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Power Economics and Management Contents

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2nd Semester, 3rd Year (13EL) Fundamental Concepts

B.E Electrical Engg. Program Time Value of Money
Simple Interest
Compound Interest
Nayyar Hussain Present and Future Value
Assistant Professor Rate of Return
Risk and Uncertainty
Lecture 17
Department of Electrical Engineering
Mehran University of Engg. & Technology,
Jamshoro

Fundamental Concepts Time Value of Money

 Cash flows — fundamental to finance, the funds
that flow between parties either now or in the
future as a consequence of a financial contract.
 Rate of return — relates cash inflows to cash
outflows.
 Time has a value
 Ifwe owe, we would prefer to pay money later
 Ifwe are owed, we would prefer to receive money
sooner
Money received now can be invested to earn additional cash


in the future.
 Interest rate — special case of rate of return (used  Relates to opportunity cost of giving up money or resources for
when the financial agreement is in the form of a period of time — either forgone investments or consumption.
debt).  Consider time significance — significant amount of time may
elapse between cash outflows and inflows.
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 Cash flows that occur at different points in time cannot simply
be added together or subtracted —

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Simple Interest Simple Interest: Present Value

 Typically used when there is only a single  Present cash equivalent of an amount to be
time period. paid or received at some future date,
calculated using simple interest.
 Interest is calculated on the original sum invested:
Interest  Principal  P   periods  t   rate  r 
 Formula: where:
S P  present value
P
Where S is the lump sum payable:
1  rt 
S  payment at future date

S  P  Ptr  P 1  rt 

r  applicable interest rate
t  number of periods before payment

Compound Interest Compound Interest (cont.)

 The backbone of many time-value calculations are the present
 Compounding involves accumulating interest value (PV) and future value (FV) based on compound interest.
on previous interest payments.
 This means that, unlike the case of simple  The sum or future value (S ) accumulated after
interest, previous interest payments will n periods is:
generate further interest. S  P 1  i 
n

 This earning of interest on interest is one of

the key differences between simple interest where:
and compound interest. i = rate per period
n = number of periods

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Compound Interest (cont.) Present and Future Values

 The future value formula can be manipulated to  Basic time value of money relationships:
provide a formula to determine the present
value. PV  FV  DF
FV  PV  C F
 The present value of a future sum is: w here PV = present value;
S FV = future value;
P
1  i  DF = discount factor = 1 /(1  R ) t
n

C F = compounding factor = (1  R ) t
 It is important to understand that the PV and FV R = interest rate per perio d; and
formulas are the inverse of each other — one is t = time in periods
derived from the other.

Present and Future Values (cont’d) Present and Future Values (cont’d)
 A present value is the discounted value of one or  Why is a dollar today worth more than a dollar
more future cash flows tomorrow?
 A future value is the compounded value of a  The discount factor:
present value  Decreases as time increases
 The discount factor is the present value of a dollar  The farther away a cash flow is, the more we discount it
invested in the future  Decreases as interest rates increase
 The compounding factor is the future value of a  When interest rates are high, a dollar today is worth much more
than that same dollar will be in the future
dollar invested today

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Rate of Return Example: Meaning of Rate of Return

Definition In 1970, when Wal-Mart Stores, Inc. went

public, an investment of 100 shares cost
A relative percentage method which measures $1,650. That investment would have
the annual rate of return as a percentage of been worth $12,283,904 on January 31,
investment over the life of a project. 2002.

What is the rate of return on that

investment?

Solution:
$12,283,904
Suppose that you invested that amount ($1,650) in a
savings account at 6% per year. Then, you could have
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0
only $10,648 on January, 2002.
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$1,650
What is the meaning of this 6% interest here?
Given: P = $1,650
F = $12,283,904
N = 32 This is your opportunity cost if putting money in savings
Find i: account was the best you can do at that time!
F  P (1  i ) N

$12,283,904 = $1,650 (1 + i )32

i = 32.13% Rate of Return

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Risk Versus Uncertainty

So, in 1970, as long as you earn more than 6%  Uncertainty involves a doubtful outcome
interest in another investment, you will take that
 What you will get for your birthday
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investment.
 If a particular horse will win at the track
Therefore, that 6% is viewed as a minimum attractive
rate of return (or required rate of return).  Risk involves the chance of loss
 Ifa particular horse will win at the track if you made a
bet
So, you can apply the following decision rule, to see
if the proposed investment is a good one.

ROR (32.13%) > MARR(6%)