INDE/EGRM 6617-02

Engineering Economy and Cost Estimating

Chapter 4: The Time Value of Money

Dr. Alireza Namdari

anamdarikhalilabad@newhaven.edu
▪ Would you prefer to have $104 million now or $198 million paid out over
25 years from now?
➢ On what basis can such an economic comparison be made?
➢ To make such comparisons, we must be able to compare the value of
money at different points in time.

EOY Plan A Plan B

0 $104M
1 $7.92M
2 $7.92M
3 $7.92M

25 $7.92M

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 Money has a time value
• A dollar today is worth more than a dollar
one or more years from now for several
reasons. Therefore, money has a time value.

➢Reasons:
1. Interest rates (chapter 4)
2. Inflation/deflation (chapter 8)
3. Currency exchange (chapter 8)

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 Simple Interest
When the total interest earned or charged is linearly
proportional to the initial amount of the loan (principal), the
interest and interest rate are said to be simple.
The total interest, I, earned or paid may be computed using
the formula below.

P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period

The total amount repaid at the end of N interest periods = P + I

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

So, the total amount repaid at the end of five

years would be the original amount ($5,000)
plus the interest ($1,750), or $6,750.

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 Compound Interest
Whenever the interest charge for any interest period is based on the
remaining principal amount plus any accumulated interest charges up to
the beginning of that period, the interest is said to be compound.

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed at Interest amount for Amount owed at
Period beginning of period period end of 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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 Different Perspectives
Interest rate:
Borrower’s perspective – interest rate paid

Rate of Return:
Lender’s or investor’s perspective – rate of return
(ROR) earned

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 The Concept of Equivalence
➢ How can alternatives for providing the same service or
accomplishing the same function be compared?

• Each alternative can be reduced to an equivalent basis that is

dependent on
– interest rate
– amount of money involved, and
– timing of monetary receipts or expenses.

• Using these elements we can “move” cash flows so that we

can compare them at particular points in time.

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• How to find the equivalent values at different points
in time?

1. Equations
2. Factors and tables
3. Excel

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 Notations
• We need some tools to find economic equivalence.

i = effective interest rate per interest period

N = number of compounding (interest) periods

P = present sum of money; equivalent value of one or more cash flows at a

reference point in time; the present

F = future sum of money; equivalent value of one or more cash flows at a

reference point in time; the future

A = end-of-period cash flows in a uniform series continuing for a certain

number of periods, starting at the end of the first period and continuing
through the last

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 Cash-Flow Diagram
• A cash flow diagram is an indispensable tool for clarifying and
visualizing a series of cash flows.
• The difference between total cash inflows (receipts) and cash
outflows (expenditures) for a specified period of time is the net cash
flow for the period.
✓ The horizontal line is a time scale.
✓ Upward arrows signify cash inflows (positive).
✓ Downward arrows signify cash outflows (negative).

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 Cash-Flow Tables
Cash flow tables are essential to modeling engineering
economy problems in a spreadsheet

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 Example

You plan to make a lump-sum deposit of $5000 now into an

investment account that pays 6% per year and you plan to
withdraw an equal end-of-year amount of $1000 for 5 years,
starting next year. At the end of 6th year you plan to close the
account by withdrawing the remaining money.
Define the engineering economy symbols!

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 Solution
P = $5000
A = $1000 per year for 5 years
F = ? at the end of year 6
i = 6%
N = 5 years for the A series and 6 for the F value

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 Example
Each year ExxonMobil expends large amounts of funds for
mechanical safety features throughout its worldwide operations.
Carla Romas, a lead engineer for Mexico and Central America
operations, plans expenditures of $1 M now and each of the next
4 years just for the improvement of field-based pressure-release
valves.
Construct the cash flow diagram to find the equivalent value of
these expenditures at the end of year 4, using a cost of capital
estimate for safety-related funds of 12% per year.

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Solution

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 Example

An electrical engineer wants to deposit an amount of P now such

that she can withdraw an equal annual amount of A1= $2000 per
year for the first five 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?

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Solution

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 Finding F when given P
Using the standard notation, we find that a present amount, P, can grow into a future
amount, F, in N time periods at interest rate i according to the formula below.

𝑭 = 𝑷(𝟏 + 𝐢)𝑵

𝑭 = 𝑷 𝑭/𝑷, 𝒊%, 𝑵
The term is read “F given P at i% interest per period for N interest periods.

