Module 4: Time Value of Money

Crisis in the Gulf

How vividly do you remember the biggest man-made environmental
catastrophe in American history—millions of gallons of oil flowing
unchecked into the Gulf of Mexico from an undersea well? In
response to this tragedy, British Petroleum (BP) will make payments
into a fund to pay for some of the damages to the Gulf Coast
resulting from their massive oil spill in April and following months
of 2010. BP will pay $3 billion at the end of the third quarter of 2010
and another $2 billion in the fourth quarter of 2010. BP will then
make payments of $1.25 billion each quarter thereafter until a total of
$20 billion has been paid into the fund. If the opportunity cost of
capital (interest rate) is 3% per quarter, what is the equivalent value
of this payment stream at the beginning of the third quarter of 2010?
This is one type of problem you can answer after studying Chapter 4.
 Chapter Objectives

At the end of this chapter, you will be able to:

• Estimate the present and future value of money
• Apply uniform, arithmetic and geometric series
in estimating capital values
• Determine economic equivalence of alternative
capital options

3
 Case Study – Warren Buffet’s Berkshire
Hathaway

 Went public in 1965: $18 per share

 Worth today (August 22, 2003): $76,200
 Annual compound growth: 24.58%
 Current market value: $100.36 Billion
 If he lives till 100 (current age: 73 years as
of 2003), his company’s total market value
will be ?

𝐹 = $100.36(1 + 0.2458)27 = $37.902 𝑡𝑟𝑖𝑙𝑙𝑖𝑜𝑛𝑠

 Assume that the company’s stock will continue to appreciate at

an annual rate of 24.58% for the next 27 years.
 Time Value of Money

Money has a time value.

 Capital refers to wealth in the form of money
or property that can be used to produce more
wealth.
 Engineering economy studies involve the
commitment of capital for extended periods
of time.
 A dollar today is worth more than a dollar
one or more years from now (for several
reasons).
 Time Value of Money

❑ Money has a time value because it can earn

more money over time (earning power).
❑ Money has a time value because its
purchasing power changes over time
(inflation).
❑ Time value of money is measured in terms of
interest rate which reflects both earning and
purchasing power in the financial market.
❑ Interest is the cost of money—a cost to the
borrower and an earning to the lender
 Capital

Return to capital in the form of interest and profit is an

essential ingredient of engineering economy studies.
 Interest and profit pay the providers of capital for forgoing its use
during the time the capital is being used.
 Interest and profit are payments for the risk the investor takes in letting
another use his or her capital.
 Any project or venture must provide a sufficient return to be financially
attractive to the suppliers of money or property.
 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.
 Interest & Annuity for Discrete
Compounding
To Find Known Factor
F P (𝐹 Τ𝑃, 𝑖%, 𝑁) = (1 + 𝑖)𝑁
P F (𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁
(1 + 𝑖)𝑁 −1
F A (𝐹 ൗ𝐴, 𝑖%, 𝑁) =
𝑖
(1 + 𝑖)𝑁 −1
P A (𝑃ൗ𝐴, 𝑖%, 𝑁) =
𝑖(1 + 𝑖)𝑁
𝑖
A F (𝐴ൗ𝐹, 𝑖%, 𝑁) =
(1 + 𝑖)𝑁 −1
𝑖(1 + 𝑖)𝑁
A P (𝐴ൗ𝑃, 𝑖%, 𝑁) =
(1 + 𝑖)𝑁 −1
1 (1 + 𝑖)𝑁 −1 𝑁
P G (𝑃ൗ𝐺, 𝑖%, 𝑁) = −
𝑖 𝑖(1 + 𝑖)𝑁 (1 + 𝑖)𝑁
1 𝑁
A G (𝐴ൗ𝐺, 𝑖%, 𝑁) = −
𝑖 (1 + 𝑖)𝑁 −1
 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.
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 F = P + I.
 Example 1 – Simple Interest

If $5,000 were loaned for five years at a simple interest rate of 7%

per year, the interest earned would be

So, the total amount repaid at the end of five years would be the
original amount ($5,000) plus the interest ($1,750), or $6,750.
 Compound Interest
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 at Interest amount Amount owed at
Period beginning of period for period end 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
𝑛 = 0; 𝐹0 = 𝑃(1 + 𝑖)0 = 𝑃
𝑛 = 1; 𝐹1 = 𝐹0 1 + 𝑖 = 𝑃 1 + 𝑖 financial transactions.
𝑛 = 2; 𝐹2 = 𝐹1 1 + 𝑖 = 𝑃 1 + 𝑖 1 + 𝑖 = 𝑃(1 + 𝑖)2
𝑛 = 3; 𝐹3 = 𝐹2 1 + 𝑖 = 𝑃 1 + 𝑖 2 1 + 𝑖 = 𝑃(1 + 𝑖)3 𝑭 = 𝑷(𝟏 + 𝒊)𝑵
𝑛 = 𝑁; 𝐹𝑁 = 𝐹𝑁−1 1 + 𝑖 = 𝑃 1 + 𝑖 𝑁−1 1 + 𝑖 = 𝑃(1 + 𝑖)𝑁
 Compounding Process
End of Beginning Interest Ending
Year Balance earned Balance
0 $1,000
1 $1,000 $80 $1,080
2 $1,080 $86.40 $1,166.40
3 $1,166.40 $93.31 $1,259.71

