Money-Time Relationship

and Equivalence

By: vkis-caingles
 money has a time value
It has been said that often the riskiest thing a
person can do with money is nothing!

Money has value, and if money remains uninvested

(like in a large bottle), value is lost.
It is a well-known fact that money makes money. The
time value of money explains the change
in the amount of money over time for funds that are
owned (invested) or owed (borrowed).
This is the most important concept in engineering
economy.
Interest and
Interest Rates
 : Interest and Interest Rates

Pay no interest
until next year!

Now 2.6 percent daily interest

on passbook accounts!
 : Interest and Interest Rates

Interest is the difference between the amount of money lent and the
amount of money later repaid. It is the compensation for giving up
the use of the money for the duration of the loan. If the difference is
zero or negative, there is no interest.

Interest = amount owed now - principal

Interest

1 period

Principal Interest rate (i) Principal

PRESENT FUTURE
 : Interest and Interest Rates

There are two perspectives to an amount of interest:

interest paid and interest earned

Interest is paid when a person or organization borrowed money (obtained a

loan) and repays a larger amount over time. Interest paid on borrowed
funds (a loan) is determined using the original amount, also called the
principal.

Interest is earned when a person or organization

saved, invested, or lent money and obtains a return of
a larger amount over time.
 : Interest and Interest Rates

Interest paid Interest earned

Borrower = Interest rate Investor = Rate of return

 : Interest and Interest Rates

When interest paid over a specific time unit is expressed as a percentage of

the principal, the result is called the interest rate.

Interest accrued per time unit

Interest rate (%) = principal x 100%

The time unit of the rate is called the interest period.

 : Interest and Interest Rates

Example:
An employee at LaserKinetics.com borrows $10,000 on May 1, 2020 and must repay a total of
$10,700 exactly 1 year later. Determine the interest amount and the interest rate paid.

Solution
Determine the interest paid:
Interest = amount owed now - principal

May 1, 2021 Interest = 10,700 – 10,000

= 700

Determine the interest rate paid for 1 year:

700
Percent interest rate = x 100% = 7% per year
10,000
 : Interest and Interest Rates

Example:
Stereophonics, Inc., plans to borrow $20,000 from a bank for 1 year at 9% interest for new
recording equipment. Compute the interest and the total amount due after 1 year.

Solution
Compute the total interest accrued
Interest = $20,000(0.09) = $1,800

The total amount due is the sum of principal and interest.

Total due = $20,000 + $1,800 = $21,800
 : Interest and Interest Rates

From the perspective of a saver, a lender, or an investor,

interest earned is the final amount minus the initial
amount, or principal.

Interest earned = total amount now - principal

 : Interest and Interest Rates

Example:
(a) Calculate the amount deposited 1 year ago to have $1000 now at an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.

Solution
(a) The total amount accrued ($1000) is the sum of the original deposit and the earned interest.
If X is the original deposit,

Total accrued = deposit + deposit(interest rate)

The original deposit is:
1000
X= = 952.38
1.05

(b) determine the interest earned

Interest = $1000 - 952.38
= $47.62
 : Interest and Interest Rates

Interest earned over a specific period of time is expressed as a percentage of

the original amount and is called rate of return (ROR).

Interest accrued per time unit

Rate of return = x 100%
Principal

The term return on investment (ROI) is used equivalently with ROR in

different industries and settings, especially where large capital funds are
committed to engineering-oriented programs.

The term interest rate paid is more appropriate for

the borrower’s perspective, while the rate of return
earned is better for the investor’s perspective.
 : Interest and Interest Rates

Inflation represents a decrease in the value of a given currency. Inflation means that cost and
revenue cash flow estimates increase over time. This increase is due to the changing value of
money that is forced upon a country’s currency by inflation, thus making a unit of currency (such
as the dollar) worth less relative to its value at a previous time

In simple terms, interest rates reflect two things: a so-called real rate of return plus the expected
inflation rate. The real rate of return allows the investor to purchase more than he or she could
have purchased before the investment, while inflation raises the real rate to the market rate
that we use on a daily basis.