Finding P when given F

In a similar way we can find P given F by

𝑷 = 𝑭(𝟏 + 𝒊)−𝑵

𝑷 = 𝑭 𝑷/𝑭, 𝒊%, 𝑵
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 Example

Betty will need $12,000 in five years to pay for a major

overhaul on her tractor engine. She has found an investment
that will provide a 5% return on her invested funds. How
much does Betty need to invest today so she will have her
overhaul funds in five years?

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 Solution

Betty’s required investment is

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 Finding F when given A
Finding the future amount from a series of end-of-period cash flows.

𝟏+𝒊 𝑵−𝟏
𝑭=𝑨
𝒊

𝑭 = 𝑨 𝑭/𝑨, 𝒊%, 𝑵

Finding A when given F

In a similar way we can find A given F by

𝒊
𝑨=𝑭
𝟏+𝒊 𝑵−𝟏

𝑨 = 𝑭 𝑨/𝑭, 𝒊%, 𝑵
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 Example

How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?

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Solution

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 Finding P when given A
Finding the present amount from a series of end-of-period cash flows.

𝟏+𝒊 𝑵−𝟏
𝑷=𝑨
𝒊 𝟏+𝒊 𝑵

𝑷 = 𝑨 𝑷/𝑨, 𝒊%, 𝑵

Finding A when given P

In a similar way we can find A given P by

𝒊 𝟏+𝒊 𝑵
𝑨=𝑷
𝟏+𝒊 𝑵−𝟏

𝑨 = 𝑷 𝑨/𝑷, 𝒊%, 𝑵
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 Example

Acme Steamer purchased a new pump for $75,000. They

borrowed the money for the pump from their bank at an
interest rate of 0.5% per month and will make a total of 24
equal, monthly payments. How much will Acme’s monthly
payments be?

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 Solution

Acme’s monthly payments are

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 Example
A company borrowed $80,000 at an interest rate of 9% compounded
annually over six years. The loan will be repaid in installments at the end
of each year according to the accompanying repayment schedule.
What will be the size of the last payment (X) that will pay off the loan?

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 Solution

$80,00 = $20,000 ∗ 𝑃/𝐴, 9%, 4 + $10,000 ∗ 𝑃/𝐹, 9%, 5 + 𝑋(𝑃/𝐹, 9%, 6)

$80,000 = $20,000 ∗ 3.2397 + $10,000 ∗ 0.6499 + X∗(0.5963)

𝑋 = $𝟏𝟒, 𝟔𝟎𝟏. 𝟕𝟏

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Introduction to Excel Spreadsheet
▪ Functions available on a computer spreadsheet
greatly reduce the amount of hand work for
equivalency computations involving compound
interest and the terms, P, F, A, i and N.

▪ As cash flow series become more complex,

spreadsheet offers a good alternative.

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 ▪ A total of seven excel functions can perform most of
the engineering economy calculations. These are:

Excel financial functions

Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell

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 Example

If you deposit $100 now (n = 0) and $200 two years from

now (n = 2) in a savings account that pays 10% interest,
how much would you have at the end of year 10?

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 Solution
F
P 100 200 FV(10%,10,0,100)
= $259.37
i 10% 10%
FV(10%,8,0,200)
n 10 8
= $428.72
FV ($259.37) ($428.72) ($688.09)

0 1 2 3 4 5 6 7 8 9 10

$100(1 + 0.10)10 = $100(2.59) = $259

$200(1 + 0.10)8 = $200(2.14) = $429
$100
$200 F = $259 + $429 = $688
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 Deferred Annuities

• Deferred annuities are uniform series that

do not begin until some time in the future.

• If the annuity is deferred J periods then the

first payment (cash flow) begins at the end
of period J+1.

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 Example
Irene just purchased a new sports car and wants to also set
aside cash for future maintenance expenses. The car has a
bumper-to-bumper warranty for the first five years. Irene
estimates that she will need approximately $2,000 per year
in maintenance expenses for years 6-10, at which time she
will sell the vehicle. How much money should Irene deposit
into an account today, at 8% per year, so that she will have
sufficient funds in that account to cover her projected
maintenance expenses?

