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EDA Lec 3a

The document discusses economic decision analysis in construction, focusing on compound interest and present value calculations. It includes various examples of calculating present worth, future worth, interest rates, and effective annual interest rates using different compounding methods. Additionally, it addresses economic equivalence and the minimum annual rate of return for investment decisions.

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Waqar Hussain
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0% found this document useful (0 votes)
22 views36 pages

EDA Lec 3a

The document discusses economic decision analysis in construction, focusing on compound interest and present value calculations. It includes various examples of calculating present worth, future worth, interest rates, and effective annual interest rates using different compounding methods. Additionally, it addresses economic equivalence and the minimum annual rate of return for investment decisions.

Uploaded by

Waqar Hussain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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ECONOMIC DECISION

ANALYSIS IN CONSTRUCTION

Dr Zahoor

Lecture 3a
COMPOUND INTEREST – PRESENT VALUE
Example: In 3 years, you need Rs 400 to pay a debt. In two more years, you need Rs
600 more to pay a second debt. How much should you put in the bank today to meet
these two needs if the bank pays a annual compound interest of 12% per year?
COMPOUND INTEREST – PRESENT VALUE
Example: In 3 years, you need Rs 400 to pay a debt. In two more years, you need Rs
600 more to pay a second debt. How much should you put in the bank today to meet
these two needs if the bank pays a annual compound interest of 12% per year?

P = 400/ (1+0.12)3 +600/ (1+0.12)5


= 284.72 + 340.44 = Rs 625.16/-

P = 400 x 0.7118 + 600 x 0.5674


= 284.72 + 340.44 = Rs 625.16/-
If interest is compounded monthly
P = 400 (P/F, 12%/12, 3*12)
+ 600 (P/F, 12%/12, 5*12)
= 400 (P/F, 1%, 36) + 600 (P/F, 1%, 60)
= 400 (0.6989) + 600 (0.5504)
= 279.56 + 330.24 = $609.80
COMPOUND INTEREST – INTEREST RATE & NUMBER OF YRS
Example: $800 is needed after F/P = 1.2155 i = (1.2155, i%, 4)
four years. What interest rate per P/F = 0.8227  i = (0.8227, i%, 4)
Check any of these values in tables against n=4
year you should be looking for if Or use the formula i= [(1/(P/F))1/n -1] x 100
you have $658.16 for investment?
F/P = 1.2155 n = (1.2155, i%, n)
Example: Investing $658.16 at the P/F = 0.8227  n = (0.8227, i%, n)
compound interest rate of 5% per Check any of these values in tables against i=5%
Or use the formula n = [ln (F/P)] / [ln (1+i)]
year. How many years will it take to
have $800 in your account?
COMPOUND INTEREST – INTEREST RATE
Example: Assume you can invest $3,000 now in a friend’s business, and
will get paid back $5,000 in 5 years: What is the interest rate?
COMPOUND INTEREST – INTEREST RATE
Example: Assume you can invest $3,000 now in a friend’s business, and
will get paid back $5,000 in 5 years: What is the interest rate?

F = P (1+i)n
5,000 = 3,000 (1+i)5
(1+i)5 = 5,000/3000 = 1.6667
(1+i) = 1.66670.20 = 1.1076
i = 1.1076 – 1 = 0.1076 = 10.76%

This project is equivalent to earning 10.76% per year


QUARTERLY COMPOUND INTEREST
Example: You put Rs 500 in a bank for 3 years at 6% compound interest per year.
Interest is compounded quarterly. Find the amount after 3 years.
QUARTERLY COMPOUND INTEREST
Example: You put Rs 500 in a bank for 3 years at 6% compound interest per year.
Interest is compounded quarterly. Find the amount after 3 years.

