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Chapter 3, “Interest and Equivalence,” focuses on explaining the role of accuracy in the engineering economy, including disbursement and the time value of money. It begins with the case of a pharmaceutical company that spent $90,000 for equipment adjustment that allowed increasing profits significantly. Several interest formulas and concepts compose the foundation of the engineering economy and help understand potential batches and savings. The importance of computing cash flows lies in resolving engineering economy problems by considering paying credit for machinery or any other consequences, where every alternative can be regarded as a disbursement or cash receipt. A set of cash flows is a way to resolve each of the alternatives, be it the initial cost or the ultimate spending period.
Money presents a valuable asset, the consequences of which often become evident in a long-time period. In this chapter, the time value of money is explained by the example of banks’ offerings to pay interest for the provisional use of others’ money. Simple interest is computed on the original sum without paying attention to accrued interest, which is stated to be a good starting point for comprehending the concept and usefulness of compound interest. The latter is used in practice more often than the simple interest because unpaid interest is added to the unpaid balance and thought of as interest on top of interest. Repaying a debt implies the selection of one of the four plans: constant principal (1), interest-only (2), constant payment (3), and all at maturity (4), meaning that no payment is made during the identified period.
As for equivalence, it depends on the interest rate acceptable for a person in comparison to the sum of money they currently possess. In the engineering economy, the understanding of alternatives allows calculating a more favorable option for receiving benefits in either long- or short-term periods. More precisely, in case the sum of $109 within a year is applicable for a person compared to today’s $100, then these two amounts can be considered equivalent. The technique of equivalence should be applied to compare the cash flows of different plans. It is clarified that the equivalent value can be determined for plans at some point in time, depending on a chosen interest rate. Accordingly, it is possible to evaluate the relative attractiveness of the given alternatives, which is the correct way to judge their relevance for a company’s goals.
The third chapter provides various examples that demonstrate the difference in repayment plans that result in different outcomes, even though they are equivalent in nature. In structure, plans 2 and 4 are characterized by remaining and increasing debt, respectively. In their turn, plans 1 and 3 show that money owed reduces with time, which is caused by different quantities of dollar-years. It is also emphasized that interest rate largely identifies equivalence since the change in the former leads to destroying the correspondence between two or more series of payments. The variances in economically equivalent plans may be expressed in the risk of non-payment, which is critical to take into account while making decisions. Furthermore, the chapter offers single payment compound interest formulas with examples and solutions. Nominal and effective interest formulas with detailed explanations contribute to an in-depth understanding of the chapter content, promoting awareness of using these theoretical underpinnings in practical settings.
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