From the borrower’s perspective, the rate of inflation is

another interest rate tacked on to the real interest rate.
And from the vantage point of the saver or investor in a
fixed-interest account, inflation reduces the real rate of
return on the investment.
 : Interest and Interest Rates

Inflation contributes to:

❑ A reduction in purchasing power of the currency
❑ An increase in the CPI (consumer price index)
❑ An increase in the cost of equipment and its maintenance
❑ An increase in the cost of salaried professionals and hourly
employees
❑ A reduction in the real rate of return on personal savings and
certain corporate investments
Terminology and Symbols

P - value or amount of money at a time designated as the present or time 0. Also P is

referred to as present worth (PW), present value (PV), net present value (NPV),
discounted cash flow (DCF), and capitalized cost (CC); monetary units, such as
dollars
F - value or amount of money at some future time. Also F is called future worth (FW) and
future value (FV); dollars
A - series of consecutive, equal, end-of-period amounts of money. Also A is called the
annual worth (AW) and equivalent uniform annual worth (EUAW); dollars per year,
euros per month
n - number of interest periods; years, months, days
I - interest rate per time period; percent per year, percent per month
t - time, stated in periods; years, months, days
 Terminology and Symbols
Example:
Today, Julie borrowed $5000 to purchase furniture for her new house. She can repay
the loan in either of the two ways described below. Determine the engineering economy
symbols and their value for each option.
(a) Five equal annual installments with interest based on 5% per year.
(b) One payment 3 years from now with interest based on 7% per year.

Solution
(a) The repayment schedule requires an (b) Repayment requires a single future
equivalent annual amount A , which is amount F, which is unknown.
unknown. P = $5000
P = $5000 i = 7% per year
i = 5% per year n = 3 years
n = 5 years F=?
A=?
 Terminology and Symbols
Example:
Last year Jane’s grandmother offered to put enough money into a savings account to generate $5000 in
interest this year to help pay Jane’s expenses at college. ( a ) Identify the symbols, and ( b ) calculate the
amount that had to be deposited exactly 1 year ago to earn $5000 in interest now, if the rate of return is
6% per year.

Solution
(a) Symbols P (last year is 1) (b) Let F total amount now and P original amount. We know
and F (this year) are needed. that F – P = $5000 is accrued interest. Now we can determine P
P=? . F = P + Pi
i = 6% per year
n = 1 year The $5000 interest can be expressed as
Interest = F – P
F = P + interest = ( P + Pi ) – P
= ? + $5000 = Pi
$5000 = P (0.06)
P = 83,333.33
CASHFLOW
 : CASHFLOW

Cash flow is the sum of money recorded as receipts or

disbursements in a project’s financial records.

Cash inflows are the receipts, revenues, incomes, and savings generated by project and business
activity. A plus sign indicates a cash inflow.
Cash outflows are costs, disbursements, expenses, and taxes caused by projects and business
activity. A negative or minus sign indicates a cash outflow. When a project involves only costs,
the minus sign may be omitted for some techniques, such as benefit/cost analysis.

Once all cash inflows and outflows are estimated (or determined for a completed project),
the net cash flow for each time period is calculated.

Net cash flow = cash inflows – cash outflows

NCF = R - D
where NCF is net cash flow, R is receipts, and D is disbursements
 : CASHFLOW

Cash Inflow Estimates

Income: + $150,000 per year from sales of solar-powered watches
Savings: + $24,500 tax savings from capital loss on equipment salvage
Receipt: + $750,000 received on large business loan plus accrued interest
Savings: + $150,000 per year saved by installing more efficient air conditioning
Revenue: + $50,000 to $75,000 per month in sales for extended battery life iPhones

Cash Outflow Estimates

Operating costs: + $230,000 per year annual operating costs for software services
First cost: + $800,000 next year to purchase replacement earthmoving equipment
Expense: + $20,000 per year for loan interest payment to bank
Initial cost: + $1 to $1.2 million in capital expenditures for a water recycling unit
 : CASHFLOW

The end-of-period convention means that all cash inflows and all cash outflows are assumed to
take place at the end of the interest period in which they actually occur. When several inflows
and outflows occur within the same period, the net cash flow is assumed to occur at the end of
the period.

