HowTime and Interest HowTime and Interest How Time and Interest How Time and Interest

Affect Money Affect Money Affect Money Affect Money

Engineering Economy Engineering Economy
Lecture no. 2 Lecture no. 2
Thursday, J une 13, 2013 Thursday, J une 13, 2013
ECONOMIC EQUIVALENCE ECONOMIC EQUIVALENCE
Two sums of money at two different points Two sums of money at two different points
in time can be made economically
equivalent if: equivalent if:
We consider an interest rate and,
No. of time periods between the two
sums
Equality in terms of Economic Value
Interest Rate Interest Rate
INTEREST - MANIFESTATION OF THE
TIME VALUE OF MONEY. THE AMOUNT
PAID TO USE MONEY.
INVESTMENT INVESTMENT
INTEREST = VALUE NOW - ORIGINAL AMOUNT
LOAN LOAN
INTEREST = TOTAL OWED NOW - ORIGINAL
AMOUNT
RENTAL FEE PAID FOR THE USE OF SOMEONE
ELSESMONEY EXPRESSEDASA% ELSES MONEYEXPRESSED AS A %
Interest Rates and Returns Interest Rates and Returns
AMOUNT ORIGINAL
UNIT TIME PER INTEREST
RATE INTEREST =
Interest can be viewed from two
perspectives:
Lending situation e d gs tuat o
Investing situation
I t t L di E l Interest Lending: Example
You borrow $10,000 for one full year
Must pay back $10 700 at the endof one year Must pay back $10,700 at the end of one year
Interest Amount (I) = $10,700 - $10,000
Interest Amount = $700 for the year
Interest rate (i) = 700/ $10,000 = 7%/ Yr Interest rate (i) 700/ $10,000 7%/ Yr
I t t R t N t ti Interest Rate - Notation
the interest rate is Expressed as a per cent
per year per year
Notation
I = the interest amount is $
i = the interest rate (%/ interest period)
N= No. of interest periods (1 for this problem)
Interest Investing Perspective Interest Investing Perspective
Assume you invest $20,000 for one year in a
venture that will return to you, 9% per year.
At the end of one year, you will have:
Original $20,000 back Original $20,000 back
Plus..
The 9% return on $20 000 = $1 800 The 9% return on $20,000 = $1,800
We say that you earned 9%/ year on the investment!
This is your RATE of RETURNon the investment This is your RATE of RETURNon the investment
Engineering Economy Factors
1. F/ P and P/ F Factors
2 P/ AandA/ PFacto s 2. P/ A and A/ P Factors
3. F/ A and A/ F Factors
4. Interpolate Factor Values
5. P/ G and A/ G Factors
6. Geometric Gradient
F/P factor F/P factor
To find F given P To find F given P
F
n
To FindFgiven P To Find F given P
N
.
P
0
Compound forward in time
F/P factor
F
1
= P(1+i)
F/P factor
1
( )
F
2
= F
1
(1+i)..but:
F
2
=P(1+i)(1+i) =P(1+i)
2
F
2
P(1+i)(1+i) P(1+i)
F
3
= F
2
(1+i) =P(1+i)
2
(1+i)
=P(1+i)
3
= P(1+i)
3
In general:
F P(1 i)
n
F
N
= P(1+i)
n
F
N
= P(F/P,i%,n)
N
( )
P/F factor discounting back in time P/F factor discounting back in time
Discounting back fromthe future Discounting back from the future
F
n
N
.
P/ Ffactor brings a single
P
P/ F factor brings a single
future sum back to a specific
point in time.
Present Worth Factor fromF/P Present Worth Factor from F/P
Since F
N
=P(1+i)
n
Since F
N
P(1+i)
We solve for P in terms of F
N
P = F{1/ (1+i)
n}
= F(1+i)
-n
Thus: Thus:
P = F(P/F,i%,n) where
(P/F,i%,n) = (1+i)
-n
Example F/P Analysis Example- F/P Analysis
Example: P=$1,000;n=3;i=10% Example: P $1,000;n 3;i 10%
What is the future value, F?
F ??
0 1 2 3
F = ??
0 1 2 3
P=$1,000
i=10%/ year
F
3
= $1,000[F/ P,10%,3] = $1,000[1.10]
3
= $1,000[1.3310] = $1,331.00 $ , [ ] $ ,
UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
Annuity Cash Flow
P ?? P = ??
0
..
n
1 2 3 .. .. n-1
$A per period
UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
Write a Present worth expression
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i

(
= + + + +
(
+ + + +

[1]
1 2 1
(1 ) (1 ) (1 ) (1 )
n n
i i i i
(
+ + + +

Term inside the brackets is a geometric progression.
Mult. This equation by 1/ (1+i) to yield a second equation
UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
The second equation
1 1 1 1 P (
[2]
2 3 1
1 1 1 1
..
1 (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i
+
(
= + + + +
(
+ + + + +

