Interest formulas

− Single payments
◦ present worth factor (F/P,i,N)
◦ capital recovery factor (P/F,i,N)
− Unequal payment series
− Equal payment series
◦ compound amount factor (F/A,i,N)
◦ sinking fund factor (A/F,i,N)
◦ present worth factor (P/A,i,N)
◦ capital recovery factor (A/P,i,N)
 Engineering economics topics on
PE exams
− Annual cost
− Breakeven analysis
− Cost-benefit analysis
− Future worth or value
− Present worth
− Valuation and depreciation
 Retirement planning
A 21-year old inherits $100,000 from a distant
relative who has deceased. She decides to
spend some and invest the rest immediately in
order to retire at 65 with a $1,000,000 savings
account. At 8% interest compounded annually,
how much must be invested?
 Solution

$1,000,000 = P (1+0.08)44
P = $1,000,000/29.56 = $33,834
$100,000 - $33,834 = $66,166
 Multiple payments

How much do you need

to deposit today (P) to
$25,000
withdraw $25,000 at n
$3,000 $5,000 =1, $3,000 at n = 2,
0

1 2 3 4
and $5,000 at n =4, if
your account earns
10% annual interest?
P

Set up spreadsheet solution

 Uneven $25,000

payment series 0
$3,000 $5,000

1 2 3 4

$25,000

$3,000 $5,000
0 0 0

1 2 3 4
+ 1 2 3 4
+ 1 2 3 4
P2
P4
P1
P1 = $25, 000( P / F ,10%,1) P2 = $3, 000( P / F ,10%, 2) P4 = $5, 000( P / F ,10%, 4)
= $22, 727 = $2, 479 = $3, 415

P = P1 + P2 + P3 = $28,622
 Check
Beginning Interest Payment Ending
balance earned balance
n=0 0 0 +28,622 28,622

n=1 28,622 2,862 -25,000 6,484

n=2 6,484 649 -3,000 4,133

n=3 4,133 413 0 4,546

n=4 4,546 455 -5,000 1

Rounding error
It should be “0.”
 College fund
Suppose you make an annual contribution of $100
each year to a college education fund for a
niece. She is 4 years old now, and you will start
next year and make the last deposit when she is
18. The fund is a money market account
earning 6.5%/year. What will it be worth
immediately after the last deposit?

Set up spreadsheet solution

 beginning ending
Age n balance deposit interest balance
4 0 0.00 0 0.00 0.00
5 1 0.00 100 0.00 100.00
6 2 100.00 100 6.50 206.50
7 3 206.50 100 13.42 319.92
8 4 319.92 100 20.79 440.72
9 5 440.72 100 28.65 569.36
10 6 569.36 100 37.01 706.37
11 7 706.37 100 45.91 852.29
12 8 852.29 100 55.40 1007.69
13 9 1007.69 100 65.50 1173.19
14 10 1173.19 100 76.26 1349.44
15 11 1349.44 100 87.71 1537.16
16 12 1537.16 100 99.92 1737.07
17 13 1737.07 100 112.91 1949.98
18 14 1949.98 100 126.75 2176.73
 Equal payment series
F

0 1 2 N
A A A

P
0 1 2 N

0 N
Equal payment series – compound
amount factor
F

0 1 2 N
A A A

N F
0 1 2

0 1 2
N

A A A
 Compound amount factor
F

A(1+i)N-2
A A A

A(1+i)N-1

0 1 2 N 0 1 2 N

F = A(1 + i)N-1 + A(1 + i)N-2 + ⋅⋅⋅ + A

 Compound amount factor
F = A(1 + i)N-1 + A(1 + i)N-2 + ⋅⋅⋅ + A

multiply by (1 + i):

F(1 + i) = A(1 + i)N + A(1 + i)N-1 + ⋅⋅⋅ + A(1 + i)

subtract:

F(1 + i) – F = A(1 + i)N – A

rearrange:
(1 + i)N – 1
F=A
Fi = A(1 + i)N – A i
Equal payment series compound amount factor
(future value of an annuity)
F
(1 + i ) N − 1
0 1 2 3 F=A
N i
A
= A( F / A, i , N )
Example
• Given: A = $5,000, N = 5 years, and i = 6%
• Find: F
• Solution: F = $5,000(F/A,6%,5) = $28,185.46
 Validation

beginning ending
n balance deposit interest balance
0 0.00 0 0.00 0.00
1 0.00 5000 0.00 5000.00
2 5000.00 5000 300.00 10300.00
3 10300.00 5000 618.00 15918.00
4 15918.00 5000 955.08 21873.08
5 21873.08 5000 1312.38 28185.46
 Finding an annuity value
(sinking fund factor)
F
i
A= F
0 1 2 3 (1 + i) − 1
N
N

A=? = F ( A / F , i, N )

Example:
• Given: F = $5,000, N = 5 years, and i = 7%
• Find: A
• Solution: A = $5,000(A/F,7%,5) = $869.50
 Equal payment series
(uniform series)
Find the future worth of the following cash flow,
assuming interest rate i.

