Time Value of Money

CE 22: Engineering Economy

Ma. Brida Lea D. Diola
Institute of Civil Engineering
TYPES OF BUSINESS

1. Proprietorship
2. Partnership
3. Corporation
1. PROPRIETORSHIP
-Business owned by one individual. This person is
responsible for the firm’s policies, owns all its assets,
and personally liable for its debts
-ADVANTAGES
*formed easily and inexpensively, no organizational
requirements, lower tax rates (compared to corporate)
-DISADVANTAGES
*personal liabilities, difficult to raise capital (inability to
issue bonds and stocks)
INTRODUCTION
TYPES OF BUSINESS

1. Proprietorship
2. Partnership
3. Corporation
2. PARTNERSHIP
-Similar characteristics as proprietorship except that it has
multiple owners
- Established by written contracts specifying salaries,
contributions to capital, distribution of profits and losses
-Additional DISADVANTAGE
*Partners risk all their personal assets, even those not
invested in the business
TYPES OF BUSINESS

1. Proprietorship
2. Partnership
3. Corporation
3. CORPORATION
-Legal entity, which is separate from owners and
managers, created under the provincial/federal law.
-MAJOR ADVANTAGES
*can raise capital from large numbers of investors by
issuing stocks and bonds
*permits easy transfer of ownership interest by trading
shared of stock
TYPES OF BUSINESS

1. Proprietorship
2. Partnership
3. Corporation
3. CORPORATION
MAJOR ADVANTAGES
*It allows limited liability – personal liability is limited to
the amount of the individual’s investment in the business

DISADVANTAGES
*Difficult and expensive to establish
*Subject to numerous governmental requirements and
regulations
Capital

 Wealth in the form of money or property

that can be used to produce more wealth.
 Debt capital (borrowed capital) is obtained
from lenders (e.g., through loans, sale of
bonds) for investment.
 Equity capital is capital owned by individuals
who have invested their money or property in
a business project or venture in the hope of
receiving a profit.
Types of Capital

Financing Definition Instrument Description

• Debt • Borrow • Bond • Promise to

financing money pay
principle &
interest;

• Equity • Sell partial • Stock • Exchange

financing ownership of shares of
company; stock for
ownership of
company;
Time Value of Money

CE 22: Engineering Economy

Ma. Brida Lea D. Diola
Institute of Civil Engineering
Which would you prefer?

 1M PhP today or assurance of

receiving 1M PhP a year from
now?
You want 1 million PhP today because of the
time value of money. There is time value in
the form of willingness of bank, businesses
and people to pay interest for its use.
Time Value of Money
 earning power
 inflation
 Time value of money
is measured in terms
of interest rate.
 Interest is the cost of
money—a cost to the
borrower and an
earning to the lender
This a two-edged sword whereby earning
grows, but purchasing power decreases
(due to inflation), as time goes by.
The Interest Rate
The Interest Rate

Contemporary Engineering Economics, 4th

edition © 2007
Elements of transactions involving
Interest
 1. An initial amount of money in transactions
involving debt or in investments is called the
principal

 2. The interest rate measures the cost or price

of money and is expressed as percentage per
period of time
Elements of transactions involving
Interest
 3. A period of time called interest period, which
determines how frequently interest is calculated

 4. A specified length of time marks the duration

of the transaction and thereby establishes a
certain number of interest periods.
Elements of transactions involving
Interest
 5. A plan for receipts or disbursements that
yields a particular cash flow pattern over a
specified length of time.

 6. A future amount of money results from the

cumulative effects of the interest rate over a
number of interest periods.
CASH FLOW DIAGRAM

The estimated inflows (revenues) and outflows (costs) of

money

(+) Inflows – Revenue, tax savings, salvage value

(-) Outflow – operating costs, initial investment, tax
End-Of-Period Convention
 To simplify the effects of interest within an interest
period, it assumed that all cash flow transactions
occurs at the end of an interest period
Cash Flow Transactions for Two
Types of Loan Repayment
 Electronics manufacturing company borrows
20,000 from a bank at a 9% annual interest
rate. In addition, the company pays a 200
loan origination fee. The bank offers 2
repayment plans
1) With equal payments made at the end of
every year for the next five years
2) single payment made after the loan period of
five years
Cash Flow Transactions for Two Types of Loan
Repayment
End of Year Receipts Payments
Plan 1 Plan 2
Year 0 $20,000.00 $200.00 $200.00
Year 1 5,141.85 0
Year 2 5,141.85 0
Year 3 5,141.85 0
Year 4 5,141.85 0
Year 5 5,141.85 30,772.48
The amount of loan = $20,000, origination fee = $200, interest rate = 9% APR
(annual percentage rate)
Cash Flow Diagram for Plan 1
Methods of Calculating Interest

 Simple interest: the practice of charging an

interest rate only to an initial sum (principal
amount).
 Compound interest: the practice of
charging an interest rate to an initial sum
and to any previously accumulated interest
that has not been withdrawn.
 Simple Interest
Example:
Suppose you deposit $1000 in a bank savings account
that pays interest at a rate of 10%, how much would
you have at the end of year 3?
End of Beginning Interest Ending
 Given: Year Balance earned Balance
0 $1,000
 P = $1,000
 i = 10% 1 $1,000 $100 $1,100
 N = 3 years 2 $1,100 $100 $1,200

3 $1,200 $100 $1,300

Simple Interest Formula
F  P  (iP) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N

F  $1, 000  (0.10)($1, 000)(3)

 $1,300
 Compound Interest
Assuming you don’t withdraw the interest earned at
the end of each period but let it accumulate

 Given: End Beginning Interest Ending

of Balance earned Balance
 P = $1,000 Year
 i = 10% 0 $1,000
 N = 3 years
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

Compounding Process

$1,100

$1,210
0 $1,331
1
$1,000
2
3
$1,100

$1,210
Compound Interest Formula

n  0: P
n  1: F1  P (1  i )
n  2 : F2  F1 (1  i )  P(1  i ) 2

n  N : F  P (1  i ) N
Cash Flow Diagram
$1,331

0 1 2

F  $1, 000(1  0.10)3

$1,000
 $1,331
Some Fundamental Laws
F  m a
V  iR
E  m c 2

The Fundamental Law of Engineering Economy

F  P(1  i) N
Practice Problem: Warren Buffett’s
Berkshire Hathaway
 Went public in 1965: $18 per
share
 Worth in 2006 (June 22, 2006):
$91,980
 Annual compound growth:
23.15%
 Current market value (2006) :
$115.802 Billion
 If his company continues to
grow at the current pace, what
will be his company’s total
market value when he reaches
100? ( lives till 100 (76 years as
of 2006)
Market Value

 Assume that the company’s stock will continue

to appreciate at an annual rate of 23.15% for the
next 24 years.

F  $115.802 M
B (1  0.2315) 24

 $17.145 trillions
Practice problem
 Problem Statement
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn a 10% interest, what would be the
balance at the end of 4 years?

0 1
$1,210

4
?
2 3

$1,000 $1,000 $1,500

 i = 10 %

$1,210 ?
0 1 3
2 4

$1,000 $1,000
$1,500
$1,100
$1,000
$1,210 $2,981
$2,100 $2,310
-$1,210 + $1,500

$1,100 $2,710
Seatwork
On the first day of the year, a man deposits $1000 in a
bank at 8% per year, compounded annually. He withdraws
$80.00 at the end of the first year, $90.00 at the end of the
second year, and the remaining balance at the end of the
third year.
a) Draw the cash flow diagram.

b) How much does he withdraw at the end of the third

year?

c) How much better off, in terms of net cash flow, would he

have been if he had not made the withdrawals at the ends
of years one and two?
 THANK YOU!
Next meeting:
Economic Equivalence
- Lea Diola