ENGINEERING ECONOMICS

1
TIME VALUE OF MONEY (TVOM)

• Money has a time value.

• The value of a given sum of money depends on both the amount
of money and the point in time when the money is received or
paid.
• Quantities of money cannot be added or subtracted unless they
occur at the same points in time.
• Due to the TVOM, we prefer to receive a fixed sum of money
sooner rather than later; likewise, we prefer to pay a fixed sum
of money later, rather than sooner.
 A CASH FLOW DIAGRAM (CFD) IS A TOOL TO
ILLUSTRATE THE TIMING OF RECEIPTS AND EXPENSES
OF MONEY FOR AN INVESTMENT

• Often shown from investor’s

viewpoint
• Upward arrow = income (+)
• Downward arrow = expense (-)

• x-axis = time
• Must indicate units of time!
– Days vs. years vs. decades, etc.
– Sooner money is received (income) = better!
– Later money is given (expense) = better!
• Size of arrows indicates size of money exchanged.
SIMPLE ILLUSTRATION OF TVOM

• Which cash flow is better for the investor?

• Is there a formal way to calculate that?
SIMPLE VS. COMPOUND INTEREST

• Simple interest applies whenever the period interest rate over

each period is applied to the original principal over periods to
calculate the total interest accrued :

• Compound interest applies whenever the accumulated interest

to date is ADDED to the principal at the beginning of each term
so that the period interest rate is applied to the sum of principal
plus accumulated interest over each period. (see next page.)
SINGLE PAYMENT FORMULA (COMPOUND INTEREST)

• Future Worth given Present Worth (F|P)

• Present Worth given Future Worth (P|F)

• Future worth = TVOM of periods in the future

• Present worth = TVOM of at the present (period 0)
EXAMPLE 1: COMPOUNDING INTEREST FOR 5 YEARS

Suppose you loan $10,000 for 1 year to an individual who agrees to pay you
interest at a compound rate of 10 percent/year.
At the end of 1 year, the individual asks to extend the loan period an
additional year.
The borrower repeats the process several more times.
Five years after loaning the person the $10,000, how much would the
individual owe you?
EXAMPLE 2: DOUBLING MONEY

• How long does it take for an investment to double in value

if it earns 2 percent annual compound interest?

=35 Years
EXAMPLE 3: SAVING MONEY

• To illustrate the computation of P given F, i, and n, suppose

you wish to accumulate $10,000 in a savings account 4
years from now, and the account pays interest at a rate of 5
percent compounded annually. How much must be
deposited today?
$8227
PRESENT WORTH OF IRREGULAR CASH
FLOWS

• Simply treat each individual cash flow as a single payment

and sum the present worths
• Let denote the cash flow (receipt – positive or expense -
negative) at the end of time period , then
Present Worth: explicit finite sum
EXAMPLE 4: COMPUTING THE PRESENT WORTH OF A
SERIES OF CASH FLOWS

• Consider the series of cash flows depicted by the CFD below. Using a 6%
period interest rate, what is the present worth equivalent of this cash flow?
EXAMPLE 4: SOLUTION

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FUTURE WORTH OF IRREGULAR CASH
FLOWS

• Simply treat each individual cash flow as a single payment

and sum the future worths
• Let denote the cash flow (receipt - positive or expense -
negative) at the end of time period , then

Future Worth: explicit finite sum

EXAMPLE 5: COMPUTING THE FUTURE WORTH OF A
SERIES OF CASH FLOWS

• Determine the future worth of the series of cash flows below at the end of
the eighth period, given a 6% period interest rate.
EXAMPLE 5: SOLUTION

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NOMINAL VS. EFFECTIVE VS. PERIOD INTEREST RATES

• Nominal interest, denoted

• Annual interest rate NOT taking into account any
compounding WITHIN the year
• Period interest, denoted

Nominal annual interest rate

• Period interest rate =
Number of interest periods per year
EFFECTIVE INTEREST RATE

• Effective interest, denoted

• Effective annual interest rate with compounding taken
into account

• Where
• = nominal annual interest rate
• = number of compounding periods per year
• = period interest rate =
EXAMPLE 6: DETERMINE EFFECTIVE
INTEREST RATE

• Given a 1-year loan with nominal annual interest ,

compounded monthly, determine the effective annual
interest,
• =12.68%
 EXAMPLE 7: EFFECTIVE AND NOMINAL INTEREST
RATES

• A bank charges 1.5% interest per month on the unpaid balance on a credit
card.
• What nominal interest rate is being charged?
• What effective interest rate is being charged?
EXAMPLE 8: DIFFERENCE OF PRESENT WORTH GIVEN
COMPOUNDING PERIOD

• How much must be invested NOW to grow to $30,000 in

seven years if the annual interest rate is 8.0% compounded
(a) annually, (b) semiannually, (c) monthly?