INTERESTS

 Simple Interest
 Compound Interest

 Effective Rate

 Nominal Rate

 Future Values

 Present Value
 Time value of Money
 Relation between present and future values.

 Simple and compound interests and the corresponding

future and present values of an amount of money
invested today
TYPES OF INTEREST
 Simple Interest (SI); which is interest earned on only
the original amount, called Principal, lent over a period
of time at a certain rate.
 Compound Interest (CI); which is interest earned on
any previous interests earned as well as on the Principal
lent.
TYPES OF INTEREST
 What is the difference between the two?
In the case of simple interest, the amount of interest paid is
based ONLY on the amount borrowed, whereas in a compound
interest scenario the amount of interest paid is based on the
amount invested PLUS the interest accumulated in the account.
SIMPLE INTEREST
The Simple interest is given by
SI = P0 · i · n
where
P0 : Present value today (deposited t = 0),
i : interest rate per period of time,
n : number of time periods
 Question:
Assume that you deposit $1000 in an account paying 7% annual
simple interest for 2 years. What is the accumulated interest at
the end of the second year?
 Solution:
SI = P0 · i · n = 1000 ·0.07· 2 = $140.
SIMPLE INTEREST AND FUTURE VALUE
 Future Value (FV) is the value at some future time of a
present amount of money evaluated at a given interest
rate.
 What is the future value of the deposit?

FVn = P0 + SI = P0(1 + n · i).

 For our example above,
FVn = 1000 + 140 = $1140.
 Note that there are 4 variables in the formula above.
Therefore, having any three of them, could be used to
find the fourth one.
SIMPLE INTEREST AND PRESENT VALUE
 Present Value (PV) is the current value of a future
amount of money evaluated at a given interest rate.

 What is the present value of the previous problem?

The present value is simply the $1000 you originally deposited. That is
the value today.
COMPOUND INTEREST
The Compound interest is given by
FVn = P0 ·(1+i )n
or
𝑟 m·t
FVn = P0 ·(1+ )
𝑚

where
P0 : Present value today (deposited t = 0),
i : interest rate per period,
n : number of time periods
r : annual interest rate
m : number of interest periods per year
COMPOUND INTEREST

Note:
Each compound interest problem involves two rates:
a) the annual rate r;
𝑟
b) the rate per compounding period, 𝑖 = .
𝑚
You have to understand the distinction between them. If
interest is compounded annually, then
i=r.
COMPOUND INTEREST
Example:
A person wants to know how large his deposit of $10000
today will become at a compound annual interest rate of
10% for 5 years.

Solution: Using the formula:

FV5 = 10000(1 + 0.1)5 = $16105.10
IMPACT OF FREQUENCY
 A person has $1000 to invest for 2 years at an annual
compound interest rate of 12%:
0.12 (1)(2)
 annual: FV2 = 1000(1 + ) = $1254.40
1
0.12 (2)(2)
 semi-annual: FV2 = 1000(1 + ) = $1262.48
2
0.12 (4)(2)
 quarterly: FV2 = 1000(1 + ) = $1266.77
4
0.12 (12)(2)
 monthly: FV2 = 1000(1 + ) = $1269.73
12
0.12 (365)(2)
 daily: FV2 = 1000(1 + ) = $1271.20
365
SIMPLE AND COMPOUND INTERESTS
CONTINUOUS COMPOUNDING OF INTEREST
 Continuous Compound Interest Formula
A = Pert
where
P = Principal
r = Annual interest rate compounded
continuously
t = Time in years
A = Accumulated amount at the end
of t years
CONTINUOUS COMPOUNDING OF INTEREST
 Find the accumulated amount after 3 years if $1000 is
invested at 8% per year compounded (a) daily, and (b)
continuously.
Solution
a. Using the compound interest formula with P = 1000,
r = 0.08, m = 365, and t = 3, we find
mt (365)(3)
 r  0.08 
A  P 1    1000  1    1271.22
 m   365 
b. Using the continuous compound interest formula with
P = 1000, r = 0.08, and t = 3, we find
A = Pert = 1000e(0.08)(3) ≈ 1271.25
Note that the two solutions are very close to each other.
EFFECTIVE RATE OF INTEREST
 The interest actually earned on an investment depends on
the frequency with which the interest is compounded.
 For clarity when comparing interest rates, we can use
what is called the effective rate (also called the annual
percentage yield):
 This is the simple interest rate that would produce the same
accumulated amount in 1 year as the nominal rate
compounded m times a year.
 We want to derive a relation between the nominal
compounded rate and the effective rate.
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