Point estimates - single-value estimates for cash flow elements of an alternative

Example: Cash inflow: Income = $150,000 per month

Range estimate – Minimum and maximum values that estimate the cash flow
Example: Cash outflow: Cost is between $2.5 M and $3.2 M
 : CASHFLOW

A cash flow diagram presents the flow of cash as arrows on a time line scaled to the
magnitude of the cash flow, where expenses are down arrows and receipts are up arrows. It is
a graphical representation of cash flows drawn on the y axis with a time scale on the x axis.
The diagram includes what is known, what is estimated, and what is needed.

The cash-flow diagram employs several conventions

1 The horizontal line is a time scale, with progression of time moving from left to right. The period (e.g., year,
quarter, month) labels can be applied to intervals of time rather than to points on the time scale.
 : CASHFLOW
The cash-flow diagram employs several conventions
The arrows signify cash flows and are placed at the end of the period. If a distinction needs to be made,
2 downward arrows represent expenses (negative cash flows or cash outflows) and upward arrows
represent receipts (positive cash flows or cash inflows).
 : CASHFLOW
The cash-flow diagram employs several conventions
The cash-flow diagram is dependent on the point of view. For example, the Figure below is based on
3 cash flow as seen by the lender (the credit card company). If the directions of all arrows had been
reversed, the problem would have been diagrammed from the borrower’s viewpoint.
 : CASHFLOW
Example
Before evaluating the economic merits of a proposed investment, the XYZ Corporation insists that its
engineers develop a cash-flow diagram of the proposal. An investment of $10,000 can be made that will
produce uniform annual revenue of $5,310 for five years and then have a market (recovery) value of $2,000 at
the end of year (EOY) five. Annual expenses will be $3,000 at the end of each year for operating and
maintaining the project. Draw a cash-flow diagram for the five-year life of the project. Use the corporation’s
viewpoint.

Cash Outflows:

Cash Inflows:
 : CASHFLOW
Example
An electrical engineer wants to deposit an amount P now such that she can withdraw an equal annual
amount of A1 $2000 per year for the fi rst 5 years, starting 1 year after the deposit, and a different annual
withdrawal of A2 $3000 per year for the following 3 years. How would the cash flow diagram appear if
i = 8.5% per year?

Cash Outflows:

Cash Inflows:
Economic
Equivalence
 : Economic Equivalence

Economic Equivalence is a combination of interest rate and time

value of money to determine the different amounts of money at different
points in time that are equal in economic value.

Illustration:
If the interest rate is 6% per year, Php100 today
(present time) is equivalent to Php106 one year
from today.
 : Economic Equivalence

Interest Periods

Interest Period Interest Is Calculated:

Semiannually Twice per year, or once every six months
Quarterly Four times a year, or once every three months
Monthly 12 times per year
Weekly 52 times per year
Daily 365 times per year
Continuous For infinitesimally small periods
 : Economic Equivalence – SIMPLE INTEREST

Simple Interest (I)

- means interest is paid each period on the value of the original investment.
- is a method of computing interest where interest earned during an interest period is not
added to the principal amount used to calculate interest in the next period.
- is calculated using the principal only, ignoring any interest accrued in preceding interest
periods.
- The interest is calculated using the principal only

I = (P)(n)(i)
where

P = principal amount lent or borrowed;

n = number of interest periods (e.g., years);
i = interest rate per interest period.
 : Economic Equivalence – SIMPLE INTEREST

Simple Interest (I)

Future Worth (F)
F=P+I
F = P + [(P)(n)(i)]
F = P (1 + ni)
where
F = value or amount of money at some future time
P = principal amount lent or borrowed;
n = number of interest periods (e.g., years);
i = interest rate per interest period.

