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4.5 INTEREST CONCEPTS AND COMPUTATION 4.5.

1 Why Objections to the use of interest-based Methods Are not Valid It has been argued that interest calculations are complicated and difficult to understand. It is also claimed that the computations required are far too time-consuming to be employed in the making of management decision Actually, this is not so. properly explained, the principles involved in interest computations are quite simple and relatively easy to understand. And with the use of pretabulated calculation sheets and graphical interpolation. Even rate-of-return calculations can be reduced to simple clerical procedures. 4.5.2 Basic Interest Principles The following terms are used in connection with interest computations : 1. Interest rate 2. Earning rate 3. Rate of return 4. Equivalent worths 5. Principle of equivalence 6. Time value of money 7. Present worth 8. Future worth 9. Single-payment factors 10. Discounting 11. Compounding 12. Trial-and-error solution Perhaps the best way to become acquainted with the principles involved in interest calculations is to learn the meaning of these terms by observing how they apply to simple familiar transaction. For instance : If $100 were deposited today in a bank paying as interest rate of 6 percent, compounded annually. One year from today the balance in this account (principal plus interest) would have grown to $106. If this balance were then last in the bank another year

at the same annually compounded 6 percent interest rate. the balance would grow to $ 112,36. lt is also possible to calculate that under these same conditions, S94.35 would have had to be deposited in the bank one year ago in order for today's balance to be $100. The difference between these balances can be tabulated as follows : DIFFERENCES $ 112.36 - $106.00 = $ 106.00 - $100.00 = $ 100.00 - $ 94.00 = BALANCE $ 6.36 $ 6.00 $ 5.65

These "differences" represent the earnings of the funds on deposit. Note that while the amounts differ, they are generated by a single interest rate. This interest rate is the rate at which the funds on deposit earn. From the point of view of the investor, this is the rate of return. Thus, the three terms-interest rate, earning rate, and rate of return-are identical in meaning. Note that if this stipulated bank interest rate can be earned by funds on deposit, the S94.35 a year are can be stated to be equivalent to Sl00 today which in turn is equivalent to $106 one year later and this to Sll2.36 the next year. Since things equivalent to the same thing must be equivalent to each other, it .also can be stated that at this interest rate 594.35 on any stipulated date must be equivalent to Sll2.35 three years later. This is known as the principle of equivalence. A word a caution : The differences tabulated above are also often referred to as the time value of money. This time value is not an inherent characteristic of money. The statement that a given sum of money received today is worth more than the same sum received at some future date must simply not valid. Money has rime value only when it can be deposited or borrowed at a stipulated rate. This means that the principle of equivalence is applicable and can be used only when the stipulated interest rate has a real significance. It is also possible to develop a common denominator by expressing all amounts in terms of their equivalent value now. Thus, the $100 of their is the "now"' or present worth now of all the other amounts. Using this principle, past, present, and future cash flows, can be expressed in terms of their present worth at the stipulated earning rate. The $106 can be labeled the future worth at the end of one year of 100 now at 6 percent interest compounded annually.