F = P (1+i)n
What’s i = ???
Whats n =???
i = 6/4 = 1.5% / 3 months
n = 3 x 4 = 12
F = 500 ( 1+0.015)12 = Rs 597.81
COMPOUND INTEREST – NUMBER OF YRS
Example: How long will it take for $1,000 to double in value, at an interest
rate of 5% compounding semi annually?
COMPOUND INTEREST – NUMBER OF YRS
Example: How long will it take for $1,000 to double in value, at an interest
rate of 5% compounding semi annually?

F = P (1 + i)n
2000 = 1000 (1.025)n  1.025 n = 2
Taking ln on both sides
n ln(1.025) = ln (2)  n = 28.07

As it is compounding semi annually, it will take 14.5 years but


amount will be a bit higher than Rs 2000
COMPOUND INTEREST – NUMBER OF YRS
Example: How long will it take for $1,000 to double in value, at an interest
rate of 5% compounding annually?
COMPOUND INTEREST – NUMBER OF YRS
Example: How long will it take for $1,000 to double in value, at an interest
rate of 5% compounding annually?

F = P (1 + i)n
2000 = 1000 (1.05)n  1.05n = 2
Taking ln on both sides
n ln(1.05) = ln (2)  n = 14.2067

It will take 15 years but amount will be a bit higher than Rs 2000
EFFECTIVE ANNUAL INTEREST RATE
Nominal Interest Rate (r):
Refers to the stated or declared
interest rate on a loan or
investment, often expressed on
an annual basis (Interest Rate
Per year). It does not take into
account the impact of
compounding or other factors
that can affect the actual cost of
borrowing or the return on an
investment.
Effective Interest Rate (r/m):
Reflects the true cost of
borrowing or the actual return on
an investment. It is equal to r/m
where m are the number of
periods per year.
QUARTERLY COMPOUND INTEREST
Example: You put Rs 500 in a bank for 3 years at 6% compound interest per year.
Interest is compounded quarterly. Find the amount after 3 years.

F = P (1+i)n
What’s i = ???
Whats n =???
i = 6/4 = 1.5% / 3 months
n = 3 x 4 = 12
F = 500 ( 1+0.015)12 = Rs 597.81
QUARTERLY COMPOUND INTEREST
Example: You put Rs 500 in a bank for 3 years at 6% compound interest per year.
Interest is compounded quarterly. Find the amount after 3 years.
F = P (1+i)n Given
r = Nominal interest rate / yr
What’s i = ??? m=Number of compounding periods/yr
Whats n =??? i =Effective interest rate per period= r/m,
i = 6/4 = 1.5% / 3 months the period can be month, quarter, half yr
etc
n = 3 x 4 = 12
F = 500 ( 1+0.015)12 = Rs 597.81 We know F = P ( 1 + i )n  F = P (1+r/m)m
Put this in (1)
What is the annual effective yearly
compound interest?? ia=? ia = [(1 + r/m)m – 1] x 100
Simple  ia = [(F – P) /P] x 100 (1) “F is for 1 yr”
YES, but lets make it more standard without “F” ia = [(1 + i)m – 1] x 100
ANNUAL EFFECTIVE YEARLY COMPOUND INTEREST
Example: You put Rs 500 in a bank for 3 years at 6% compound interest per year.
Interest is compounded quarterly. Find the annual effective interest rate and the
amount after 3 years.
F = P (1+i)n
What is i = ???
Whats is n =???
ia = [(1 + r/m)m – 1] x 100
i = 6/4 = 1.5% / 3 months
n = 3 x 4 = 12 ia = [(1+0.06/4)4-1] x 100 = 6.13
F = 500 ( 1+0.015)12 = Rs 597.8
Check F= 500 (1.0613)3= Rs 597.8/-
Given
r = Nominal interest rate /yr
m = Number of compounding periods/yr
i =Effective interest rate per period= r/m
EFFECTIVE ANNUAL INTEREST RATE

X Y
5% 5.0945%
6% Y
10% 10.3813%

Quarterly interest rate (for i = 6% annual) can also be


(Y2-Y1)/(X2-X1) = (Y-Y1)/(X-X1) interpolated between semi-annual interest rate
(6.0900%) and monthly interest rate (6.1678%)
Y= [(Y2-Y1)/(X2-X1)] [(X-X1)] +Y1
 Gives 6.13
ANNUAL EFFECTIVE YEARLY COMPOUND INTEREST
Example: “If I give you 5000 Rupees on Monday, then you owe me 5010 Rupees the
following Monday?
1.What is the nominal rate, r?
2. What is the annual effective rate, ia?

