٠٢/١٨/١۴٣٧

PLANT DESIGN AND

ECONOMICS
(7) Zahra Maghsoud

INTEREST AND INVESTMENT COSTS

(Ch. 7 Peters and Timmerhaus )
٢

 Engineers define interest as the compensation paid

for the use of borrowed capital.

 This definition permits distinction between profit and

interest.

١
٠٢/١٨/١۴٣٧

TYPES OF INTEREST
٣

Interest

Compound Continuous
Simple Interest
Interest Interest

Ordinary and
Exact Simple
Interest

1-Simple Interest
۴

 The simplest form of interest requires compensation

payment at a constant interest rate based only on
the original principal.
 Thus, if $1000 were loaned for a total time of 4
years at a constant interest rate of 10 percent/year,
the simple interest earned would be:
400 $ =1000$ x 0.1 x 4
I=Pxixn
The amount of simple interest number of time units
Principal Interest rate

٢
٠٢/١٨/١۴٣٧

1-Simple Interest
۵

 The entire amount S of principal plus simple interest

due after n interest periods is:

S=P + I = P(1+in) “simple interest”

 For calculation of the compound interest, It is

assumed that the interest is not withdrawn but is
added to the principal and then in the next period
interest is calculated based upon the principal plus
the interest in the preceding period.

2-Compound Interest
۶

 Thus, an initial loan of $1000 at an annual interest

rate of 10 percent would require payment of $100
as interest at the end of the first year.
 The interest for the second year would be
($1000 + $100)(0.1) = $110
 and the total compound amount due after 2 years
would be
$1000 + $100 + $110 = $1210

٣
٠٢/١٨/١۴٣٧

2-Compound Interest
٧

 The compound amount due after any discrete

number of interest periods can be determined as
follows:

2-Compound Interest
٨

 Therefore, the total amount of principal plus

compounded interest due after n interest periods
and designated as S is:
n
S = P(1+i)
n
 The term (1+i) is commonly referred to as the
discrete single-payment compound-amount factor.
Values for this factor at various interest rates and
numbers of interest periods are given in Table 1.

۴
٠٢/١٨/١۴٣٧

2-Compound Interest

NOMINAL AND EFFECTIVE INTEREST RATES

١٠

 There are cases where time units other than 1 year

are employed. Even though the actual interest
period is not 1 year, the interest rate is often
expressed on an annual basis.

 Consider an example in which the interest rate is 3

percent per period and the interest is compounded
at half-year periods. A rate of this type would be
referred to as “6 percent compounded
semiannually.” Interest rates stated in this form are
known as nominal interest rates.

۵
٠٢/١٨/١۴٣٧

NOMINAL AND EFFECTIVE INTEREST RATES

١١

 The actual annual return on the principal would not be

exactly 6 percent but would be somewhat larger
because of the compounding effect at the end of the
semiannual period.

 It is desirable to express the exact interest rate based

on the original principal and the convenient time unit
of 1 year.

NOMINAL AND EFFECTIVE INTEREST RATES

١٢

 A rate of this type is known as the effective interest

rate. In common engineering practice, it is usually
preferable to deal with effective interest rates
rather than with nominal interest rates.

 The only time that nominal and effective interest

rates are equal is when the interest is compounded
annually.

۶
٠٢/١٨/١۴٣٧

NOMINAL AND EFFECTIVE INTEREST RATES

١٣

 Nominal interest rates should always include a

qualifying statement indicating the compounding
period.
 For example, using the common annual basis, $100
invested at a nominal interest rate of 20 percent if
 compounded annually would amount to $120.00 after 1
year;
 compounded semiannually, the amount would be $121.00;
 compounded continuously, the amount would be $122.14.

 The corresponding effective interest rates are 20.00

percent, 21.00 percent, and 22.14 percent,
respectively.

NOMINAL AND EFFECTIVE INTEREST RATES

١۴

 Let r be the nominal interest rate under conditions

where there are m interest periods per year.

٧
٠٢/١٨/١۴٣٧

Applications of different types of interest

١۵

 Example 1 It is desired to borrow $1000 to meet a

financial obligation. This money can be borrowed
from a loan agency at a monthly interest rate of 2
percent. Determine the following:
a)The total amount of principal plus simple interest due after 2
years if no intermediate payments are made.
b)The total amount of principal plus compounded interest due
after 2 years if no intermediate payments are made.
c)The nominal interest rate when the interest is compounded
monthly.
d)The effective interest rate when the interest is compounded
monthly.