 The primary difference between simple and compound

interest is that compound interest includes interest on the
interest earned in the previous record, while simple does not.
 The nominal and effective interest rates have also the same
basic relationship.
 The difference here is that the concepts of nominal and
effective must be used when interest is compounded more
than once each year.
 Nominal interest rate, r, is an interest rate that does not
include any consideration of compounding.
r = interest rate per period x number of periods
 A nominal rate r may be stated for any time period, 1 year, 6
months, quarter, month, week, day, etc.
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

 EX: The nominal rate of r = 1.5% per month is the same

as each of the following rates;
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

 Effective interest rate is the actual rate that applies for a stated period of time. The
compounding of interest during the time period of the corresponding nominal rate is
accounted for by the effective interest rate.
 It is commonly expressed on an annual basis as the effective annual rate ia, but any
time basis can be used.
 An effective rate has the compounding frequency attached to the nominal rate
statement.
 EX: 12% per year, compounded monthly
12% per year, compounded quarterly
3% per quarter, compounded monthly
6% per 6 months, compounded weekly
3% per quarter, compounded quarterly (compounding same as time period)

 All examples are nominal rate statements; however, they will not have the same
effective interest rate value over all time periods, due to the different compounding
frequencies.
 In the last example, the nominal rate of 3% per quarter is the same as the effective rate
of 3% per quarter, compounded quarterly.
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

 Time units associated with an interest rate statement

 Time period: The basic time unit of the interest rate
 Compounding period (CP): The time unit used to determine the
effect of interest.
 The compounding frequency, m: The number of times that
compounding occurs within the time period t.
 EX:
 8% per year, compounded monthly, has a compounding frequency
of m=12 times per year.
 A rate of 8% per year, compounded weekly, has a frequency of
m=52.
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

EX: Determine the effective rate on the basis of the

compounding period for each interest rate.
a) 9% per year, compounded yearly
b) 6% per year, compounded quarterly
c) 8% per year, compounded monthly
d) 5% per 6- months, compounded weekly
NOMINAL AND EFFECTIVE INTEREST RATE
STATEMENTS

 Sometimes it is not obvious whether a stated rate is

nominal or an effective rate. Basically there are three
ways to express interest rates.
EFFECTIVE ANNUAL INTEREST RATES
 The effective interest rate is the one rate that truly
represents the interest earned in a year.
 Like compound interest, the effective interest rate at any
point during the year includes (compounds) the interest
rate at any point during the year.
 The following formula should be used for the future
worth calculation;

 Where;
 F is the future worth
 P is the present worth

 i is the effective interest rate per compounding period (CP) = r/m

 m is the number of compounding periods per year

EFFECTIVE ANNUAL INTEREST RATES
EX: Suppose you deposit 10.000 TL in a savings account that pays you
at an interest rate of 9% compounded quarterly. Here, 9% represents
the nominal interest rate, and the interest rate per quarter is 2,25%
(9%/4). Below table shows the example of how the interest is
compounded when it is paid quarterly.