It is finding interest rate for 1x week


ia = [(1 + r/m)m – 1] x 100
So n=1 Given
F = P (1+i)n  i= (5010/5000)-1 r = Nominal interest rate/yr (%)
m = Number of compounding periods/yr
=0.002/week = 0.2%/wk i =Effective interest rate per period= r/m

r = (0.2%/wk) x (52 wk/yr) = 10.4%/yr ia = [(1 + i)m – 1] x 100


ia =[(1+0.104/52)52 -1] x100 =10.94% / yr
Effective Interest Rate is Not Always Annual
Annual Effective Interest Rate ia=[(1 + r/m)m-1]x100 ia = [(1 + i)m – 1]x 100

r = Nominal interest rate / yr; m= Number of compounding periods/yr; i=Effective interest


rate/compounding period (month, quarter, half yr etc) = r/m

Question: For Nominal interest rate is of 1%, Calculate Effective Annual interest rate,
if compounding: a. Yearly b. Semi-annually c. Monthly d. Daily

a. r=1%, m=1 i =1ia = [(1+1%)1-1] x100 = 1%


b. r=1%, m=2 i =1/2 ia = [(1+0.005)2-1] x100 = 1.0025%
c. r=1%, m=12 i =1/12 ia = [(1+0.00083)12 -1] x100 = 1.0046%
d. r=1%, m=365 i =1/365 ia = [(1+0.0000273)365 -1] x100 = 1.0050%
Effective Interest Rate is Not Always Annual
Annual Effective Interest Rate ia=[(1 + r/m)m-1]x100 ia = [(1 + i)m – 1]x 100
r = Nominal interest rate / yr; m= Number of compounding periods/yr; i=Effective interest
rate/compounding period (month, quarter, half yr etc) = r/m

Question:- What is the Monthly Effective Interest Rate if r=1%, and compounding is
a. Monthly b. Weekly c. Daily

Non Annual Effective Interest Rate; ip=[(1 + r/m)p-1]x100ip=[(1 + i)p-1]100


Where p is no of compounding sub-periods in the period in question

a. r=1%, m=12,  i =1/12 i1 =[(1+0.00083)1-1] x100 =0.083%  Simply 1/12 = 0.0833%


b. r=1%, m=48,  i= 1/48 i4=[(1+ 0.00020833)4-1]x100 = 0.083359%
c. R=1%, m=336, 1/336 i28=[(1+0.00002976)28-1]x100 = 0.083366%
ECONOMIC EQUIVALENCE
Which one would you prefer? USEFUL TO FIND THE NET BENEFIT OR
• $20,000 today COMPARE TWO OPTIONS FOR DECISION
• $50,000 ten years from now MAKING
• $8,000 each year for the next ten years
Present Worth Method: Based on
We need to compare their economic worth!
concept of equivalent worth, all cash flows
Economic equivalence exists between cash are converted into present worth. Total PW
flows if they have the same economic effect
= PW of benefits - PW of costs
Which depends on
• Interest rate Future Worth Method: Based on concept
• Amounts of money involved
• Time Period of equivalent worth, all cash flows are

BOTH SYSTEMS SHOULD HAVE SAME TIME converted into future worth. Total FW =
VALUE OF MONEY FW of benefits - FW of costs
ECONOMIC EQUIVALENCE - MINIMUM ANNUAL RATE OF RETURN (PRESENT
WORTH METHOD)

