ENGM401 X1 2010 09 Lecture - 18 TimeValueOfMoney

ENGM 401 & 620 – X1
Fundamentals of Engineering Finance

Winter 2010
Lecture 18:
The Time Value of Money
“Many people take no care of their money till they come nearly to the end of it, and others
do just the same with their time.”
- Goethe
M.G. Lipsett
Department of Mechanical Engineering
University of Alberta
http://www.ualberta.ca/~mlipsett/ENGM401_620/ENGM401_620.htm

Engineering Management Group
Time
Time Value
Value of
of Money
Money
• We have to consider timing when making financial
decisions
• Consider that you have a choice to receive $1000 today or
$1000 five years from now
– Which would you choose? Why?
• One of the most important economics concepts is the time

value of money
• We use the concept of the time value of money to decide

whether to spend money on ways to make create value
– i.e., to invest or not to invest
ENGM 401 & 620 – Fundamentals of Engineering Finance,

© MG Lipsett, 2010 2 Lecture 18: Time Value of Money
1
PossibleCase
Possible CaseStudies
Studiesfor Time Value of Money
• Should we build a new plant now or two years from now?

Will it be economical to build and operate?
• How much should an oil sands operating company be
saving to reclaim an oil sands tailings pond thirty years from
now?
• How much will an LRT expansion cost?
• How fast should I pay off my student loan?
• Should I buy a new car or a used one?
• Other examples?


Why
Why Does
Does Money
Money Have
Have A Time Value?
a Time Value?
• Cash is:
– Liquid
• it doesn’t need to be converted to anything before it is used
– Available
• it can be used at once
– Relatively safe
• inflation and government stability are the risk factors
– Storable
• Money is subject to supply and demand forces like any

other commodity

2
Time
Time--Value
Time Value of
of Money
Money (3)
(3)
(3)
• Things change value over time
• Very few things increase in value
• Most things eventually lose value (even intangibles)
• Since money represents value, even cash is not worth as much

in the future as it is today

Monetary
Monetary Entropy
Entropy
• Recall the analogy of money as energy
– 1st “Law”: In an closed equilibrium system, money can be transformed
but not created or destroyed
• Assets = Liabilities + Equity
– 2nd “Law”: The value of a good can not maintained forever in a stable
or expanding economy
• Financial calculations thus have to account for time-value
What method have we already learned?

3
Why
Why Does
Does Money
Money Have
Have A Time Value?
a Time Value? (2)
(2)
• Interest is the cost of money.

– If you rent an apartment, you expect to pay for it.
– In the same way, you pay for money if you borrow or “rent” it
• The cost is related to:
• Another Way to Think of Time Value of Money:


Value
Value in
in the
the Eyes
Eyes of
of the
the Lender or Investor
Lender/Investor
• The lender or investor has a time value for money that is
specific to each investment and reflects:
• The time value must exceed the inflation rate if value is to

be created

4
Value
Value in
in the
the Eyes
Eyes of
of the
the Borrower
Borrower
• Some borrowing is for personal and non-monetary values
– e.g., home mortgages because we’d prefer a house to an apartment,
car loans because we like to have our own means of travel, etc.
• Some borrowing (commercial borrowing) is always based

on the belief that you can create value at a higher rate than
the cost of borrowing the money
– i.e., you create value that can be retained


The
The Concept
Concept of
of Interest
Interest
• The main principle of the concept of interest is that the cash
put in to the investment must yield a return (value) in every
time period (e.g., a month or a year)
– A dollar today will be worth more in the future, because if you
lend or invest it you expect to create value over time
– A future dollar is worth less today because you could invest a
lesser amount today and have the future dollar
Time Period
Return on investment:
Value
Extra value created
Today Future
5
The
The Concept
Concept of
of Interest
Interest (2)
(2)
• Some terms in investment analysis are used somewhat interchangeably
• The concept of interest is used more broadly than just payment for debt


The
The Historical
Historical Value
Value of
of Interest
Interest Rates
Rates
20
.
18
Bank of Canada Int. Rate
16
14
12
10
8
6
4
2
0
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
Year
Source: Statistics Canada

6
Federal Debt:
Federal Debt: One
One Source
Source of
of Demand
Demand for
for Money
Money
50,000
Federal Debt (M$)
Net Change in Canadian
40,000
30,000
20,000
10,000
0
-10,000
35
39
43
47
51
55
59
63
67
71
75
79
83
87
91
95
99
03
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
-20,000
Year


The
The Concept
Concept of
of Inflation
Inflation
• Inflation is the concept where as time moves forward, the
purchasing power of a unit of currency (money) decreases
– A dollar tomorrow will buy less than it does today
• In Canada, inflation is often measured by the Consumer

