Centre for Management of

Technology and Entrepreneurship

University of Toronto

Time Value of Money -

Part A

Copyright: Joseph C. Paradi

1996-2003

Centre for Management of Technology and Entrepreneurship Course: CHE349

File: CHE349/TimeValueMoneyA2
Value and Utility Economic
Concepts
Value: a measure of the worth a person ascribes to a
good or service
The value is inherent in what someone wants to pay for it
Value and cost are not the same!
The cost of production, the price asked and the price paid are
connected, but they are not the same
Value changes from person to person
Utility: is a measure of the power of a good or service to
satisfy human wants
As in value it is the person who sets it
The satisfaction derived is the utility
Value is utility to a person in terms of money

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Life Cycle Costs
All things have a life cycle from new to obsolete
(physically, economically, technologically etc.)
100

75
Percent Cost
Committed

50

DESIGN OPERATIONS
25

LIFE CYCLE
0
Detailed Design & Production Product/System use
Conceptual Design
Development and/or Phaseout/Disposal
Construction
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Decisions usually involve
tradeoffs
Frequently, engineers must evaluate tradeoffs between a
number of factors:
time
money
quality
In the end it is a Cost/Benefit decision and answers the
question:
"What's in it for me?"
If that answer is "enough" then the deal is on.
The major consideration is the time value of money and
this will hinge on the cash flow from the investment
Hence, TIME and VALUE are most important.
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Some key definitions
Horizon - the time interval for the project
Interest - rate of "rent" the lender offers money or the
required return on an investment
First Cost - the cost incurred at the start of the project
Future Cost/value - the value at the end of a period
Operations and maintenance (O&M) - annual expense,
can include ; electricity, labour, repairs, etc.
Salvage value(s) - receipt/cost at project termination
Revenues/Income - annual receipts due to sale of
products or services
Overhauls - major capital expenditure that occurs part
way through the life of the asset
Prepaid expenses - annual expenses, such as leases and
insurance payments, that must be paid in advance
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Interest and interest rate
Engineering decisions involve comparing the costs and
benefits that occur in different time periods
Invest in a project today and get the benefits in the future
Interest
Having money today is preferable than having the same amount
one year later - interest is compensation for loss of use of cash
Interest rate
Is the percentage that borrowed money will cost
If you have the choice of having $100 today or $100 a
year from now, most would prefer the money today.
You could buy a machine and use it to make money from the
initial investment, or invest it elsewhere.
Investment opportunity is lost (or diminished) if the
funds are not available until next year.
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Cash Flows and Timing
Timing is very important in calculating cash flows
because inflows and outflows must be matched carefully.
So, in compound interest calculations the assumption is
that the current balance includes accrued interest that
has not been paid as well as the remaining principal
amount
We can compare different loans using the compound
interest calculation
Interest periods: Semi-annual; Quarterly; Monthly; Weekly
(seldom used); Daily (bank accounts); Continuous

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Present and Future Worth
P= amount of money today
F= future amount
i= interest rate
F=P+I
F=P+Pi
F=P(1+i)

I
1 Period
P P F
Interest rate i

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

An Example - 2.1 in text
Samuel bought a 1 year GIC from the bank
he LENT them the money for a fixed time period
The bank paid 10% interest
Sam will get $500 as "rent" for lending the $5,000
This is a simple interest loan
therefore he receives the money when the GIC MATURES
MATURE means that the borrower must pay the loan back
Why would the bank want to borrow money from Sam?
They will have lent it out at some higher percentage (interest rate)
to someone else
the difference between what they paid Sam and what they
charged the borrower is the MARGIN they make.
Example: F=5,000(1+0.1) = $5,500
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Simple vs. Compound interest
Therefore, simple interest is calculated as:
F = P(1+Ni) - not really usable in EE
Compound Interest is:
F = P(1+i)N
interest rate per compounding period = i
number of periods during the term = N
amount of money invested = P
residual payment at the end of the term = F
usually the same as the principal, but could be very different
Loans are often for several periods

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Graphically - Simple vs.
Compound interest
800
Interest = 10% per annum
700

600

500

400
Compound interest
300

200
Simple interest
100

0
5 10 Years 15 20
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Compound Interest - see
Table 2.1 in text
Beginning of Amount Interest Amount
Period Lent Amount Owed at
Period End
1 P Pi P(1+i)

2 P(1+i) P(1+i)i P(1+i)2

3 P(1+i)2 [P(1+i)2]i P(1+i)3

N P(1+i)N-1 [P(1+i)N-1]i P(1+i)N

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Example 2.2
You lend $100 for 3 years at 10% interest compounded
annually. How much interest would you get at the end of
the three years? What about for compound interest??

Beginning Amount Interest Amount owed at

of year lent earned year end
1 100 100x0.1 110.00
2 110 110x0.1 121.00
3 121 121x0.1 133.10

Total interest earned will be $33.10

Ic = P(1+i)N-P = compound interest
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
The power of compounding
In 1626, Dutch West Company paid $24 to purchase
Manhattan Island from the Native Americans. If the
company had invested the $24 in a savings account that
earned 8% interest per annum, how much would it have
been worth in 2000?
P = $24, i = 8%, N = 374 years

Simple F = $24 [1 + (0.08*374)]=$742

Compound F = $24(1 + 0.08)374 = $75.9 trillion

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Interest Period
Interest rates are typically stated for some period, almost
always for a year, but the computation of interest may be
based on shorter compounding sub-periods like months.