Example:- $10,000 investment yields a uniform revenue and expenses of $5,310, and $3,000,
respectively, each year for 5 years. Salvage value is $2,000. Company will accept the project if
annual return > 10%. Show whether this is a desirable investment by using the PW method.
ECONOMIC EQUIVALENCE - MINIMUM ANNUAL RATE OF RETURN (PRESENT
WORTH METHOD)

Example:- $10,000 investment yields a uniform revenue and expenses of $5,310, and $3,000,
respectively, each year for 5 years. Salvage value is $2,000. Company will accept the project if
annual return > 10%. Show whether this is a desirable investment by using the PW method.

$5,310 $5,310 $5,310 $5,310 $7,310 $2,310 $2,310 $2,310 $2,310 $4,310

1 2 3 4 5 1 2 3 4 5

$3000 $3000 $3000 $3000 $3000 $10000


$10000
ECONOMIC EQUIVALENCE - MINIMUM ANNUAL RATE OF RETURN (FUTURE
WORTH METHOD)

Example:- $10,000 investment yields a uniform revenue and expenses of $5,310, and $3,000,
respectively, each year for 5 years. Salvage value is $2,000. Company will accept the project if
annual return > 10%. Show whether this is a desirable investment by using the PW method.
$5,310 $5,310 $5,310 $5,310 $7,310 $2,310 $2,310 $2,310 $2,310 $4,310

1 2 3 4 5 1 2 3 4 5

$3000 $3000 $3000 $3000 $3000


$10000
$10000
PV of net profit = 2310/1.10 + 2310/1.10 2 +
2310/1.103 + 2310/1.104 + 4310/1.105 = $10000
 Net PV = $10000-$10000=0
The project is marginally acceptable
ECONOMIC EQUIVALENCE - MINIMUM ANNUAL RATE OF RETURN (FUTURE
WORTH METHOD)

Example:- $10,000 investment yields a uniform revenue and expenses of $5,310, and $3,000,
respectively, each year for 5 years. Salvage value is $2,000. Company will accept the project if
annual return > 10%. Show whether this is a desirable investment by using the PW method.
$5,310 $5,310 $5,310 $5,310 $7,310 $2,310 $2,310 $2,310 $2,310 $4,310

1 2 3 4 5 1 2 3 4 5

$3000 $3000 $3000 $3000 $3000


$10000
$10000
PV of net profit = 2310/1.10 + 2310/1.10 2 + FV of net profit = 2310x1.104 + 2310 x 1.103
2310/1.103 + 2310/1.104 + 4310/1.105 = $10000 + 2310 x1.102 + 2310 x 1.10 + 4310 = $16105
 Net PV = $10000-$10000=0 FV of $10000 = 16105
The project is marginally acceptable Net FV = $16105-16105=0
The project is marginally acceptable
ECONOMIC EQUIVALENCE – PRESENT AND FUTURE WORTH METHODS

Example:- Suppose the company has $75,000 in a bank. It has two options.
1. Take the money out from bank and invest it in a project which will pay back $24,400
after one year, $27,340 after 2 years, and $55,760 at the end of 3rd year, or
2. Keep the money in the bank (at i=15%, n=3 years).
$24400 $27340 $55760 $???

1 2 3 1 2 3
i=15%

$75000 $75000
ECONOMIC EQUIVALENCE – PRESENT AND FUTURE WORTH METHODS

Example:- Suppose the company has $75,000 in a bank. It has two options.
1. Take the money out from bank and invest it in a project which will pay back $24,400
after one year, $27,340 after 2 years, and $55,760 at the end of 3rd year, or
2. Keep the money in the bank (at i=15%, n=3 years).
$24400 $27340 $55760 $???
The Future Worth of the three pay backs; FW
1 2 3 1 2 3 =24400x(1.15)2+27340x1.15+55760= 119470/-
i=15%
The Future Worth of 75000 =75000*1.153
$75000 $75000
=114065
The Present Worth of the three pay The Future Worth of second option is 119470 -
backs; PW = 24400/(1.15) + 27340/ 114065 = $5405/- less than the first option. So
1.152 + 55760/1.153 = 78553/- the first option is preferred option
Example: Assuming both the cash flows to be same calculate the value of ‘C’
assuming an interest rate of 12%.
$300 $300 $300

