The Time Value of Money

Dr. Joseph Awad

MEC4312

William G. Sullivan and Elin M. Wicks, Engineering Economy,16th Edition

1
 Contents
 Introduction
 Simple
p Interest
 Compound Interest
 The Concept of Equivalence
 Cash-Flow Diagrams
 Single Cash Flows
 Uniform Series (Annuity)
 Summary for Discrete Compounding
 Nominal and Effective Interest Rates 2
 Introduction
 Capital represents wealth in the form of money or
property that can be used to produce more wealth.
 Money today is worth more than its value in the
future because of the interest (or profit) it can earn.
 Return on capital is an incentive to accumulate
capital by savings to create wealth in the future.
 Interest and profit are payments for the risk the
investor takes allowing another person, or an
organization,
i ti to
t use hihis or her
h capital.
it l
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 Simple Interest
I = P * N * i,
Where:
I = total interest;
P = principal amount lent or borrowed;
N = number of interest periods (e.g., years);
i = interest rate per interest period
period.

Final sum after N periods = P + I = P * (1 + N * i)

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 Simple Interest: Example
Ex: $1000 were loaned for 3 years at simple interest
rate of 10% per year. Find interest earned and total
amount owed at the end of 3 years.
Solution:
I = $1000 * 3 * 0.10 = $300
Total amount owed = P + I = $1000 + $300
= $1300

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 Compound Interest
Interest paid (earned) for any period is based on the
principal amount plus any accumulated interest
earned up to the beginning of that period.

Total compound interest = P [ (1+i)N – 1 ]

Final sum after N periods = P (1+i)N

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 Compound Interest: Example
Ex: $1000 were loaned for 3 years at compound
interest rate of 10% per year. Find interest earned
and total amount owed at the end of 3 years.
Solution:
Total owed = P (1+i)N = $1000(1+0.10)3 = $1331
I = Total owed – P = $
$1331 - $
$1000 = $331
$
Period Owed: Beginning Interest Owed: End
1 $1000 $100 $1100
2 $1100 $110 $1210
3 $1210 $121 $1331 7
The Concept of Equivalence

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Cash-Flow Diagrams

F = future sum of money, A = end-of-period cash flows

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 Relating Present and Future Equivalent
Values of Single Cash Flows

 Finding F when Given P

 Finding
g P when Given F
 Finding the Interest Rate Given P, F, and N
 Finding N when Given P, F, and i

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Finding F when Given P
F = P (1+i)N = P (F/P, i%, N)

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 Finding F when Given P: Example
Example:
P=$$8000,, i = 10%,, N = 4,, F =?
Solution:
F = P (1+i)N = P (F/P
(F/P, i%
i%, N)
F = $8000 (F/P, 10%, 4)
F = $8000 (1.4641)
(1 4641)
F = $11713

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 Finding P when Given F
F = P (1+i) N
1 N N
P  F( )  F (1  i )  F ( P / F , i %, N )
1 i
 (1+i) -N = single payment present worth factor
 Cash flow cannot added or subtracted unless at the
same point
 Move cash flow forward by
y one p p y byy ((1+i))
period: multiply
 Move cash flow backward by one period: divide by (1+i)
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 Finding P when Given F: Example
Example:
F=$$10000,, i = 8%,, N = 6,, P =?
Solution:
P = F (1+i)-N = F (P/F
(P/F, i%
i%, N)
P = $10000 (P/F, 8%, 6)
P = $10000 (0.6302)
(0 6302)
P = $6302

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 Finding the Interest Rate Given P, F, and N

i  F / P 1
N

Example:
F = $1000, P = $500, N = 10, i =??
Solution:

i  10 $1000 / $500  1  0.0718 or 7.18% per year

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 Finding the Interest Rate Given P
P, F
F, and N:
Example

Ex: The average gasoline price in 2005 was

$2.31/gallon. In 1993, it was $1.07/gallon. Find the
average annual rate of increase of its price over this
12 years period.
Solution:
F = $2
$2.31,
31 P = $1.07,
$1 07 N = 12,
12 i =?

i  12 $2.31 / $1.07  1  0.0662 or 6.62%

6 62% per year
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 Finding N when Given P, F, and i