Price Index (CPI)
– CPI is the retail price of a representative “shopping basket” of
approximately 600 goods and services that the typical household will
purchase (food, housing, transportation, furniture, clothing,
recreation)
• Inflation is often higher in times of high interest rates

– One reason: long-term investment is less likely with high interest
rates, increasing the pressure and prices on short term purchasing

7
The
The Concept
Concept of
of Inflation
Inflation (2)
(2)
20
15
Annual Change in CPI
10
0
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
-5
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
-10
-15
Year
For wacky finance fun, try the inflation calculator at:

http://www.bankofcanada.ca/en/rates/inflation_calc.html Source: Statistics Canada


Causes
Causes of
of Inflation
Inflation
• Loss of confidence in a country’s currency
– Loss of investment in economy
– Investors move their money to another currency
• Governments printing too much money
• Prices rising to match inflation
• If government is not prudent, “positive feedback”

(vicious circle) can even lead to hyperinflation

8
Hyperinflation
Hyperinflation in
in Weimar
Weimar Germany
Germany
Weimar Inflation Rates: Cost of a Loaf of Bread in Berlin, 1918-1923
1E+12
1E+11
1E+10
1E+09
1E+08
1E+07
1E+06
Marks
100000
10000
A German woman
1000 feeding a stove with
currency notes, which
100 burn longer than the
amount of firewood
10 they can buy.
1
Dec-
0.1
Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec- Jun- Dec-
18 19 19 20 20 21 21 22 22 23 23
http://en.wikipedia.org/wiki/Hyperinflation

Real
Real vs. Market
versus Interest
Market Rates
Interest Rates
• The value of money increases over time, but at the same
time, its purchasing power becomes less
– Two competing forces
• The real interest rate realized by a lender is approximately

the difference between the interest rate paid by the
borrower (nominal
nominal or market interest rate) and inflation:

9
Real
Real Interest
Interest: Nominal Interest Minus Inflation
20
.
18
Bank of Canada Int. Rate

16
14
12
10
8
Nominal Interest Rate 6

4
2
0
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20 Year
15
Annual Change in CP I
10
Inflation Rate 5
0
25
30
35
40
45
50
55
60
65
70
75
80
85
90
95
00
05
-5
19
19
19
19
19
19
19
19
19
19
19
19
19
19
19
20
20
-10
-15
Year

Real
Real Interest
Interest:(2)
Nominal Interest minus Inflation
"Real" Interest Rate: Nominal
10.00
5.00
minus Delta CPI
0.00
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
-5.00
-10.00
-15.00
Year

10
Real Interest
Summary
• Things of value do not their value forever
• Even money is not worth as much in the future as it is today
• Interest is the “rent” on borrowing
– If I’m not going to have the use of my money for a while, I want to be
compensated for it
• Interest is affected by many factors
• Inflation tracks the loss of purchasing power of a currency
with time

11

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ENGM 401 & 620 – X1

Fundamentals of Engineering Finance

Department of Mechanical Engineering

• One of the most important economics concepts is the time

• We use the concept of the time value of money to decide

ENGM 401 & 620 – Fundamentals of Engineering Finance,

• Should we build a new plant now or two years from now?

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

• Money is subject to supply and demand forces like any

ENGM 401 & 620 – Fundamentals of Engineering Finance,

• Most things eventually lose value (even intangibles)

• Since money represents value, even cash is not worth as much

Department of Mechanical Engineering

• Financial calculations thus have to account for time-value

What method have we already learned?

ENGM 401 & 620 – Fundamentals of Engineering Finance,

• Interest is the cost of money.

• The cost is related to:

• Another Way to Think of Time Value of Money:

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

• The time value must exceed the inflation rate if value is to

ENGM 401 & 620 – Fundamentals of Engineering Finance,

• Some borrowing (commercial borrowing) is always based

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Source: Statistics Canada

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

• In Canada, inflation is often measured by the Consumer

• Inflation is often higher in times of high interest rates

ENGM 401 & 620 – Fundamentals of Engineering Finance,

For wacky finance fun, try the inflation calculator at:

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

• If government is not prudent, “positive feedback”

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Department of Mechanical Engineering

• The real interest rate realized by a lender is approximately

ENGM 401 & 620 – Fundamentals of Engineering Finance,

Bank of Canada Int. Rate

Nominal Interest Rate 6

Department of Mechanical Engineering

ENGM 401 & 620 – Fundamentals of Engineering Finance,

ENGM 401 & 620 – Fundamentals of Engineering Finance,

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