To isolate an expression for P in terms of A, subtract
Eq [1] from Eq. [2]. Note that numerous terms will
ddrop out.
UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
Setting up the subtraction
1 1 1 1
P A
(
= + + + +
(
[2]
1 1 1 1 (
2 3 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
+
= + + + +
(
+ + + +

[2]
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i

(
= + + + +
(
+ + + +

[1]
-
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
(
=
(
+ + +

=
[3]
1 (1 ) (1 ) i i i + + +

UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
Simplifying Eq. [3] further
(
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
(
=
(
+ + +

( ) ( )

1
1
A
P
(
=
(
(1 ) 1
0
n
i
P A f i
(
+
=
(
1
1
(1 )
n
P
i i
+
=
(
+

( )
0
(1 )
n
P A for i
i i
= =
(
+

UniformSeries Present Worth Uniform Series Present Worth
and Capital Recovery Factors
This expression will convert an annuity cash
flow to an equivalent present worth amount one
period to the left of the first annuity cash flow.
(
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
(
+
= =
(
+

/ %, P A i n factor
Capital Recovery Factor: Capital Recovery Factor:
A/P, i%, n
The present worth point of
an annuity cash flow is
always one periodto the
Given the P/A factor
(1 ) 1
0
n
i
P A f i
(
+
=
(
Solve for Ain terms of P
always one period to the
left of the first A amount
( )
0
(1 )
n
P A for i
i i
= =
(
+

Solve for A in terms of P
Yielding.
(1 )
n
i i
A P
(
+
=
(
Yielding.
A/ P i% f t
(1 ) 1
n
A P
i
=
(
+

A/ P,i%,n factor
F/A and A/F Derivations
$F
F/A and A/F Derivations
Annuity Cash Flow
$F
Annuity Cash Flow
0
..
N
0
$A per period
Find $A given the
Future amt. - $F
Si ki F d d S i C d Sinking Fund and Series Compound
amount factors (A/F and F/A)
Recall:
Al
1
P F
(
=
(
Substitute P and
simplify!
Also:
(1 )
n
P F
i
=
(
+

(
(1 )
(1 ) 1
n
n
i i
A P
i
(
+
=
(
+

A/F F t A/F Factor
1 (1 )
n
i i
( ( +
By substitution we
see:
1 (1 )
(1 ) (1 ) 1
n
n n
i i
A F
i i
( ( +
=
( (
+ +

Simplifying we have:
(
Which is the
(A/F,i%,n) factor
(1 ) 1
n
A
i
i
F =
(
(
+

(1 ) 1 i +

F/A f t f th A/F F t F/A factor from the A/F Factor
i
(
Given:
(1 ) 1
n
i
A F
i
(
=
(
+

Solve for F in terms of
) (1 1
n
i
(
A
)
=A
(1 1
F
n
i
i
(
+
(

i
(

F/A and A/F Derivations
$F
F/A and A/F Derivations
Annuity Cash Flow
$F
Annuity Cash Flow
0
..
N
0
$A per period
Find $F given thethe
$A amounts
E l Example
Formasa Plastics has major fabrication j
plants in Texas and Hong Kong.
It is desired to know the future worth of
$1,000,000 invested at the end of each year
for 8 years, starting one year from now.
The interest rate is assumed to be 14% per
year.
E l Example
A= $1 000 000/ yr; n = 8 yrs i = 14%/ yr A = $1,000,000/ yr; n = 8 yrs, i = 14%/ yr
F
8
= ??
E l Example
Solution:

Solution:
The cash flow diagram shows the annual
payments starting at the end of year 1 and
ending in the year the future worth is desired.
Cash flows are indicated in $1000 units. The F
value in 8 years is value in 8 years is
F = l000(F/ A,14%,8) = 1000( 13.23218)
$13 232 80 13 232 illi 8 = $13,232.80 = 13.232 million 8 years
from now/
Interpolation of Factors
All texts on Engineeringeconomy will provide All texts on Engineering economy will provide
tabulated values of the various interest factors
usually at the end of the text in an appendix
Refer to the back of your text for those tables.
I t l ti f F t Interpolation of Factors
Typical Format for Tabulated Interest Tables
Arithmetic Gradient Factors
In applications the annuity cash flowpattern is In applications, the annuity cash flow pattern is
not the only type of pattern encountered
Two other types of endof periodpatterns are Two other types of end of period patterns are
common
The Linear or arithmetic gradient g
The geometric (% per period) gradient
An arithmetic (linear) Gradient is a cash flow
Arithmetic Gradient Factors
An arithmetic (linear) Gradient is a cash flow
series that either increases or decreases by a
contestant amount over n time periods.
A linear gradient is always comprised of TWO
components:
The Gradient component
The base annuity component y p
The objective is to find a closed form expression
for the Present Worth of an arithmetic gradient
Linear Gradient Example
A +n 1G
Linear Gradient Example
Assume the following:
A
1
+n-2G
A
1
+n-1G
g
A +2G
A
1
+G
A
1
+2G
0 1 2 3 n-1 N
This represents a positive, increasing arithmetic gradient
E l Li G di t Example: Linear Gradient
Typical Negative IncreasingGradient: G=$50 Typical Negative, Increasing Gradient: G=$50
The Base Annuity
= $1500
A ith ti G di t F t 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 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!
The A/G Factor
Convert G to an equivalent A
( / , , )( / , , ) A G P G i n A P i n =
How to do it
Gradient Example Gradient Example
Consider the followingcash flow Consider the following cash flow
$300
$400
$500
$100
$200
$300
0 1 2 3 4 5
Present Worth Point is here!
Find the present worth if i = 10%/yr; n = 5 yrs
And the Gamt. = $100/ period
Gradient Example- Base Annuity Gradient Example Base Annuity
First The Base Annuity of $100/ period First, The Base Annuity of $100/ period
A = +$100
0 1 2 3 4 5
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
The Gradient Component The Gradient Component
$300
$400
$0
$100
$200
$300
0 1 2 3 4 5
We desire the PW of the Gradient Component at t = 0
P
G@t=0
= G(P/ G,10%,5) = $100(P/ G,10%,5) P
G@t=0
G(P/ G,10%,5) $100(P/ G,10%,5)
Th G di t C t The Gradient Component
$300
$400
$0
$100
$200
$300
0 1 2 3 4 5
P
G@t=0
= G(P/ G,10%,5) = $100(P/ G,10%,5)
G (1 ) 1
N
i N
(
Couldsubstituten=5, i=10%
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
(
+