$1,080
$1,166.40
0 $1,259.71
1
2
$1,000
3
$1,080
$1,166.40
 Compounding
1 Process
Beginning Ending
Balance Interest Balance
Year
earned P = $1,000
BOY EOY
i = 8%
0 $1,000
N = 1, 2, 3
1 $1,000 $80 $1,080
𝑭 = 𝑷(𝟏 + 𝒊)𝑵
2 $1,080 $86.40 $1,166.40
3 $1,166.40 $93.31 $1,259.71
$1,000.00

0 1 2 3
$1,080.00 $1,166.40 $1,259.71

0 1 0 1 2 0 1 2 3
n=1 n=2 n=3
 Compounding Process

A Typical Compound Interest Table at 12% 𝑭 = 𝑷(𝑭Τ𝑷, 𝟏𝟐%, 𝟏𝟎)

𝐹 = $20,000 3.1058 = $62,116
To find the compound
interest factor when
the interest rate is 12%
and the number of
interest periods is 10,
we could evaluate the
following equation
using the interest table.
 Economic Equivalence

Economic equivalence allows us to compare alternatives on a

common basis.

 Each alternative can be reduced to

an equivalent basis dependent on
 interest rate,
 amount of money involved, and
 timing of monetary receipts or
expenses.
 Using these elements we can
“move” cash flows so that we can
compare them at particular points
in time.
 Economic Equivalence

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
 Cash Flow Diagram

A Graphical Representation of Cash Transactions over Time

Borrow $20,000 at 9% interest
over 5 years, requiring $200
loan origination fee upfront.
The required annual
repayment is $5,141.85 over 5
years.

o n = 0: $20,000
o n = 0: $200
𝑨 = 𝑷(𝑨Τ𝑷, 𝟗%, 𝟓)
o n = 1 ~ 5: $5,141.85
𝐴 = $20,000 0.2571 = $5,142
Cash Flow Tables-(Example 4-2)
 Cash Flow Tables-(Example 4-2)

Cash flow tables are essential to modeling engineering

economy problems in a spreadsheet
 Example 2 – Repayment Plan

Which Repayment Plan?

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)
 Example 2 – Repayment Plan

Plan 1 𝑃 = $20,000 − $200 − 𝐴(𝑃Τ𝐴, 9%, 5)

$20,000.00
𝑃 = $19,800 − ($5,141.85)(3.890)
1 2 3 4 5
0 𝑃 = −$201.80

$200 A=$5,141.85

$20,000.00 Plan 2 𝑃 = $20,000 − $200 − 𝐹(𝑃Τ𝐹, 9%, 5)

𝑃 = $19,800 − ($30,772.48)(0.6499)
1 2 3 4 5
0 𝑃 = −$166.54

$200 $30,772.48

Choose Plan 2
 Future-Present Value

We can apply compound interest formulas to “move” cash

flows along the cash flow diagram.
Using the standard notation, we find that a present amount, P, can
grow into a future amount, F, in N time periods at interest rate i
according to the formula below.

In a similar way we can find P given F by

 Interest Formula

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.”

is called the single payment present worth factor.

 Example 3 – Time Value
We can use these to find economically equivalent values at different
points in time.
$2,500 at time zero is equivalent to how much after six years if the interest rate is 8% per year?
𝐹 = $2,500(𝐹 Τ𝑃, 8%, 6) = $2,500 1.589 = $𝟑, 𝟗𝟔𝟕 (1 + 𝑖)𝑁 = (𝐹 Τ𝑃, 8%, 6)

$2,500 F (1 + 0.08)6 = 1.5869

=

0 6
$3,000 at the end of year seven is equivalent to how much today (time zero) if the interest
rate is 6% per year?
𝑃 = $3,000(𝑃Τ𝐹, 6%, 7) = $3,000 0.6651 = $𝟏, 𝟗𝟗𝟓
(1 + 𝑖)−𝑁 = (𝑃Τ𝐹, 6%, 7)
$3,000 P
= (1 + 0.06)−7 = 0.6651

7 0
 Excel Spreadsheet

There are specific spreadsheet functions to find N and i.

The Excel function used to solve for N is

NPER(rate, pmt, pv), which will compute the number of payments of
magnitude pmt required to pay off a present amount (pv) at a fixed
interest rate (rate).

