Engineering Economics [CENG 5011]

Chapter 4

Time Value of Money

Lecture # 4

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Interest: The Cost of Money

A. Option 1: Single lump sum payment of 10 million Birr.

B. Option 2: Annual payment of 3 million for 10 years [total of 30 m]

Which one is better from a strictly economic viewpoint?

 Over time money can earn money = interest, therefore the earlier a
sum of money is received, the more it is worth

 Engineering projects are commitments of capital for extended periods

of time, therefore the effect of time on value of money must always
be considered.
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Interest Cont’d
 Used to designate a rental for the use of money.
 Same as the rental paid for the use of equipment, building etc.
 Usually expressed as a percentage of the amount owed.
 It is due and payable at the close of each period of time involved
in the agreed transaction [usually every year or month].

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Interest Rate [i]

 Rate of capital growth.

 Rate of gain received from an investment over a period of time.

 Usually expressed on an annual basis.

 For the lender, it consists, for convenience, of [1] risk of loss, [2]
administrative expenses, and [3] profit or pure gain.

 For the borrower, it is the cost of using a capital for immediately

meeting his or her needs.
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Time Value of Money [TVM]  Money- Time Relationships

 Means that two equal amount at different points of time do not
have equal value if the interest rate is greater than zero.
 Money has both earning power [it can be put in the bank to earn
interest] and purchasing power [Usually decreases over time:
inflation]
 Money has a time value because it can earn interest over time.
 One birr today is worth more than one birr tomorrow.
 Failure to pay the bills results in additional charge10/10/2013/14
termed interest.
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Interest [ I ] [Simple]
 Total interest is directly proportional to the amount of loan
[principal], the interest rate, and the number of interest periods

I = [P] [n] [i]

 I : total interest
 P : principal
 n : number of interest periods
 i : interest rate per interest period.
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Simple Interest [i] :- Example:

 If 1,000.00 birr is borrowed at 14% interest, then interest on the
principal of 1,000.00 birr after one year is 0.14 x 1, 000, or
140.00 birr.
 If the borrower pays back the total amount owed after one year,
she/he will pay 1,140.00 birr.

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Interest [i] [Compounded] Cont’d

 If someone does not pay back any of the amount owed after one
year, then normally the interest owed, but not paid, is considered
now to be additional principal, and thus the interest is
compounded
 After two years she will owe 1,140.00 birr + 0.14 X 1,140.00, or
1,299.60.

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Economic Equivalency
 The banker in the previous example normally does not care
whether you pay him 1,140.00 birr after one year or 1,299.60 birr
after two years.
 To him, the three values [1,000, 1,140, and 1,299.60 birr] are
equivalent.
 1,000 Birr today is equivalent to 1,140 birr one year from today
and 1,000 Birr today is equivalent to 1,299.60 Birr two years from
today.
 NB: The three values are not equal but equivalent
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Economic Equivalency Cont’d

 It is to be noted that:

1. The concept of equivalence involves timing of money, amount

of money receipt/expenses and a specified rate of interest.

 The three preceding values are only equivalent for an interest rate

of 14%, and then only at the specified times.

2. Equivalence means that one sum or series differs from another

only by the accumulated interest at rate i for n periods of time.

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Cash Flow Diagram

 It is strongly recommended for situations in which the analyst
needs to visualize what is involved when flows of money occur
at various times.
 The usefulness of cash flow diagram for economic analysis
problems is analogous to that of the free body diagrams of
Engineering mechanics problems.

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Cash Flow Diagrams

 P = a present single amount of money

 F = a future single amount of money, after n periods of time
 A = end-of-period cash flows in a uniform series for a specified number
of periods, starting at the end of first period and continuing through the
last period.
 i = the rate of interest per interest period [usually one year]
 n = the number of periods of time [usually years]
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Cash Flows Over Time: Example

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In a cash-flow diagram:
 Horizontal line represents time scale,
 Arrows represent cash flows.
 Downward arrows represent expenses [negative cash flows or
cash outflows] and upward arrows represent receipts [positive
cash flows or cash inflows].
 The CFD is dependent on the point of view. In the course, without
explicitly mention, the company’s [investor’s] point of view will
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Cash-Flow Diagram Cont’d

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Example [CFD]
 You are analyzing a project with five-year life. The project
requires a capital investment of $50,000 now, and it will
generate uniform annual revenue of $6,000. Further, the project
will have a salvage value of $4,500 at the end of the fifth year
and it will require $3,000 each year for the operations.
 Develop the cash-flow diagram for this project from the
investor’s viewpoint.
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Example [CFD]: Solution

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Rules for performing arithmetic calculations with cash flows

[Three Rules]

1. Cash flows cannot be added or subtracted unless they occur at

the same point in time.