To convert a given amount today to its future worth one year later using annual compounding. the amount is multiplied by (l+i) where I is the interest rate. This calculation is called compounding forward. To compound further into the future, the multiplier is ( I + i)n where n is the number of years. To find the present worth at a stipulated earlier year, we could merely divide by ( I + t)'. however, it is usually more convenient to multiply by the reciprocal l/(l +r)". This is called discounting back. The (l j-i)" and l/(l -1.i)'are called single-payment compounding and discounting factors. They are called this because they permit the conversion of a specific amount of money at one point in time to a single equivalent amount at another point in time at a stipulated interest rate. 4.5.3 Selecting the Most Appropriate Type of Interest-based Evaluation Fairly widespread agreement now exists that interest-based calculations are essential if accurate, dependable evaluations of economic productivity are to be obtained. There still is, however, considerable disagreement as to which of the many different promulgated methods is the most suitable. Most of this disagreement appears to stem from either failure to realize that each of these methods measures a different aspect of economic productivity, or confusion as to just what aspect should be used in making decisions. All valid interest-based methods utilize the principle of equivalence. I n each of these methods, individual disbursements and receipts are converted to equivalents and compared. The equivalent to which the conversion is made determines what is measured by the answer. There are many of these interest-based methods, but they all fall into three basic categories, each measuring a different aspect of investment profitability. The three categories are: l. Net equivalent worth at a specific rime 2. Net level annual equivalent 3. Rate of return 4.5.3.1 Net Equivalent Worth at a Specific Time. In this method, a stipulated interest rate is used to convert and net out all cash flows to a stated point in time. When the stated point in time is the start of the project, the answer is called the "net present worth." When the stated point is the end of the project, the answer is called the "net terminal value." These answers measure the results achieved by a given sum of money during an agreed-upon study period. They report the weighted average performance of the project and all other uses' to which the funds are applied

during the agreed-upon study period. : These answers are expressed as a single number which is in no way comparable to other answers when investment size or project life varies. 4.5.3,2 Net Level Annual Equivalent. In this method, all disbursements and receipts are converted to level annual equivalents at a stipulated interest rate and netted out. The answer measures the annual equivalent of the results of perpetual repetition of the prospective project. This method also yields a single-number answer, but it is adjusted for investment size and project life so that direct comparisons between alternatives with such variations arc feasible. 4.5.3.3 Rate of Return. This method requires no stipulations as to reference point in time, applicable interest rate, or study period. The answer obtained by this method is "the interest rate at which the proposed disbursements would have to be invested in an annuity fund, in order for that fund to be able to make payments equal to and at the same time as the receipts anticipated 'from the project." It measures the equivalent average earning rate of the project as an annual interest rate and permits direct comparisons between projects varying both in size and length of life. 4.5.3.4 Summary end Recommendations. The rate of return is the only one of these evaluation methods that gives an unequivocal answer to the question, "lf the enterprise commits the required investment, what will the project it implements earn for the enterprise?" It is the only method that yields an answer which is directly comparable with the cost of borrowing the required funds. it is an evaluation method rather than a decision technique. 4.5.4 The Rate-of-Return Concept To determine the interest rate (rate of return) of a single disbursement which result in at single receipt at a later date is a simple matter. To illustrate: Suppose it is anticipated that $408 can be invested all at one time to yield an instantaneous receipt of $800 exactly two years later. The relationship between these two figures and the applicable interest rate I is stated by the following equation: i : 0.40=40 percent The following calculations demonstrate that the answer of 40 per cent is the interest rate at which the $408 would have to be deposited in order to achieve a balance sufficient to pay out the $800 two years later as required by the rate-of-return concept. $ 108 x 1.4 : $571 $ 57l x 1.4 : $800

Now suppose a project involving four separate pairs of anticipated disbursements and receipts, as in Table 4. l, is to be evaluated. (Disbursements are shown as negative cash flows, receipt's as positive flows.) Calculation of the rate of return exhibited by the additional pairs of disbursements and receipts yields the answers tabulated. But suppose all of these disbursements and receipts are anticipated to occur in connection with a single project and the only data available are the overall cash flows shown in the last column. Could we not state the rate of return of the project to be the interest rate at which the two overall net disbursements would have be invested in an annuity fund in order for the fund to be able to make payments equal to and at the same time as the three net overall receipts of the project ?. The interest rate that satisfies conditions for the overall net cash flows tabulated in Table 4.1 is 20 percent. The validity of the answer. is demonstrated by Table 4.2. This table also makes two other facts clear: l. lf this project performs is anticipated, it will pay back the total of $3000 invested plus 20 percent interest on the funds in use. This interest rate is suitable for direct comparison wiht the cost of capital. 2. The rate-of-return concept as demonstrated involves neither explicit nor implicit reinvestment of proceeds. 4.5.5 The Calculation Algorithm The foregoing answer of 20 percent was demonstrated to be Correct, but how can it be calculated? The overall net cash flows as previously tabulated provide an excellent, demonstration problem illustrating many of the computational difficulties encountered in rate of-return calculations. Note that despite the fact that there are only five figures, the following four difficulties are introduced : 1. Disbursements are made at more than one time. 2. Disbursements vary in amount. 3. Receipt timing is irregular. 4. Receipts vary in amount. The first step in the solution is the selection of a reference or zero point. Any zero point can be used. The choice made will in no way affect the answer obtained, but it can greatly affect the ease of computation' In most cases, the selection of the beginning of the first year of receipts as the zero point will result in calculations of minimum complexity.