One Excel function used to solve for i is

RATE(nper, pmt, pv, fv), which returns a fixed interest rate for an annuity
of pmt that lasts for nper periods to either its present value (pv) or future
value (fv).
 Excel Spreadsheet

Present Value, PV P =PV(rate,nper,pmt,[fv])

Future Value, FV F =FV(rate,nper,pmt,[pv])
Uniform Payment, PMT A =PMT(rate,nper,pv,[fv])
Interest Rate, RATE i =RATE(nper,pmt,pv,[fv])
Period of payment, NPER N =NPER(rate,pmt,pv,[fv])
 Excel 1 – Future Value
❑ Given: P = $2,500,
 i = 8%, N = 6 years

❑ Find: F
𝐹 = $2,500(𝐹 Τ𝑃, 8%, 6) = $2,500 1.589 = $𝟑, 𝟗𝟔𝟕

A B
1 P 2,500
2 i 8%
3 N 6 = 𝐹𝑉(8%, 6,0, −2500)
4 = 𝐹𝑉(𝐵2, 𝐵3,0, −𝐵1)
5 F $3,967.19
 Exercise 1 – Present Value

Betty will need $12,000 in five years to pay for a major overhaul
on her tractor engine. She has found an investment that will
provide a 5% return on her invested funds. How much does Betty
need to invest today so she will have her overhaul funds in five
years?
$12,000 𝑃 = 𝐹(𝑃Τ𝐹, 5%, 5) = $12,000 0.7835 = $𝟗, 𝟒𝟎𝟐
0
(1 + 𝑖)−𝑁 = (𝑃Τ𝐹, 5%, 5)
5
(1 + 0.05)−5 = 0.7835
P
A B
1 F 12,000
2 i 5%
3 N 5 = 𝑃𝑉(5%, 5,0, −12000)
4 = 𝑃𝑉(𝐵2, 𝐵3,0, −𝐵1)
5 P $9,402.31
 Exercise 2 – Multiple Payments
Finding an Equivalent Value for Multiple Payments
Compute the equivalent value
of the cash flow series at n = 3,
using i = 10%. $200 V
$150

$100
$120
$100
=
(𝐹 Τ𝑃, 𝑖%, 𝑁) = (1 + 𝑖)𝑁 $80

(𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁 0 1 2 3 4 5 0 1 2 3 4 5

𝑉3 = 100(𝐹 Τ𝑃, 10%, 3) + 80(𝐹 Τ𝑃, 10%, 2) + 120(𝐹 Τ𝑃, 10%, 1) + 150 + 200(𝑃Τ𝐹, 10%, 1) + 100(𝑃Τ𝐹, 10%, 2)

𝑉3 = 100 1.331 + 80 1.210 + 120 1.100 + 150 + 200 0.9091 + 100(0.8264)

𝑉3 = 133.1 + 96.8 + 132 + 150 + 181.82 + 82.64 = $𝟕𝟕𝟔. 𝟑𝟔
 Types of Cash Flows

Common Cash Flows

a) Single cash flow

b) Equal (uniform) payment series at
regular intervals
c) Linear gradient series
d) Geometric gradient series
e) Irregular (random) payment series
 Future Values of Annuity

There are interest factors for a series of end-of-period cash flows.

How much will you have in 40 years if you save $3,000 each year and
your account earns 8% interest each year?
 Excel 2 – Future Value
F

0 1 2 3 4 5 36 37 38 39 40

A=$3,000 A=$3,000

1+𝑖 𝑁−1
(𝐹 ൗ𝐴, 8%, 40) =
𝑖
1 + 0.08 40 − 1
=
0.08
= 259.0565
𝐹 = $3,000(𝐹 Τ𝐴, 8%, 40) = $3,000 259.0565 = $𝟕𝟕𝟏, 𝟏𝟕𝟎
A B
1 A 3,000
2 i 8%
3 N 40 = 𝐹𝑉(8%, 40, −3000)
4 = 𝐹𝑉(𝐵2, 𝐵3, −𝐵1)
5 F $777,169.56
 Present Values of Annuity

Finding the present amount from a series of end-of-period cash flows.

How much would is needed today to provide an annual amount of

$50,000 each year for 20 years, at 9% interest each year?
 Excel 3 – Present Value
P

0 1 2 3 4 5 16 17 18 19 20

A=$50,000 A=$50,000

1+𝑖 𝑁−1
(𝑃ൗ𝐴, 9%, 20) =
𝑖(1 + 𝑖)𝑁
1 + 0.09 20 − 1
=
(0.09)(1 + 0.09)20
= 9.1285
𝑃 = $50,000(𝑃Τ𝐴, 9%, 20) = $50,000 9.1285 = $𝟒𝟓𝟔, 𝟒𝟐𝟓
A B
1 A 50,000
2 i 9%
3 N 20 = 𝑃𝑉(9%, 20, −50000)
4 = 𝑃𝑉(𝐵2, 𝐵3, −𝐵1)
5 P $456,427.28
 Sinking Fund

Finding A when given F.