F  P(1  i ) N

(1  i )  ( F / P )
N

N log(1  i )  log( F / P)
log( F / P)
N
l (1  i )
log(
Ex: F=$1000, P=$500, i=15%, N=?
log($1000 / $500)
Sol: N  4.96  5 years
log(1.15) 17
 Finding N when Given P, F, and i: Example

Ex: The average gasoline price in 2005 was

$2.31/gallon. The average annual rate of increase in
the price is 6.62%. How long will it be for the price to
reach $5/gallon?
Solution:
F = $5
$5, P = $ 2.31,
2 31 i = 6.62%,
6 62% N=?
log($5.00 / $2.31)
N  12.05 years
log(1  0.0662)
We expect that the price will reach $5/gallon in 2017
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 Relating a Uniform Series (Annuity) to Its
Present and Future Equivalent Values

 Finding F when Given A

 Finding
g P when Given A
 Finding A when Given F
 Finding A when Given P
 Finding N when Given A, P, and i
 Finding i Given A,
A F,
F and N

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 Finding F when Given A
 1  i N  1
F  A   AF A, i %, N 
 i 
The quantity in square brackets is called “uniform
series compound
p amount factor”. A occurs at the end
of periods 1 through N, inclusive.
Ex: A=$23000, i=6%, N=40, F=?
Solution:
F=$ $23000(F/A,
( / , 6%,, 40)) = $23000(154.762)
$ ( )
= $3,559,526
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 Finding P when Given A
 1  i N  1
P  A N 
 AP A, i %, N 
 i 1  i  
The quantity in square brackets is called “uniform
series p
present worth factor”.
Ex: A=$450,000, i=12%, N=10, P=?
So ut o
Solution:
P = $450,000(P/A, 12%, 10) = $450,000(5.6502)
= $2,542,590
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 Finding A when Given F
 
  F  A F , i %, N 
i
A  F
 1  i   1
N

The quantity in square brackets is called “sinking fund

factor”.
Ex: F=$2,143.60, i=10%, N=8, A=?
So ut o
Solution:
A = $2,143.60(A/F, 10%, 8) = $2,143.60(0.0874)
= $187.45
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 Finding A when Given P
 i 1  i N 
A  P   P A P, i %, N 
 1  i   1
N

The quantity in square brackets is called “capital

recoveryy factor”.
Ex: P=$17,000, i=1%, N=4, A=?
So ut o
Solution:
A = $17,000(A/P, 1%, 4) = $17000(0.2563)
= $4,357.10
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 Finding N when Given A, P, and i
 1  i N  1
P  A
Pi
N 

 1  1  i  
N

 i 1  i  A   Pi  
 log1  A  
 Pi   
1  i   1  
N
N   
 A  log1  i  
 
Ex: P=$100,000,
P=$100 000 A=10,000,
A=10 000 i=8%,
i=8% N=?
Solution:
By substation in the above equation N = 20.91 20 91 ≈ 21
Excel: N = NPER(0.08, −10000, 100000) = 20.91 24
 Finding i when Given A, F, and N
 1  i N  1
F  A   AF A, i %, N 
 i 
Ex: F=$60,000 , A=$6,000, N=8, i=?
Solution: $60,000 = $6,000(F/A, i%, 8)
(F/A, i%, 8) = 10, Solve with interpolation
Tables: (F/A,
(F/A 6%,
6% 8)=9.8975,
8)=9 8975 (F/A,
(F/A 7%,
7% 8)=10.2598
8)=10 2598
i  0.06 0.07  0.06 , i‘=0.0628 or 6.28% /year

10  9.8975 10.2598  9.8975
Excel: i′ = RATE(8,−6000, 0, 60000) = 0.0629 or 6.29% per year
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Summary of Interest Formulas and
Relationships for Discrete Compounding

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 Nominal and Effective Interest Rates
i = (1+r/M) M - 1
Where:
r = nominal interest rate annually
M = number of compounding periods per year
i = effective interest rate annually
Ex: r=16.5%,
r=16 5% M=12 (Montly),
(Montly) i=?
Solution:
i = (1 + 0.165/12)
0 165/12)12 -1 = 0.1781
0 1781 or 17.81%/year
17 81%/year
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