INTEREST AND

EQUIVALENCE
EKONOMI TEKNIK
Teknik Industri
Semester Ganjil 2024/2025
COMPUTING CASH FLOW
• Installing expensive machinery in a plant obviously has
economic consequences that occur over an extended period of
time. If the machinery was bought on credit, the simple process
of paying for it could take several years. What about the
usefulness of the machinery?
• Certainly it was purchased because it would be a beneficial
addition to the plant. These favorable consequences may last as
long as the equipment performs its useful function.
• In these circumstances, we describe each alternative as cash
receipts or disbursements at different points in time. Since
earlier cash flows are more valuable than later cash flows, we
cannot just add them together. Instead, each alternative is
resolved into a set of cash flows.
Example 1
Example 2
TIME VALUE OF MONEY
• Money is quite a valuable asset—so valuable that 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.
• The importance of interest is demonstrated by banks and
savings institutions continuously offering to pay for the use of
people’s money, to pay interest.
• If the current interest rate is 9% per year and you put $100 into
the bank for one year, how much will you receive back at the
end of the year?
• You will receive your original $100 together with $9 interest,
for a total of $109. This example demonstrates the time
preference for money:
• we would rather have $100 today than the assured promise
of $100 one year hence; but we might well consider leaving
the $100 in a bank if we knew it would be worth $109 one
year hence.
• This is because there is a time value of money in the form
Simple Interest
• Simple interest is interest that is computed only on the
original sum, not on accrued interest.
• Thus if you were to loan a present sum of money P to
someone at a simple annual interest rate i (stated as a
decimal) for a period of n years, the amount of interest
you would receive from the loan would be
Total interest earned = P × i × n
• At the end of n years the amount of money due you, F,
would equal the amount of the loan P plus the total
interest earned. That is, the amount of money due at the
end of the loan would be
F = P + P.i.n
F = P(1 + in)
Example 3
Compound Interest
• With simple interest, the amount earned (for invested money) or
due (for borrowed money) in one period does not affect the
principal for interest calculations in later periods.
• However, this is not how interest is normally calculated. In
practice, interest is computed by the compound interest
method.
• For a loan, any interest owed but not paid at the end of the year
is added to the balance due. Then the next year’s interest is
calculated on the unpaid balance due, which includes the unpaid
interest from the preceding period.
• In this way, compound interest can be thought of as interest on
top of interest. This distinguishes compound interest from
simple interest.
Example 4
To better understand the mechanics of interest,
let us say that $5000 is owed and is to be repaid
in 5 years, together with 8% annual interest.
Plan 1 (Constant Principal), repays 1/n th of the principal each year.
• So in Plan 1, $1000 will be paid at the end of each year plus the
interest due at the end of the year for the use of money to that
point.
• Thus, at the end of Year 1, we will have had the use of $5000.
The interest owed is 8%×$5000=$400.
• The end-of-year payment is $1000 principal plus $400 interest,
for a total payment of $1400.
• At the end of Year 2, another $1000 principal plus interest will be
repaid on the money owed during the year.
• This time the amount owed has declined from $5000 to $4000
because of the Year 1 $1000 principal payment.
• The interest payment is 8%×$4000=$320, making the end-of-
year payment a total of $1320.
To better understand the mechanics of interest,
let us say that $5000 is owed and is to be repaid
in 5 years, together with 8% annual interest.
Plan 2 (Interest Only) only the interest due is paid each year, with
no principal payment.
• Instead, the $5000 owed is repaid in a lump sum at the end of
the fifth year. The end-of-year payment in each of the first 4
years of Plan 2 is 8%×$5000=$400.
• The fifth year, the payment is $400 interest plus the $5000
principal, for a total of $5400.
To better understand the mechanics of interest,
let us say that $5000 is owed and is to be repaid
in 5 years, together with 8% annual interest.
Plan 3 (Constant Payment) calls for five equal end-of-year
payments of $1252 each.
• Picture below will show how the figure of $1252 is computed.
To better understand the mechanics of interest,
let us say that $5000 is owed and is to be repaid
in 5 years, together with 8% annual interest.
Plan 4 (All at Maturity) repays the $5000 debt like calculation in
compound interest.
• In this plan, no payment is made until the end of Year 5, when
the loan is completely repaid.
• Note what happens at the end of Year 1: the interest due for the
first year—8%×$5000=$400—is not paid; instead, it is added to
the debt.
• At the second year then, the debt has increased to $5400. The
Year 2 interest is thus 8%×$5400=$432. This amount, again
unpaid, is added to the debt, increasing it further to $5832.
• At the end of Year 5, the total sum due has grown to $7347 and
is paid at that time.
Calculation in Excel
Four Ways to Repay a Debt: equivalent
in nature but different in structure.