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 Solution
Present value, at EOY 5, of maintenance expenses in years
6-10, is

Now move this value to time zero

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 Example
You are going to purchase a new car. And you plan to drive it for 8 years.
Every year you will spend some money on the maintenance. Let’s suppose no
salvage value left at the end of the 8th year. Interest rate 𝒊 = 15%.

EOY Expenses
1 0
2 $40
3 $100
4 $100
5 $100
6 $250
7 $300
8 $350

Develop a cash flow diagram?

Determine the present (P), future (F), and annual (A) equivalent expenditures?
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 Solution
0 1 2 3 4 5 6 7 8

$40

$100 $100 $100

$250

$300
$350
P=?

P = $40(P/F,15%,2) + $100(P/A,15%,3)( P/F,15%,2) + $250(P/F,15%,6) + $300(P/F,15%,7)

+ $350(P/F,15%,8)
= $40(0.7561) + $100(2.2832)( 0.7561) + $250(0.4323) + $300(0.3759) + $350(0.3269)
= $538.14
F = $538.14(F/P, 15%, 8) = $538.14(3.059) = $1,646.17
A = $538.14(A/P, 15%, 8) = $538.14(0.2229) = $119.95
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Uniform Gradient of Cash Flows
• Sometimes cash flows change by a constant amount
each period
The table below shows such a gradient.

End of Period Cash Flows

1 0
2 G
3 2G
: :
N (N-1)G

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Similar to the other types of cash flows, there is a formula (albeit
quite complicated) we can use to find the present value, and a set of
factors developed for interest tables.
1 1+i 𝑁−1 𝑁
𝑃 = 𝐺( ) ∗ 𝑁
− 𝑁
𝑖 𝑖 1+i 1+i
𝑃 = 𝐺 𝑃/𝐺, 𝑖%, 𝑁

We can also find A or F equivalent to a uniform gradient series.

1 𝑁
𝐴=𝐺 −
𝑖 1+i 𝑁−1
𝐴 = 𝐺 𝐴/𝐺, 𝑖%, 𝑁

1 1+i 𝑁−1 𝑁
𝐹 = 𝐺( ) ∗ −
𝑖 𝑖 𝑖
𝐹 = 𝐺 𝐹/𝐺, 𝑖%, 𝑁
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The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an
2 3,000
annuity portion of the cash
flows and a gradient 3 4,000
portion. 4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

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 Example
The cost of heat loss in one factory is $1000 at the end of the
first year, which rises by $200 per year (uniform gradient)
until the end of 15th year; the interest rate is 10%.
What is the present equivalent value (P) of the heat loss?

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 Solution

P = $1000(P/A, 10%, 15) + $200 (P/G, 10%, 15)

= $1000(7.6061) + $200 (40.152)

= $15,636.5

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Geometric Sequences of Cash Flows

Sometimes cash flows change by a constant rate, ,each

period--this is a geometric gradient series.

This table presents a End of Year Cash Flows ($)

geometric gradient series. It
begins at the end of year 1
and has a rate of growth, ,
of 20%.
1 1,000
2 1,200
3 1,440
4 1,728

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We can find the present value of a geometric series
by using the appropriate formula below.

𝐼𝑓 𝑓 ≠ 𝑖
𝑨𝟏 [𝟏 − 𝑷/𝑭, 𝒊%, 𝑵 𝑭/𝑷, 𝒇%, 𝑵 ]
𝑷=
𝒊−𝒇

𝐼𝑓 𝑓 = 𝑖
𝑷 = 𝑨𝟏 𝑵 𝑷/𝑭, 𝒊%, 𝟏

Where is the initial cash flow in the series.

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 Example
Acme Miracle projects good things for their new weight loss
pill, LoseIt. Revenues this year are expected to be $1.1
million, and Acme believes they will increase 15% per year
for the next 5 years. What are the present value and
equivalent annual amount for the anticipated revenues?
Acme uses an interest rate of 20%.

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 Solution
Use the geometric gradient formula to find the present value,
then convert the present amount to an annual amount.

$1,100,000[1 − 𝑃/𝐹, 20%, 5 𝐹/𝑃, 15%, 5 ]

𝑃=
0.20 − 0.15
= $4,216,974

𝐴 = $4,216,974 𝐴/𝑃, 20%, 5 = $1,410,071

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Interest Rates that Vary with Time
• In practice – interest rates do not stay the same
over time unless by contractual obligation.
• There can exist “variation” of interest rates over
time – quite normal!
• If required, how do you handle that situation?

