TIME VALUE OF MONEY

Chapter objectives
At the end of this topic, you should able to:
1. Describe the return to capital concept in the form of
interest.
2. Illustrate how basic equivalence calculations are made
with respect to the time value of capital in engineering
economy studies.

Introduction

The term capital refers to wealth in the form of money

or property that can be used to produce more wealth.
The majority of engineering economy studies involve
commitment of capital for extended periods of time, so
the effect of time must be considered.
In this regard, it is recognized that a dollar today is worth
more than a dollar one or more years from now because
of the interest (or profit) it can earn. Therefore, money
has a time value.

Why consider return to capital

Capital in the form of money for the people, machines,

materials, energy, and other things needed in the operation
of an organization may be classified into two basic
categories:
1.

2.

Equity capital is that owned by individuals who have invested

their money or property in a business project or venture in the
hope of receiving a profit.
Debt capital / borrowed capital is obtained from lenders
(e.g. through the sale of bonds) for investment. In return the
lenders receive interest from the borrowers. Lenders do not
receive any other benefits that may accrue from the investment
of borrowed capital. They are not owners of the organization
and do not participate as fully as the owners in the risks of the
project or venture.

Interest rate and interest

Interest rate is the ratio of the gain received from an

investment and the investment over a period usually one
year. Also, an interest rate may be expressed as a ratio
between the amount paid for the use of funds and the
amount of funds use.

Interest is an amount of money received as a result of

investing funds either by loaning it or by using it in the
purchase of materials, labor or facilities. Interest received
in this connection is a gain or income.

Example 1
An employee at LaserKinetics.com borrows $10,000 on
May 1 and must repay a total of $10,700 exactly 1 year later.
Determine the interest amount and the interest rate paid.
Solution
Interest paid =
Interest rate =

Time value of Money: Simple Interest

The payment of interest at a fix rate based on the principal
value, P. The total interest I for the principal value P at
interest rate i per year for n years is given by the following
equation:
Where P = principal amount lent or borrowed
i = interest rate per interest period
n = number of interest periods
The total amount repaid at the end of n interest periods is,

Example 2
P = RM100, n = 3 years, i = 10% per year
Find the total amount of payback.
Solutions

Figure shows the cash flow:

Time value of Money: Compound Interest

For compound interest, the interest accrued for each

interest period is calculated on the
principal plus the total amount of interest accumulated in
all previous periods. Thus,
the compound interest means interest on top of interest.

Example 3
The effect of compounding of interest can be seen in the
following table for $1000 loaned for three periods at an
interest rate of 10% compounded each period.

Equivalence
In engineering economy, when considered together, the time
value of money and the interest rate help develop the
concept of economic equivalence, which means that
different sums of money at different times would be equal
in economic value.

Example 4
If the interest rate is 6% per year, $100 today (present time)
is equivalent to $106 one year from today and $94.34 one
year ago ($100/1.06).
Solution

Amount in one year

Amount one year ago

Activity 1
a)

Calculate the amount deposited 1 year ago to have

$1000 now at an interest rate of 5% per year.

b)

Calculate the amount of interest earned during this

time period.

Activity 2
Compare the interest earned by $500 for 10 years at 8%
simple interest with that earned by the same amount for 10
years at 8% compounded annually.

Interest Factor Derivations

a. Single-Payment Compound-Amount Factor
This factor may be used to find the compound amount, F,
of a present principal amount, P.

F P (1 i ) N
or
F P ( F / P, i %, n)

Example 5
X borrowed RM1000 for 8 years with 10% interest per year.
How much should he pay after the 8th years?

Solutions
Or by referring to the table of
discrete compounding; i= 10%

b. Single-Payment Present-Worth Factor

This factor is used to find the present worth, P of a future
amount, F, for the investment.

1
P F
n
1 i
or
P F ( P / F , i %, n)

Example 6
Y wants to have RM 1000 in 6 years time from now. How
much should Y invest from now, if the interest rate per year is
10%.

Solutions

Or by referring to the table of

discrete compounding; i= 10%

Activity 3
What is the present value of these future payments?
1.

$5500, 6 years from now at 9% compounded annually.

2.

$1700, 12 years from now at 6% compounded annually.

c. Equal-Payment-Series Compounded-Amount Factor

This factor used to find the single future value that would
accumulate from a series of equal payments occurring at the
end of succeeding annual interest periods.

1 i n 1
F A

or
F A( F / A, i %, n)

Example 7
For 3 yearly investment of RM2000 continuously, how much
money will it gain after the last investment, given i is 10%?

Solutions
Or by referring to the table of
discrete compounding; i= 10%

Activity 4
A future amount, F, is equivalent to RM1500 now when six
years separate the amounts and the annual interest rate is
12%. What is the value of F?

d. Equal-Payment-Series Present-Worth Factor

To find what single amount must be deposited now so that
equal end-of-year payments can be made, P must be found
in terms of A.
Given
F P 1 i

1 i n 1
A

Therefore,
1 i n 1
P A

n
i 1 i

or
P A( P / A, i %, n)

Example 8

How much need to be invested to be able to get RM100

continuously in 9 years time, given i is 10%?

Solutions

Or by referring to the table of

discrete compounding; i= 10%

e. Deferred Annuities (Uniform Series)

All annuities (uniform series) discussed to this point
involve the first cash flow being made at the end of the
first period, and they are called ordinary annuities.
If the cash flow does not begin until some later date, the
annuity is known as deferred annuity.

Example 9
X wants to buy a present worth RM2000 on her daughters
18th, 19th, 20th and 21st birthdays. How much money should
she invest on the day of her child birth, given i=5%?

Solutions

f. Uniform Gradient
A cash flow diagram of a sequence of end-of-period cash
flows increasing by a constant amount, G, in each period. The
G is known as the uniform gradient amount.
The timing of cash flows on which the derived formulas and
tabled values are based is as follows:

Notice that the first cash flow occurs at the end of

period two. The direct use of gradient conversion factors
applies when there is no cash flow at the end of period
one. There may be an A amount at the end of period one,
but it is treated separately (see example later).
Finding A when given G
A=G (A/G, i %, n)
Finding P when given G
P= G (P/G, i %, n)

Example 10
Suppose that certain end-of-year cash flows are expected to be
$1,000 for the second year, $2,000 for the third year, and
$3,000 for the fourth year, and that if interest is 15% per year, it
is desired to find the (a) present equivalent value at the
beginning of the first year, and (b) uniform annual equivalent at
the end of each of the four years.
Solution
(a)The present equivalent
can be calculated as

(b) The annual equivalent

can be calculated as

Example 11
Suppose that one has cash flows as follows:

One wishes to calculate their present equivalent at i=15% per

year using arithmetic gradient interest formulas.

Example 11 (continued)