3- Continuous Interest
١۶

 Although in practice the basic time interval for interest

accumulation is usually taken as one year, shorter time
periods can be used as, for example, one month, one
day, one hour, or one second.

 The extreme case, of course, is when the time interval

becomes infinitesimally small so that the interest is
compounded continuously.

٨
٠٢/١٨/١۴٣٧

3- Continuous Interest
١٧

r.n
S=P e

Calculations with continuous interest compounding

١٨

 Example 2. For the case of a nominal annual interest

rate 20.00 percent, determine:
 The total amount to which one dollar of initial principal
would accumulate after one 365-day year with daily
compounding.
 The total amount to which one dollar of initial principal
would accumulate after one year with continuous
compounding.
 The effective annual interest rate if compounding is
continuous.

٩
٠٢/١٨/١۴٣٧

Present Worth and Discount

١٩

 It is often necessary to determine the amount of money which

must be available at the present time in order to have a certain
amount accumulated at some definite time in the future.

 The present worth (or present value) of a future amount is the

present principal which must be deposited at a given interest
rate to yield the desired amount at some future date.

Present Worth and Discount

٢٠

n
S = P(1+i)
 Therefore, the present worth can be determined by
merely rearranging the above Equation:

n
Present worth: P = S/(1+i)
n
 The factor 1/(1+i) is commonly referred to as the
discrete single-payment present-worth factor.
 Similarly, for the case of continuous interest compounding:
rn
Present worth: P = S/e

١٠
٠٢/١٨/١۴٣٧

Present Worth and Discount

٢١

 Some types of capital are in the form of bonds

having an indicated value at a future date.

 In business terminology, the difference between the

indicated future value and the present worth (or
present value) is known as the discount.

Determination of present worth and discount

٢٢

 Example 4 A bond has a maturity value of $1000

at an effective annual rate of 3 percent. Determine
the following at a time four years before the bond
reaches maturity value:
a) Present worth.
b) Discount.
c) Discrete compound rate of effective interest which
will be received by a purchaser if the bond were
obtained for $700.
d) Repeat part (a) for the case where the nominal
bond interest is 3 percent compounded continuously.

١١
٠٢/١٨/١۴٣٧

Annuities
٢٣

 An annuity (R) is a series of equal payments

occurring at equal time intervals. Payments of this
type can be used to pay off a debt, accumulate a
desired amount of capital.

 An annuity term is the time from the beginning of the

first payment period to the end of the last payment
period.

Relation between Amount of Ordinary Annuity and

the Periodic Payments
٢۴

 The first payment of R is made at the end of the

first period and will bear interest for n - 1 periods.

 The second payment of R is made at the end of the

second period and will bear interest for n - 2
periods giving an accumulated amount of R(1+i) .
n-2

 By definition, the amount of the annuity is the sum of

all the accumulated amounts from each payment.

١٢
٠٢/١٨/١۴٣٧

Relation between Amount of Ordinary Annuity and

the Periodic Payments
٢۵

Continuous Cash Flow and Interest Compounding

 Let represent the total of all ordinary annuity payments occurring
regularly and uniformly throughout the year so that /m is the
uniform annuity payment at the end of each period.

Continuous Cash Flow and Interest

Compounding
٢۶

 For the case of continuous cash flow and interest

compounding, m approaches infinity

١٣
٠٢/١٨/١۴٣٧

Present Worth of an Annuity

٢٧

 The present worth of an annuity is defined as the

principal which would have to be invested at the
present time at compound interest rate i to yield a
total amount at the end of the annuity term equal to
the amount of the annuity.

Present Worth of an Annuity

٢٨

 The expression [(l + i)n - l]/[i(l + i)n] is referred to as

the discrete uniform-series present-worth factor or the
series present-worth factor.

 while the reciprocal [i(l + i)n]/[(l + i)n - l] is often

called the capital-recovery factor.

١۴
٠٢/١٨/١۴٣٧

Present Worth of an Annuity

٢٩

 For the case of continuous cash flow and interest

compounding:

Application of annuities in determining amount of depreciation

with discrete interest compounding.
٣٠

Example 5 A piece of equipment has an initial installed value

of $12,000. It is estimated that its useful life period will be
10 years and its scrap value at the end of the useful life will
be $2000.

 The depreciation will be charged by making equal charges

each year, the first payment being made at the end of the
first year. The depreciation fund will be accumulated at an
annual interest rate of 6 percent.

 At the end of the life period, enough money must have been
accumulated to account for the decrease in equipment value.
Determine the yearly cost due to depreciation under these
conditions.

