Time Value of Money

Supplemental Reading, Chapter 3 and 4 in

Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000
© Nishant Balakrishnan, 2020
Learning Objectives
• Understand the concept of the time value of money and have a
knowledge of both the reason it exists and the factors that cause it.
• Be able to solve simple projects that use both simple and compound
interest.
• Be able to understand and apply the concept of discounting correctly
and evaluate its effect on the valuation of a lump sum or a simple
series of payments.
• Fundamentally: understand that transactions that involve time as an
aspect are to be approach differently than those that don't
What is money?
• Originally meant to serve as a stand in for bartering (commodity
money for example), meant to represent fixed value.
• Allows for exchange without encumbrance
• Allows for storing money and value at a later time
• Fiat Currency – currency that has no use value or commodity value
• Ex: what does a coin cost to make? What does a $20 bill cost to make?
• Two different causes for variance: purchasing power and interest
 Value Change Over Time

Image ref: https://www.bbc.com/news/business-52350082

Image ref: https://goldprice.org/gold-price-history.html
Image ref: https://www150.statcan.gc.ca/n1/daily-quotidien/140221/dq140221a-eng.htm
 Value Change Over Time

Image ref: https://www.bbc.com/news/business-52350082

Image ref: https://goldprice.org/gold-price-history.html
Image ref: https://www150.statcan.gc.ca/n1/daily-quotidien/140221/dq140221a-eng.htm
 Time Value of Money
• Historical precedent has established that you can make money via
lending/borrowing
• Interest rate, determines how much this is valued at
• Risk vs. interest rate
• Examples of simple rates:
• Bonds
• Stocks and Mutual Funds
• Bank savings rates
• Rates typically vary, typically are positive
• Relationship to the “Do Nothing Option”
• Example of current rates?
 Time Value of Money
• Simple Interest
• Interest applied ONLY to original sum
• Never calculated on accrued interest

• Where: P = present sum, i = interest rate/period,

n = # of time periods

• Total money after ‘n’ periods (F):

• Or F=P(1+in), where: F = future sum

Example 1
Problem:
You have agreed to lend a friend $5,000 for five years at a
simple interest rate of 8%. How much interest will you
receive from the loan and how much will your friend pay
you at the end of the five years?
Time Value of Money
• Compound interest

• Interest calculated on accumulated amount and not

simply original amount
• “Interest on top of interest”
• Normally used in calculations
• The more frequently interest is assessed, the more it is
considered to “compound”
• Compounding can occur at different intervals (days,
weeks, months, years, etc…)

Note: Simple interest is not used unless stated otherwise

Example 2

Problem:
You have agreed to lend a friend $5,000 for five years at a
compound interest rate of 8%. How much interest will
you receive from the loan? How much will your friend pay
you at the end of the five years?
 Example 2

Image Ref: Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018).
Engineering Economic Analysis (4th Canadian edition). Oxford University Press.
Single Payment Compound Interest
Formulas
• Notation:
• i = interest rate per period
• n = number of interest periods
• P = present sum of money
• F = future sum of money
• If ‘n’ is in years:
• Future amount at end of year one would be:
• F = P(1+i)
• After two years, future amount at end of year two would be
additional interest on year one’s total:
• F = P(1+i) + i P(1+i) = P(1+i)(1+i) = P(1+i)2
 Single Payment Compound Interest
Formulas

• Generalizing: F = P(1+i)n

or the compound interest tables method:

F = P(F/P, i, n)

Image Ref: Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018).
Engineering Economic Analysis (4th Canadian edition). Oxford University Press.
Example 3

Problem:
You have agreed to lend a friend $1,000 for five years at a
compound interest rate of 10%. How much do they owe
you after 1 year, 2 years, what about 10 years?
Compounding Periods
Compounding Periods
Effective
Yearly
Continuous

Monthly

Yearly
 Compounding Periods
• Higher rates of compounding are equivalent to a higher
interest rate compounded less frequently
• To find equivalent yearly rate:
• Determine Nominal Rate, and the Period (M) for the nominal rate.

Effective Interest = (1+ is)M – 1,

Where, is = (Nominal Rate / M)

• Example: a loan is provided but the rate is stated as 12%

per year (nominal), compounded monthly. What is the
effective interest rate?
Compounding Periods

Interest Compounding Use interest

Interest rate example Interest rate type
period sub-period rate as is

i = 12% per year, compounded yearly Year Year Effective (ia = i) YES

i = 12% per year Year Year Effective (ia = i) YES

i = 12% Year Year Effective (ia = i) YES

i = 12% per year, compounded quarterly Year Quarter Nominal ( r ) NO

i = 12%, compounded quarterly Year Quarter Nominal ( r ) NO

i = 3%, per quarter, compounded yearly DOES NOT EXIST!

