EDA Lec 3a
EDA Lec 3a
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?
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%
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
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%
Question: For Nominal interest rate is of 1%, Calculate Effective Annual interest rate,
if compounding: a. Yearly b. Semi-annually c. Monthly d. Daily
Question:- What is the Monthly Effective Interest Rate if r=1%, and compounding is
a. Monthly b. Weekly c. Daily
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
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
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
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
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