Types of Simple Interest (I)
1. Ordinary Simple Interest
- is computed on the
basis of 12 months of
30 days each or 360
days a year.
- 1 year is equal to 360
days
- 1 interest period is
360 days
: Economic Equivalence – SIMPLE INTEREST
2. Exact Simple Interest
- is computed on the basis of exact number of days
in a year
- Ordinary year has 365 days
- Leap year has 366 days (The year must be evenly
divisible by 4 however for the century years, it
must evenly divisible by 100 the n 400).
 : Economic Equivalence – SIMPLE INTEREST

Example:
Assume you borrow 10,000 for 10 years at 6% per year of simple interest. Compute the
amount you will pay after 10years.

Solution:
Given: P = 10,000 Cash flow:
n = 10 years 10,000
i = 6%
600
The interest for each year
yearly
Interest per year = P(i)
= (10,000)(0.06)
= 600 10,000
Total interest for 10 years is: Total amount due after 10 years
I = (P)(n)(i) F=P+I
I = (10,000)(10)(0.06) F = 10,000 + 6,000
I = 6,000 F = 16,000
 : Economic Equivalence – SIMPLE INTEREST

Example:
On May 30, 2012, a businessman loans P15,000 in the bank for the expansion of his
restaurant. It was agreed that he will pay the amount with 6% rate of interest on August 10,
2012. What is the ordinary simple interest to be paid?

Solution:
Given: P = 15,000 Interest to be paid is:
i = 6% I = (P)(n)(i)
n = let us count the days I = (15,000)(1/5)(0.06)
May 31 = 1 day I = 180
June 1-30 = 30 days
July 1 - 31 = 31 days
August 1 - 10 = 10 days
Total = 72 days
1 year 1
n = 72 days x = year
360 days 5
 : Economic Equivalence – SIMPLE INTEREST

Example:
Louie borrowed 1,800 from his aunt last December 25, 2010. He promised that he will pay
his aunt on February 14, 2011 at 8% interest. Find the exact simple interest to be paid by
Louie.

Solution:
Given: P = 1,800 Interest to be paid is:
i = 8% I = (P)(n)(i)
n = let us count the days I = (1,800)(51/365)(0.08)
December 26-31= 6 days I = 20.12
January 1-31 = 31 days
February 1 - 14 = 14 days
Total = 51 days

n = 51 days x 1 year = 51 year

365 days 365
 : Economic Equivalence – COMPOUND INTEREST

Compound Interest (Ic)

- the interest accrued for each interest period is calculated on the principal plus the total
amount of interest accumulated in all previous periods.
- defined by an account where the interest paid is left in the account, and the next
period’s interest is paid on the principle plus accumulated interest.

Ic = P(1 + i)n - P
where

P = principal amount lent or borrowed;

n = number of interest periods (e.g., years);
i = interest rate per interest period.
 : Economic Equivalence – COMPOUND INTEREST

Compound Interest (Ic)

 : Economic Equivalence – COMPOUND INTEREST

Example:
Assume you borrow 1,000 for 3 years at 10% per year of compounded interest. Compute
the amount you will pay after 3 years.

Solution:
Total Interest for 3 years
Ic = P(1+i)n – P
Ic = 1,000(1+0.10)3 – 1,000
Ic = 331
 : Economic Equivalence – COMPOUND INTEREST

Example:
Assume you borrow 5,000 for 5 years at 8% per year of compounded interest. Which of the
following payment scheme has the lowest amount paid?
Plan 1: Pay all at end. No interest or principal is paid until the end of year 5. Interest
accumulates each year on the total of principal and all accrued interest.
Plan 2: Pay interest annually, principal repaid at end. The accrued interest is paid each
year, and the entire principal is repaid at the end of year 5.
Plan 3: Pay interest and portion of principal annually. The accrued interest and one-fifth of
the principal (or $1000) are repaid each year. The outstanding loan balance decreases
each year, so the interest for each year decreases.
Plan 4: Pay equal amount of interest and principal. Equal payments are made each year
with a portion going toward principal repayment and the remainder covering the accrued
interest. Since the loan balance decreases at a rate slower than that in plan 3 due to the
equal end-of-year payments, the interest decreases, but at a slower rate.
 : Economic Equivalence – COMPOUND INTEREST

Solution:

Plan 1: Pay all at end.

