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NE 364
Engineering Economy
Lecture 3 F
Money-Time Relationships Time
and Equivalence
(Part 1: Single Payment)
P

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The objective of this lecture is to

explain the time value of money.

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Money − Time Value

 Capital refers to wealth in the form of money or
property that can be used to produce more wealth.

 Engineering economy studies involve the

commitment of capital for extended periods of time.

 A dollar today is worth more than a dollar one or

more years from now.

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Return to capital or Interest

 Interests and profit are payments for the risk the
investor takes in letting another use their capital.
 Any project or venture must provide a sufficient return
to be financially attractive to the suppliers of money or
property.

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Simple Interest
When interest earned or charged is not accumulated.

I=P*N*i
P = principal amount lent or borrowed
N = number of interest periods (e.g., years, months,…)
i = interest rate per interest period

The total amount repaid at the end of N interest periods is

F = P + I.

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Example on Simple Interest

 If $5,000 were loaned for five years at a simple interest
rate of 7% per year, the interest earned would be

 I = $5,000 * 5 * 0.07 = $1,750

 So, the total amount repaid at the end of five years
would be

 F = P + I = $5000 + $1,750 = $6,750

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Compound Interest
Whenever the interest charge for any interest period is
based on the

remaining principal amount + any accumulated interest

charges

up to the beginning of that period, the interest is said to

be compound.

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Compound Interest Calculations

for $1,000 at 10%
(1) (2)=(1)x10% (3)=(1)+(2)
Amount owed Interest Amount owed
at beginning of amount for at end of
Period period period period
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

Compound interest is commonly used in personal and professional financial

transactions.

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Simple versus Compound Interest

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Cash-flow Diagram

Arrow Up=
Receipts

Arrow Down=
Expenses

Horizontal Line is the Time Scale

The Cash-flow is dependent on the point of view

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Example on Cash-flow
 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.
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Example on Cash-flow
(Solution)

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Single Payment

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Cash-flow Calculation Rules

• Rule 1: Cash flows cannot be added or
subtracted unless they occur at the same time.
• Rule 2: To move a cash flow forward in time by
one time unit, multiply the magnitude of the cash
flow by (1 + i), where i is the interest rate.
• Rule 3: to move a cash flow backward in time by
one time unit, divide the magnitude of the cash
flow by (1 + i).

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Arithmetic on Cash flow

P

0 1 2 3 4 5 6

i% Time (years)

Multiply by (1+i) Compounding

Divide by (1+i) Discounting

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Arithmetic on Cash flow

P*(1+i)

0 1 2 3 4 5 6

i% Time (years)

Multiply by (1+i) Compounding

Divide by (1+i) Discounting

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Arithmetic on Cash flow

P*(1+i)2

0 1 2 3 4 5 6

i% Time (years)

Multiply by (1+i) Compounding

Divide by (1+i) Discounting

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Arithmetic on Cash flow

P*(1+i)3

0 1 2 3 4 5 6

i% Time (years)

Multiply by (1+i) Compounding

Divide by (1+i) Discounting

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Single Payment (cont.)

 If an amount of P dollars is invested at a point in time
with interest rate i%, the amount will grow to a future
amount :

 after period one

P+Pi =P(1+i)

 after period two

P(1+i)+P(1+i)i=P(1+i)[1+i]=P(1+i)2

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Single Payment (cont.)

 After period 3
2 2 2 3
P(1+i) + P(1+i) i= P(1+i) [1+i]= P(1+i)

 After period N:
N-1 N-1 N-1 N
P(1+i) + P(1+i) i= P(1+i) [1+i]= P(1+i)

 Hence ,
 F=P(1+i)N

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We can apply compound interest formulas

to “move” cash flows along the cash flow
diagram.

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Example on Compound Interest

Estimating the Future

 You decide to invest $2,500 at the bank. The bank

offers 8% yearly interest rate.

 How much will you have in six years?

 F=$2,500 * (1+ 0.08)6 = $3,967.19

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Example on Compound Interest

Estimating the Present
 An investor (owner) has an option to purchase a tract of
land that will be worth $10,000 in six years.

 If the value of the land increases at 8% each year, how

much should the investor be willing to pay now for this
property?

 P = $10,000 * (1+ 0.08)− 6 = $6301.70

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We can use the

discrete compounding tables
to compute F or P

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Interest Tables

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Example on Compound Interest

Estimating the Future
using Discrete Compounding Tables

 You decide to invest $2,500 at the bank. The bank

offers 8% yearly interest rate.

 How much will you have in six years?

F=$2,500 * (F/P, 8%, 6)

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Interest Tables

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Example on Compound Interest

Estimating the Future
using Discrete Compounding Tables

 You decide to invest $2,500 at the bank. The bank

offers 8% yearly interest rate.

 How much will you have in six years?

F=$2,500 * (F/P, 8%, 6)

= $2,500 * 1.5869

=$3,967.25

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Example on Compound Interest

Estimating the Present
using Discrete Compounding Tables
 An investor (owner) has an option to purchase a tract of
land that will be worth $10,000 in six years.

 If the value of the land increases at 8% each year, how

much should the investor be willing to pay now for this
property?

P = $10,000 * (P/F, 8%, 6)

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Example on Compound Interest

Estimating the Present
using Discrete Compounding Tables
 An investor (owner) has an option to purchase a tract of
land that will be worth $10,000 in six years.

 If the value of the land increases at 8% each year, how

much should the investor be willing to pay now for this
property?

P = $10,000 * (P/F, 8%, 6)

= $10,000 * 0.6302

=$6302.00

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Exam Dates Reminder

 7th Week Assessment
 Exam (20pt.) + Quizzes (10pt)
 Exam on Thursday of 6th week.
 Quizzes in the tutorial.

 12th Week Assessment

 Exam (15 pt.) + Quizzes (5 pt.)
 Exam on Thursday of 12th week.
 Quizzes in the tutorial.

 Continuous Assessment (10 pt.)

 Participation in Lecture + Attendance

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