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MS-291: Engineering Economy(3 Credit Hours)

IntroductionCourse Instructor: Dr. Muhammad SabirTeaching Assistant: Ms Sabahat Orakzai

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What are you expectingfrom this course ?

• Let me ask you first ?• Economics theory? ….• GDP ?• Stock Market ?• Exchange Rates ?• Economic Growth ?• Inflation ?• Taxes ?• May be “Game theory”?

Syllabus & Study Plan

Week Contents Reading Materials

Week 1to

Week 4

Foundation of Engineering Economy,various cost concepts

Chapter 1: (B&T 2012)

Factors: How time and Interest Affect Money Chapter 2: (B&T 2012)

Nominal and Effective Interest Rates Chapter 3: (B&T 2012)

Week Contents Reading Materials

Week 5to

Week 8

Present Worth Analysis, Annual WorthAnalysis

Chapter 5 & Chapter 6:(B&T 2012)

Rate of Return Analysis: Single Alternativeand Multiple Alternatives

Chapter 7 & Chapter 8:(B&T 2012)

Benefit/Cost Analysis and Public SectorEconomics

Chapter 9: (B&T 2012)

Week 9 Mid-Term

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Syllabus & Study Plan (II)

Week Contents Reading Materials

Week 10to

Week 14

Project Financing and NoneconomicAttributes

Chapter 10: (B&T 2012)

Independent Projects with BudgetLimitations

Chapter 12: (B&T 2012)

Breakeven and Payback Analysis Chapter 13: (B&T 2012)

Week Contents Reading MaterialsWeek 14

toWeek 16

Effects of Inflation Chapter 14: (B&T 2012)

Depreciation Measures Chapter 16: (B&T 2012)

Week 17 Final Term

Recommended Books

Major Course BookReference book for Economics

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Grading PolicyGrading PolicyClass participation: 5%Assignments: 10%Quizzes: 10%Mid-term Exam: 35%Final Exam: 40%Attendance: 100 % (80 min.) to qualify to sitin the final examination

Please note down that final term will consist of completecourse covered rather than course covered after mid-term

Very Important Note!!!

• NEW Attendance Policy ………

• We will be uploading attendance during same week in whichthe classes are

• Anyone missing the class for whatever reason, has to adjusthis/her absences with Examination Section

• We have authorities of doing attendance on BINARYCODE…. i.e. Present /Absent …. With no other option for us.

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Very Important Note2!!!

• Any one attending this course MUST have his/her ownnotebook/paper and a Calculator in EVERY class

• There is 5% weight for class participation

• Assignments will be of two types… home assignments(allgraded) and Class assignments(some graded some not)

• You should have your paper/note book & calculator

• Cell phone calculator use in class is not preferable …duringquizzes, mid or final…not allowed

A word of Warning

• Please keep your mobilesswitch off during my class ….I may take strict actionagainst you on that.

• Be on time for class

• No entrance once the classroom doors closed

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LETS START THE WORK NOW

MS291: Engineering Economy

Chapter 1Foundations Of

Engineering Economy

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Contents of the Chapter

What is Economics? Why Economics for Engineers ? What is Engineering Economy ? How to Performing Engineering Economy Study ? Some Basic Concepts

– Utility & Various cost concepts– Time value of money (TVM)– Interest rate and Rate of Returns– Cash Flow– Economic Equivalence– Simple and compound interest rates– Minimum Attractive Rate of Return

Setting the Scene

Lets start with a simple question ? What isEconomics ? Anyone ?

There are variety of definitions of Economics but letme place the most relevant one for this course

A social science that studies how individuals,governments, firms and nations make choices onallocating scarce resources to satisfy theirunlimited wants

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Why Engineer Need to know aboutEconomics ?

Individuals, Engineers, Managers all made choiceamong various alternatives in their every day life..Any Example ?

