MM 314 Engineering Economy INTEREST RATE AND ECONOMIC EQUIVALENCE

SPRING SEMESTER 2011-2012

MM 314 ENGINEERING ECONOMY DR. MUSTAFA YURDAKUL

WHAT DOES Money has a time value MEAN?

EVERY COMPANY DOES ITS JOB (SELLS ITS PRODUCTS; PROVIDES SERVICES) TO INCREASE ITS WEALTH. TO INCREASE ITS WEALTH A COMPANY MAKES INVESTMENTS, DEVELOPS PROJECTS SO THAT MONEY IS NOT HIDDEN. INSTEAD, MONEY IS USED TO EARN MORE MONEY.

Capital refers to wealth in the form of money or property

that can be used to produce more wealth. Engineering economy studies involve the commitment of capital for extended periods of time. Commitment of capital for extended periods of time (more than one year) increases the importance of time value of money.
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A dollar today is worth more than a dollar one or more years from now. We prefer to receive a dollar NOW instead of receiving it one year later or two years later even we assume there is no inflation.
WHY? WHEN WE RECEIVE ONE DOLLAR NOW, WE CAN USE ONE DOLLAR IN PROJECTS AND MAKE ONE DOLLAR 1.10 DOLLAR ONE YEAR LATER. SO, ONE DOLLAR BECOMES 1.10 DOLLAR ONE YEAR LATER, 1.21 DOLLAR TWO YEARS LATER SO ON. SO THAT WE PREFER TO RECEIVE MONEY EARLIER THAN LATER.

$1,000 becomes $1,331 at 10% earning rate in three years

If you have no current use for one dollar (no projects or investments to use money to EARN more money (no earning rate 1 dollar will remain as 1 dollar in the coming years)), you can let someone else use it to earn more money. WHY SHOULD A FIRM LET SOMEONE ELSE USE ITS MONEY? ---Because the lender receives a portion ot the borrowers earnings. The borrower pays INTEREST to the lender let him use its money. The charge for using money is called INTEREST. Cost of using the borrowed money is measured by interest rate a percentage that is periodically applied and added to an amount of money over specified length of time

THEN WE CAN SAY THAT-----

IF OUR EARNING RATE FROM PROJECTS IS 10%, 1 DOLLAR NOW IS EQUIVALENT TO 1.10 DOLLAR ONE YEAR LATER. OR WE MAY LEND 1 DOLLAR NOW AT AN INTEREST RATE OF 10% AND RECEIVE 1.10 DOLLAR ONE YEAR LATER.
THEN 1 DOLLAR NOW IS EQUIVALENT TO 1.10 DOLLAR ONE YEAR LATER. SO WHAT?

TIME VALUE OF MONEY (1.10 DOLLAR IS EQUIVALENT TO 1 DOLLAR NOW ) LEADS US THE ABILITY TO REPLACE 1.10 DOLLAR ONE YEAR LATER WITH ONE DOLLAR NOW . FOR EXAMPLE, AT 10% INTEREST RATE (=EARNING RATE) WE CAN REPLACE OPTION 1 WITH OPTION 2. IT MEANS THEY ARE ECONOMICALLY EQUIVALENT TO EACH OTHER. WE DO NOT PREFER ONE OPTION OVER THE OTHER OPTION.

NOW WE CAN START TO COMPARE DIFFERENT CASH FLOWS AND DETERMINE WHICH ONE IS ECONOMICALLY PREFERRED USING ECONOMIC EQUIVALENCE CONCEPT.

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BEFORE WE BEGIN TO APPLY ECONOMIC EQUIVALENCE

CONCEPT WE NEED TO UNDERSTAND THE INTEREST

RATE.

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BEFORE GOING ANY FURTHER WE SHOULD MAKE SOME POINTS CLEAR SUCH AS CASH FLOWS OCCUR AT DICRETE POINTS

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SHOW THAT P= $ 2000 IS EQUIVALENT TO F= $4,287.18 EIGHT YEARS LATER AT THE INTEREST RATE OF 10% USING THE FORMULATIONS

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SHOW THAT P= $ 10 IS EQUIVALENT TO F= $20 FIVE

YEARS LATER AT THE INTEREST RATE OF i=14.87%.

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SHOW THAT P= $ 6000 IS EQUIVALENT TO F= $1200

N=3.80 YEARS LATER AT THE INTEREST RATE OF 20%.

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Number of years required to double an initial investment at various interest rates?

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Decomposition of uneven cash flow series

HOW DO YOU CALCULATE P (= THE EQUIVALENT VALUE OF THE FOLLOWING CASH FLOW)?

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WAIT A MINUTE! WHAT DOES IT MEAN (P/F,10%,1)? WE CAN EITHER USE FORMULATIONS

OR TABLES.

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AN EXAMPLE---A worker receives a bonus of $12,000, and decides to invest the whole amount to the bank for 20 years at 8% per each year. Calculate the amount of money he will get 20 years later.

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AN EXAMPLE--- Foreman family decided to start investing to their son Erics college fund. They started it by depositing $1,000 on January 1, 2008 to the Washington Mutual Bank. They plan to deposit $2,000 on June 31, 2010 and $3,000 on June 31, 2013. If they manage to invest according to that plan, how much money will they have on January 1, 2018 if the interest is taken as 8% per each year.

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UP TO NOW WE HAVE ONLY SINGLE PAYMENT CASH FLOWS. BUT IN REAL LIFE WE HAVE OTHER TYPES OF CASH FLOWS. Five types of cash flows: (a) Single cash flows, (b) equal (uniform) payment series, (c) lineargradient series, (d) geometric-gradient series, and (e) irregular payment series.

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EQUAL (UNIFORM) PAYMENT SERIES

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EXAMPLE--- Calculate A to make payments eqivalent to receipts at the interest rate of 10%.

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EXAMPLE--- Calculate C to make cash flow 1 equivalent to cash flow 2 at the interest rate of 10%.

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EXAMPLE--- How much money has to deposited at he end of year 1 through year 18 to receive $40,000 in years 18 through 21 at the interest rate of .%.

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EXAMPLES OF UNIFORM (EQUAL) PAYMENT SERIES X = ?; C = ?; P (t = 0) = ?

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LINEAR (ARITHMETIC) GRADIENT SERIES

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A TYPICAL EXAMPLE FOR LINEAR (ARITHMETIC) GRADIENT SERIES CALCULATE P (t = 0) OF THE FOLLOWING CASH FLOW

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ANOTHER EXAMPLE

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TWO EXAMPLES FOR LINEAR (ARITHMETIC) GRADIENT SERIES

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TWO EXAMPLES FOR LINEAR (ARITHMETIC) GRADIENT SERIES

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GEOMETRIC GRADIENT SERIES

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1 (1 g ) N (1 i ) A1 i g NA1 /(1 i),

, eer i eer i

g g

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Given:
g = %7 i = %12 N = 5 years A1 = $54,440

P (t =0)=?
Aa ( P / A1 ,%7,%12.5) 1 (1 0.07)5 (1 0.12) 54,440 * 0.12 0.07 $222,283
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Yaz 2008

END 321 Mhendislik Ekonomisi

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