Chapter 3
INTEREST AND EQUIVALENCE
Computing Cash Flows
Cash Flow Diagram (CFD) illustrates the size,
sign, and timing of individual cash flows
Cash flows have:
Costs (disbursements) is a negative number
Benefits (receipts) is a positive number
Cash flow diagram for Example 3-1
Time Value of Money
Money has value
• People are willing to pay to have money available for their use
• Money can be rented in roughly the same way one rents
an apartment, only with money, the charge is called
interest instead of rent
• If one puts $100 in a bank at 8% interest for one time
period he will receive back his original $100 plus $8
Original amount to be returned = $100
Simple Interest
Interest that is calculated only on the original or
principal amount
Total interest earned =
Where
P – present amount of money
i – interest rate
n – number of periods (years)
If some one invests $100 for two years at an interest rate
of 8%, the total=$
𝑇𝑜𝑡𝑎𝑙𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 interest he will earn:
100 𝑥 .08/𝑝𝑒𝑟𝑖𝑜𝑑 𝑥 2𝑝𝑒𝑟𝑖𝑜𝑑𝑠=$ 16
Future Value of a Loan with
Simple Interest
Amount of money due at the end of a loan
Where
= future value
•Will you accept payment with simple interest terms?
•What about the lender (bank)?
Compound Interest
Interest that is computed on the original unpaid debt and
the unpaid interest
Total interest earned =
Where
P – present sum of money
i – interest rate
n – number of periods (years)
Comparison of Simple and
Compound Interest Over Time
If you loaned a friend money for
short period of time the difference
between simple and compound
Example 3-4
interest is negligible
If you loaned a friend money for a
long period of time the difference
between simple and compound
interest may amount to a
considerable difference
Future Value of a Loan with
Compound Interest
Amount of money due at the end of a loan
Where
•Will you accept payment with compound interest terms?
Simple interest vs compound interest
Comparison of simple and compound interests
Example 3-4
Loan Repayment – Four Options
Table 3-1
Equivalence
When one wants to investigate as to whether it has a
present amount now is equal to some other sum of money
(or series of sums of money) in the future
The present sum of money is equivalent to the future sum
or series of sums
Table 3-1
Each of the four plans on the previous slide is equivalent
because each repays $5000 at the same 8% interest rate
Technique of Equivalence
• Calculate a single equivalent value at a point in time
for plan 1. Application of
• Calculate a single equivalent value at a point in time
Equivalence, page 72
for plan 2.
• Compare them with the same interest rate
• Examine the two alternatives from the comparable
equivalent values
Interest Formulas
To understand equivalence, the underlying interest
formulas must be analyzed.
Notation:
i = Interest rate per interest period
n = Number of interest periods
P = Present sum of money (Present worth)
F = Future sum of money (Future worth)
Single Payment Compound
Interest
Year Beginning Interest of Ending
balance Period balance
1
2
3
n
Note: P at time 0 increases to P(1+i)n at the end
of time n.
Notation for
Calculating a Future Value
Formula:
is the
single payment compound amount factor.
Functional notation:
which is dimensionally correct
Examples
3.5-3-8
