revenue/profit-dominated cash flow diagram, the profit, revenue,
salvage value (all inflows to an organization) will be assigned with
positive sign. The costs (outflows) will be assigned with negative sign.
▪
[Link]-Dominated Cash Flow Diagram
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A generalized revenue-dominated cash flow diagram to demonstrate the present
worth method of comparison is presented in Fig.
To find the present worth of the above cash flow diagram for a
given interest rate, the formula is
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...
+ Rj [1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
Note:-The project (Alternative) is acceptable for investment when: PW ≥
0. The better alternative is that of higher PW.
[Link]-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the
present worth method of comparison is presented in Fig.
9
To compute the present worth amount of the above cash flow diagram for
a given interest rate i, we have the formula
PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]
+ Cn[1/(1 + i)n] – S[1/(1 + i)n]
EXAMPLE - 1
Alpha Industry is planning to expand its production operation. It has identified
three different technologies for meeting the goal. The initial outlay and annual
revenues with respect to each of the technologies are summarized in Table 1.
Suggest the best technology which is to be implemented based on the present
worth method of comparison assuming 20% interest rate, compounded annually.
Solution
In all the technologies, the initial outlay is assigned a negative sign
and the annual revenues are assigned a positive sign.
TECHNOLOGY 1
Initial outlay, P = Rs. 12,00,000
Annual revenue, A = Rs. 4,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is as shown in Fig. 4.3.
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Fig. Cash flow diagram for technology 1.
The present worth expression for this technology is
PW(20%)1 = –12,00,000 + 4,00,000 (P/A, 20%, 10)
= –12,00,000 + 4,00,000 (4.1925)
= –12,00,000 + 16,77,000
= Rs. 4,77,000
TECHNOLOGY 2
Initial outlay, P = Rs. 20,00,000
Annual revenue, A = Rs. 6,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is shown in Fig. 4.4.
Fig. Cash flow diagram for technology 2.
The present worth expression for this technology is
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PW(20%)2 = – 20,00,000 + 6,00,000 (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 (4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500
TECHNOLOGY 3
Initial outlay, P = Rs. 18,00,000
Annual revenue, A = Rs. 5,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is shown in Fig. 4.5.
Fig. Cash flow diagram for technology 3.
The present worth expression for this technology is
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PW(20%)3 = –18,00,000 + 5,00,000 (P/A, 20%, 10)
= –18,00,000 + 5,00,000 (4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250
From the above calculations, it is clear that the present worth of technology 2 is the
highest among all the technologies. Therefore, technology 2 is suggested for
implementation to expand the production.
Example -2: An investment of $5,000 can be made in a project that will produce a uniform annual revenue of
$5,310 for five years and then have a market (salvage) value of $2,000. Annual expenses will be $3,000 each
year. The company is willing to accept any project that will earn 10% per year or more, on all invested capital.
Show whether this is desirable investment by using the PW method.
Solution:
PW = – $5,000 + $2,310 (P/A, 10%, 5) + $2,000 (P/F, 10%, 5)
PW = – $5,000 + $2,310 (3.7908) + $2,000 (0.6209)
PW = + 5000
The project is acceptable.
Example – 3: A piece of new equipment has been proposed by engineers to increase the productivity of
certain manual welding operation. The investment cost is $25,000 and the equipment will have the
market value of $5,000 at the end of a study period of five years. Increased productivity attributable to
the equipment will amount to $8,000 per year after extra operating costs have been subtracted from
the revenue generated by the additional production. If the firm’s MARR is 20% per year, is this proposal
a sound one? Use the PW method.
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Example 4: Three Alternatives: Assume i = 10% per year.
Which Alternative – if any, should be selected based upon a present worth analysis?
Solution: Cash Flow Diagrams
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Gradient series
● Linear gradient
● Geometric gradient
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Example – present value calculation for a gradient series.