F
A A A

0 1 2 N 1 2 N

How much would you need to set aside each year for 25 years, at 10%
interest, to have accumulated $1,000,000 at the end of the 25 years?
 Excel 4 – Equivalent Annual Value
$1,000,000

0 1 2 3 4 5 20 22 23 24 25

A A

𝑖
(𝐴ൗ𝐹, 10%, 25) =
(1 + 𝑖)𝑁 −1
0.10
=
(1 + 0.10)25 −1
= 0.0102
𝐴 = $1,000,000(𝐴Τ𝐹, 10%, 25) = $1,000,000 0.0102 = $𝟏𝟎, 𝟐𝟎𝟎
A B
1 F 1,000,000
2 i 10%
3 N 25 = 𝑃𝑀𝑇(10%, 25,0, −1000000)
4 = 𝑃𝑀𝑇(𝐵2, 𝐵3,0, −𝐵1)
5 A $10,168.07
 Annual Payout

Finding A when given P.

0 1 2 N
A A A
P
0 1 2 N
Equivalent Present Worth
0 N

If you had $500,000 today in an account earning 10% each year, how
much could you withdraw each year for 25 years?
 Excel 5 – Equivalent Annual Value
$500,000

0 1 2 3 4 5 20 22 23 24 25

A A

𝑖
(𝐴ൗ𝑃, 10%, 25) =
(1 + 𝑖)𝑁 −1
0.10
=
(1 + 0.10)25 −1
= 0.0102
𝐴 = $500,000(𝐴Τ𝑃, 10%, 25) = $500,000 0.1102 = $𝟓𝟓, 𝟏𝟎𝟎
A B
1 P 500,000
2 i 10%
3 N 25 = 𝑃𝑀𝑇(10%, 25,0, −1000000)
4 = 𝑃𝑀𝑇(𝐵2, 𝐵3,0, −𝐵1)
5 A $55,084.04
 Exercise 3 – Instalments

Acme Steamer purchased a new pump for $75,000. They

borrowed the money for the pump from their bank at an interest
rate of 0.5% per month and will make a total of 24 equal, monthly
payments. How much will Acme’s monthly payments be?
Acme’s monthly payments are

A B
1 P 75,000
2 i 0.5%
3 N 24
4
5 A $3,324.05
 Interest Rate vs Period

It can be challenging to solve for N or i.

 We may know P, A, and i and want to find N.
 We may know P, A, and N and want to find i.
 These problems present special challenges that are best
handled on a spreadsheet.
 Example 4 – Loan Period
Finding N
Acme borrowed $100,000 from a local bank, which charges them an interest
rate of 7% per year. If Acme pays the bank $8,000 per year, now many years
will it take to pay off the loan? A B
P 100,000
i 7.0%
A 8,000

N 30.73

= 𝑁𝑃𝐸𝑅(7%, −8000,100000)
So,
𝑵 = 𝟑𝟎. 𝟕

This can be solved by using the interest tables and interpolation, but we
generally resort to a computer solution.
 Payback Period

❑ Principle
N Cash Flow Cum. Flow
How fast can I recover my initial
investment? 0 −$105,000+$20,000 −$85,000
❑ Method 1 $15,000 −$70,000
Based on the cumulative cash 2 $25,000 −$45,000
3 $35,000 −$10,000
flow (or accounting profit) $45,000 $35,000
4
❑ Screening Guideline 5 $45,000 $80,000
If the payback period is less than 6 $35,000 $115,000
or equal to some specified bench-
mark period, the project would be Payback period should occurs
considered for further analysis. somewhere between
❑ Weakness N = 3 and N = 4.
Does not consider the time value
of money
 Example 5 – Rate of Return
Finding i
Jill invested $1,000 each year for five years in a local company and sold her
interest after five years for $8,000. What annual rate of return did Jill earn?
A B
1 F 8,000
2 A 1,000
3 N 5
4
5 i 23.69%

= 𝑅𝐴𝑇𝐸(5, −1000,0,8000)
So,
i = 23.65%

Again, this can be solved using the interest tables and interpolation, but
we generally resort to a computer solution.
 Exercise 4 – Interest Rate

Finding an Interest Rate that Establishes an Economic Equivalence

At what interest rate
would you be indifferent
choosing between the two
cash flows?
Approach
Step 1: Select a base period to compute the equivalent
value (say, N = 3).
Step 2: Find the equivalent worth of each cash flow
series at N = 3.