 Examples – Time Value of Money
Problem: A company is looking to provide seed funding to spin off a small
startup. The startup is asking for $140,000 and is willing to pay it back in 5
years at a nominal interest rate of 7% per year compounded monthly. How
much does the startup have to pay back for the loan to break-even?
 Examples – Time Value of Money
Problem: As you're walking through University Centre, a person approaches you to
talk about a great student credit card. Their card offers a nominal interest rate of
22.6%, compounded daily on any balance that isn't paid off at the end of the
month. The sales rep mentions how you could easily buy the tablet that's in the
bookstore window on sale for $2355 and as long as you pay it back by the end of
the year there's no interest (otherwise you pay full interest for the year). If you
bought it on credit, how much you owe at the end of the year if you couldn't make
the payment?
 Examples – Time Value of Money
Problem: A business student is looking to create a startup and comes to you with a
fairly astonishing proposal. He's willing to give you 40% return on your investment
if you can fund his startup. You realize he means that he is talking about a total
gain of 40% over the term and that he'll pay you back after 8 years. What interest
rate is he actually offering you (yearly)?
 Examples – Time Value of Money
Problem: Your company has the option to invest in a variety of investments with a
$11,000 surplus it has this year. It can invest in bonds of $3000 in value (can't be
bought for less) that average 7% interest per year and are for a period of 8 years
(can't be redeemed sooner), and can put the rest in mutual funds at an expected
return of 6% per year. If you are willing to invest the money for 10 years, how
much would you expect to make and how would you split up the investment?
 Discounting
• Companies typically don't borrow their money from a bank
to fund a project, capital comes from:
• Investors
• Earnings based on existing capital
• Other projects you can invest in
• This leads to discounting:
• Money today can be spent on what you intend to spend it on, or
other items that provide returns
• Opportunity Cost
• Money spent today is usually more valuable than money
coming back tomorrow
 Discounting
Example: Dave typically gets 4.5% return (yearly compounding) for any
money he puts in his mutual funds. You have a cool idea to farm
microgreens but are cash-poor and idea-rich. You ask Dave to borrow
$500 to fund your greenhouse, and you'll pay him back after you get up
and rolling. How much has Dave actually given you, if you pay him back
after: 1 Month? 1 Year? 3 Years?
 Discounting
• Companies typically are limited in the amount of capital they
have and can invest with
• This means most companies have an expectation for liquid
cash to be investable.
• Money that isn't being spent on projects and gaining
returns: why not invest?
• Some examples of discount rate basis:
• Standards and Poor's Fund (S&P 500)
• WACC (Weighted Average Cost of Capital)
• CAPM (Capital Asset Pricing Model)
• COC (Cost of Capital)
• Cost of capital or discount rate can vary widely depending
on the type of company and it’s financial structure.
 Discounting
Example: An engineering company who has a discount rate
of 5% is deciding on the profitability of a project. A new
engineer preps a report and shows that the overall cost of a
project is $10,000 today and is expected to return $13,000 5
years later. Is this project profitable?
 Discounting
Example: An engineering company who has a discount rate
of 5% is deciding on the profitability of a project. A new
engineer preps a report and shows that the overall cost of a
project is $10,000 today and is expected to return $6000 next
year and $ 7000 2 years later. Is this project profitable?
 Discounting - Dangers
• Discounting relies on the assumption that your discount rate
can be achieved regardless of your specific project
• Some Issues?
• Economic downturn
• Mediocre product returns
• Increase in costs
• Example: An engineering company who has a discount rate
of 5% is deciding on the profitability of a project. A new
engineer preps a report and shows that the overall cost of a
project is $10,000 and is expected to return $13,000 5 years
later. Is this profitable? What if the discount rate increases
by 1 full percent?
 Discounting - Dangers
Example: An engineering company who has a discount rate of 5% is deciding on
the profitability of a project. A new engineer preps a report and shows that the
overall cost of a project is $10,000 and is expected to return $13,000 5 years later.
Is this profitable? What if the discount rate increases by 1 full percent?
 Examples – Discount Rate
Problem: Your company is looking to invest some money in renovating the floors
of their production facility. The vendor has some flooring available now at a
discount price of $10,000. You can alternatively wait 10 years until your current
floor has fallen apart and can buy the flooring at the regular price of $15,000. If
your cost of capital is 4.5%, should you buy the flooring now or later from a purely
economic standpoint?
 Examples – Discount Rate
Problem: You have an issue in your plant with a failing generator. You are offered
a fix for the generator today that costs $5000, and $5000 again in five years to
have it last a total of 10 more years, or you can spend money on a refurbished
generator unit that lasts ten years. If you want both options to cost the same
(today) what would you would pay for the refurb generator? Your cost of capital is
4.5%.
 Examples – Discount Rate
Problem: An engineering project you are pitched costs $100,000 and is expected
to return $75,000 of that next year and have a salvage value of $35,000 ten years
from now. What is the lowest the discount for this to be profitable?
 Examples – Discount Rate
Problem: An investor pitches a project to you that costs your company $10,000 but
returns: $5000 in a year, $6000 in three years, $3000 in five years and $1000 in
ten years. If your cost of capital is 4.2%, is this project profitable? How much does
it make (in dollars, today)?
 The Benjamin Franklin Problem
Problem: Benjamin Franklin left a fund for the cities of Boston and Philadelphia for
the equivalent of £1000 Sterling (~5k CAD each) when he died. Conditions of this
gift – both cities must loan all of the money out at 5% interest rate (compounded
yearly) to “worthy” loans for 100 years. After 100 years, the cities can spend ¾ of
the total value of the fund (after collecting it all back). The rest (1/4 of the year 100
value) must be loaned out again for another 100 years. After the whole 200 years,
what would each city be left with?
Overview:
• By now you should:
• Understand the concept of the time value of money and have a knowledge of both
the reason it exists and the factors that cause it.
• Be able to understand how to work with compounding at different rates
• Be able to solve simple projects that use both simple and compound interest.
• Be able to understand and apply the concept of discounting correctly and evaluate
its effect on the valuation of a lump sum or series of payments.

• Fundamentally: understand that transactions that involve time as an

aspect are to be approach differently than those that don't
Time Value of Money
Module 2