Mostly these choice is associate with money (morespecifically capital or capital funds) but money (orresources) is limited

The selection of any choice depends on theexpected future return of each alternative

Engineers plays a vital role in “such decision” dueto their ability and experience to design, analyzeand synthesize

Engineers design and create Designing involves economic decisions … Why ? Engineers must be able to incorporate economic

analysis into their creative efforts Often engineers must select and implement from

multiple alternatives Understanding and applying “engineering

economy tools ( such as time value of money,economic equivalence, and cost estimation) arevital for engineers

A proper economic analysis for selection andexecution is a fundamental task of engineering

Why Engineer Need to know aboutEconomics ? (II)

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What is EngineeringEconomy ?

Engineering Economy involves– Formulating– Estimating, and– Evaluating

expected economic outcomes ofalternatives designed toaccomplish a defined purpose

DefinedPurpose

Differentalternativeswith expectedeconomicoutcomes

- Formulate- Estimate- EvaluateExpectedoutcomes ofeach alternatives

Select the bestalternative

Where Engineering Economylearning is useful ?

It is useful in many different engineering decisions

How should the engineering project be designed ? Has civil or mechanical engineer chosen the best thickness

for insulation ?

Which engineering projects should have a higher priority ? Has the industrial engineer shown which factory

improvement projects should be funded with the availableresources

Which engineering projects are worthwhile ? Has the mining or petroleum engineer shown that mineral or

oil deposits is worth developing ?

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Performing EngineeringEconomy Study

Keeping in mind, what is economics andengineering economy?

For doing any engineering study we willneed to do many things such as:Problem identifications, its objectives, itsvarious alternatives, information abouteach alternatives, choosing the bestamong all alternatives etc.

Steps in an EngineeringEconomy Study

Problem descriptionObjective statement

Available dataAlternatives for solution

Cash flows and otherestimates

Engineering EconomicAnalysis

Measure of worthcriterion

(PW, B/C, IRR etc)

Best alternativeSelection

New Problemdescription

Step 1 inStudy

Step 2

Step 3

Step 5

Step 4

Step 6

Step 7

One or more approachesto meet objectives

• Expected life• Revenues• Costs• Taxes• Project Financing

Implementation andMonitoring

New engineeringeconomic study begins

Step 1 inStudy

Time Passes

Tools u will be learningin this course are usedhere

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Some Basic Concepts– Utility & Various cost concepts– Time value of money (TVM)– Interest rate and Rate of Returns– Cash Flow– Economic Equivalence– Simple and compound interest rates– Minimum Attractive Rate of Return

Utility• What is Utility ? Anyone ?• In economics utility refers to the power of a

good or service that satisfy human wants• E.g. A glass of water has utility that it satisfy

one’s thirst• Utility is the one of the very basic and

important concept of economics• Marginal Utility refers to Utility derived from

one additional unit of a good

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Law of DiminishingMarginal Utility

0

10

20

30

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Marg

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(2)Total

Utility,Utils

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TU

MU

Total Utility

Marginal Utility

Units Consumed Per glass

Units Consumed Per glass

Utils refers toUnit in which

utility canbe measured

Various Type of Costs• There are different type of costs and can be

classified by various ways• This lecture includes costs classifications

mostly use by economists• Fixed & Variable Costs, Average Costs & Marginal

Costs, Private & Social Costs• Opportunity Costs• Some other important cost concept you may come

across: Sunk Cost and Sinking funds, Operation &Maintenance Cost (O&M Costs), Life-cycle Costsetc.

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Fixed and Variable Costs

• Fixed Costs: those costs that do not vary withthe quantity of output produced.…any example ?

Examples: rent to paid for factory building, interest oninvested capital, maintenance, taxes etc.