2. To move a cash flow forward in time by one time unit, multiply

the magnitude of the cash flow by [1 + i].

3. To move a cash flow backward in time by one time unit, divide

the magnitude of the cash flow by [1 + i].
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Financial Engineering Analysis [Single Payment Series]

1. Single Payment Compound-Amount Factor [SPCAF]:

OR

Find F When P is
given

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Financial Engineering Analysis [Single Payment]

2. Single Payment Present-Worth Factor [SPPWF]: Find P when F
is given;

OR

 Notation: P = F [P/F, i%, N] where the factor in the parentheses

is read "find P given F at i% interest per period for N interest
periods.
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Single Payment Analysis

 To calculate the future value F of a single payment P after n
periods at an interest rate i, we make the following calculation:

 At the end of the first period: F1 = P + Pi = P[1+i]

 At the end of the second period: F2 = P + Pi + [P + Pi]i = P[1 + i]2

 At the end of the nth period: Fn = P[1 + i]n

 The future single amount of a present single amount is F = P[1 +

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i]n
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Single Payment Analysis

 Note: F is related to P by a factor which depends only on i and n.
 This factor, termed the single payment compound amount factor
[SPCAF], makes F equivalent to P.
 SPCAF may be expressed in a functional form;

 The present single amount of a future single amount is;

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Single Payment Analysis

 Note: The factor 1/[1+i]n is called the present worth compound
amount factor [PWCAF]

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E.G 1: [Single Payment Analysis]

 A contractor wishes to set up a revolving line of credit at the bank to
handle his cash flow during the construction of a project.
 He believes that she needs to borrow12,000 Birr with which to set up
the account, and that he can obtain the money at 1.45% per month.
 If he pays back the loan and accumulated interest after 8 months, how
much will she have to pay back?
 F = 12,000[1 + 0.0145]8 = 12,000[1.122061]= 13,464.73 =13,465 Birr.
 The amount of interest will be:13,465 - 12,000 = 1,465 Birr.
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E.G 2: [Single Payment Analysis]

 A construction company wants to set aside enough money today
in an interest-bearing account in order to have 100,000 Birr five
years from now for the purchase of a replacement piece of
equipment.
 If the company can receive 8% interest on its investment, how
much should be set aside now to collect the100,000 Birr five
years from now?
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 E.G 2: Solution
 P = 100,000/[I + 0.08]5 =100,000/[1.46933] = 68,058.32 Birr =
68,060 Birr
 To solve this problem you can also use the interest tables.
 P = 100,000 [P/F, 8%, 5] = 100,000[0.6805832] 68,058.32 Birr=
68,060 Birr.

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Uniform/Equal Payment Series

 Often payments or receipts occur at regular intervals, and such
uniform values can be handled by the use of additional functions.
 Another symbol: A = uniform end-of-period payments or
receipts continuing for a duration of n periods
 If a uniform amount A is invested at the end of each period for n
periods at a rate of interest i per period, then the total equivalent
amount F at the end of the n periods will be:
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Uniform Payment Analysis

 By multiplying both sides of above equation by [1+i] and

subtracting from the original equation, the following expression
is obtained:
 Which can be rearrange to give

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Uniform Payment Analysis

3. Uniform [Equal payment] Series Compound-Amount Factor

[USCAF]: Find F when A is given;

OR

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Uniform Payment Analysis

4. Uniform [Equal payment] Series Sinking-Fund Factor [USSFF]:

Find A when F is given;

OR

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Uniform Payment Analysis

5. Uniform [Equal payment] Series Capital-Recovery Factor

[USCRF]: Find A when P is known;

OR

Note: This is the case of loans [mortgages]

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Uniform Payment Analysis

6. Uniform [Equal payment] Series Present-Worth Factor

[USPWF]: Find P when A is given;

OR

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Cash Flow Diagram for Single Payment

Cash Flow Diagram for Uniform Payment

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Uniform Gradient Payment Series : involve receipts or

disbursements that are projected to increase or decrease by a
uniform amount each period thus contributing an arithmetic
series.
 Linear Gradient Example:

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 Example: Linear Gradient typical negative, Increasing Gradient:

G = $50.

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Arithmetic Gradient Factors

 The “G” amount is the constant arithmetic change from one time
period to the next.
 The “G” amount may be positive or negative!
 The present worth point is always one time period to the left of
the first cash flow in the series or,
 Two periods to the left of the first gradient cash flow!

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Derivation: Gradient Component Only: Focus Only on the

gradient Component.

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The Present worth point of a linear gradient is always:

 2 periods to the left of the “1G” point or,
 1 period to the left of the very first cash flow in the gradient
series.

DO NOT FORGET THIS!

