Chapter 4 Time Value of Money (Part1)

ENGINEERING
ECONOMY
Chapter 4: The Time Value of Money
(PART 1)
Time Value of Money
4.1 Introduction
4.2 Simple Interest
4.3 Compound Interest
4.4 The Concept Equivalence
4.5 Cash Flow-Diagram Table
4.6 Applications of Future and Present
Values
Copyright ©2012 by Pearson Education, Inc.

Engineering Economy, Fifteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
4.1 Why consider return of capital?
Return of 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.
Type of interest
Simple Interest
Compounded Interest

4.2 Simple interest
■ For Simple interest, the total interest, I, earned or paid may

be computed using the formula below.
𝐼= 𝑃 𝑁 𝑖
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.

Example:
If $5,000 were loaned for five years at a simple interest
rate of 7% per year, the interest earned would be
𝐼= 𝑃 𝑁 𝑖
𝐼 = $5,000 5 0.07 = $1,750
■ 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.

Exercise:
Amirah has borrowed RM1,000 from ABC bank.

If loan interest per year is at 5%, how much
the total loan would be paid after 3 years?

Exercise:
An employee at Majukekal Sdn Bhd borrows

$10,000 on 15 Feb, and must repay a total of
$10,700 exactly one year later. Determine the
interest rate and amount of interest?

4.3 Compounded interest
■ Based on the remaining principal amount

at a certain interest unit period.
■ Compound interest is commonly used in

personal and professional financial
transactions.

Example:
For $1,000 loaned for three periods at an interest of 10%

compounded each period.
(𝑃) (𝑃 + 𝐼)
(𝐼 = 𝑃 × 𝑖) Amount owed
Amount owed at
beginning of Interest amount at end of
Period period for period period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

FINAL EXAMINATION
SEMESTER I
SESSION 2013/2014

FINAL EXAMINATION
SEMESTER I
SESSION 2013/2014

4.4 Economic equivalence
■ Allows us to compare alternatives on a common basis.
■ Equivalent basis is dependent on:
– Interest Rate
– The amount of money involve
– The time of the monetary receipts and expense
■ Economic equivalence means in a specified interest rate,

different amounts of money raised at different times to the
same value in terms of economy.

Example :
10% annual interest rate, currency RM1000 now (at present)

is equivalent with the RM1100 in one year from now.
F = 1000 + 1000(0.10) = 1000 (1.1) = RM1100

Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8%
TOTAL OWED
YEAR AMOUNT OWED AT INTEREST OWED FOR AT PRINCIPAL TOTAL END-OF YEAR
THE BEGINNING OF YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
Plan 1 AT THE END OF EACH YEAR PAY $ 1000 PRINCIPAL + INTEREST DUE Pay every year
1 $5,000 $400 $5,400 $1,000 $1,400
2 $4,000 $320 $4,340 $1,000 $1,320
3 $3,000 $240 $3,240 $1,000 $1,240
4 $2,000 $160 $2,160 $1,000 $1,160
5 $1,000 $80 $1,080 $1,000 $1,080
$1,200 $5,000 $6,200
Plan 2 PAY INTEREST DUE AT END OF EACH YEAR AND PRINCIPAL AT END OF FIVE YEARS Pay
1 $5,000 $400 $5,400 $0 $400
2 $5,000 $400 $5,400 $0 $400
3 $5,000 $400 $5,400 $0 $400
4 $5,000 $400 $5,400 $0 $400
5 $5,000 $400 $5,400 $5,000 $5,400
$2,000 $5,000 $7,000

By William
copyright @ G. Sullivan, Elin M. Wicks, and C. Patrick Koelling All rights reserved.
mia
16
Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8% (cont.)
AMOUNT OWED AT
YEAR THE BEGINNING OF INTEREST OWED FOR TOTAL OWED AT PRINCIPAL TOTAL END-OF YEAR
YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
Plan 3 PAY IN FIVE EQUAL END-OF-YEAR PAYMENTS Pay every year

1 $5,000 $400 $5,400 $852 $1,252
2 $4,148 $331 $4,479 $921 $1,252
3 $3,227 $258 $3,485 $994 $1,252
4 $2,233 $178 $2,411 $1,074 $1,252
5 $1,159 $93 $1,252 $1,159 $1,252
$1,260 $5,000 $6,260
Plan 4 PAY PRINCIPAL AND INTEREST IN ONE PAYMENT AT END OF FIVE YEARS Pay
1 $5,000 $400 $5,400 $0 $0
2 $5,400 $432 $5,832 $0 $0
3 $5,832 $467 $6,299 $0 $0
4 $6,299 $504 $6,803 $0 $0
5 $6,803 $544 $7,347 $5,000 $7,347
$2,347 $5,000 $7,347

By William
mia
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4.5 Cash Flow Diagrams
■ A cash flow diagram is an indispensable tool for clarifying
and visualizing a series of cash flows.
Example of cash flow diagram

4.5 Notation and Cash Flow Diagrams and Tables
■ Notation used in formulas for compound interest calculations.

– i = effective interest rate per interest period
– N = n = number of compounding (interest) periods, year
– 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 = Annually…end-of-period cash flows in a uniform series/
each year..continuing for a certain number of periods,
starting at the end of the first period and continuing through
the last

TEST 2 SEMESTER I
SESI 2012/2013
Q2 (b) Explain what are these standard notation stand for;
(i) I (ii) N (iii) P
(iv) F (v) A
(c) Draw a Cash Flow Diagram when P= RM 25,000,

N= 5 years, A=RM6,097, F=RM 35,064.