The base unit of time over which an interest rate is

calculated.
6% per year
6% per year compounded semi-annually
6% monthly, compounded monthly
6% compounded daily

The longer the interest period, the higher the interest

rate must be to provide the same return.
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Nominal and Effective Interest
Rates
The difference between these two terms is the frequency
of compounding in a time period
Given a 10% per year interest, compounded monthly, but
paid yearly. What is the effective interest rate?
In effect, we have 10/12% per compounding period
The formula is: i=(1+r/m)N*m - 1 Where:
i = effective interest rate
r = nominal interest
m = number of compounding periods in a year
N = number of years
Simple interest = 10%, Effective interest for our example
= 10.47% or [(1+0.1/12)12-1=0.1047]
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Nominal Interest Rate - r
Calculated by:
multiplying interest rate per compounding period
by # compounding periods per year
Assume a time period is divided into m equal sub-
periods. There is a stated nominal interest rate, r for the
full period.
By convention, the interest rate for each sub-period is:
is = r/m
A nominal interest rate of 18%/year, compounded
monthly, is the same as 0.18/12 = 0.015 or 1.5% per
month
Take care with this - it is a crucial concept!
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Effective Interest Rate - ie
Actual, but usually not stated rate, found by converting a
given interest rate with an arbitrary compounding period
(normally < 1 year) to an equivalent interest rate with a 1-
year compounding period
To compute an effective interest rate, given a nominal
rate and the number of compounding periods per year:
r m
ie (1 ) 1
m
But note that this formula is only suitable for converting
from a nominal rate r to an annual effective rate. To
calculate effective interest rates for a longer period, use:
ie = (1 + is)m - 1
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Continuous compounding
As the periods get smaller (Year, month, day ..) the
calculations get more and more tedious.
We can develop a compounding formula from:
ie = (1 + is)m - 1
By allowing the compounding periods to become
infinitely large:
r m
ie lim (1 ) 1
m m
But noting that the natural exponential function e is:
r m
lim (1 ) 1 e r

m m
Then we end up with: ie = er - 1

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Example - Credit Cards
18%/year, compounded monthly
For a $1000 balance at the beginning of the year, find the effective
annual interest rate and total owed at the end of the year.
Assume you make no payments throughout the year.
r m
ie (1 ) 1
m
12 compounding periods/year, m = 12
r/m = 18%/12 = 1.5%/month
ie = (1+0.015)12-1 = 0.1956 = 19.56%
F = $1,000(1.1956) = $1,195.60
F = P(F/P,i ,N)
Two options:
i per month, and N in months
ie (per year) and N in years

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Example - Car Loan
What are the monthly payments on a 5-yr car loan of
$12,500 at 12% /yr compounded monthly?
Nominal interest rate = 12%/yr
Interest rate/period = 12%/yr/12 mo/yr= 1.0%/mo
No. interest periods = 5 yrs * 12 mo/yr = 60
A = P(A/P,I,N) = $12,500(A/P,1%,60) = $277.50

How much will you pay?

60 * $277.50 = $16,650

How much interest will you pay? $4,150

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Example - Annuity
Annuity is a plan to invest a fixed sum now and arrange
for equal withdrawals some time later.

If you deposit $10,000 today, what equal amounts can

you withdraw at the end of each quarter for the next 4
years, when the nominal interest rate is 10%
*compounded quarterly*

P = $10,000
Withdrawals form an annuity where n = 16 and i = 10%/4
quarters = 2.5%/period
A = $10,000(A/P, 2.5, 16) = $10,000(0.07660) = $766

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Example - Loan
A loan of $1000 is made today under an arrangement
that $1400 will be received in payment in the future.
When should the $1400 be received if the loan is to earn
interest at 8% compounded quarterly?
P = $1000, F= $1400
i=r/m = 8%/4 = 2% */quarter*
Find n (in quarters)
F/P = $1400/$1000 = 1.4
F/P factor, n = 17 quarters (from tables)
or ie = (1+0.08/4)4-1 = 0.082
Interpolate between 8% and 9% tables, n between 4 and 5
years (F/P, 8.2, n) = 1.4
Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Example - Market investment
Continuous Compounding
Nominal rate 18% compounded continuously
What is effective interest rate?
ie = e0.18-1 = 1.1972-1 = 0.1972 = 19.72%

Continuously

Monthly

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Categories of Cash Flows
First/Capital Cost expense to build or to buy and install
Operation and Maintenance (O&M) Cost annual
expense, e.g., electricity, labour, repairs
Salvage Value(s) receipt at project termination for
disposal of equipment (can be a cost)
Revenues annual receipts due to sale of products or
services
Overhauls major capital expenditure that occurs part
way through the life of an asset
Prepaid Expenses annual expenses, such as leases and
insurance payments that must be paid in advance

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Cash Flows and Timing
Timing is very important in calculating cash flows
because inflows and outflows must be matched carefully.

So, in compound interest calculations the assumption is

that the current balance includes accrued interest that
has not been paid as well as the remaining principal
amount

We can compare different loans using the compound

interest calculation

Now lets see what this looks like

Centre for Management of Technology and Entrepreneurship Course: CHE349 #
Four loan types - amounts
owed illustrations
Cash flows for the four loans:
Yr0 Yr1 Yr2Yr3 Yr4 Yr5
Business +1,000 -1,610.51

Bond +1,000 -100 -100 -100 -100 -1,100

Consumer +1,000 -263.80

Equal payments each year

Constant +1,000 -300 -280 -260 -240 -220

Principal Payment

Centre for Management of Technology and Entrepreneurship Course: CHE349 #

Summary
Life cycle costs consider all costs over the life cycle of a
project or investment, thus it is a complete statement of
the cost of a product, system or structure.
Interest is an amount charged for the use of money by
those who have saved.
The relationship between interest and time leads to the
concept of the time value of money.
Investment in producer goods that increase productivity
leads to the concept of the earning power of money.
A dollar today is worth more than a dollar in the future
Inflation and deflation act to alter the purchasing power
of money.
Centre for Management of Technology and Entrepreneurship Course: CHE349 #