Chapter 2 – Time value of money

– Interest: the cost of

money
– Economic equivalence
– Interest formulas –
single cash flows
– Equal-payment series
– Dealing with gradient
series
– Composite cash flows. Power-Ball Lottery
 Decision dilemma – take a lump sum or
annual installments

A suburban Chicago couple

won the Power-ball.
They had to choose
between a single lump
sum $104 million, or $198
million paid out over 25
years (or $7.92 million
per year).
The winning couple opted
for the lump sum.
Did they make the right
choice? What basis do
we make such an
economic comparison?
 Option A Option B
(lump sum) (installment plan)

0 $104 M
1 $7.92 M
2 $7.92 M
3 $7.92 M

25 $7.92 M
 What do we need to know?

To make such comparisons (the lottery decision

problem), we must be able to compare the value
of money at different point in time.
To do this, we need to develop a method for
reducing a sequence of benefits and costs to a
single point in time. Then, we will make our
comparisons on that basis.
End-of-period convention

0
1

Beginning of End of interest

Interest period period

0 1
 Methods of calculating interest

– Simple interest: rarely used; but the point is that

there are different types of interest

– Compound interest: what people generally mean

when they say “interest”
 Investment variables

P Æ present value
F Æ future value
I Æ total interest
i Æ interest rate
N Æ number of interest periods
n Æ identifier of an interest period
Bn Æ balance at the end of interest period n
 Compounding process

$1,080

$1,166.40
0 $1,259.71
1

$1,000
2
3
$1,080

$1,166.40
 $1,259.71

0 1 2

F = $1, 000(1 + 0.08)3

$1,000
= $1, 259.71
 Compound interest formula
n = 0:P
n = 1: F1 = P (1 + i )
n = 2 : F2 = F1 (1 + i ) = P (1 + i ) 2

M
n = N : F = P (1 + i ) N

The fundamental law of engineering economy

(1 + i)N Æ compound amount factor

 Practice problem: Warren Buffett’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 ?
 Market value

Assume that the company’s stock will continue to

appreciate at an annual rate of 24.58% for the next
27 years.

F = P(1 + i)N = $100.36(1 + 0.2458)27 = $37,902

$37.902 trillion
 Practice problem

If you deposit $100 now (n = 0) and $200 two

years from now (n = 2) in an account that pays
10% interest, how much would you have at the
end of year 10?
 Solution

0 1 2 3 4 5 6 7 8 9 10

$100(1+0.10)10 = $100(2.59) = $259

$100
$200 $200(1+0.10)8 = $200(2.149) = $429
F = $259 + $429 = $688
 Practice problem
Consider the following sequence of deposits &
withdrawals over a period of 4 years. If you earn
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

 $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
 Solution
End of Beginning Deposit Withdraw Ending
Period balance made balance

n=0 0 $1,000 0 $1,000

n=1 $1,000(1 + 0.10) $1,000 0 $2,100

=$1,100

n=2 $2,100(1 + 0.10) 0 $1,210 $1,100

=$2,310

n=3 $1,100(1 + 0.10) $1,500 0 $2,710

=$1,210

n=4 $2,710(1 + 0.10) 0 0 $2,981

=$2,981
 Economic equivalence

What do we mean by “economic equivalence?”

Why do we need to establish an economic
equivalence?
How do we establish an economic equivalence?
 Economic equivalence

– Economic equivalence exists between cash

flows that have the same economic effect and
could therefore be traded for one another.
– Even though the amounts and timing of the cash
flows may differ, the appropriate interest rate
makes them equal.
 Equivalence in personal finance

If you deposit P dollars

today for N periods at i,
you will have F dollars at
F = P(1+i)N
the end of period N. 0
N

P ≡ F P
 Alternate way of defining equivalence

F dollars at the end of

period N is equal to a
single sum P dollars
0 N
now, if your earning
power is measured in
terms of interest rate i. F

P = F (1+ i)− N

0 N
(1 + i)-N Æ present worth factor
 Practice problem
At 8% interest, what is the equivalent worth
of $2,042 now, 5 years from now?