$1,000
$500 Option A : F3 = $500(1 + i)3 + $1,000
Option B: F3 = $502(1 + i)2 + $502(1 + i) + $502 $1,000
A
$500
0 1 2 3 i = 8% A
Option A : F3 = $500(1.08)3 + $1,000 0 1 2 3
= $1,630
$502 $502 $502
Option B : F3 = $502(1.08)2 + $502(1.08) + $502
$502 $502 $502
B = $1,630
B

0 1 2 3 0 1 2 3
 Deferred Annuity

We need to be able to handle cash flows that do not

occur until some time in the future.
 Deferred annuities are uniform series that do not begin until
some time in the future.
 If the annuity is deferred J periods then the first payment (cash
flow) begins at the end of period J+1.
 Value of Deferred Annuity

Finding the value at time 0 of a deferred annuity is a two-step

process.
1. Use (P/A, i%, N-J) find the value of the deferred annuity at
the end of period J (where there are N-J cash flows in the
annuity).
2. Use (P/F, i%, J) to find the value of the deferred annuity at
time zero.
 Exercise 5 – Maintenance Expenses

Irene just purchased a new sports car and wants to also set aside cash for
future maintenance expenses. The car has a bumper-to-bumper warranty
for the first five years. Irene estimates that she will need approximately
$2,000 per year in maintenance expenses for years 6-10, at which time she
will sell the vehicle. How much money should Irene deposit into an account
today, at 8% per year, so that she will have sufficient funds in that account
to cover her projected maintenance expenses?
P5
P0
i=8%

1 2 3 4 5 6 7 8 9 10

𝑃0 = 𝐴(𝑃Τ𝐴, 𝑖%, 𝑁 − 𝐽)(𝑃Τ𝐹, 𝑖%, 𝐽)

$2,000
𝑃0 = 𝐴(𝑃Τ𝐴, 8%, 10 − 5)(𝑃Τ𝐹, 8%, 5)
𝑃0 = $2,000 3.9927 0.6806 = $5,435
 Uniform Gradient

Sometimes cash flows change by a constant amount each period.

We can model these situations as a uniform gradient of cash flows.
The table below shows such a gradient.
End of Period Cash Flows
1 0
2 G
3 2G
: :
N (N-1)G

present value
 Uniform Gradient

We can also find A or F equivalent to a uniform gradient series.

 Example 6 – A/G
The annual equivalent of this End of Year Cash Flows ($)
series of cash flows can be found
by considering an annuity portion 1 2,000
of the cash flows and a gradient 2 3,000
portion. 3 4,000
4 5,000

End of Year Annuity ($) Gradient ($)

1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000
 Geometric Gradient

Sometimes cash flows change by a constant rate,

each period--this is a geometric gradient series.

This table presents a geometric

gradient series. It begins at the end
of year 1 and has a rate of growth,
, of 20%.

End of Year Cash Flows ($)

1 1,000
2 1,200
3 1,440
4 1,728
Geometric Gradient
 Geometric Gradient
We can find the present value of a geometric series by using the
appropriate formula below.

Where is the initial

cash flow in the series.
 Exercise 5 – Revenue Estimation

Acme Miracle projects good things for their new weight loss pill, LoseIt.
Revenues this year are expected to be $1.1 million, and Acme believes they
will increase 15% per year for the next 5 years. What are the present value
and equivalent annual amount for the anticipated revenues? Acme uses an
interest rate of 20%.

Use the geometric gradient formula to find the present value, then
convert the present amount to an annual amount.

𝐴1 1 − (𝑃Τ𝐹, 𝑖%, 𝑁)(𝐹 Τ𝑃, 𝑓 ҧ %, 𝑁)

𝑃0 =
𝑖 − 𝑓ҧ

$1,100,000 1 − 𝑃Τ𝐹, 20%, 5 𝐹 Τ𝑃, 15%, 5

𝑃0 = = $20,221,914
0.20 − 0.15

𝐴 = $20,221,914(𝐴Τ𝑃, 20%, 5) = $6,762,208

 Variable Interest

When interest rates vary with time different procedures

are necessary.

 Interest rates often change with time (e.g., a variable rate

mortgage).
 We often must resort to moving cash flows one period at a time,
reflecting the interest rate for that single period.
 Variable Interest

The present equivalent of a cash flow occurring at the end of period N

can be computed with the equation below, where ik is the interest rate for
the kth period.
𝑭𝑵
𝑷=
σ𝑵
𝒌=𝟏(𝟏 + 𝒊𝒌 )

If F4 = $1,000 and i1=10%, i2=12%, and i3=13%, and i4=10%, then

𝑃 = $1,000(𝑃Τ𝐹, 10%, 1)(𝑃Τ𝐹, 12%, 1)(𝑃Τ𝐹, 13%, 1)(𝑃Τ𝐹, 10%, 1)

𝑃 = $1,000 0.9091 0.8929 0.8850 0.9091 = $653
 Variable Interest

The present equivalent of a cash flow occurring at the end of period N

can be computed with the equation below, where ik is the interest rate for
the kth period.
𝑭𝑵
𝑷=
σ𝑵
𝒌=𝟏(𝟏 + 𝒊𝒌 )

If F3 = $2,500 and i1=8%, i2=10%, and i3=11%, then

 Variable Interest
𝑭𝑵
If F3 = $2,500 and i1=8%, i2=10%, and i3=11%, then 𝑷=
σ𝑵
𝒌=𝟏(𝟏 + 𝒊𝒌 )

2,500

0 1 2 3 2,500
𝑃= = $1,896
(1 + 0.08)(1 + 0.10)(1 + 0.011)
P
𝑁

𝑃 = 𝐹𝑁 ෍ (𝑃Τ𝐹, 𝑖𝑘 , 1)
𝑘=1
 Interest Rates

Nominal and effective interest rates.