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Exercise: – linear gradient
You are trying to decide between 2 job offers. Allied Signal has offered to pay you
$50,000/year, with guaranteed pay increases of $2,000/year. Raytheon has
offered to start you at $54,000/year, with no pay increases over the next 5 years.
What is the present worth of each cash flow over the next 5 years, using the end
of year convention and assuming an 8% interest rate is available?
2. FUTURE WORTH METHOD
✔ In the future worth method of comparison of alternatives, the future worth
of various alternatives will be computed.
✔ Then, the alternative with the maximum future worth of net revenue or with
the minimum future worth of net cost will be selected as the best alternative
for implementation.
[Link]-Dominated Cash Flow Diagram
A generalized revenue-dominated cash flow diagram to demonstrate the future
worth method of comparison is presented in Fig.
In Fig. P represents an initial investment, Rj the net-revenue at the end of the jth
year, and S the salvage value at the end of the nth year.
The formula for the future worth of the above cash flow diagram for a given
interest rate, i is
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FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...
+ R j(1 + i)n–j + ... + Rn + S
In the above formula, the expenditure is assigned with negative sign and the
revenues are assigned with positive sign.
[Link]-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the future
worth method of comparison is given in Fig.
In Fig. 5.2, P represents an initial investment, Cj the net cost of
operation and maintenance at the end of the j th year, and S the
salvage value at the end of the nth year.
The formula for the future worth of the above cash flow
diagram for a given interest rate, i is
FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ... + Cj(1 + i)n–j + ... + Cn – S
EXAMPLE
Consider the following two mutually exclusive alternatives:
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At i = 18%, select the best alternative based on future worth method of
comparison.
Solution: Alternative A
Initial investment, P = Rs. 50,00,000
Annual equivalent revenue, A = Rs. 20,00,000
Interest rate, i = 18%, compounded annually
Life of alternative A = 4 years
The cash flow diagram of alternative A is shown in Fig.
The future worth amount of alternative B is computed as
FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4)
= –50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
Alternative B
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Initial investment, P = Rs. 45,00,000
Annual equivalent revenue, A = Rs. 18,00,000
Interest rate, i = 18%, compounded annually
Life of alternative B = 4 years
The cash flow diagram of alternative B is illustrated in Fig..
The future worth amount of alternative B is computed as
FWB(18%) = – 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A, 18%, 4)
= – 45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
Note: -
⮚ The project (Alternative) is acceptable for investment when: FW ≥ 0.
⮚ The better alternative is that of higher FW.
Example - A piece of new equipment has been proposed by engineers to increase
the productivity of certain manual welding operation. The investment cost is
$25,000 and the equipment will have the market value of $5,000 at the end of a
study period of five years. Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating costs have been subtracted
from the revenue generated by the additional production. If the firm’s MARR is
20% per year, is this proposal a sound one? Use the FW method.
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Solution –
The project is acceptable.
ANNUAL EQUIVALENT METHOD
✔ In the annual equivalent method of comparison, first the annual equivalent
cost or the revenue of each alternative will be computed.
▪
✔ Then the alternative with the maximum annual equivalent revenue in the
case of revenue-based comparison or with the minimum annual equivalent
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cost in the case of cost- based comparison will be selected as the best
alternative.
[Link]-Dominated Cash Flow Diagram
A generalized revenue-dominated cash flow diagram to demonstrate the annual
equivalent method of comparison is presented in Fig.
Fig. Revenue-dominated cash flow diagram.
In Fig. P represents an initial investment, Rj the net revenue at the
end of the j th year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow
diagram using the following expression for a given interest rate, i:
PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
In the above formula, the expenditure is assigned with a negative sign and the
revenues are assigned with a positive sign.
[Link]-Dominated Cash Flow Diagram
A generalized cost-dominated cash flow diagram to demonstrate the annual
equivalent method of comparison is illustrated in Fig.
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In Fig, P represents an initial investment, Cj the net cost of operation and
maintenance at the end of the jth year, and S the salvage value at the end of
the nth year.