• Variable Costs: are those costs that do vary withthe quantity of output produced

Examples: consumption of fuel for power generation ….itwill vary as the production of a factory increases ordecrease

Total Costs

• It maybe noted that Fixed Costs (FC) andVariable Costs(VC) may consist of more thanone component and the sum of all respectivecomponents will make up TFC and TVCrespectively

• Total Costs (TC) is equal to sum of TotalFixed Costs (TFC) and Total variable costs(TVC):TC = TFC + TVC

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Average Costs• Average Costs

– Average costs can be determined by dividing thefirm’s total costs by the quantity of output itproduces

– The average cost is the cost of each typical unitof product

• Average Costs can also be obtained byadding Average Fixed Costs (AFC) andAverage Variable Costs (AVC) …i.e: ATC =AFC + AVC

Average Costs: Formulas

Fixed cost

Quantity

FCAFC

Q

Variable cost

Quantity

VCAVC

Q

Total cost

Quantity

TCATC

Q

Example: a firm produce 100 units of output at cost of$1000, what is the average cost of the firm?

= 1000/100 => $10Total cost

Quantity

TCATC

Q

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Marginal Costs• Marginal Cost

– Marginal cost (MC) measures the increase intotal cost that arises from an extra unit ( or nextunit) of production

– Marginal cost helps answer the followingquestion:

• How much does it cost to produce an additional unitof output?

(change in total cost)

(change in quantity)

TCMC

Q

Private / Social Cost• Private costs (benefits) of an action

– accruing to the actor only

• Social costs (benefits)– total costs of activity including those that accrue

to people other than the actor

• Example: driving a car– Private costs: fuel, maintenance– Social costs include pollution, road wear

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Opportunity Costs

I got a lottery of worthRs 10 millions

11 22 33

Ranking the Choices

The Next best use is “buying house” that’s Iforgone for paying my Credit card debts so that’s

my Opportunity cost

Opportunity Cost:The Next Best Decision you could make

Sunk Cost• Sunk Cost: is the costs

that are incurred in thepast and can not berecovered by any futureaction

• Theory states: ignore sunk costs, becausethey are paid in either case, and cannot berecovered

• For example: If you lost the movie ticket worth Rs. 800 - you can't get it back - ifyou decide not to buy a second ticket and go home you won't get the first ticketyou lost, back

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Sinking fund

• A sinking fund is a fund established byan economic entity(such as a firm) by settingaside revenue over a period of time to fund afuture capital expense, or repayment of a long-term debt

• Sinking funds can also be used to set aside moneyfor purposes of replacing capital equipment as itbecomes obsolete, or major maintenance or renewalof elements of a fixed asset, typically a building

Operation and Maintenance Cost(O&M Costs)

• Operation and Maintenance Cost is the group of costsexperienced continually over the useful life of theactivity… any example ?

• This includes costs like, labour costs for operating &maintenance personal, fuel and power costs, spareand repair part costs, costs for taxes etc.

• These costs can be substantial and can exceed the initialcosts

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Recurring &Non-recurring costs

• Recurring costs – known, anticipated andoccurs at regular intervals.– Purchasing food, paying rent.

• Non-recurring costs - one-of-a-kind eventthat occurs at an irregular interval (sometime called extra-ordinary costs too).– Emergency maintenance expenses.

Sometimes we attempt to plan for large non-recurring costsby buying insurance. Paying the periodic insurancepremium turns this expense into a recurring cost.

Capital Cost• Some time also called first cost, initial costs• Capital costs are fixed, one-time expenses incurred on the

purchase of land, buildings, construction and equipmentused in the production of goods or in rendering of services

• Capital costs include expenses for tangible goods such as thepurchase of plants and machinery, as well as expenses forintangibles assets such as trademarks and softwaredevelopment.

• Unlike O&M Costs capital costs are one-time expenses butpayment may be spread out over many years in financialreports and tax returns. Capital costs are fixed and aretherefore independent of the level of output.

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Incremental Costs• An incremental cost is the difference between the

costs of two alternatives.Example

• Choose between alternative models A and B. Whatincremental costs occur with model B?