$C $C
$100 $100 $C $C

0 1 2 3 4 5 0 1 2 3 4 5
Example: Assuming both the cash flows to be same calculate the value of ‘C’
assuming an interest rate of 12%.
$300 $300 $300

$C $C
$100 $100 $C $C

0 1 2 3 4 5 0 1 2 3 4 5

Time Value of Money Time Value of Money


100/1.12 + 100/ (1.12)2 + 300/1.123 + 743 = C/1.12 + C/1.122 + C/1.124 + C/1.125
300/1.124 + 300/1.125 = $743 743 = 0.8928C + 0.7971C + 0.6355C + 0.5674C
743 = 2.8928C  C= $257
ECONOMIC EQUIVALENCE
Example: Ali borrowed Rs 5,000 from a bank at 8% interest rate and have to pay it back
in 5 years. There are many ways the debt can be repaid.
• Plan A: At end of each year pay Rs 1,000 principal plus interest due.
• Plan B: Pay interest due at end of each year and principal at end of five years.
• Plan C: Pay Rs 1252/- in five end-of-year payments.
• Plan D: Pay principal and interest in one payment at end of five years.
PLAN A PLAN B PLAN C PLAN D

Time Equivalent “Present Values” at 8% for all the systems


1400/1.08 + 1320/1.082 400/1.08 + 400/1.082 + 1252/1.08 + 1252/1.082 0+ 0 + 0+ 0+
+ 1240/1.083 400/1.083 +400/1.084 + 1252/1.083 7347/1.085 =5000
+1160/1.084 +5400/1.085 = 5000 +1252/1.084
+1080/1.085 = 5000 +1252/1.085 =5000
ECONOMIC EQUIVALENCE
Plan A: Pay Rs 1,000 Plan B: Pay Yrly interest Plan C: Pay in five end- Plan D: Pay principal +
principal + interest (Yrly) & principal after 5 yrs of-year payments interest after five years
ECONOMIC EQUIVALENCE
Example: Ali borrowed Rs 5,000 from a bank at 8% interest rate and have to pay it back in 5
years. There are many ways the debt can be repaid.
• Plan A: At end of each year pay Rs 1,000 principal plus interest due.
• Plan B: Pay interest due at end of each year and principal at end of five years.
• Plan C: Pay in five end-of-year payments.
• Plan D: Pay principal and interest in one payment at end of five years.

SUMMARY OF PAYMENT PLAN What is the common property in all Plans?


It is Interest Rate = Total Interest / Area under
a b c d the curve
Amount Total Area Under Curve Ratio Or
Plan
Paid Interest (Amount OWED) b/c Total Interest = Interest Rate x Area under the
A 6,200 1,200 15,000 0.08 curve
B 7,000 2,000 25,000 0.08 Ratio .08 is constant.
All payment methods are equivalent.
C 6,260 1,260 15,768 0.08 Equivalence is established between all
D 7,347 2,347 29,333 0.08 alternatives
Uncertain interest rate
3

 If there is an annual series of payments, this gets more


complicated:

 Can find n (using logarithms), but not i!


• Because i appears twice:
• Once with an exponent
• Once without measure
Uncertain interest r 3

rate
 How to solve?
 Two options
• Trial and error:
• Try different values of i until you converge
• i.e. until P = A [1 - 1/(1+i)n]/i
• Use look-up tables
• (e.g., tables at back of textbook) and interpolate
?
Any Questions

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