Lecture 6

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Application of Money Time Relationship

Eng.|Mohammed Ismaeel Shekfa

Chapter 5
These slides prepared by Prof. Osama and modified by Eng. Mohammed
Ismaeel Shekfa

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 Applications of Money- Time
Relationships

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Objectives:

Eng.|Mohammed Ismaeel Shekfa

1. Illustrate several basic methods for making engineering economy
studies considering the time value of money.

2. Describe briefly the underlying assumptions and interrelationships

among these methods.

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 Applications of Money- Time
Relationships

Introduction

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• As pattern of capital investment, revenue cash flows (inflows), and cost cash flow
(outflows) can vary between different projects. Several different methods are
used to perform engineering economic analysis for different projects.

Eng.|Mohammed Ismaeel Shekfa

• The following presents four methods used for evaluating the economic
profitability of an alternative (single proposed problem solution).

• These four methods are: Present Worth (PW), Future Worth (FW), Annual Worth
(AW) and Internal Rate of Return (IRR).

• The first three methods convert cash flows of a proposed solution into their
equivalence worth at the present, the future or annual worth, respectively, by
using an interest rate known as the Minimum Attractive Rate of Return (MARR).
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 Applications of Money- Time
Relationships

Determining the Minimum Attractive Rate of Return (MARR)

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• The MARR is usually a policy issue resolved by top management of an organization to
maximize its economic well being in view of the following considerations:

Eng.|Mohammed Ismaeel Shekfa

1- The amount of money available for investment and the cost of these funds.

2- The number of good projects available for investment and their purpose,
whether they are essential to sustain present operations or whether they are
elective to expand present operations.

3- The amount of perceived risk associated with investment opportunities available

to the firm.

4- The type of organization involved ( governmental, public utility, or competitive

industry).
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 Applications of Money- Time
Relationships

• The opportunity cost view point is one popular approach used to establish a MARR. This results from the
phenomenon of capital rationing which exists when management decides that the amount of available

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capital is not sufficient to sponsor all worthy investment opportunities.

• The figure shows an example of capital rationing in which there is a limit of $ 6 million on available capital.
Annual Rate of Profit (%)

Eng.|Mohammed Ismaeel Shekfa

• In view of this limitation, the last
35 Independent projects (Demand)
funded project would be E and the 35
Any subset or all can be selected
best rejected project is F. 30
30
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Approximate cost of
• In this case the MARR, by the opportunity 25 23
capital obtained
A 19
cost principle, would be 16%, by not being 20
($ 6 million)
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able to invest in project F. B 14
15 C D
E Reject F and G
• The figure shows also that the cost 10 F
of capital will tend to increase gradually 5
G
as larger sums of money are acquired
through borrowing (debt) or issuing new common 1 2 3 4 5 6 7 8
stock (equity). Cumulative Investment Amount (Million of Dollars) 5
 Applications of Money- Time
Relationships

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The Present Worth Method (PW)

Eng.|Mohammed Ismaeel Shekfa

• In this method , all cash inflows and outflows are discounted to the present point
in time at an interest rate that is equal to the MARR.

• A positive PW for an investment project is a dollar amount of profit over the

minimum amount required by investors. To find the PW of a series of cash inflows
and outflows, as a function of i %, future amounts are discounted to the present as
follows:
PW (i%) = F0 (1 + i) 0 + F1 (1 + i) −1 + ..... + Fk (1 + i) − k + .... + FN (1 + i) − N
k =N
=  Fk (1 + i) −k
k =0
Where: i is effective interest rate (=MARR) per compounding period, K is the index
of each compounding period, Fk is the future cash flow at the end of period k, N is 6
the number of compounding periods.
 Applications of Money- Time
Relationships

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Present Worth PW

i = 0% $1000
1000
• The figure shows that the higher the interest

Eng.|Mohammed Ismaeel Shekfa

800 i = 5%
rate and the further into the future a cash flow $614
600
occurs, the lower its PW. i = 10%
400
$386
i = 20%
200
• As long as the PW (present equivalent of cash $162

inflows minus cash outflows) is greater than or 2 4 6 8 10

End of year k
equal to zero, the project is economically justified
otherwise, it is not acceptable.
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 Example 1

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 Applications of Money- Time
Relationships

The Future worth Method, FW

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• The FW method is based on the equivalent worth of all cash inflows and outflows at the end
of the project life at an interest rate of the MARR.

Eng.|Mohammed Ismaeel Shekfa

• The FW of a project is equivalent to its PW, that is FW = PW (F/P, i%, N).
If FW ≥ 0, for a project, it would be economically justified.

• The following equation summarizes the general calculations to determine a FW:

FW (i %) = F0 (1 + i ) N + F1 (1 + i ) N −1 + ..... + FN (1 + i ) 0
k =N
=  k
F
k =0
(1 + i ) N −k

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 Applications of Money- Time
Relationships

The Annual-Worth Method

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• The Annual Worth (AW) of a project is an equal annual series of dollar amounts, for
a stated project life, that is equivalent to the cash inflows and outflows at an
interest rate that is generally the MARR.

Eng.|Mohammed Ismaeel Shekfa

• In other words, the AW of a project is annual equivalent revenues or savings (R)
minus annual equivalent expenses (E), minus its annual equivalent Capital Recovery
(CR). All computed for a project life, N, and interest rate i, as given by the following
equation :

AW (i%) = R – E – CR (i%)

• The AW of a project can also be calculated from its PW and FW as follows:

AW = PW(A/P, i%, N) and AW = FW(A/F, i%, N) 10
 Applications of Money- Time
Relationships

• As long as the AW is greater than or equal to zero, the project is

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economically attractive, otherwise it is not.