4.6 Present & Future Equivalent
Values of Single Cash Flows
■ 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
𝑁 Finding F
𝐹 =𝑃 1+𝑖 when Given P
■ In a similar way we can find P given F by
−𝑁 Finding P
𝑃 =𝐹 1+𝑖 when Given F

Terminology and Symbols
 t = time index in periods; years, months, etc.
 P = present sum of money at time t = 0; $
 F = sum of money at a future time t; $
 A = series of equal, end-of-period cash flows;
currency per period, $ per year
 n = total number of periods; years, months
 i = compound interest rate or rate of return; %
per year

1 - 26 Upper Saddle River, New Jersey 07458
Single Payment Formulas
 EXAMPLE:
If you had RM 2,000 now and
invested it at 10%, how much would
it be worth in 8 years?
– Draw Cash Flow Diagram

By William
mia
27
 SOLUTION:
 Based on Formulas
𝐹 = 𝑃(1 + 𝑖)𝑛
= 2000(1 + 0.1)8
= 𝑅𝑀4,287.18
 Based on Compound Interest Table

𝐹 = 𝑃 𝐹 Τ𝑃 , 𝑖, 𝑛
= 2,000 𝐹 Τ𝑃 , 10%, 8
= 2,000(2.1426)
= 𝑅𝑀4,287.20
By William
mia
28
EXERCISE:
Suppose that RM 1,000 is to be received in 5
years. At an annual interest rate of 12%, what
is the present worth of this amount?

32
 EXAMPLE
Suppose you buy a share for RM10 and sell it for

RM20, your profit is RM10. If that happens within a
year, your rate of return is an impressive 100%. If that
takes 5 years, what would be the average annual rate
of return on your investment?

34
 SOLUTION:
 Based on Compound Interest Table
F = P(F/P, i, n)
20 = 10 (F/P, i, 5)
If i = 15%
20 ? 10 (2.0114)
20 ? 20.114
If i = 14%
20 ? 10 (1.9254)
20 ? 19.254
With iteration,
i = 14.87%

35
Copyright
Upper Saddle River,
River, New Jersey 07458
 EXAMPLE
You have just purchased 100 shares of General Electric

stock at RM60 per share. You will sell the stock when its
market price has doubled. If you expected the stock
price to increase 20% per year, how long do you expect
to wait before selling the stock?

40
 Based on Formula
F = P (1+i) n
12,000 = 6,000 (1+0.20) n

2 = (1+0.20) n
log 2 = n log 1.2

n = log 2
log 1.2
n = 3.8
≈4 years

41

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ENGINEERING

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

■ For Simple interest, the total interest, I, earned or paid may

■ The total amount repaid at the end of N interest

Copyright ©2012 by Pearson Education, Inc.

■ So, the total amount repaid at the end of five years

Copyright ©2012 by Pearson Education, Inc.

Amirah has borrowed RM1,000 from ABC bank.

Copyright ©2012 by Pearson Education, Inc.

An employee at Majukekal Sdn Bhd borrows

Copyright ©2012 by Pearson Education, Inc.

■ Based on the remaining principal amount

■ Compound interest is commonly used in

Copyright ©2012 by Pearson Education, Inc.

For $1,000 loaned for three periods at an interest of 10%

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

■ Equivalent basis is dependent on:

– The amount of money involve

– The time of the monetary receipts and expense

■ Economic equivalence means in a specified interest rate,

Copyright ©2012 by Pearson Education, Inc.

10% annual interest rate, currency RM1000 now (at present)

F = 1000 + 1000(0.10) = 1000 (1.1) = RM1100

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Plan 3 PAY IN FIVE EQUAL END-OF-YEAR PAYMENTS Pay every year

Copyright ©2012 by Pearson Education, Inc.

Example of cash flow diagram

Copyright ©2012 by Pearson Education, Inc.

■ Notation used in formulas for compound interest calculations.

Copyright ©2012 by Pearson Education, Inc.

(c) Draw a Cash Flow Diagram when P= RM 25,000,

Copyright ©2012 by Pearson Education, Inc.

■ In a similar way we can find P given F by

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

– Draw Cash Flow Diagram

Copyright ©2012 by Pearson Education, Inc.

 Based on Compound Interest Table

Copyright ©2012 by Pearson Education, Inc.

Suppose you buy a share for RM10 and sell it for

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

You have just purchased 100 shares of General Electric

Copyright ©2012 by Pearson Education, Inc.

12,000 = 6,000 (1+0.20) n

log 2 = n log 1.2

Copyright ©2012 by Pearson Education, Inc.

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