 The total amount annual interest payment for a principal amount of

10.000 TL can also be calculated with the formula.
F = P(1+i)m
P = 10.000 TL, i = 2,25%, m= 4
F= 10.000 TL (1+0,0225)4
F= 10.930,83 TL
EFFECTIVE ANNUAL INTEREST RATES

 You are earning more than 9% on your original deposit. In fact,

you are earning 9,3083% (930.83 TL / 10.000 TL).
 Effective annual interest rate per year, ia, = 930.83 / 10.000 =
0,093083 = 9,3083%
 Earning 2,25% interest per quarter for four quarters is
equivalent to earning 9,3083% interest just one time each year.
Effective annual interest rate, ia = (1+i)m -1
 Again for the same example, but this time by the formula;

ia = (1+i)m -1 = (1+0,0225)4 -1 = 0,093083 = 9,3083 %

EFFECTIVE ANNUAL INTEREST RATES
EX: For a 1.000 TL balance at the beginning of the year, if the
stated rate is 18% per year, compounded monthly, find the
effective annual rate and the total amount owned after 1 year.
There are 12 compounded periods per year, thus m = 12.
i = 18%/ 12 = 1,5% per month
ia = (1+i)m -1 = (1+0,015)12 -1 = 1,19562 -1 = 0,19562
F = P(1+i)m = 1.000 TL (1,19562) = 1195,62 TL
Hence, 19,562% or 195,62 TL owned!!
EFFECTIVE INTEREST RATES FOR ANY
TIME PAYMENT PERIOD
 The payment period is the frequency of the payment or receipts in
other words, is cash flow transaction period.
 It is important to distinguish the compounding period and the payment
period!
EX: If company deposits money each month into an account that pays a
nominal interest rate of 14% per year, compounded semiannually, the
payment period is 1 month while the compounding period is 6 months.
 The effective annual interest rate formula is easily generalized to any
nominal rate by substituting r/m for the period interest rate

Where;
M is the number of interest per year
C is the number of interest periods per payment period
K is the number of payment periods per year
EX: Suppose that you make quarterly deposits in a savings account that
earns 9% interest compounded monthly. Compute the effective interest rate
per quarter.
R = 9%, C = three interest periods per quarter, K = four quarterly
payments per year, M = 12 interest periods per year.
Using Effective i = (1+r/CK)c -1
i = ( 1+ 0,09/12)3-1 = 2,27 %
EX: A dot-com company plans to place money in a new venture capital
that fund that currently returns 18% per year, compounded daily. What
effective rate is this a) yearly and b) semiannually?
a) r = 18%, C = 365 interest periods per year, K = 1 payment per year, M = 365
interest periods per year
Using Effective i = (1+r/CK)c -1
i = ( 1+ 0,18/365)365-1 = 19,716 %

b) r = 18%, C = 182 interest periods per semiannual, K = 2 payment per year, M =

365 interest periods per year
Using Effective i = (1+r/CK)c -1
i = (1+ 0,18/365)182-1 = 9,415 %
EFFECTIVE RATE OF INTEREST
 The accumulated amount after 1 year at a simple interest
rate R per year is
A  P(1  R)
 The accumulated amount after 1 year at a nominal
interest rate r per year compounded m times a year is
m
 r
A  P 1  
 m
 Equating the two expressions gives
m
 r
P(1  R )  P  1  
 m
m
 r
1  R  1  
 m
EFFECTIVE RATE OF INTEREST
 Solving the last equation for R we obtain the formula for
computing the effective rate of interest:
m
 r
reff   1    1
 m

where
reff = Effective rate of interest
r = Nominal interest rate per year
m = Number of conversion periods per year
EFFECTIVE RATE OF INTEREST
 Find the effective rate of interest corresponding to a
nominal rate of 8% per year compounded
a. Annually
b. Semiannually
c. Quarterly
d. Monthly
e. Daily
EFFECTIVE RATE OF INTEREST
a. Annually.
Let r = 0.08 and m = 1. Then
1
 0.08 
reff   1   1
 1 
 1.08  1
 0.08

or 8%.
EFFECTIVE RATE OF INTEREST
b. Semiannually.
Let r = 0.08 and m = 2. Then
2
 0.08 
reff   1   1
 2 
 1.0816  1
 0.0816