 : Economic Equivalence – COMPOUND INTEREST

Solution:

Plan 2: Pay interest annually, principal repaid at end.

 : Economic Equivalence – COMPOUND INTEREST

Solution:

Plan 3: Pay interest and portion of principal annually.

 : Economic Equivalence – COMPOUND INTEREST

Solution:

Plan 4: Pay equal amount of interest and principal.

 : Economic Equivalence – COMPOUND INTEREST

Solution:

Summary

Plan 1: Pay all at end.

$7346.64 at the end of year 5

Plan 2: Pay interest annually, principal repaid at end.

$400 per year for 4 years and $5400 at the end of year 5
Thus, the total amount paid is $7000 within 5 years

Plan 3: Pay interest and portion of principal annually.

Decreasing payments of interest and partial principal in years 1 ($1400)
through 5 ($1080). Thus, the total amount paid is $6200 within 5 years

Plan 4: Pay equal amount of interest and principal.

$1252.28 per year for 5 years.
Thus, the total amount paid is $6261.40 within 5 years
 : Economic Equivalence –

Nominal and Effective Interest Rates

Nominal Interest Rates

- is the annual interest rate (per year) for a certain compounding period.
Nominal interest rate can be applied to the advertised or stated interest rate on a
loan, without taking into account any fees or compounding of interest. The nominal
interest rate can be calculated using the formula:

r
is =
m
where:
r - the periodic interest rate
is - the nominal/stated rate
m - the number of compounding periods
 : Economic Equivalence –

Nominal and Effective Interest Rates

Effective Interest Rates

- is the annual interest rate compounded annually. It may be seen on a loan or
financial product restated from the nominal interest rate and expressed as the
equivalent interest rate if compound interest was payable annually in arrears. If we
compound interest every subperiod, we have:

F = P(1 + is)m
where:
F - future amount
P - present amount
is - the nominal/stated rate
m - the number of compounding periods
 : Economic Equivalence –

Nominal and Effective Interest Rates

Effective Interest Rates

We want to find the effective interest rate, ie, that yields the same future amount F at
the end of the full period from the present amount P.

P(1 + ie) = P(1 + is)m

Then
1 + ie = (1 + is)m
ie = (1 + is)m - 1
 : Economic Equivalence –

Various Interest Statements and Their Interpretations

Interest rate statement Interpretations

i = 12% per year i = effective 12% per year compounded yearly
i = 1% per month i = effective 1% per month compounded monthly
i = 3 ½ per quarter i = effective 1% per quarter compounded quarterly

i = 8% per year compounded monthly i = nominal 8% per year compounded monthly

i = 4% per quarter compounded monthly i = nominal 4% per quarter compounded monthly
i = 14% per year compounded semiannually i = nominal 14% per year compounded semiannually

i = effective 10% per year compounded monthly i = effective 10% per year compounded monthly
i = effective 6% per quarter i = effective 6% per quarter compounded quarterly
i = effective 1% per month compounded daily i = effective 1% per month compounded daily
 : Economic Equivalence –

Example:
What is the nominal rate of interest on a company that has a 7.77% rate of effective
interest annually?

Solution:
Given ie = 7.77% = 0.0777
m = 12months in a year

ie = (1 + is)m – 1
r 12
0.0777 = (1 + ) –1
12
r = 0.0751 = 7.51% compounded monthly per year
 : Economic Equivalence –

Example:
A credit card company charges 21% interest per year, compounded monthly. What
effective annual interest rate does the company charge?

Solution:
Given r = 21% = 0.12
m = 12months in a year

ie = (1 + is)m – 1
0.12 12
ie = (1 + ) –1
12
ie = 0.2314 = 23.14% compounded annually per year
Thank you!