 More often than not, the time between
successive compounding, or the interest 18% Compounded Monthly
period, is less than one year (e.g., daily,
monthly, quarterly).
 The annual rate is known as a nominal Interest
Nominal
rate. period
interest rate
 A nominal rate of 12%, compounded
monthly, means an interest of 1% Annual
(12%/12) would accrue each month, and percentage
the annual rate would be effectively rate (APR)
somewhat greater than 12%.
 The more frequent the compounding the
greater the effective interest.
 Effective Interest

The effect of more frequent compounding can be easily determined.

Let r be the nominal, annual interest rate and M the number of

compounding periods per year. We can find, i, the effective interest by
using the formula below.

𝒓 𝑴
𝒊= 𝟏+ −𝟏
𝑴
 Interest Rates
Nominal and Effective Interest Rates with Different
Compounding Periods
Effective Rates
Nominal Compounding Compounding Compounding Compounding Compounding
Rate Annually Semi-annually Quarterly Monthly Daily

4% 4.00% 4.04% 4.06% 4.07% 4.08%

5 5.00 5.06 5.09 5.12 5.13

6 6.00 6.09 6.14 6.17 6.18

7 7.00 7.12 7.19 7.23 7.25

8 8.00 8.16 8.24 8.30 8.33

9 9.00 9.20 9.31 9.38 9.42

10 10.00 10.25 10.38 10.47 10.52

11 11.00 11.30 11.46 11.57 11.62

12 12.00 12.36 12.55 12.68 12.74

 Effective Interest Rates

Finding effective interest rates.

For an 18% nominal rate, compounded quarterly, the effective interest is.

For a 7% nominal rate, compounded monthly, the effective interest is.

 Exercise 6 – Motorcycle Loan

Ali plans to buy a Honda 500Z with MSRP $20,870 with instant rebate $2,443.
He is required to pay down payment of $3,427 on a loan with 6.25% APR for a
total of 72 months. What would be his monthly payment?
 Continuous Compounding

Interest can be compounded continuously.

 Interest is typically compounded at the end of discrete periods.
 In most companies cash is always flowing, and should be immediately
put to use.
 We can allow compounding to occur continuously throughout the
period.
 The effect of this compared to discrete compounding is small in most
cases.

C
 r 
i = lim 1 +  − 1 C→
C →
 CK 
= er /K − 1
 Effective Interest Rates

We can use the effective interest formula to derive the

interest factors.

As the number of compounding periods gets larger (M gets

larger), we find that
 Exercise 7 – Motorcycle Loan
F =?
If you invest $1,000 in a savings account that pays 6% annual interest
compounded continuously, what would be the balance at the end of 3 years?

0
1 2 3

$1,000

ia = e0.06 − 1
= 6.18%
F = $1, 000( F / P, 6.18%,3)
= $1,197.09
 Effective Interest Rates

Continuous compounding interest factors.

The other factors can be found from these.

 Summary
69

 Capital expenditure evaluation require time value

projection of money.

 Time value of money can be estimated using (1) uniform,

(2) arithmetic, (3) geometric series interest rates

 Future values, present values, annuities, and interest rates

estimation is determined with appropriate
methods/formulae
 Example 2 – Pumping System
Life Cycle Cost comparison for all design options

𝒅−𝒊
𝒓=
𝟏+𝒊

70
 Example 2 – Pumping System
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

$11,088 + $500 $5,568 + $1,000

$5,000 $21,500
$2,500 $2,500

Option A Option C

0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

$6,720 + $500 $11,088 + $500 + $4,000

$2,250
$2,500 $2,500

Option B Option D

71
 Example 2 – Pumping System

0 1 2 3 4 5 6 7 8
Option A

12,052 12,534 13,035 13,556 14,098 14,662 15,249 15,859

5,000

2,704 2,925
3,163 3,421

𝑷 = 𝟓, 𝟎𝟎𝟎 + 𝟏𝟐, 𝟎𝟓𝟐 𝑷Τ𝑭 , 𝟖%, 𝟏 + 𝟏𝟓, 𝟐𝟑𝟖 𝑷Τ𝑭 , 𝟖%, 𝟐 + 𝟏𝟑, 𝟎𝟑𝟓 𝑷Τ𝑭 , 𝟖%, 𝟑 + 𝟏𝟔, 𝟒𝟖𝟏 𝑷Τ𝑭 , 𝟖%, 𝟒
+𝟏𝟒, 𝟎𝟗𝟖 𝑷Τ𝑭 , 𝟖%, 𝟓 + 𝟏𝟕, 𝟖𝟐𝟓 𝑷Τ𝑭 , 𝟖%, 𝟔 + 𝟏𝟓, 𝟐𝟒𝟗 𝑷Τ𝑭 , 𝟖%, 𝟕 + 𝟏𝟗, 𝟐𝟖𝟎(𝑷Τ𝑭 , 𝟖%, 𝟖)

