Lecture 4

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Time Value of Money(Part 1)

Chapter 4
These slides prepared by Prof. Osama and modified by Eng. Mohammed
Ismaeel Shekfa
Sunday, October 09, 2011
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 Money- Time Relationships and
Equivalence

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Objectives:

1. Describe the return to capital in the form of interest or profit.

2. Illustrate how basic equivalence calculations are made with respect

to the time value of the capital in engineering economy studies.

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 Money- Time Relationships and
Equivalence
• Capital used in business (money, machines, materials, energy,…etc) may be classified
into two basic categories; equity capital and borrowed (debt) capital.

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• Equity capital is that owned by individuals investing their money in a business in the
hope of receiving a profit.

• Borrowed capital is obtained from lenders (e.g., through the sale of bonds) for
investment. In return, lenders receive interest from the borrowers.

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 Money- Time Relationships and
Equivalence

• Two reasons justify the return to capital in the form of interest or profit :

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1‐ Interest or profit pays the providers of capital for forgoing (giving up) its
use during the time the capital is being used.
2‐ Interest and profit are payments for the risk the investor takes in
permitting another person to use his capital.

• The return to capital should be equal or more than that gained in a similar‐
risk project.

• The interest or profit available from an alternative investment represents the

opportunity cost of using the capital in the proposed undertaking.

• Principles of time value (cost) of capital are vital to the proper evaluation of
engineering projects. 4
 Money- Time Relationships and
Equivalence

Simple interest

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I = (P) (N) (i) where:

I is the total interest earned or paid,

P is the initial amount lent or borrowed,
N is the number of interest periods ( e.g., years),
i is the interest rate per interest period.

• Notice that for simple interest , I is linearly proportional to P, N, and i.

• The total amount repaid at the end of N interest periods is: P + I .

• Simple interest is not used frequently in modern commercial practice.

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 Money- Time Relationships and
Equivalence
Compound interest
• In compound interest, 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 following tables and graph show the difference between simple and compound interest
for a principal amount of $ 1000 for a period of 3 years at an interest rate of 10%.
Simple
Period, (2) Amount owed at (3) = (2) x N x (i%) (4) = (2) + (3)
N, Years beginning of period Interest for period Amount owed at end of period
3 $ 1000 1000 x 3 x 10%= $300 $ 1300

Compound

Period, (1) Amount owed at
N, Years beginning of period
1 $ 1000
2 $ 1100
3 $ 1210
(2) = (1) x (i%) (3) = (1) + (2)
Interest for period Amount owed at end of period
1000 x 10%= $100 $ 1100
1100 x 10% = $110 1100 + 110 = $ 1210
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1210 x 10% = $ 121 1210+ 121 = $ 1331

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 Money- Time Relationships and
Equivalence

• Simple interest considers the time value of money but does not involve

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compounding of interest.

$ 1331
Amount owed, $
Compound interest
$ 1300

$ 1210
$ 1200

Simple interest
$ 1100
$ 1100

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1 2 3
End of interest period
 Money- Time Relationships and
Equivalence

The concept of equivalence

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• Alternatives, providing the same service or function, should be compared by
reducing them to an equivalent basis.

• This is affected by :
1‐ The amount of money involved.
2‐ The interest rate.
3‐ The timing of monetary received or expenses.
4‐ The manner in which the interest or profit is paid and the initial capital
recovered.

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 Money- Time Relationships and
Equivalence

• An example, if interest rate remains constant, at 1%, suppose that we have a

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$17,000 balance on the credit card. And deciding to repay the balance in four
months. Page 133 in the 13th edition illustrate three different scenarios.
• Plan one: payments will take place after the forth month. $17000x4=$68000 .
This is the total borrowing and 1%is $680

• Plan two: pay $4357.10 every month. From the table we say that total
interest on the principal is $427.10. this plan is less than plan 1 because the
principal is being paid every month.

• Plan three: no principal paid and no interest paid each month. There fore the
total amount borrowed is interest plus the accumulated principal with a total
of $69026.8. at 1% will be $690.27. this is the largest to be repaid.
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 Money- Time Relationships and
Equivalence
Important notation:

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i = effective interest rate per interest period.

N = number of compounding periods.

P = present sum of money, the equivalent value of one or more cash flows at
a reference point in time called the present.

F = future sum of money, the equivalent value of one or more cash flows at a
reference point in time called the future.

A = end of period cash flows, or equivalent end of period values, in a uniform

series continuing for a specified number of periods, starting at the end of
the first period and continuing through the last period. 14
 Money- Time Relationships and
Equivalence
Cash‐flow diagrams
• Cash flow diagrams help the analyst to visualize the flows of money occurring at

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various times.
• The following shows two cash flows representing alternatives 3 and 4 in the example
given in table 3‐1
F = $ 11713
A = $ 2524
0
0
1 2 3 4=N
1 2 3 4=N

P = $ 8000 Years i = 10% per year Years i = 10% per year

P = $ 8000

• The following conventions are employed in cash flow diagrams:

1‐ The horizontal line is a time scale.
2‐ The arrows signify cash flow and are placed at the end of period. Downward
arrows represent expenses ( negative cash flow or outflows).
Upward arrows represent receipts (positive cash flows or cash inflows).
3‐ The cash flow diagram is dependent on the point of view. As shown they
represent the view of lender. If direction of arrows is reversed they represent the 15
borrower view point.
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 Money- Time Relationships and
Equivalence

Interest formulas relating present and future equivalent values of

single cash flows:
Finding F when Given P
1 2 3
F = Future
Equivalent (Find)
i = Interest Rate per Period
0
1 2 3 N-2 N-1 N
If an amount P dollars is invested at Period
P = Present Equivalent (Given)
a point in time and i% is the interest
rate (profit or growth) per
period, the amount will grow to a future amount P +Pi = P (1+i) by the end of
one period, by the end of two periods the amount will be P (1+i)+ P(1+i)i  P (1  i) 2
And by the end of N period, the amount will grow to: F  P (1  i) N 17

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 Money- Time Relationships and
Equivalence
• The amount (1  i) N in the previous equation is called the single
payment compound amount factor .

• Numerical values for this factor are given in Appendix C for a wide range of
values of I and N (See your text book).

• (1  i) N can also be used in its functional form as (F/P, i%, N), thus equation
can be written F  P (1  i) N as F = P (F/P, i%, N).

• The factor in the parentheses is read “ find F given P at i% interest per

period for N interest periods”.

• The calculated amount of F , at the point of time at which it occurs, is

equivalent to (can be traded for) the known value ,P, at the point of time at
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which it occurs for the given interest, or profit rate.

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 Money- Time Relationships and
Equivalence

Finding P when given F

• As F  P (1  i), Nthis gives P  F (1  i) -N

• The quantity (1  i) -N is called the single payment present worth factor. Numerical
values for this factor are given in the third column of tables in Appendix C, in your text
book, for a wide range of I and N.

• In the functional form, the last equation can be written in the following form:

P = F (P/F, i% , N)

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