The first step is to find the net present worth of the cash flow diagram
using the following relation for a given interest rate, i.
PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...
+ Cj/(1 + i) j + ... + Cn/(1 + i)n – S/(1 + i)n
EXAMPLE
A company provides a car to its chief executive. The owner of the
company is concerned about the increasing cost of petrol. The cost per
litre of petrol for the first year of operation is Rs. 21. He feels that the
cost of petrol will be increasing by Re.1 every year. His experience with
his company car indicates that it averages 9 km per litre of petrol. The
executive expects to drive an average of 20,000 km each year for the
next four years. What is the annual equivalent cost of fuel over this
period of time?. If he is offered similar service with the same quality on
rental basis at Rs. 60,000 per year, should the owner continue to provide
company car for his executive or alternatively provide a rental car to his
executive? Assume i = 18%. If the rental car is preferred, then the
company car will find some other use within the company.
Solution
Average number of km run/year = 20,000 km
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Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00 = Rs.
23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00 = Rs.
24.00
Fuel expenditure for 1st year = 2222.2 21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 24 = Rs. 53,332.80
The annual equal increment of the above expenditures is Rs. 2,222.20
(G). The cash flow diagram for this situation is depicted in Fig.
Fig. Uniform gradient series cash flow diagram.
In Fig., A1 = Rs. 46,666.20 and G = Rs. 2,222.20
A = A1 + G(A/G, 18%, 4)
= 46,666.20 + 2222.2(1.2947)
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= Rs. 49,543.28
The proposal of using the company car by spending for petrol by the company will
cost an annual equivalent amount of Rs. 49,543.28 for four years. This amount is
less than the annual rental value of Rs. 60,000. Therefore, the company should
continue to provide its own car to its executive.
The project (Alternative) is acceptable for investment when: AW ≥ 0
The better alternative is that of higher AW.
Example - 2
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νA piece of new equipment
has been proposed by
engineers
to increase the productivity
of certain manual welding
operation.
νThe investment cost is
$25,000 and the equipment
will have
the market value of $5,000
at the end of a study period
of
five years.
νIncreased productivity
attributable to the
equipment will
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amount to $8,000 per year
after extra operating costs
have
been subtracted from the
revenue generated by the
additional production.
νIf the firm’s MARR is 20%
per year, is this proposal a
sound
one?
νUse the PW method.
Example - A piece of new equipment has been proposed by engineers to increase
the productivity of certain manual welding operation. The investment cost is
$25,000 and the equipment will have the market value of $5,000 at the end of a
study period of five years. Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating costs have been subtracted
from the revenue generated by the additional production. If the firm’s MARR is
20% per year, is this proposal a sound one? Use the AW method.
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Example - Determine the PW, FW, and AW of the following engineering project
when the MARR is 15% per year. Investment cost $10,000 Expected Life 5 years
Market (Salvage) value -$1,000 Annual receipts $8,000 Annual expenses $4,000.
Solution.
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Example - You purchase a building five years ago for $100,000. Its annual
maintenance expense has been $5,000 per year. At the end of three years, you
spent $9,000 on roof repairs. At the end of five years (now), you sell the building
for $120,000. During the period of ownership, you rented the building for $10,000
per year paid at the beginning of each year. Use the AW method to evaluate this
investment when your MARR is 12% per year.
Solution:
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Exercise: Deere Construction just purchased a new track hoe attachment costing
$12,500. The CFO, John, expects the implement will be used for five years when it
is estimated to have a salvage value of $4,000. Maintenance costs are estimated
to be $0 the first year and will increase by $100 each year thereafter. If a 12%
interest rate is used, what is the equivalent uniform annual cost of the
implement?
Solution:
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EUAC = 12,500(A/P, 12%, 5) - 4,000(A/F, 12%, 5) + 100(A/G, 12%, 5)
= $3,015.40
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