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 Example
Determine the present equivalent value of the following
cash-flow diagram when the annual interest rate varies
with time as indicated.

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 Solution

P
= $1,000(P/F, 8%, 1) + $2,000(P/F, 10%, 1)(P/F, 8%, 1)
+ $1,000(P/F, 6%, 1)(P/F, 8%, 1)(P/F, 10%, 1)(P/F, 8%, 1)
+ $2,000(P/F, 10%, 1)(P/F, 6%, 2)(P/F, 8%, 1)(P/F, 10%, 1)(P/F, 8%, 1)

P
= $1,000 ∗ 0.9259 + $2,000 ∗ 0.9091 ∗ 0.9259 + $1,000 ∗ 0.9434 ∗ 0.9259 ∗ 0.9091 ∗ 0.9259
+ $2,000 ∗ 0.9091 ∗ 0.8900 ∗ 0.9259 ∗ 0.9091 ∗ 0.9259

P = $4,606

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 Nominal and Effective Interest Rates
• The annual rate is known as a nominal rate.

• A nominal rate (as quoted) does not reference the

frequency of compounding.

• Very often the time between successive compounding, or

the interest period, is less than one year (e.g., daily,
monthly, quarterly).

• An Effective interest rate is a true, periodic interest rate.

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The relationship between effective interest and
nominal interest:

𝑖 = (1 + r/M)𝑀 −1
M: the number of compounding periods per year
i: effective interest
r: nominal interest

18% per year, compounded monthly

r = 18 % per year
m = 12 interest periods per year
What is the effective annual interest rate? It must be larger than 18% per year!

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 Compounding Number of Effective Rate for Nominal Rate of
Frequency Compounding Periods 6% 8% 10% 12% 15% 24%
Annually 1 6.00 8.00 10.00 12.00 15.00 24.00
Semiannually 2 6.09 8.16 10.25 12.36 15.56 25.44
Quartely 4 6.14 8.25 10.38 12.55 15.87 26.25
Bimonthly 6 6.15 8.27 10.43 12.62 15.97 26.53
Monthly 12 6.17 8.30 10.47 12.68 16.08 26.82
Daily 365 6.18 8.33 10.52 12.75 16.18 27.11

➢The more frequent the compounding the greater the effective interest.

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 Example

You borrow $10,000 at an interest rate of 12% per year

compounded monthly. How much do you owe after 5 years?

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 Solution

𝑖𝑒𝑓𝑓 = (1 + 12%/12)12 −1 = 12.68%

𝐹 = $10,000(F/P, 12.68%, 5) = $18,167

Or
12%
Interest rate per month = = 1% for 60 months
12

𝐹 = $10,000(F/P, 1%, 60) = $18,167

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 Continuous Compounding
Cash Flows
• We can allow compounding to occur
continuously throughout the period.
• The effect of this compared to discrete
compounding is small in most cases.

r = e𝑖 − 1

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Continuous compounding interest factors:

(F/P, r%, N) = e𝑟𝑁

1
(P/F, r%, N) =
(F/P, r%, N)

e𝑟𝑁 − 1
(F/A, r%, N) = 𝑟
e −1
1
(A/F, r%, N) =
(F/A, r%, N)

e𝑟𝑁 − 1
(P/A, r%, N) = 𝑟𝑁 𝑟
e (e − 1)
1
(A/P, r%, N) =
(P/A, r%, N)
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 Example
If a nominal interest rate of 8% is compounded continuously,
determine the unknown quantity in each of the following
situations:
a) What uniform end-of-year amount for 10 years is equivalent
to $8,000 at the end of year 10?
b) What is the present equivalent value of $1,000 per year for 12
years?
c) What is the future equivalent at the end of the sixth year of
$243 payments made every six months during the six years?
The first payment occurs six months from the present and the
last occurs at the end of the sixth year.

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 Solution

$8,000
A = $8,000 ∗ (A/F, 8%, 10) = = ($8,000/14.7147) = $543.67
(F/A, 8%, 10)

P = $1,000 ∗ (P/A, 8%, 12) = $1,000 ∗ 7.4094 = $7,409.40

r = 8%/2 = 4%
e0.04∗12 − 1
𝐹 = $243 ∗ (F/A, 4%, 12) = $243 ∗ = $243 ∗ 15.01959
e0.04 − 1
= $3,668.30

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