Plan Repay Repay Interest Interest Earned

Principal
1 Equal annual Interest on Declines
installments unpaid balance
2 End of loan Interest on Constant
unpaid balance
3 Equal annual installments Declines at
increasing rate
4 End of loan Compound and Compounds at
pay at end of increasing rate
loan until end of loan
EQUIVALENCE
• When an organization is indifferent as to
whether it has a present sum of money now or
the assurance of some other sum of money (or
series of sums of money) in the future, we say
that the present sum of money is equivalent to
the future sum or series of sums.
• Each of the plans on the previous example is
equivalent because each repays $5000 at the
same 8% interest rate.
How might two alternatives with
different cash flows be compared?
• If you were given your choice between the
two alternatives, which one would you
choose?
• Obviously the two plans have cash flows
that are different, and you cannot compare
the −$6200 and −$7000. Plan 1 requires
that there be larger payments in the first 4
years, but the total payments are smaller.
To make a decision, we must use the
technique of equivalence.
• We can determine an equivalent value at
some point in time for Plan 1 and a
comparable equivalent value for Plan 2,
based on a selected interest rate.
• Then we can judge the relative
attractiveness of the two alternatives, not
from their cash flows, but from comparable
equivalent values.
Table below repeats the end-of-year payment
schedules from four plan before and also graphs
each plan to show the debt still owed at any point
in time.
• Since $5000 was borrowed at the beginning of the first year, all
the graphs begin at that point. We see, however, that the four
plans result in quite different amounts of money owed at any
other point in time.
• In Plans 1 and 3, the money owed declines as time passes. With
Plan 2 the debt remains constant, while Plan 4 increases the
debt until the end of the fifth year. These graphs show an
important difference among the repayment plans—the areas
under the curves differ greatly.
• Since the axes are Money Owed and Time, the area is their
product: Money owed × Time, in years.
Plan 1 (Constant Principal): At the
end o each year pay $1000 principal
plus interest due
Plan 2 (Interest Only): Pay interest
due at end of each year and principal
at end of 5 years
Plan 3 (Constant Payment): Pay in
fivr equal end-of-year payments
Plan 4 (All at Maturity): Pay principal
and interest in one payment at end
of 5 years
With the area under each curve computed in
dollar-years, the ratio of total interest paid to
area under the curve may be obtained:
• From our calculations, we more easily see why the
repayment plans require the payment of different total
sums of money, yet are actually equivalent.
• The key factor is that the four repayment plans provide
the borrower with different quantities of dollar-years.
Since dollar-years times interest rate equals the interest
charge, the four plans result in different total interest
charges.
Equivalence Is Dependent on
Interest Rate
• In the example of Plans 1 to 4, all calculations were made at
an 8% interest rate. At this interest rate, it has been shown
that all four plans are equivalent to a present sum of $5000.
But what would happen if we were to change the problem by
changing the interest rate?
• If the interest rate were increased to 9%, we know that the
interest payment for each plan would increase, and the
calculated repayment schedules (Table 3-1, column f ) could
no longer repay the $5000 debt with the higher interest.
Instead, each plan would repay a sum less than the principal
of $5000, because more money would have to be used to
repay the higher interest rate.
• This leads to the conclusion that equivalence is dependent
on the interest rate. Changing the interest rate destroys
the equivalence between two series of payments.
SINGLE PAYMENT COMPOUND
INTEREST FORMULAS (1)
To facilitate equivalence computations, a series of interest
formulas will be derived, use the following notation:
i = interest rate per interest period; in the equations the
interest rate is stated as a decimal (that is, 9% interest is
0.09)
n = number of interest periods
P = a present sum of money
F = a future sum of money at the end of the nth interest
period, which is equivalent to P with interest rate I
SINGLE PAYMENT
COMPOUND INTEREST
FORMULAS (2)
• In other words, a present sum P increases in n periods to P(1 + i)n .
We therefore have a relationship between a present sum P and its
equivalent future sum, F.
Future sum = (Present sum) (1 + i)n
F = P(1 + i)n
• This is the single payment compound amount formula and is
written in functional notation as
F = P(F/P, i, n)
• The notation in parentheses (F/P, i, n) can be read as follows: To find
a future sum F, given a present sum, P, at an interest rate i per
interest period, and n interest periods hence. Or Find F, given P, at i ,
over n.
• Without proceeding further, we can see that when we derive a
compound interest factor to find a present sum P, given a future sum
F, the factor will be (P/F, i, n); so, the resulting equation would be
P = F(P/F, i, n)
Example 5, 6, 7
NOMINAL AND EFFECTIVE
INTEREST
• Nominal interest rate per year, r, is the
annual interest rate without considering the
effect of any compounding.
• Effective interest rate per year, ia , is the
annual interest rate taking into account the
effect of any compounding during the year.
Example 8, 9
Example 10
CONTINUOUS COMPOUNDING
• If we increase m, the number of compounding subperiods per
year, without limit, m becomes very large and approaches
infinity, and r/m becomes very small and approaches zero.
• This is the condition of continuous compounding: that is, the
duration of the interest period decreases from some finite
duration t to an infinitely small duration dt, and the number of
interest periods per year becomes infinite. In this situation of
continuous compounding:
Example 11, 12, 13, 14