0 1 2 3 4 N-3 N-2 N-1 N

$A $A $A $A $A $A $A $A
 Custodial account
Suppose you decide to open a custodial account
for your niece, who was born today. The
minimum deposit is $100 on opening the
account today, and you will put in $100 each
year up to and including her 18th birthday.
What is the account worth when it is turned
over to the child at age 18? You expect to
earn 10% interest per year.
 Custodial account cash flow
012…

18
$100 …

012…
⎡ (1 + i ) N − 1 ⎤
F = A⎢ ⎥
⎣ i ⎦ 18
$100 …

⎡ (1.10)18 − 1 ⎤
F = $100 ⎢ ⎥ = $4559.92
⎣ 0.10 ⎦
Custodial account cash flow

012… 18

$100 …
012… 18

$100 …
Custodial account cash flow

012… 18

$100 …
012… 19

$100 …
-1 0 1 … 18

$100 …
 Sinking fund
You are saving up money to make a 20% down
payment on a $100,000 house when you
graduate in 4 years. You plan to invest $A at the
end of each summer in a money market account
earning 6.5%/year. Find A.
 Sinking fund
You are saving up money to make a 20% down
payment on a $100,000 house when you
graduate in 4 years. You plan to invest $A at the
end of each summer in a money market account
earning 6.5%/year. Find A.

(1 + i)N – 1 (1 + 0.065)4 – 1
F=A =A = $100,000
i 0.065

4.41 A = $100,000

A = $100,000/4.41 = $22,690
 Annuity factor
(capital recovery factor)
You want to obtain a loan of $20,000 to buy a used car.
You will pay off the loan in yearly payments over the next
5 years. The salesman quotes a 6% annual interest rate
and yearly payments of $4,878. Is $4,878 an accurate
payment for this loan?
 Annuity factor
(equal series capital recovery factor)

(1 + i)N – 1
F=A
i

i i
A=F = P (1 + i)N
N (1 + i)N – 1
(1 + i) – 1

i (1 + i)N
A=P
(1 + i)N – 1

A = P(A/P,i,N)
 Annuity factor
(capital recovery factor)
You want to obtain a loan of $20,000 to buy a used car.
You will pay off the loan in yearly payments over the next
5 years. The salesman quotes a 6% annual interest rate
and yearly payments of $4,878. Is $4,878 an accurate
payment for this loan?

i (1 + i)N 0.06 (1 + 0.06)5

A=P = $20,000
(1 + i)N – 1 (1 + 0.06)5 - 1

0.237 x $20,000 = $4,748

 Deferred payments
Suppose you get a student loan for $8,000, and your
payments are deferred until after you graduate, 2 years
from now. Then, you will make 15 yearly payments
(starting 2 years from now). What are your payments?
The interest rate is 8%/year.
 Deferred payments
Suppose you get a student loan for $8,000, and your
payments are deferred until after you graduate, 2 years
from now. Then, you will make 15 yearly payments
(starting 2 years from now). What are your payments?
The interest rate is 8%/year.

i (1 + i)N 0.08 (1 + 0.08)15

A=P = $8,000
(1 + i)N – 1 (1 + 0.08)15 - 1

0.1168 x $8,000 = $934

Capital recovery factor (annuity factor)

 Present worth
Your father is about to get downsized out of his position. He has been
with the previous company through 3 previous mergers, and is
disgusted with that nature of the business. He is considering retiring
rather than seeking a new job. What would his retirement savings
have to be worth today in order to withdraw $50,000/year for the
next 15 years? He expects to invest conservatively, earning 5% per
year during his retirement years.
 Present worth
Your father is about to get downsized out of his position. He has been
with the previous company through 3 previous mergers, and is
disgusted with that nature of the business. He is considering retiring
rather than seeking a new job. What would his retirement savings
have to be worth today in order to withdraw $50,000/year for the
next 15 years? He expects to invest conservatively, earning 5% per
year during his retirement years.

(1 + i)N - 1 (1 + 0.05)15 - 1
P=A = $50,000
i (1 + i)N 0.05 (1 + 0.05)15

10.38 x $50,000 = $519,000

Present worth factor

Example: early savings plan – 8% interest
?

Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10

44

$2,000
?

Option 2: Deferred Savings Plan

0 1 2 3 4 5 6 7 8 9 10 11 12
44

$2,000
 Option 1 – early savings plan

F10 = $2,000 (F/A,8%,10)

= $28,973 Option 1: Early Savings Plan

F44 = $28,973 (F/P,8%,34) 0 1 2 3 4 5 6 7 8 9 10

= $396,645 44

$2,000

Age 31 65
 Option 2: Deferred Savings Plan

F44 = $2,000 (F/A,8%,10) Option 2: Deferred Savings Plan

= $317,233
0 11 12
44

$2,000
 At what interest rate would these two
options be equivalent?

Option 1:
F44 = $2, 000( F / A, i,10)( F / P, i, 34)
Option 2:
F44 = $2, 000( F / A.i,34)
Option 1 = Option 2
$2, 000( F / A, i,10)( F / P, i, 34) = $2, 000( F / A.i,34)
Solve for i
 A B C D E F
1
2 Year Option 1 Option 2
3 0
4 1 $ (2,000)
5 2 $ (2,000) Interest rate 0.08
6 3 $ (2,000)
7 4 $ (2,000) FV of Option 1 $ 396,645.95
8 5 $ (2,000)
9 6 $ (2,000) FV of Option 2 $ 317,253.34
10 7 $ (2,000)
11 8 $ (2,000) Target cell $ 79,392.61
12 9 $ (2,000)
13 10 $ (2,000)
14 11 $ (2,000)
15 12 $ (2,000)
16 13 $ (2,000)
17 14 $ (2,000)
18 15 $ (2,000)
19 16 $ (2,000)
20 17 $ (2,000)
21 18 $ (2,000)
22 19 $ (2,000)
40 37 $ (2,000)
41 38 $ (2,000)
42 39 $ (2,000)
43 40 $ (2,000)
44 41 $ (2,000)
45 42 $ (2,000)
46 43 $ (2,000)
47 44 $ (2,000)
Using excel’s goal seek function
Result