Cost Items A BPurchase price 10,000.00$ 17,500.00$ 7,500.00$Installation costs 3,500.00$ 5,000.00$ 1,500.00$Annual maintenance costs 2,500.00$ 750.00$ (1,750.00)$Annual utility expenses 1,200.00$ 2,000.00$ 800.00$Disposal costs after useful life 700.00$ 500.00$ (200.00)$

ModelCosts

Incremental

Life-cycle Costs

• Life-cycle of a product ?• all the time from the initial conception of an

idea to the death of a product (process)• Life-cycle costs - sum total of all the costs

incurred during the life cycle• Life-cycle costing - designing a product with

an understanding of all the costs associatedwith a product during it’s life-cycle

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Product Life-cycleBegin EndTime

Needsassessment

andjustification

Conceptual orpreliminary

design phase

Conceptual orpreliminary

design phase

Detaileddesignphase

Productionor

ConstructionPhase

OperationalPhase

Decline andretirement

phase

Requirements

OverallFeasibility

ConceptualDesignPlanning

Impact Analysis

Proof ofconcept

PrototypeDevelopmentand testing

Detailed designplanning

Allocation ofresources

Detailedspecification

Componentand supplierselection

Productionorconstructionphase

Product,goods andservicebuilt

Allsupportingfacilitiesbuilt

Operational useplanning

Operational Use

Use by ultimatecustomer

Maintenanceand support

Process,materials andmethods use

Declined andretirementplanning

DecalingUse

Phase out

Retirement

Responsible disposal

Time Value of Money(TVM)

• A Rupee (or dollar) received today is worthmore than a rupee received tomorrow– because a dollar received today can be

invested to earn interest/return– The amount of interest earned depends on the

rate of return that can be earned on theinvestment

• Time value of money quantifies the valueof a dollar through time

The time value of money is the most important concept inengineering economy

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Interest• What is Interest ?– It is the manifestation (or display) of the time value of

money– Fee that one pays to use someone else’s money– Computationally, interest is the difference between an

ending amount of money and a beginning amount ofmoney

• There are two perspectives for interest:1- Borrower’s perspective – Interest paid

Interest Paid= amount owed now – principal2- Lender’s or investor’s perspective – Interest Earned

Interest Earned= Total amount now – principal

Interest paid

Interest rate (i) Rate of Return(ROR)

Interest

=−Interest earned=−

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Interest Rate &Rate of Return (ROR)

• Interest rate – Interest paid over a time periodexpressed as a percentage of principal

• ROR refers to Interest earned over a period oftime expressed as a percentage of the originalamount (principal)

interest accrued per time unitRate of return (%) = x 100%

original amount

% = × 100%

Benefits• So far we have focused on costs only.

• However, you may often need to estimate benefits.

• Example benefits include sales of products,revenues from bridge tolls and electric power sales,cost reductions from reduced material or laborcosts, reduced time spent in traffic jams, andreduced risk of flooding.

• These benefits are the reasons that manyengineering projects are undertaken.

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Salvage Value

• to estimate the total cost of doing a project…Cost is reduced if we can sell the equipmentat end of project.

• Salvage value is the money that can beobtained at the end of the project byselling equipment. Salvage value is abenefit rather than a cost.

Cash Flows (CFs): Basics

The costs and benefits of engineering projects occur over time and aresummarized on a Cash Flow Diagram (CFD).

Specifically, a CFD illustrates the size, sign, and timing of individualcash flows. In this way the CFD is the basis for engineering economicanalysis.