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 Gradient Component

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Cont’d
 PW of the Base Annuity is at t = 0
 PW Base Annuity= $100 (P/A,i%,7)

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Present Worth [PW]: Linear Gradient

 The present worth of a linear gradient is the present worth of the
two components:

1. The Present Worth of the Gradient Component and,

2. The Present Worth of the Base Annuity flow

 Requires 2 separate calculations!

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Cont’d
 The PW of the Base Annuity is simply the Base Annuity: A{P/A, i
%, n} factor
 What is needed is a present worth expression for the gradient
component cash flow.
 We need to derive a closed form expression for the gradient
component.

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General CF Diagram – Gradient Part Only

 To Begin- Derivation of P/G, i%, n

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Cont’d
 Factor out G and re-write as ….. Factoring G out…. P/G factor

 What is inside of the { }’s?

 Replace (P/F’s) with closed-form

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 Multiply both sides by (1+i)

 We have 2 equations [1] and [2].

 Next, subtract [1] from [2] and work with the resultant equation.

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The P/G factor for i and N

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The A/G factor

 Some authors also include the derivation of the A/G factor.
 A/G converts a linear gradient to an equivalent annuity cash flow.
 Remember, at this point one is only working with gradient
component.
 There still remains the annuity component that you must also
handle separately!

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The A/G Factor Cont’d

 Convert G to an equivalent A; How to do it…………
  A/G factor using A/P with P/G

 The results follow…..

 Resultant A/G factor

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Gradient Example: Consider the following cash flow

 Base Annuity: First, The Base Annuity of $100/period

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 PW(10%) of the base annuity = $100(P/A,10%,5)

 PW Base = $100(3.7908)= $379.08
 •Not Finished: We need the PW of the gradient component and
then add that value to the $379.08 amount.
  Focus on the Gradient Component

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 We desire the PW of the Gradient Component at t = 0

 The Set Up

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 Calculating or looking up the P/G,10%,5 factor yields the

following:
  Pt=0 = $100(6.8618) = $686.18 for the gradient PW
 Final Result
 PW(10%)Base Annuity = $379.08
 PW(10%)Gradient Component = $686.18
 Total PW(10%) = $379.08 + $686.18 = $1065.26

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 Note: The two sums occur at t =0 and can be added together: -

concept of equivalence
  Example Summarized; This Cash Flow…
 

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Shifted Gradient Example: i =10%; Consider the following

Cash Flow

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1. This is a “shifted” negative, decreasing gradient.

2. The PW point in time is at t = 3 (not t = o)

 The base annuity is a $600 cash flow for 3 time periods

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 PW of the Base Annuity: 2 Steps

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 PW of Gradient Component: G = -$50

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E.G 3: You plan to deposit $2,000 to your savings account at the

end of every month for the next 15 months starting from the next
month. If the interest rate you can earn is 2% per month how
much money will accumulate immediately after your last deposit
at the end of the 15th month?
 Solution: A = $2,000, i = 2% per month, N = 15 months.
 F =?

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E.G. 4: What uniform monthly amount should you deposit in

your savings account at the end of each month for the following
10 months in order to accumulate $75,000 at the time of the 10th
deposit? Assume that the interest rate you can earn is 4% per
month and the first deposit will be made next month.
 Solution: F = 75; 000, i = 4% per month, N = 10 months.
 A =?

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E.G 5: How much should you deposit to your savings account

now at an annual interest rate of 10% to provide for 5 end-of-
year withdrawals of $15,000 each?
 Solution: A = 15; 000, i = 10% per year, N = 5 years.
 P =?

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E.G 6: You plan to borrow a loan of $100,000 which you will

repay with equal annual payments for the next 5 years. Suppose
the interest rate you are charged is 8% per year and you will
make the first payment one year after receiving the loan. How
much is your annual payment?
 Solution: P = 100; 000, i = 8% per year, N = 5 years.
 A =?

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E.G. 7: A machine cost $45,000 to purchase. Fuel, oil,

grease [FOG], and minor maintenance are estimated to cost

$12.34 per operating hour [those hours when the engine is

operating and the machine is doing work]. A set of tires

cost $3,200 to replace, and their estimated life is 2,800 use

hours. A $6,000 major repair will probably be required after

4,200 hr of use.
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E.G. 7 Cont’d
 The machine is expected to last for 8,400 hr, after which it
will be sold at a price [salvage value] equal to 10% of the
original purchase price. A final set of new tires will not be
purchased before the sale. How much should the owner of
the machine charge per hour of use, if it is expected that the
machine will operate 1,400 hr per year? The company's cost
of capital rate is 15%.
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 First solve for n, the life;

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Solution

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End of Chapter 4

Time Value of Money

Lecture # 4

Thank You All!!!

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