• In the previous equation, E+CR is called Equivalent Uniform Annual Cost

Eng.|Mohammed Ismaeel Shekfa

EUAC. A low-valued EUAC (i%) is preferred to high-valued EUAC (i%).

• The CR amount for a project is the equivalent uniform annual cost of the
capital invested. It covers the following two items:

1- Loss in value of the assets.

2- Interest on the invested capital (MARR).

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Applications of Money- Time
Relationships
• The following formulas can be used to calculate the CR of a project:

CR (i%) = I (A/P, i%, N) – S (A/F, i%, N) …… or

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CR (i%) = (I –S)(A/F, i%, N) + I (i%) ………….. or

Eng.|Mohammed Ismaeel Shekfa

CR (i%) = (I –S)(A/P, i%, N) + S (i%)

Where:
I …… is the initial investment for the project
S …….is the salvage (market) value at the end of the project life
N …….is the project life (study period)

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 Example 2

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 Applications of Money- Time
Relationships

The Internal Rate of Return Method (IRR)

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• This method solves for the interest rate that equates the equivalent worth of an
alternative’s cash inflows (receipts or savings) to the equivalent worth of cash

Eng.|Mohammed Ismaeel Shekfa

outflows (expenditure including investment cost).

• Equivalent worth may be computed using the PW, FW or AW methods. The

resultant interest rate is called the Internal Rate of Return IRR.

• For a single alternative, from the lender’s viewpoint, the IRR is not positive unless
the following two conditions are satisfied:
1- Both receipts and expenses are present in the cash flow pattern.
2- The sum of the receipts exceeds the sum of all cash outflows.
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 Applications of Money- Time
Relationships

• By using the PW method:

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k=N k=N

 R ( P / F , i %, k ) =  E ( P / F , i %, k )
k =0
k
'

k =0
k
'

where

Eng.|Mohammed Ismaeel Shekfa

Rk = net revenues or savings for the kth year
Ek = net expenditur es including any investment costs for the kth year
N = project life
• Once i ' has been calculated, it is compared with the MARR. If i'≥ MARR, the
alternative is acceptable, otherwise it is not.

• The above equation can be written in the following popular form:

k =N k=N
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net PW =  R ( P / F , i %, k ) −  E
k =0
k
'

k =0
k ( P / F , i ' %, k ) = 0
 Applications of Money- Time
Relationships
Net PW(i%)
• The following is a graph of net PW versus the

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interest rate for an alternative with a single
investment cost at the present time (k=0) +
i’ %
followed by a series of positive cash inflows 0 i'

Eng.|Mohammed Ismaeel Shekfa

over N. i%
-
Net PW versus interest rate

• The point at which the net PW = 0, defines i'

which is the IRR.

• The value of i ' can also be determined through the FW as follows:

k =N k=N
FW =  R ( F / P, i %, k ) −  E
k =0
k
'

k =0
k ( F / P, i ' %, k ) = 0
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 Applications of Money- Time
Relationships
Unrecovered
investment
balance, $

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P (1+ i’)
‘ [P (1+ i’) - (R1-E1)] (1+ i’)
1+ i’ )

(R1-E1) 1+ i’ Note this would include market

Eng.|Mohammed Ismaeel Shekfa

1+ i’ (salvage) value, if any, at time N
(R2-E2)

Initial (R3-E3)
1+ i’
investment= P
(RN-1-EN-1) (RN-EN)

1 2 3 N
Years
Investment balance diagram showing IRR

• The figure shows an investment balance diagram which illustrate another way to interpret
the IRR.

• The figure shows that the IRR is the value of i ' that causes the unrecovered investment 17
balance to exactly equal zero at the end of the project.
 Example 3

Eng.|Mohammed Ismaeel Shekfa 2/23/2021

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 Example 4

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Payback Period
• All methods presented so far (PW, FW, AW, IRR) reflects the profitability
of a project.

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• The payback method (Simple payout method), mainly indicates a
project’s liquidity rather than its profitability.

Eng.|Mohammed Ismaeel Shekfa

• The payback method calculates the number of years required for cash
inflows to accumulate to equal or exceed cash outflows. This might be
defined as the breakeven life of a project.

• A small number of years for the payback method is considered

desirable. It is an indication of a smaller risky project since investment
will be recovered faster .

• The payback period can produce misleading results and it is 20

recommended as supplemental information only in conjunction with
one or more of the above four methods.
Payback period
• Sometimes referred to as payout period method

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• Indicates liquidity (riskiness) rather than profitability

Eng.|Mohammed Ismaeel Shekfa

• Ignoring the time value of money:
• Simple payback period: θ

• Considering the time value of money:

• Discounted payback period: θ’ 21
Payback Period
• For a project where all capital investment occurs at time zero
(0):

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Eng.|Mohammed Ismaeel Shekfa
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Payback Period
• Payback periods of three years or less are often desired in the
U.S. industry. Projects having greater than three years might

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be rejected though they might be profitable.

Eng.|Mohammed Ismaeel Shekfa

• See table 4-4 to show the calculation of the simple payback
period and the discounted payback period .

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 Example 4

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 Solution

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