CFs are amount of money estimated for future projects or observed forproject events that have taken place

CFs are during specific time period

CF is difficult to estimate as its predicting future

There are three important concepts related to Cash flows: Cash Inflows,Cash Outflows, Net Cash flows

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Cash Flows: Terms

• Cash Inflows – Revenues (R), receipts, incomes,savings generated by projects and activities that flow in.represented with a plus sign and upward arrow

• Cash Outflows – Disbursements (D), costs, expenses,taxes caused by projects and activities that flow out.Represented with a minus sign and downward arrow

• Net Cash Flow (NCF) for each time period:NCF = cash inflows – cash outflows = R – D

• End-of-period assumption:Funds flow at the end of a given interest period (its

important because cash may not flow in/out at the endof period always)

Cash Flows: Estimating

There are two ways for estimating Cash flows:Point estimate – A single-value estimate of a cash

flow element of an alternativeCash inflow: Income = $150,000 per month

Range estimate – Min and max values thatestimate the cash flow

Cash outflow: Cost is between $2.5 M and $3.2 M- Point estimates are commonly used;

- however, range estimates with probabilities attached provide a betterunderstanding of variability of economic parameters used to makedecisions

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Cash Flow: Diagrams

Draw a time line

One timeperiod

Show the cash flows (to approximate scale)

Always assume end-of-period cash flows

Time

Remember:One and onlyone of theperspectives isselected todevelop CFdiagrams…Either lender orborrower

0 1 2 n-1 n--- --- --- --- ---

0 1 2 n-1 n--- --- --- --- ---Cash flows are shown as directed arrows: + (up) for inflow

― (down) for outflow

Cash Flow Diagram: ExampleDraw CF diagram for CFs observed over last 8 yearsand estimated sale next year for $150. Draw a NetCash flow diagram

$-2500

$650 $625 $600 $575 $550 $525 $500

$600

Years-7 -6 -5 -4 -2 0 1-1-3

Net Cashflow is equalto What ?

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Class Practice: Cash Flow5 Minutes Time

• An electrical engineer wants to deposit an amountP now such that she can withdraw an equal annualamount of A1 $3000 per year for the first 5 years,starting 1 year after the deposit, and a differentannual withdrawal of A2 $5000 per year for thefollowing 3 years. How would the cash flowdiagram appear if i 8.5% per year?

Economic Equivalence

• Different sums of money at different times may be equal ineconomic value at a given rate

01

$100 now

$110

Rate of return = 10% per year

• $100 now is economically equivalent to $110 one year fromnow, if the $100 is invested at a rate of 10% per year

Year

• Economic Equivalence: Combination of interest rate(rate of return) and time value of money to determinedifferent amounts of money at different points in timethat are economically equivalent

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Commonly used Symbols

t = time, usually in periods such as years or monthsP = value or amount of money at a time t

designated as present or time 0F = value or amount of money at some future

time, such as at t = n periods in the futureA = series of consecutive, equal, end-of-period

amounts of moneyn = number of interest periods; years, monthsi = interest rate or rate of return per time period;

percent per year or month

Minimum Attractive Rateof Return (MARR)

Also termed hurdle rate,benchmark rate and cutoff rate

MARR is a reasonable rate ofreturn (percent) establishedfor evaluating and selectingalternatives

An investment is justifiedeconomically if it is expected toreturn at least the MARR

MARR is established by thefinancial managers of thefirm Rate of return on

safe investment

MARRAll proposalsmust offer atleast MARR tobe considered

Range for the rate ofreturn on acceptedproposals, if otherproposals wererejected for somereasons

Expected rate ofreturn on a newproposal

Rate of return,Per cent

Size of MAAR relative to other rate ofreturn values

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Factors determiningMARR

Many elements contribute to determining theMARR such as:

• Amount, source, and cost of moneyavailable

• Number and purpose of good projectsavailable

• Perceived risk of investment opportunities• Type of organization

Source of Capital forindividuals

• Suppose you have tobuy a HDTV … u mayhave followingoptions

Bank loan @9%annually

Credit Card@15% ..monthly

Cash paymentfrom savingaccounts @5%earnings per year

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• So 9%, 15%, 5% are your various options forraising money (or are the cost of capital)

• Similarly, cooperation's also raise money(capital) from various sources and at differentrates (cost of capital) for their investments

• In general there are two ways through whichfirms generate capital for itself

Cost of Capital

• Equity financing: uses of its own funds from cash onhand, stock sales, or retained earnings. Individuals can usetheir own cash, savings, or investments. In the exampleabove, using money from the 5% savings account is equityfinancing.