𝑷 = 𝟓, 𝟎𝟎𝟎 + 𝟏𝟐, 𝟎𝟓𝟐 𝟎. 𝟗𝟐𝟓𝟗 + 𝟏𝟓, 𝟐𝟑𝟖 𝟎. 𝟖𝟓𝟕𝟑 + 𝟏𝟑, 𝟎𝟑𝟓 𝟎. 𝟕𝟗𝟑𝟖 + 𝟏𝟔, 𝟒𝟖𝟏 𝟎. 𝟕𝟑𝟓𝟎 + 𝟏𝟒, 𝟎𝟗𝟖 𝟎. 𝟔𝟖𝟎𝟔
+𝟏𝟕, 𝟖𝟐𝟓 𝟎. 𝟔𝟑𝟎𝟐 + 𝟏𝟓, 𝟐𝟒𝟗 𝟎. 𝟓𝟖𝟑𝟓 + 𝟏𝟗, 𝟐𝟖𝟎(𝟎. 𝟓𝟒𝟎𝟑)

𝑷 = $𝟗𝟏, 𝟖𝟐𝟔

𝑨 = 𝟗𝟏, 𝟖𝟐𝟔 𝑨Τ𝑷 , 𝟖%, 𝟖 = 𝟗𝟏, 𝟖𝟐𝟔 𝟎. 𝟏𝟕𝟒𝟎 = $𝟏𝟓, 𝟗𝟕𝟖

$15,978
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟 = = $2.66
6,000 ℎ𝑟
72
 Example 2 – Pumping System
OPTION A 0 1 2 3 4 5 6 7 8
Capital 5,000
Energy 11,088 11,532 11,993 12,472 12,971 13,490 14,030 14,591 15,175
Maintenance 500 520 541 562 585 608 633 658 684
Repair 2,500 2,704 2,925 3,163 3,421
Others
Year Total 5,000 12,052 15,238 13,035 16,481 14,099 17,826 15,249 19,280
(P/F,8%,N) 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403
PV 5,000 11,159 13,063 10,347 12,114 9,595 11,234 8,898 10,417 Total PV $ 91,827
A $ 15,979

Cost/hr $2.66

OPTION B 0 1 2 3 4 5 6 7 8
Capital 2,250
Energy 6,720 6,989 7,268 7,559 7,861 8,176 8,503 8,843 9,197
Maintenance 500 520 541 562 585 608 633 658 684
Repair 2,500 2,704 2,925 3,163 3,421
Others
Year Total 2,250 7,509 10,513 8,122 11,371 8,784 12,299 9,501 13,302
(P/F,8%,N) 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403
PV 2,250 6,952 9,013 6,447 8,358 5,979 7,751 5,544 7,187 Total PV $ 59,480
A $ 10,350

Cost/hr $1.73
73
 Example 2 – Pumping System
OPTION C 0 1 2 3 4 5 6 7 8
Capital 21,500
Energy 5,568 5,791 6,022 6,263 6,514 6,774 7,045 7,327 7,620
Maintenance 1,000 1,040 1,082 1,125 1,170 1,217 1,265 1,316 1,369
Repair 2,500 2,704 2,925 3,163 3,421
Others
Year Total 21,500 6,831 9,808 7,388 10,608 7,991 11,474 8,643 12,410
(P/F,8%,N) 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403
PV 21,500 6,325 8,408 5,865 7,797 5,439 7,231 5,043 6,705 Total PV $ 74,313
A $ 12,931

Cost/hr $2.16

OPTION D 0 1 2 3 4 5 6 7 8
Capital 0
Energy 11,088 11,532 11,993 12,472 12,971 13,490 14,030 14,591 15,175
Maintenance 500 520 541 562 585 608 633 658 684
Repair 2,500 2,704 2,925 3,163 3,421
Others 4,000 4,160 4,326 4,499 4,679 4,867 5,061 5,264 5,474
Year Total 0 16,212 19,564 17,534 21,160 18,965 22,887 20,513 24,755
(P/F,8%,N) 1.0000 0.9259 0.8573 0.7938 0.7350 0.6806 0.6302 0.5835 0.5403
PV 0 15,010 16,772 13,919 15,553 12,908 14,423 11,969 13,375 Total PV $ 113,929
A $ 19,825

Cost/hr $3.30
74
 Example 2 – Pumping System
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