Now suppose the present worth of all net cash flows are calculated at a stipulated interest rate. The results of such a calculation using an annually compounded interest rate of l0 percent are tabulated below Note that the $800 receipt discounted back to zero time has a present worth of $728' This also means that if $7l8 were deposited in a bank at l0 per cent interest compounded annually, one year later the amount on deposit would be $800 or just enough to make a payment equal to that anticipated from the project. In the same way, the $1360 deposited at the same time would grow to $2000 in four years and the $2420 to $3904 in five years. Thus, if the sum of $728*$1360+$2420 or $4508 were deposited at time zero, at the stipulated l0 percent interest compounded annually, these deposits, plus the interest carried, would be just sufficient to make payments equal to and at the same time as the project. Note that this amount is larger than the present worth of the prospective investment ($3100). Since the project's prospective investment is much smaller than the amount that would have to be invested in the bank at l0 percent in order to achieve the same results, the prospective rate of return is demonstrated to be greater than l0 percent. Now note : If it is assumed that the bank will pay an interest rate higher than l0 percent, the sum of the present worth of disbursement will increase and the sum of the present worth of receipts will decrease. Obviously, there must be some interest rate at which these two figures will be equal. This is the answer for which we must solve, for it is also by definition the interest rate at which deposits of identical amounts and timing would have to be made in order to provide exactly enough funds to make payments equal to and at the same time as receipts from the prospective project. In other. words, we would have determined a bank interest rate exactly equivalent to the earning rate of the prospective project. The only way this interest rate can be computed is by trial and error. As ordinarily performed, this requires repeated trials at different interest rates until the correct answer is determined. This can be a tedious and time-consuming operation. It has long tended to be a serious roadblock to the widespread acceptance and use of this method. 4.5.6 The Use of Pre-tabulated Worksheets and Graphical Interpolation The "profitability index" approach utilizes Pre-tabulated worksheets and graphical interpolation to reduce the necessary trial-and-error computations to routine clerical procedure's. The use of these technique's to solve the demonstration problem is illustrated in Fig. 4.1

4.5.6.1 The Worksheet and Graphical Interpolation Chart (Fig. 4.1). Separate schedules are provided on the worksheet for disbursements and receipts. The zero points of both, however, are identical and are identified by a heavy line with a diamond at the left. The design of the form facilitates the assumption of the beginning of the first year of receipts as the zero point. Singlepayment compounding and discounting factors are provided for three different interest rates together with adjacent blank columns for entering appropriate present worth. (On this demonstration form, the pre-tabulated present worth factors are based upon annual compounding and instantaneous cash flows. Conversion to the more frequently used convention of continuous compounding and during the year receipt is merely a matter of substituting different present worth factor ) The chart at the bottom of the page is for plotting the ratio (horizontal scale) of the sum of the present worth disbursements to the sum of the present worth of receipts it each of the stipulated interest rates (vertical scale). 4.5.6.2 Using the worksheet and Chart. The use of this worksheet to find the rate of return of the demonstration problem is illustrated in Fig 4.1 The predicted disbursements and receipts are entered in the blank column head "trial = I at 0 percent interest" und on the lines corresponding to the time the cash flows are anticipated to occur. The comparison of the totals of actual disbursements and receipts is equivalent to making a trial at zero percent interest and provides one point on our interpolation chart. "Trial = 2 at l0 percent" is made by multiplying each of the actual amounts by the adjacent present worth factor in the next column and entering the present worth in the next blank column. Similar trials are made at 25 and 40 percent The at cash trial rate, including that at 0 percent, the sum of the present worth of the disbursements is divided by the sum of the present worth of the receipts and the ratios entered on the line labeled ratios A/8. The interest rate at which the sum of the present worth of receipts is exactly equal to the sum of the present worth of disbursements is determined by plotting on the chart in Fig.4.I each of the ratios obtained against the interest rate at which they were calculated, drawing a curve through these points and reading on the vertical scale the point where this curve intersects the unity ratio line. This shows, as it should, that the rate of return on this demonstration problem is 20 percent. 4.5.6.3 Comments on Accuracy and Validity of This Algorithm. As long as this algorithm is applied to the type of problem for which it is designed (see Par. 4.5.7 for discussion of when