• Debt financing: borrowing from outside sources and repaysthe principal and interest according to some schedule.Sources of debt capital may be bonds, loans etc.Individuals, too, can utilize debt sources, such as the creditcard (15% rate) and bank options (9% rate) describedabove.

Sources of Capital for firms

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Weighted Average Cost ofCapital (WACC)

• If capital is used from more than one source ….. Such ascombinations of debt-equity financing …then the cost ofcapital is a weighted average cost of capital (WACC)

• If the HDTV is purchased with 40% credit card money at15% per year and 60% savings account funds earning 5%per year,

• the Weighted Average Cost of Capital is:• 0.4(15%) + 0.6(5%) = 9% per year.

Class Practice

A large multinationalcorporation is consideringfollowing six projects.They are using 10%equity financing costing9% per year and 90%debt financing with a costof debt capital of 16% peryear, which projectsshould the companyundertake?

SolutionReturn on project shouldbe “greater” than Weightedaverage Cost of Capital(WACC)

WACC = 10%(0.09) + 90%(0.16) = 15.3%

should undertake the inventory, technology,and warehouse projects

Which one company should undertake ?

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Commonly used Symbols

t = time, usually in periods such as years or monthsP = value or amount of money at a time t

designated as present or time 0F = value or amount of money at some future

time, such as at t = n periods in the futureA = series of consecutive, equal, end-of-period

amounts of moneyn = number of interest periods; years, monthsi = interest rate or rate of return per time period;

percent per year or month

Simple Interest

– Interest is calculated using principal only

– Mathematically:Simple Interest = (principal) x (number of periods) x (interest rate)

I = P x n x iP= principle amountn = number of periodi = interest rate

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ExampleGreenTree Financing lent an engineeringcompany $100,000 to retrofit anenvironmentally unfriendly building. The loanis for 3 years at 10% per year simpleinterest. How much money will the firmrepay at the end of 3 years?

I = P x n x iP= principle amount = $100,000n = number of period = 3i = interest rate = 10% or 0.01

I = P x n x iI = $100,000 x 3 x 0.01

I = $30,000

Total due = $100,000 + 30,000= $130,000

Solution

Compound Interest Rate

• It must be noted that …. Bank do not use SimpleInterest instead they use “Compound Interest rate”

• Most of the time, we talk about interest we meancompound interest rate

• So when ever you are said to calculate interest rateand it is not specified …it will always meanCOMPOUND Interest rate. So be careful with thisdistinction.

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Compound InterestWith Compound Interest, you work out the interest for the first period,add it to the principle, and then calculate the interest for the next period,and so on ..., like this:

Let suppose You deposited $1000 in a bank with compound interest rateof 10%

Period1

Period2

Period3

Compound Interest

– Interest is based on principal plus allaccumulated interest

– That is, interest compounds over time

• Mathematically:Compound Interest = (principal + all accumulated interest)

x (interest rate)

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Simple InterestHereP=$100,000n= 3i= 10%Simple interest = P X n x iInterest = 100,000(3)(0.10)

= $30,000Total due = 100,000 +

30,000= $130,000

Compound Interest• Interest, year 1: I1 = 100,000(0.10) = $10,000• Total due, year 1: F1 = 100,000 + 10,000

=$110,000

• Interest, year 2: I2 = 110,000(0.10) = $11,000• Total due, year 2: F2 = 110,000 + 11,000

= $121,000

• Interest, year 3: I3 = 121,000(0.10) = $12,100• Total due, year 3: F3 = 121,000 + 12,100

= $133,100

Simple and Compound Interest:Comparison

Example: $100,000 lent for 3 years at interest rate i= 10% per year. What is repayment after 3 years ?

Simple: $130,000: Compounded: $133,100

Comparison of Simple andCompound Interest

Simple Interest Case Compound Interest Case

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Thank You