$11,088 + $500 $5,568 + $1,000

$5,000 $21,500
$2,500 $2,500

Option A Option C

0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8

$6,720 + $500 $11,088 + $500 + $4,000

$2,250
$2,500 $2,500

Option B Option D

𝒅 − 𝒊 𝟎. 𝟎𝟖 − 𝟎. 𝟎𝟒
𝒓= = = 𝟎. 𝟎𝟑𝟖𝟓
𝟏+𝒊 𝟏 + 𝟎. 𝟎𝟒
75
 Example 2 – Pumping System
0 1 2 3 4 5 6 7 8 (1 + 𝑖)𝑁 −1
(𝑃ൗ𝐴, 𝑖%, 𝑁) =
𝑖(1 + 𝑖)𝑁
$11,088 + $500
(𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁
$5,000
$2,500
𝑖(1 + 𝑖)𝑁
(𝐴ൗ𝑃, 𝑖%, 𝑁) =
Option A (1 + 𝑖)𝑁 −1
(1 + 0.0385)8 −1
𝑃𝑉1 = 5,000 + 11,088 + 500 8
= $83,504
0.0385 1 + 0.0385

𝑃𝑉2 = 2,500 (1 + 0.0385)−2 +(1.0385)−4 +(1.0385)−5 +(1.0385)−8 = $8,308

𝑷𝑽𝑨 = $𝟖𝟑, 𝟓𝟎𝟒 + $𝟖, 𝟑𝟎𝟖 = $𝟗𝟏, 𝟖𝟏𝟐

(0.08)(1 + 0.08)8 15,977

𝐴𝑉𝐴 = 91,812 = $15,977 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑜𝑟 = $2.66 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟
(1 + 0.08)8 −1 6,000

76
 Example 2 – Pumping System
1 2 3 4 5 6 7 8
0 (1 + 𝑖)𝑁 −1
(𝑃ൗ𝐴, 𝑖%, 𝑁) =
𝑖(1 + 𝑖)𝑁
$6,720 + $500

$2,250 (𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁

$2,500
𝑖(1 + 𝑖)𝑁
(𝐴ൗ𝑃, 𝑖%, 𝑁) =
Option B (1 + 𝑖)𝑁 −1
(1 + 0.0385)8 −1
𝑃𝑉1 = 2,250 + 6,720 + 500 8
= $51,163
0.0385 1 + 0.0385

𝑃𝑉2 = 2,500 (1 + 0.0385)−2 +(1.0385)−4 +(1.0385)−5 +(1.0385)−8 = $8,308

𝑷𝑽𝑩 = $𝟓𝟏, 𝟏𝟔𝟑 + $𝟖, 𝟑𝟎𝟖 = $𝟓𝟗, 𝟒𝟕𝟏

(0.08(1 + 0.08)8 10,349

𝐴𝑉𝐵 = 59,471 = $10,349 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑜𝑟 = $1.73 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟
(1 + 0.08)8 −1 6,000

77
 Example 2 – Pumping System
0 1 2 3 4 5 6 7 8
(1 + 𝑖)𝑁 −1
(𝑃ൗ𝐴, 𝑖%, 𝑁) =
𝑖(1 + 𝑖)𝑁
$5,568 + $1,000

$21,500 (𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁

$2,500
𝑖(1 + 𝑖)𝑁
Option C (𝐴ൗ𝑃, 𝑖%, 𝑁) =
(1 + 𝑖)𝑁 −1
(1 + 0.0385)8 −1
𝑃𝑉1 = 21,500 + 5,568 + 1,000 8
= $65,996
0.0385 1 + 0.0385

𝑃𝑉2 = 2,500 (1 + 0.0385)−2 +(1.0385)−4 +(1.0385)−5 +(1.0385)−8 = $8,308

𝑷𝑽𝑪 = $𝟔𝟓, 𝟗𝟗𝟔 + $𝟖, 𝟑𝟎𝟖 = $𝟕𝟒, 𝟑𝟎𝟒

(0.08)(1 + 0.08)8 12,930

𝐴𝑉𝐶 = 74,304 = $12,930 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑜𝑟 = $2.16 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟
(1 + 0.08)8 −1 6,000

78
 Example 2 – Pumping System
0 1 2 3 4 5 6 7 8 (1 + 𝑖)𝑁 −1
(𝑃ൗ𝐴, 𝑖%, 𝑁) =
𝑖(1 + 𝑖)𝑁
$11,088 + $500 + $4,000
(𝑃Τ𝐹, 𝑖%, 𝑁) = (1 + 𝑖)−𝑁
$2,500
𝑖(1 + 𝑖)𝑁
(𝐴ൗ𝑃, 𝑖%, 𝑁) =
Option D (1 + 𝑖)𝑁 −1
(1 + 0.0385)8 −1
𝑃𝑉1 = 11,088 + 500 + 4,000 8
= $105,602
0.0385 1 + 0.0385

𝑃𝑉2 = 2,500 (1 + 0.0385)−2 +(1.0385)−4 +(1.0385)−5 +(1.0385)−8 = $8,308

𝑷𝑽𝑫 = $𝟏𝟎𝟓, 𝟔𝟎𝟐 + $𝟖, 𝟑𝟎𝟖 = $𝟏𝟏𝟑, 𝟗𝟏𝟎

(0.08)(1 + 0.08)8 19,822

𝐴𝑉𝐷 = 113,910 = $19,822 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑜𝑟 = $3.30 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟
(1 + 0.08)8 −1 6,000

79