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ENGINEERING ECONOMICS

▪ BASIC CONCEPTS AND

TERMINOLOGIES
▪ DEPRECATION

▪ INTEREST ▪ DEPLETION

▪ INFLATION ▪ METHODS OF ECONOMY STUDIES

▪ ANNUITY ▪ SELECTION OF ALTERNATIVES

▪ UNIFORM GRADIENT & GEOMETRIC ▪ BREAK-EVEN ANALYSIS

SEQUENCE OF CASH FLOWS
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When a bank lends money to someone in the form of a loan, the amount of
money is called the Principal. At the end of the loan period, the borrower pays the
principal together with the interest. The lender views the interest as the income of
money which has been invested, while the borrower views it as the amount paid for
the use of borrowed money.
The cash flow diagram below shows the present value or principal, P, and
a future value, F, separated by n periods with interest at r% per period.
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SIMPLE INTEREST
When the interest charged per period is constant or is linearly proportional to
the initial amount of the loan, the interest rate, and the number of interest periods
for which the principal is committed, the interest and the interest rate are said to be
simple.
𝑰 = 𝑷𝒓𝒏
Finding F
The future amount F consists of the present value, P plus the interest, I.

𝐹 =𝑃+𝐼
𝐹 = 𝑃 + 𝑃𝑟𝑛
𝑭 = 𝑷(𝟏 + 𝒓𝒏)
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Finding P
From the formula for F, solving P in terms of F, we have

𝑭
𝑷=
𝟏 + 𝒓𝒏

where: I = interest
P = principal or the present value
n = number of interest periods
r = interest rate per interest period
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ORDINARY AND EXACT SIMPLE INTEREST

• Ordinary Simple Interest considers 1 month has 30 days, thus there are 360
days in one year.

• Exact Simple Interest is made by counting the actual number of days in one
year, thus there are 365 days in one ordinary year, and 366 days for a leap year.
• Leap years are years divisible by 4. Examples of leap years are years 1996,
2012, 2000, and 2020 because they are divisible by 4.
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Problem 1

Compute the simple interest due on ₱ 5,000 for 3 years at a rate of 10%.

Solution:
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Problem 2
Engr. Marquez borrowed money from a loan firm at a simple interest of 10%. At the
end of 2 years, he will pay ₱ 41,400 which consist of the principal plus the total
interest. How much is the interest?

Solution:
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Problem 3
In buying a computer disk, the buyer was offered the options of paying ₱ 250 cash
at the end of 30 days or ₱ 270 at the end of 120 days. At what rate is the buyer
paying simple interest if he agrees to pay at the end of 120 days?
Solution:
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Problem 4
Compute the exact simple interest due on ₱ 1,200 at an interest rate of 12% from
January 23, 2016 to October 12, 2016.
Solution:
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Solution:
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COMPOUND INTEREST
Simple Interest is not frequently used in practice, or if used that is suited for
short period loans only. For long term loans, compound interest is being used in
which the interest per period is not only computed on the principal but also the
interest that has been earned on the previous periods.
To illustrate the compound interest, let us consider an investment of ₱ 5,000
for 3 years at an interest rate of 10% compounded annually. This was solved in
Problem 1 with simple interest. Now let’s see the difference if we use the
compound interest. Below is the tabulated interest per year.
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The future value is ₱ 6,655 and I = 6,655 – 5,000 = ₱ 1,655. This shows that
the compound interest is ₱ 155 greater than the simple interest. ( I = ₱ 1,500 in
Problem 1 ). This is because the interest in the previous periods also earn interests
during the succeeding periods. The term compound means interest over interest.

Future Value Formula: 𝑭 = 𝑷(𝟏 + 𝒊)𝒏

The quantity (𝟏 + 𝒊)𝒏 is called the simple payment compound amount factor.

Present Value Formula: w + 𝒊)−𝒏

𝑷 = 𝑭(𝟏
The quantity is (𝟏 + 𝒊)−𝒏 is called the single payment present worth factor.
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Compounding Periods and Interest Rates

The compound period should be the same as the period of the interest, i. The
nominal interest rate, r, is the interest rate per year and states the number of
compounding periods in one year. For example, 10% compounded semi-annually.
This means that the interest rate per year is 10% and the computation of the
interest is twice a year.
The interest rate per period, i, is equal to the nominal rate divided by the
number of periods in one year, that is
𝒓
𝒊=
𝒏
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The following examples illustrate the value of r, n, and i.
a) 12% compounded semiannually -----r = 0.12, n = 2, and i = 0.12/2 = 0.06
b) 12% compounded quarterly ---------- r = 0.12, n = 4, and i = 0.12/4 = 0.03
c) 12% compounded monthly ----------- r = 0.12, n = 12, and i = 0.12/12 = 0.01

Effective Interest Rate (EIR)

Suppose you make a loan ₱ 1,000 and the loan firm charges you a 10%
compounded quarterly. You may think that the interest in 1 year is 0.10(1,000) = ₱
100. Compute the interest, we have
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The Effective Interest Rate (EIR) of a given nominal rate is the actual
interest rate of the principal in one year. It is simple interest that will yield the same
amount of interest after 1 year. From the previous illustration, using a one year
period

Effective Interest Rate Formula:

𝒓 𝒎
𝑬𝑰𝑹 = (𝟏 + 𝒊)𝒎 −𝟏 𝒐𝒓 𝑬𝑰𝑹 = 𝟏 + −𝟏
𝒎
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Problem 5
Compute the effective rate of interest of 15% compounded monthly.

Solution:
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Problem 6
What rate of interest compounded monthly is equivalent to an interest rate of 14%
compounded quarterly?
Solution:
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Problem 7
Find the difference between simple interest and compounded interest on a savings
deposit of fifty thousand pesos at 10 percent per annum for 3 years.
Solution:
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Problem 8
A businessman buys a property which is worth ₱ 2M. He paid a down payment of
₱ 500,000 and at the end of the first year he paid another ₱ 1M and the remaining
to be paid on the 3rd year if money is worth 24% compounded semi-annually.
Solution:
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Solution:
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CONTINUOUS COMPOUNDING

In the previous discussion, the interest is compounded at the end of discrete

periods of time say monthly, quarterly, or annually. This is not always the case
however, in most enterprises cash is flowing in and out in an almost continuous
stream. Because cash, whenever it is available, can usually be used profitably ,
this situation creates opportunities for very frequent compounding of interest
earned. This situation is called continuous compounding.
Continuous compounding assumes that cash flows occur at discrete intervals
(e.g. once a year) but that compounding is continuous throughout the interval.
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Future Value Formula: 𝑭 = 𝑷𝒆𝒓𝒏

The quantity 𝒆𝒓𝒏 is called the simple payment compound amount
factor in continuous compounding.

Present Value Formula: 𝑷 = 𝑭𝒆−𝒓𝒏

The quantity is 𝒆−𝒓𝒏 is called the single payment present worth
factor in continuous compounding.

In continuous compounding, the effective interest rate is given by the formula

𝑬𝑰𝑹 = 𝒆𝒓 − 𝟏
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Problem 9
A savings bank is selling long-term savings certificates that pay interest at the rate
of 7 ½% per year, compounded continuously. Compute the effective interest rate.

Solution:
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Problem 10
Compute the difference in the future amount of ₱ 500 compounded annually at
nominal rate of 5% and if it is compounded continuously for 5 years at the same
rate.
Solution: