CHAPTER 4 CHAPTER 4

THE TIME VALUE OF MONEY THE TIME VALUE OF MONEY

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INTRODUCTION
The term capital refers to financial resources that can be used to produce more wealth. It is one of the factors of production (inputs or resources to produce goods or services) Factors of production: Land: comprising all naturally occurring resources; economically referred to as land or raw materials. Examples: agriculture, plants, coal, fossil fuels, rock, minerals, forestry,
pasture, soils, water, ocean, lakes, river

Labor: the physical and mental capacity of humans to produce goods and services Capital: financial resource to operate and enterprise, man-made goods such as machines to facilitate further production of goods and services Entrepreneurship: the creative ability of individuals to seek profits by combining land, labor, and capital to produce goods and services Information: includes market forecasts, specialized knowledge of the human SEMESTER JANUARY 2010 resource, other economic data.
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Majority of the engineering economy studies involve commitment of capital for extended periods of time. Therefore, the effect of time must be considered. Money changes in value due to changes in the interest rate, inflation (or deflation), and currency exchange rates
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INTEREST INTEREST
The fee that a borrower pays to a lender The fee that a borrower pays to a lender for the use of his or her money. for the use of his or her money. INTEREST RATE INTEREST RATE The percentage of money being borrowed The percentage of money being borrowed that is paid to the lender on some time that is paid to the lender on some time basis. basis.

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 The total interest earned or charged is linearly The total interest earned or charged is linearly

SIMPLE INTEREST SIMPLE INTEREST

proportional to the initial amount of the loan proportional to the initial amount of the loan (principal), the interest rate and the number of (principal), the interest rate and the number of interest periods for which the principal is interest periods for which the principal is committed. committed. When applied, total interest I may be found When applied, total interest I may be found by I = ( P ) ( N ) ( ii ), where by I = ( P ) ( N ) ( ), where
P = principal amount lent or borrowed P = principal amount lent or borrowed N = number of interest periods ( e.g., years ) N = number of interest periods ( e.g., years ) ii = interest rate per interest period = interest rate per interest period
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COMPOUND INTEREST COMPOUND INTEREST

Whenever the interest charge for any interest Whenever the interest charge for any interest
period is based on the remaining principal period is based on the remaining principal amount plus any accumulated interest charges amount plus any accumulated interest charges up to the beginning of that period. up to the beginning of that period.
Amount Owed Amount Owed Beginning of Beginning of period period
(1) (1)

Period Period

Interest Amount Interest Amount for Period for Period ( @ 10% ) ( @ 10% )
(2) = (1) * 10% (2) = (1) * 10%

Amount Owed Amount Owed at end of at end of period period

(3) = (1) + (2) (3) = (1) + (2)

1 1 2 2 3 3

$1,000 $1,000 $1,100 $1,100 $1,210 $1,210

$100 $100 $110 $110 $121 $121

$1,100 $1,100 $1,210 $1,210 $1,331 $1,331

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ECONOMIC EQUIVALENCE ECONOMIC EQUIVALENCE

The question: How to compare the various alternatives (proposals The question: How to compare the various alternatives (proposals
or options) involve in the economic analysis? or options) involve in the economic analysis?

Considers the comparison of alternative options, or proposals, by Considers the comparison of alternative options, or proposals, by

reducing them to an equivalent basis, depending on: reducing them to an equivalent basis, depending on: interest rate; interest rate; amounts of money involved; amounts of money involved; timing of the affected monetary receipts and/or expenditures; timing of the affected monetary receipts and/or expenditures; manner in which the interest ,, or profit on invested capital is paid manner in which the interest or profit on invested capital is paid and the initial capital is recovered. and the initial capital is recovered.