or 8.16%.
EFFECTIVE RATE OF INTEREST
c. Quarterly.
Let r = 0.08 and m = 4. Then
4
 0.08 
reff  1   1
 4 
 1.08243  1
 0.08243

or 8.243%.
PRESENT VALUE
 Consider the compound interest formula:
mt
 r
A  P 1  
 m
 The principal P is often referred to as the present value, and the
accumulated value A is called the future value, since it is realized at
a future date.
 On occasion, investors may wish to determine how much money
they should invest now, at a fixed rate of interest, so that they will
realize a certain sum at some future date.
 This problem may be solved by expressing P in terms of A.
 Present value formula for compound interest
P  A 1  i 
n

𝑟
Where 𝑖 = and 𝑛 = 𝑚𝑡
𝑚
 How much money should be deposited in a bank paying
a yearly interest rate of 6% compounded monthly so that
after 3 years the accumulated amount will be $20,000?
Solution
 Here, A = 20,000, r = 0.06, m = 12, and t = 3.

 Using the present value formula we get

 mt
 r 
P  A 1  
 m
 (12)(3)
 0.06 
 20,000  1  
 12 
 16,713
EQUIVALENCE RELATIONS: COMPARING
PAYMENT PERIOD AND COMPOUNDING
PERIOD LENGHTS
 All the examples up to here assumed annual payments
and annual compounding. However, a number of
situations involve cash flows that occur at intervals that
are not the same as the compounding intervals often used
in practice.
 Whenever payments and compounding periods differ
from each other, one or the other must be transformed so
that both conform to the same unit of time.
 Equivalence Relations: Single Amounts with PP ≥ CP

 When only single-amount cash flows are involved, there

are two equally correct ways to determine i and n for P/F
and F/P factors.
 Method 1 is easier to apply, because the interest tables
can usually provide the factor value.
 Method 2 likely requires a factor formula calculation,
because the resulting effective interest rate is not an
integer.
EQUIVALENCE RELATIONS: SINGLE AMOUNTS
WITH PP ≥ CP

 Method 1
Determine the effective interest rate over the compounding
period CP, and set n equal to the number of compounding
periods between P and F. The relations to calculate P and F are
 P = F (P/F, effective i% per CP, total number of periods n)
 F = P (F/P, effective i% per CP, total number of periods n)

 !!! The CP is the best because only over the CP can the
effective rate have the same numerical value as the nominal
rate over the same time period as the CP.
EQUIVALENCE RELATIONS: SINGLE AMOUNTS
WITH PP ≥ CP

 Method 2
 Determine the effective interest rate for the time period t
of the nominal rate, and set n equal to the total number of
periods using this same time period
 The P and F relations are the same as in above equations
with the term effective i% per t substituted for the
interest rate.
EQUIVALENCE RELATIONS: SERIES WITH PP
≥ CP
 When uniform or gradient series are included in the cash flow
sequence, the procedure is basically the same as method 2
above, except that PP is now defined by the frequency of the
cash flows.
 This also establishes the time unit of the effective interest rate.
 For example, if cash flows occur on a quarterly basis, PP is a
quarter and the effective quarterly rate is necessary.
 Then n value is the total number of quarters. If PP is a quarter,
5 years translates to an n value of 20 quarters.
 This is a direct application of the following general guideline:
 When cash flows involve a series (i.e. A, G, g) and the payment
period equals or exceeds the compounding period in length,
 Find the effective I per payment period.
 Determine n as the total number of payment periods.
 Following table shows the correct formulation for
several cash flow series and interest rates. Note that n is
always equal to the total number of payment periods and
I is an effective rate expressed over the same time period
as n.
EQUIVALENCE RELATIONS: SINGLE AMOUNTS
AND SERIES WITH PP < CP
The computational procedure for establishing economic
equivalence is as follows.
 Step 1: Identify the number of compounding periods per year
(M), the number payment periods per year (K); and the
number of interest periods per payment period (C):
 Step 2: Compute the effective interest rate per payment
period.
 For discrete compounding, compute
i = (1+r/M)c -1
 For continuous compounding, compute
i = er/K -1
 Step 3: Find the total number of payment periods:
N = K x (number of years)
 Step 4: Use i and N in the appropriate formulas from the
table.
 EX: Suppose you make equal quarterly deposits of 1.500
TL into a fund that pays interest at a rate of 6% compounded
monthly. Find the balance at the end of year 2.
 Given: A = 1.500 TL per quarter, r = 6% per year, M = 12
compounding periods per year and N = 8 quarters
 Find: F!
 Step 1: Identify the parameter values for M, K and C, where
 M = 12 compounding periods per year
 K = 4 payment periods per year
 C = 3 interest periods per payment period (quarter)

