Engineering Economy

The Time Value of Money

Chapter 1 time value of money : subjects covered

➢Simple Interest

➢Compound Interest

➢Notation and Cash-Flow Diagrams

➢Relating Present and Future Equivalent Values of Single Cash Flows

• Finding F when Given P
• Finding P when Given F
• Finding the Interest Rate Given P, F, and N
• Finding N when Given P, F, and

➢The Concept of Equivalence

➢Annuities
➢Nominal and Effective Interest Rates
 Time Value of Money: Introduction

• A dollar today is worth more than a dollar one or

more years from now. (because of profit it can
earn now)
• Capital refers to wealth in the form of money or
property, that can be used to produce more
wealth.
 Simple Interest

Simple interest is used infrequently.

When the total interest earned or charged is linearly
proportional to the initial amount of the loan
(principal), the interest rate, and the number of
interest periods, the interest and interest rate are said
to be simple.
 Simple Interest : Computation of simple interest

The total interest, I, earned or paid may be computed

using the formula below.

P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period
The total amount repaid at the end of N interest
periods is P + I.
 Simple Interest: Concept and Computation

Example1:
If $1,000 were invested for three years at a simple interest rate of 10% per
year, what would be the interest earned and the total amount owed at the end
of three years?

Solution:

I= 1000x3x0.1=$300
 Compound Interest: Concept and Computation

Compound interest reflects both the remaining principal and any

accumulated interest. For $1,000 at 10%…

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed Interest Amount
at beginning of amount for owed at end
Period period period of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

Compound interest is commonly used in personal and professional financial

transactions.
 Cash Flow Diagrams

A cash flow diagram is an indispensable tool for

clarifying and visualizing a series of cash flows.

View point: lender

 Cash Flow Diagrams

Example3:
An investment of $10,000 will produce uniform
annual revenues of $5,310 for five years and then
have a market (recovery) value of $2000 at the end
of year 5.
Annual expenses will be $3000 at the end of each
year for operating and maintaining the project.

Draw a cash flow diagram for the five- year life of

the project. Use the lender’s viewpoint
Cash flow diagram
Economic equivalence allows us to compare alternatives on a common basis

We need some tools to find economic

equivalence.
• Notation used in formulas for compound interest
calculations.
– i = effective interest rate per interest period
– N = number of compounding (interest) periods
– P = present sum of money; equivalent value of one or
more cash flows at a reference point in time; the
present
– F = future sum of money; equivalent value of one or
more cash flows at a reference point in time; the future
– A = end-of-period cash flows in a uniform series
continuing for a certain number of periods, starting at
the end of the first period and continuing through the
last
Economic equivalence allows us to compare alternatives on a common basis
Economic equivalence allows us to compare alternatives on a common basis

Writing in more efficient way we can

say that:

$ 1,191.02 =$1000 x (1.06)^3

Present Value of a Single Amount
Remember our equation?

n
F = P (1 + i)

We can solve for PV and get . . . .

F
P = n
(1 + i)
 It is common to use standard notation for
interest factors.

This is also known as the single payment

compound amount factor.
The term on the right is read “F given P at i
% interest per period for N interest periods.”
P
 It is common to use standard notation for
interest factors.
.
The term on the right is read “P given F at i
% interest per period for N interest periods.”

F
is called the single payment present worth
factor.
 Present Value of a Single Amount
Assume you plan to buy a new car in 5 years and
you think it will cost $20,000 at that time.
What amount must you invest today in order to
accumulate $20,000 in 5 years, if you can earn 8%
interest compounded annually?
 Present Value of a Single Amount
i = .08, n = 5 , F=$20,000

Solution by using the equation:

P=F(1+0.08)^-5=20000(1.08)^-5=$13,612
 Present Value of a Single Amount
i = .08, n = 5 , F=$20,000

Solution by using the interest rate table:

P=F(P/F,8%,5)
 Present Value of a Single Amount
i = .08, n = 5 , F=$20,000

Solution by using the interest rate table:

P=F(P/F,8%,5)

P= $20,000 × .6806 = $13,612

If you deposit $13,611.60 now, at 8% annual
interest, you will have $20,000 at the end of 5
years.
 Solving for Other Values

FV = PV (1 + i)n
Number
of Compounding
Future Present Interest Periods
Value Value Rate

There are four variables needed when

determining the time value of money.
If you know any three of these, the fourth
can be determined.
 Example: Untabulated i
Determine the value for (F/P, 8.3%,10)

Formula: F = (1 + 0.083)10 = 2.2197 OK

Interpolation: 8% ------ 2.1589

8.3% ------ x
9% ------ 2.3674

x = 2.1589 + [(8.3 - 8.0)/(9.0 - 8.0)][2.3674 – 2.1589]

= 2.2215

Absolute Error = 2.2215 – 2.2197 = 0.0018 , 0.08 %

 Compound Interest: Concept and Computation

Example 1:
An investor has an option to purchase a tract of land that will be worth $10,000 in six
years. If the value of the land increases at 8% each year, how much should the
investor be willing to pay now for this property?
 Compound Interest: Concept and Computation

Solution :
F=$10,000 , N=6 years, i=8% each year, how much should the investor be willing to
pay now for this property?
P=F(P/F,8%,6)=10,000 (0.6302)=$6305
 Compound Interest: Concept and Computation

Example 2 :
If we want to turn $500 into $1000 over a period of 10 years, at what interest rate
would we have to invest it?

Solution :

P=500, F=1000, N=10 years

F=p(F/P,I,10)=p(1+i)^n, SO:
1000=500(1+i)^10
2=(1+i)^10
i=0.071
i=7.1%
 Compound Interest: Concept and Computation
Example 3:
How long would it take for $500 invested today at 15% interest per year to be worth
$1,000?
P=500, F=1000
Solution :
F=p(F/P, 15%, N)
1000=500(F/P, 15%, N)
2=(F/P, 15%, N), BY looking at the column of F/P, the value is almost 2 when N=5

So, N=5 years