Established when we are indifferent between a future payment, or a Established when we are indifferent between a future payment, or a
series of future payments, and a present sum of money. series of future payments, and a present sum of money.
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CASH FLOW DIAGRAMS / TABLE NOTATION CASH FLOW DIAGRAMS / TABLE NOTATION
Cash flow refers to the movement of cash into or out of a business or Cash flow refers to the movement of cash into or out of a business or a project. It is usually measured during a specified, finite period of a project. It is usually measured during a specified, finite period of time. time. A cash flow diagram is a tool used by accountants and engineers to A cash flow diagram is a tool used by accountants and engineers to represent the transactions which will take place over the course of a represent the transactions which will take place over the course of a given project. given project.
ii = effective interest rate per interest period = effective interest rate per interest period N = number of compounding periods (e.g., years) N = number of compounding periods (e.g., years) P = present sum of money; the equivalent value of one or more cash flows at the P = present sum of money; the equivalent value of one or more cash flows at the present time reference point present time reference point F = future sum of money; the equivalent value of one or more cash flows at a F = future sum of money; the equivalent value of one or more cash flows at a future time reference point future time reference point A = end-of-period cash flows (or equivalent end-of-period values )) in a uniform A = end-of-period cash flows (or equivalent end-of-period values in a uniform series continuing for a specified number of periods, starting at the end of the series continuing for a specified number of periods, starting at the end of the first period and continuing through the last period first period and continuing through the last period G = uniform gradient amounts --- used if cash flows increase by a constant G = uniform gradient amounts --- used if cash flows increase by a constant amount in each period amount in each period
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CASH FLOW DIAGRAM NOTATION 1 1 2 3 4 5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval.

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CASH FLOW DIAGRAM NOTATION 1

P =$8,000

1 2

5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender.

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CASH FLOW DIAGRAM NOTATION A = $2,524 3 1

P =$8,000

1 2

5=N

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender. Annual income (cash inflow) of $2,524 for lender.
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2 3

CASH FLOW DIAGRAM A = $3,500

3
3 4 5=N

P =$8,000

i = 10% per year

1 2 3 4

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. P = Present investment (cash outflow) of $10,000 A = Annual revenue (cash inflow) of $3,500 i = Rate of return

N = number of compounding period

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CASH FLOW DIAGRAM NOTATION A = $2,524 3 5 1

P =$8,000

1 2

3 4

5=N

i = 10% per year

Time scale with progression of time moving from left to right; the numbers represent time periods (e.g., years, months, quarters, etc...) and may be presented within a time interval or at the end of a time interval. Present expense (cash outflow) of $8,000 for lender. Annual income (cash inflow) of $2,524 for lender. Interest rate of loan. 5 Dashed-arrow line indicates SEMESTER JANUARY 2010 13 amount to be determined.

2 3 4

RELATING PRESENT AND FUTURE EQUIVALENT RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS VALUES OF SINGLE CASH FLOWS

Finding F when given P: Finding F when given P: Finding future value when given present value Finding future value when given present value F = P (( 1+i )) N F = P 1+i N
(1+i)N single payment compound amount factor (1+i)N single payment compound amount factor functionally expressed as F = ( F / P, i%,N ) functionally expressed as F = ( F / P, i%,N ) predetermined values of this are presented in predetermined values of this are presented in column 2 of Appendix C of text. column 2 of Appendix C of text.
P N=
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0 F=?
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Future Equivalent of a Present Sum

Suppose you borrow $8,000 now, and promise to pay back the loan principal plus accumulated interest in four years at interest rate of 10% per year. How much would you repay at the end of the fourth year?
P = $8,000
0 i = 10% per year
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4 F=?
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RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOWS Finding P when given F: Finding P when given F: Finding present value when given future value Finding present value when given future value N P = F [1 // (1 + ii )) ]] N P = F [1 (1 +
(1+i)-N single payment present worth factor (1+i)-N single payment present worth factor functionally expressed as P = F ( P / F, i%, N ) functionally expressed as P = F ( P / F, i%, N ) predetermined values of this are presented in predetermined values of this are presented in column 3 of Appendix C of text; column 3 of Appendix C of text;
0 N= P=? SEMESTER JANUARY 2010 F
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Present Equivalent of Future Sum