(
+ +

Could substitute n 5, i 10%
and G = $100 into the P/ G
closed form to get the value
of the factor.
PW f th G di t C t PW of the Gradient Component
P
G@t=0
= G(P/ G,10%,5) = $100(P/ G,10%,5)
P/ G,10%,5)
Sub. G=$100;i=0.10;n=5
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
(
+

(
+ +

6.8618
Calculating or looking up the P/ G,10%,5 factor
yields the following:
P
t=0
= $100(6.8618) = $686.18 for the gradient
PW
G di t E l Fi l R lt Gradient Example: Final Result
PW(10%)
BaseAnnuity
= $379.08 ( )
Base Annuity
PW(10%)
Gradient Component
= $686.18
T t l PW(10%) $379 08 $686 18 Total PW(10%) = $379.08 + $686.18
Equals $1065.26
Note: The two sums occur at t =0 and can be
added together concept of equivalence
Example Summarized Example Summarized
$500
This Cash Flow
$200
$300
$400
$500
This Cash Flow
$100
$200
0 1 2 3 4 5
Is equivalent to $1065.26 at time 0 if the interest rate
is 10% per year!
Wh th i t i k When the i rate is unknown
A class of problems may deal with all of the p y
parameters know except the interest rate.
For many application-type problems, this can
become a difficult task
Termed, rate of return analysis
In some cases:
i can easily be determined y
In others, trial and error must be used
E l i k Example: i unknown
Assume one can invest $3000 now in a venture $
in anticipation of gaining $5,000 in five (5)
years.
If these amounts are accurate, what interest
rate equates these two cash flows?
$5,000
0 1 2 3 4 5
F = P(1+i)
n
$3,000
( )
5,000 = 3,000(1+i)
5
(1+i)
5
= 5,000/ 3000 = 1.6667
E l i k Example: i unknown
Assume on can invest $3000 now in a venture in $
anticipation of gaining $5,000 in five (5) years.
If these amounts are accurate, what interest
rate equates these two cash flows?
$5,000
0 1 2 3 4 5
(1+i)
5
= 5,000/ 3000 = 1.6667
$3,000
( ) , /
(1+i) = 1.6667
0.20
i = 1.1076 1 = 0.1076 = 10.76%
F i k For i unknown
In general, solving for i in a time value g , g
formulation is not straight forward.
More often, one will have to resort to some form
of trial and error approach as will be shown in
future sections.
l d h d l f hi bl A sample spreadsheet model for this problem
follows.
U k N b f Y Unknown Number of Years
Some problems require knowing the number of p q g
time periods required given the other
parameters
Example:
How long will it take for $1,000 to double in
l if h di i value if the discount rate is 5% per year?
Draw the cash flow diagram as.
F
n
= $2000
i = 5%/ year; n is unknown!
0 1 2 . . . . . . . n
P = $1,000
U k N b f Y Unknown Number of Years
Solving we have..
F = $2000
g
F
n
= $2000
0 1 2 . . . . . . . n
P $1 000 P = $1,000
F
n=?
= 1000(F/ P,5%,x): 2000 = 1000(1.05)
x
Solve for x in closed form
U k N b f Y Unknown Number of Years
Solving we have.. g
(1.05)
x
= 2000/ 1000
Xln(1.05) =ln(2.000)
X = ln(1.05)/ ln(2.000)
X = 0.6931/ 0.0488 = 14.2057 yrs
With discrete compoundingit will take 15 With discrete compounding it will take 15
years to amass $2,000 (have a little more that
$2,000)