algorithm cannot be used), the accuracy of the answers obtained by this graphical interpolation method will be as exact as the number of decimal points in the present worth factors and the legibility of the chart permit. In fact, because of the use of the most sensitive ratio, which is that at zero interest rate, as one point on the curve, this method offers the maximum accuracy of results obtainable with a given number of decimal places in the present worth factors. In addition, this method is to a certain extent self-checking. Only three points are required to establish the curve. The fourth serves as a check. lf a smooth curve cannot be drawn through all four points, an error in computation or plotting has been made. 4.5.7 Limitations of the Algorithm . and How to handle Them The method of determining the earning rate or rate of return of a prospective investment by solving for the interest rate at which the sum of the present worth of receipts is equal to the sum of the present worth of disbursements has been labeled an "algorithm." This term has been applied because it is a trick method of limited application. It can be employed only when the problem to be solved is in the form for which the method was designed. Recognition of this limitation is extremely important. Improper use of this method can result in misconceptions and serious errors in evaluations. The algorithm has been designed to compute the interest rate that relates one or more receipts to one or more prior disbursements. Valid answers will be obtained only if the problem can be reduced to this configuration. Specifically, if this method is misused to evaluate proposals in which all net disbursements do not precede all net receipts, over' stated, or in some cases multiple overstated, answers may be obtained. Fortunately, however, many of the problems to which this algorithm cannot be directly applied can be rearranged to a solvable form. A suggested method of handling two types of such cases is illustrated as follows: Direct application of the algorithm to the above data yields an answer of 38 percent. This is not the earning rate on the $ll00 commitment but actually the earning rate on the implied "equity" in accordance with the following net annual disbursements and receipt schedule. It is suggested that the outright acquisition cost be obtained and two separate calculations be made. With the outright acquisition cost estimated to be $1000, the following calculations can be made: Answer given by algorithm: 6 per cent. The true earning rate of the project, 15.? Percent, provides a basis for determining whether the project is sufficiently profitable. The cost of capital,

6 percent, provides a basis for determining whether the cost of financing via a conditional sale is acceptable. problem results in two answers: 35 percent and 63 percent. The successful trials at these interest rates are tabulated here: Neither of these answers represents a valid evaluation. Both overstate the earning rate by building in reinvestment of funds at the solution interest rate, which is higher than any reasonable expectation. The best solution offered to date for this type of problem appears to be a compromise in which a stipulated, highly believable reinvestment rate is used to convert the unsolvable problem into a form to which the algorithm can be validly applied. The application of this "crutch" is illustrated in the two tables shown below. If a l0 percent stipulated interest rate is used as I "crutch" the successful trial rate is 19 percent. If a 6 percent stipulated interest rate is used as a "crutch" the successful trial rate is a7 percent. On the basis of the foregoing calculations, it seems reasonable to consider this project equivalent in profitability to other projects with a rate of return somewhere between 17 an 19 percent