An investor has an option to purchase a plot of land that will be worth $25,000 in six years. If the interest rate is 8% per year, how much should the investor be willing to pay now for this property?
F = $25,000
0 P=? 6 i = 10% per year
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RELATING A UNIFORM SERIES (ORDINARY ANNUITY) RELATING A UNIFORM SERIES (ORDINARY ANNUITY) TO PRESENT AND FUTURE EQUIVALENT VALUES TO PRESENT AND FUTURE EQUIVALENT VALUES Finding F given A: Finding F given A: Finding future equivalent income (inflow) value given Finding future equivalent income (inflow) value given a series of uniform equal Payments a series of uniform equal Payments ( 1 + ii ) N - 1 (1+ )N-1 F=A F=A ii uniform series compound amount factor in [ ] uniform series compound amount factor in [ ] functionally expressed as F = A ( F / A,i%,N ) functionally expressed as F = A ( F / A,i%,N ) predetermined values are in column 4 of Appendix predetermined values are in column 4 of Appendix C of text C of text
F=? A=
1 2 3 4 5 6 7 SEMESTER JANUARY 2010 8
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( F / A,i%,N ) = (P / A,i,N ) ( F / P,i,N ) ( F / A,i%,N ) = ( F / P,i,N-k )

k=1 N

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RELATING A UNIFORM SERIES (ORDINARY RELATING A UNIFORM SERIES (ORDINARY ANNUITY) TO PRESENT AND FUTURE EQUIVALENT ANNUITY) TO PRESENT AND FUTURE EQUIVALENT VALUES VALUES Finding P given A: Finding P given A: Finding present equivalent value given a series of Finding present equivalent value given a series of uniform equal receipts uniform equal receipts ( 1 + ii ) N - 1 (1+ )N-1 P=A P=A ii ( 1 + ii ) N (1+ )N uniform series present worth factor in [[ ]] uniform series present worth factor in functionally expressed as P = A ( P // A,i%,N ) functionally expressed as P = A ( P A,i%,N ) predetermined values are in column 5 of Appendix predetermined values are in column 5 of Appendix C of text C of text A= 1 2 3 4 5 6 7 8
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P=?

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( P / A,i%,N ) = ( P / F,i,k )
N k=1

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RELATING A UNIFORM SERIES (ORDINARY RELATING A UNIFORM SERIES (ORDINARY ANNUITY) TO PRESENT AND FUTURE EQUIVALENT ANNUITY) TO PRESENT AND FUTURE EQUIVALENT VALUES VALUES Finding A given F: Finding A given F: Finding amount A of a uniform series when given the Finding amount A of a uniform series when given the equivalent future value equivalent future value ii A=F A=F ( 1 + ii ) N -1 ( 1 + ) N -1 sinking fund factor in [[ ]] sinking fund factor in functionally expressed as A = F ( A // F,i%,N ) functionally expressed as A = F ( A F,i%,N ) predetermined values are in column 6 of Appendix predetermined values are in column 6 of Appendix F= C of text C of text
1 2 3 4 5 6 7 SEMESTER JANUARY 2010 8

A =?

22

( A / F,i%,N ) = 1 / ( F / A,i%,N ) ( A / F,i%,N ) = ( A / P,i%,N ) - i

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RELATING A UNIFORM SERIES (ORDINARY RELATING A UNIFORM SERIES (ORDINARY ANNUITY) TO PRESENT AND FUTURE EQUIVALENT ANNUITY) TO PRESENT AND FUTURE EQUIVALENT VALUES VALUES Finding A given P: Finding A given P: Finding amount A of a uniform series when given the Finding amount A of a uniform series when given the equivalent present value equivalent present value ii ( 1+i )N ( 1+i )N A=P A=P ( 1 + ii ) N -1 ( 1 + ) N -1 capital recovery factor in [[ ]] capital recovery factor in functionally expressed as A = P ( A // P,i%,N ) functionally expressed as A = P ( A P,i%,N ) predetermined values are in column 7 of Appendix predetermined values are in column 7 of Appendix P= C of text C of text
1 2 3 4 5 6 7 SEMESTER JANUARY 2010 8

A =?

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( A / P,i%,N ) = 1 / ( P / A,i%,N )

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CONCEPT OF EQUIVALENCE
A sum of $10,000 is borrowed by a refining oil company. The capital and interest have to be repaid within four (4) years at an interest rate of five (5) percent per year. Q1. Proposed four (4) different equivalent plans of payments Q2. Construct the cash flow diagram for each plan of payment.
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Proposal of the four (4) plans

Year Investment ($) 0 1 2 3 4 10,000 500 500 500 10,500 2,500+500 2,500+375 2,500+250 2,500+125 2,820 2,820 2,820 2,820 0 0 0 12,155
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Plan I ($)

Plan II ($)

Plan III ($)

Plan IV ($)

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