 Step 2: Compute the effective interest:

 i = (1+r/M)c -1
 = (1+ 0,06/12)3 -1
 = 1,5075% per quarter

 Step 3: Find the total number of payment periods, N:

 N = K(number of years) = 4(2) = 8 quarters
 Step 4: Use I and N in the appropriate equivalence formulas:
 F = 1.500 TL (F/A, 1,5075%, 8) = 12,652.61 TL
EX: Calculate the Present Value of the cash flow given below
where the nominal interest rate is 3% per quarter compounding
monthly.

 In this example it is seen that nominal rate is given per quarter

with a monthly compounding rate whereas the payments are
made with 2-year time period. Therefore, actual interest rate,
the effective interest rate that applies for 2-year time period
should be calculated.
 Step 1: Effective interest rate for Compounding Period (CP)
𝑖𝐶𝑃=𝑟/𝑚 where m is compounding frequency for the given period for
nominal interest. Therefore, effective monthly interest rate is:
𝑖𝐶P=3/3=1% .
 Step 2: Effective interest rate for Payment Period (PP)
(1+𝑖𝑃𝑃)=(1+𝑖𝐶𝑃)𝑛 where n is compounding frequency in payment periods.
Shortly, 𝑖𝑃𝑃=(1+𝑖𝐶𝑃)𝑛−1.
 In this example, payment periods for the given cash flow is 2 years,
therefore, effective interest rate for 2-year period is;
𝑖2−𝑦𝑒𝑎𝑟=(1+0,01)24−1=0,2697=26,97%.
 Step 3: Cash Flow Calculation
PW = – 1000 + 500 (P/A, 26,97%, 5)
(P/A, 26,97%, 5) = [(1+0,2697)5 – 1] / [0,2697 (1+0,2697)5] = 2,5842
PW = – 1000 + 500 (2,5842)
PW = – 1000 + 1292,1
PW = 292,1 TL
COMPARISON OF ALTERNATIVES
1. Present worth analysis (Güncel değer yöntemi)
2. Annual equivalent method (Senelik eşdeğer maliyet yöntemi)
3. Rate of return analyses (İç verimlilik)