$2,042
If you deposit $2,042 today in an account
that pays 8% interest annually how much
would you have at the end of 5 years?

0 1 2 3 4 5

0 1 2 3 4 5
 Solution

F = $2,042(1 + 0.08)5 = $3,000

Using interest tables: (F/P,8%,5) = 1.4693

$2,042 X 1.4693 = $3,000

 At what interest rate
would these two amounts be equivalent?

$2,042
i=? $3,000

0 5
 Equivalence between two cash flows

Step 1: Determine the base

period, say, year 5. $2,042 $3,000
Step 2: Identify the interest
rate to use.
Step 3: Calculate
equivalence value.
0 5
i = 6% , F = $2, 042 (1 + 0 .06 ) 5 = $2, 733
i = 8% , F = $2, 042 (1 + 0 .08 ) 5 = $3, 000
i = 10% , F = $2, 042 (1 + 0 .10 ) 5 = $3,289
 Example - equivalence
Various dollar amounts that will be economically
equivalent to $3,000 in 5 years, given an interest rate
of 8%.
$3,000
P= = $2,042
(1 + 0.08)5

P F
$2,042 $2,205 $2,382 $2,572 $2,778 $3,000
0 1 2 3 4 5
 Example

$200 V
$150
$120
$100 $100
$80

0 1 2 3 4 5 0 1 2 3 4 5

Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.

 Approach
V

$200

$150
$120
$100 $100
$80

0 1 2 3 4 5
 V3 = $511.90 + 264.46 = $776.36
V

$200(1 + 0.10)-1 + $100(1 + 0.10)-2

$200 = $264.46

$150
$120
$100 $100
$80

0 1 2 3 4 5

$100(1 + 0.10)3 + $80(1 + 0.10)2 + $120(1 + 0.10) + $150

= $511.90
 Practice problem
How many years would it 2P
take an investment to
double at 10% annual
interest?
0

F = 2 P = P(1 + 0.10) N N=?

2 = 1.1
N P

log 2 = N log1.1
log 2
N=
log1.1
= 7.27 years
 Rule of 72

Approximately how
72
long it will take for N≅
a sum of money to interest rate (%)
double
72
=
10
= 7.2 years
 Practice problem

You just purchased 100 shares of stock at $60

per share. You will sell when the market price
has doubled. If you expect the stock price to
increase 20% per year, how long do you expect
to wait until selling?
 Practice problem

$1,000
$500
Given: i = 10%,
A

Find: C that makes the 0 1 2 3

two cash flow streams
to be indifferent C C

0 1 2 3
 Approach
$1,000
Step 1: Select the base
period to use, say n = 2. $500
Step 2: Find the equivalent A
lump sum value at n = 2
for both A and B. 0 1 2 3
Step 3: Equate both
equivalent values and
C C
solve for unknown C.
B

0 1 2 3
 Solution

A $1,000
V2 = $500(1 + 0.10)2 + $1,000(+0.0)-1 = $500
$1,514.09
A
0 1 2 3
B V2 = C(1 + 0.10) + C = 2.1C

C C

To find C: B
2.1C = $1,514.09
0 1 2 3
C = $721
 Practice problem

$1,000
$500
At what interest rate
would you be A

indifferent between the 0 1 2 3

two cash flows?
$502 $502 $502

0 1 2 3
 Approach

Step 1: Select the base period $1,000

to compute the equivalent
value (say, n = 3) $500
Step 2: Find the net worth of A
each at n = 3.
0 1 2 3

$502 $502 $502

0 1 2 3
 Establish equivalence at n = 3

Option A : F3 = $500(1 + i ) + $1, 000

3

Option B : F3 = $502(1 + i ) 2 + $502(1 + i ) + $502

– Find the solution by trial and error, say i = 8%

O ption A : F3 = $500(1.08) 3 + $1, 000

= $1, 630
O ption B : F3 = $502(1.08) 2 + $502(1.08) + $502
= $1, 630