١۵
٠٢/١٨/١۴٣٧

Application of annuities in determining amount of depreciation

with continuous cash flow and interest compounding.
٣١

 Example 6 Repeat Example 5 with continuous cash flow

and nominal annual interest of 6 percent compounded
continuously.

PERPETUITIES AND CAPITALIZED COSTS

٣٢

 A perpetuity is an annuity in which the periodic

payments continue indefinitely.

 This type of annuity is of particular interest to

engineers, for in some cases they may desire to
determine a total cost for a piece of equipment or
other asset under conditions which permit the asset
to be replaced perpetually without considering
inflation or deflation.

١۶
٠٢/١٨/١۴٣٧

PERPETUITIES AND CAPITALIZED COSTS

٣٣

useful-life:10 years

equipment

$12,000 scrap value: $2000

Capitalized cost +
$12650
supply $10,000 every 10 years

($12,650)(1 + 0.06)10 = $22,650

Needed fund: $12,650

PERPETUITIES AND CAPITALIZED COSTS

٣۴

n
S = P(1+i) CR=S-P

K: capitalized cost
CR : Replacement cost
CV : original cost

١٧
٠٢/١٨/١۴٣٧

Determination of capitalized cost

٣۵

 Example 7 A new piece of completely installed

equipment costs $12,000 and will have a scrap value
of $2000 at the end of its useful life. If the useful-life
period is 10 years and the interest is compounded at
6 percent per year, what is the capitalized cost of the
equipment?

Comparison of alternative investments using

capitalized costs
٣۶

 Example 8. A reactor, which will contain corrosive liquids, has been

designed.
 If the reactor is made of mild steel, the initial installed cost will be
$5000, and the useful-life period will be 3 years.
 Since stainless steel is highly resistant to the corrosive action of the
liquids, stainless steel, as the material of construction, has been
proposed as an alternative to mild steel.

 The stainless-steel reactor would have an initial installed cost of

$15,000. The scrap value at the end of the useful life would be zero
for either type of reactor, and both could be replaced at a cost equal
to the original price.
 On the basis of equal capitalized costs for both types of reactors, what
should be the useful-life period for the stainless-steel reactor if money
is worth 6 percent compounded annually?

١٨
٠٢/١٨/١۴٣٧

Example 8
٣٧

 the useful-life period of the stainless-steel reactor

should be 11.3 years for the two types of reactors to
have equal capitalized costs.

 If the stainless-steel reactor would have a useful life

of more than 11.3 years, it would be the
recommended choice, while the mild-steel reactor
would be recommended if the useful life using
stainless steel were less than 11.3 years.

RELATIONSHIPS FOR CONTINUOUS CASH FLOW AND

CONTINUOUS INTEREST OF IMPORTANCE FOR PROFITABILITY
ANALYSES
٣٨

 The fundamental relationships dealing with continuous

interest compounding can be divided into two general
categories:
1. Those that involve instantaneous or lump-sum
payments, such as a required initial investment or a
future payment that must be made at a given time

2. Those that involve continuous payments or continuous

cash flow, such as construction costs distributed evenly
over a construction period.

١٩
٠٢/١٨/١۴٣٧

RELATIONSHIPS FOR CONTINUOUS CASH FLOW AND

CONTINUOUS INTEREST
٣٩

 The symbols S, P, and R represent discrete lump-sum

payments as future worth, present principal (or present
worth), and end-of-period (or end-of-year) payments,
respectively.

 A bar above the symbol, such as , , or , means that

the payments are made continuously throughout the time
period under consideration.

 For example, consider the case where construction of a

plant requires a continuous flow of cash to the project
for one year, with the plant ready for operation at the
end of the year of construction.

RELATIONSHIPS FOR CONTINUOUS CASH FLOW AND

CONTINUOUS INTEREST
۴٠

 The symbol represents the total amount of cash put into the
project on the basis of one year with a continuous flow of cash.
At the end of the year, the compound amount of this is

 The future worth of the plant construction cost after n years

with continuous interest compounding is:

٢٠
٠٢/١٨/١۴٣٧

Discount and compounding factors

۴١

Fd
۴٢

 For the case of continuous cash flow declining to zero at

a constant rate over a time period of nT the linear
equation for R is

 g = the constant declining rate or the gradient

 Ř = instantaneous value of the cash flow
 a = a constant

 A situation similar to this exists when the sum-of-

the years-digits method is used for calculating
depreciation

٢١
٠٢/١٨/١۴٣٧

Table 3
۴٣

Compounding factors
۴۴

٢٢
٠٢/١٨/١۴٣٧

۴۵

PROBLEMS (Ch 7)
۴۶

٢٣