 The minimum attractive rate of return, simply called

as MARR, is the minimum rate of return that the
company is willing to accept on the money it invests. It
is also called as minimum acceptable rate of return or
hurdle rate.
MARR
 MARR is generally determined by the board of the
company according to financial reports prepared by the
financial analyst(s) of the company.
 It is not a constant rate, it can vary from project to
project, or time to time.
 Many parameters can change the value of MARR in a
project.
MARR
 The most common parameters in the determination of the MARR in a project are as follow:
 Project Risks
Project specific risk covers risks in the market such as unavailable raw materials, ineffective labor force,
price deviation in raw materials etc.; social, economic, political and environmental risk in the project
location. Therefore, the company is expected to increase the value of MARR as the risk gets greater. For
instance, MARR for the highway project in Libya in 2014 is expected to be higher than the one in 2006
at the same location; since the political instability may increase the completion time of the project and
may cause delay in the progress payments. Therefore, risk level in the project changes the MARR value.
 Investment Opportunities
The company may have alternative investment opportunities. For instance, investing the money into
bank is a do nothing option. If the company gets higher return than the one in the investment project, it
does not need to invest in the project. The company may want to decrease its profit rate to expand in a
market. Then, the MARR value is decreased for the projects in that market.
 Limits on Available Capital
If the capital of the company is limited, it needs to get credit from a bank and pay the bank higher
amount of money. Therefore, the company must increase its total profit in the project to get the same
profit amount after paying the credit to bank. Therefore, the MARR value is increased.
 Rate of Return of Other Companies
In a competitive market, the company must consider MARR value of its rivals to compete with them.
For instance, in an airport project tender, if the company does not take into consideration the MARR
values of its rivals, it may bid much higher price for the project when it is compared to other companies
and one of the other companies is expected to get the tender.
EXAMPLE
 Two different methods are being considered for elevating rock
into a crusher. It is expected that the rock crusher will be used
for 6 years. Cost estimates for the two methods are as follows:
Method A Method B
First Cost 42000 $ 28000 $
Salvage Value 60000 $ 10000 $
Annual Fuel Cost 2000 $/yr 4500 $/yr
Annual 1300 $/yr 3000 $/yr
Maintenance Cost
Extra Annual Cost 600 $ -

 Compare the present worth and annual equivalent of these two

alternatives by using a MARR of 12%.
SOLUTION (ANNUAL EQUIVALENT)
Method A: 6000$

2000 $/yr
1300 $/yr
42000$ 600 $/yr

AEA= -42000(A/P,12%,6)+6000(A/F,12%,6)-2000-1300-600=-13,376 $/yr

Method B: 10000$

4500 $/yr
3000 $/yr
28000$

AEB= -28000(A/P,12%,6)+10000(A/F,12%,6)-4500-3000=-13,078 $/yr

Select Alternative B!
SOLUTION (PRESENT WORTH)
Method A: 6000$

2000 $/yr
1300 $/yr
42000$ 600 $/yr

PWA= -42000+(2000+1300+600)(P/A,12%,6)+6000(P/F,12%,6)=-54.993 $

Method B: 10000$

4500 $/yr
3000 $/yr
28000$

PWB= -28000-(4500+3000)(P/A,12%,6)+10000(P/F,12%,6)=-53.766 $
Select Alternative B!
ALTERNATIVES WITH UNEQUAL SERVICE LİVES
 PW: Common multiplier of lives
 AE: No need such a thing as we will look at the annual costs.

EX: Find the present worth of the two alternatives whose cash
flows are given below if MARR is 10%.
300.000 $/yr 400.000 $/yr

1.000.000 $ 900.000 $

Method A Method B
SOLUTION
AEA= -100000(A/P,10%,5)+300000=36200 $/yr
AEA= -90000(A/P,10%,5)+400000=38101 $/yr SELECT B!!!!

PWA= 36200 (P/A,10%,15)=275337 $

PWB= 38101 (P/A,10%,15)=289767 $ SELECT B!!!
EXAMPLE
Plan R Plan S
First Cost 25 000 $ 45 000 $
Useful Life 20 years 30 years
Salvage Value 5000 $ -
Annual Disbursements 5500 $/yr 2800 $/yr
MARR 8%

SOLUTION:
AER= -25000 (A/P,8%,20)-5500+5000 (A/F,8,20) = -7988 $/yr
AES= -45000 (A/P,8%,30)-2800 = -6796 $/yr

PWR= -7988 (P/A,8%,60) = -98245 $ SELECT S!!!

PWS= -6796 (P/A,8%,60) = -844111 $
REPLACEMENT
 Basic reasons for replacement:
 Physical impairment
 Obsolescense

 Methods:
 The outsider viewpoint method
 Comparative use value method
 Receipts and disbursement method