9/10/2023

Lecture 2
Time Value of Money (Ch 2)
Other Perspectives on Scoping
Electricity Rate Structures

Learning Goals (1 of 2)
2.1 Recognize key terminology used in understanding the
application of interest to money
2.2 Differentiate between compound and simple interest,
and be able to calculate compound interest over several
periods
2.3 Calculate an effective interest rate given the nominal
rate, and vice versa.
2.4 Calculate an effective interest rate under continuous
compounding.
2.5 Construct cash flow diagrams

1
 9/10/2023

Learning Goals (2 of 2)
2.6 Differentiate among common depreciation
methods, and calculate the book value of an asset
at any future time.
2.7 Appraise the validity of financial calculations.

Key Summary: Course to date and coming soon

• Variables and parameters (puzzle pieces):
– Different kinds of interest rates
– Discount rates
– Costs and cost savings or revenues, now and in the future
– Different expected lives of the possible project/purchases
– Salvage value
– Taxes and tax savings
– How these escalate

• Analysis methods (ways to put the pieces together):

– Present worth analysis (Net Present Value)
– Equivalent uniform annual cost analysis
– Rate of return analysis
– Benefit-cost ratio analysis
– Payback period
– Cost-effectiveness analysis

2
 9/10/2023

Computing Cash Flows

• We describe the benefits and costs as receipts (cash flowing

in) and disbursements (cash flowing out) at different points
in time
• The foundation of engineering economic analysis is a set of
techniques for comparing the value of money at different
dates

Introduction (1 of 1)
• Engineering decisions frequently involve tradeoffs among
costs and benefits occurring at different times.
– Typically, we invest in a project today to gain future
benefits.
• The key to making comparisons of benefits and costs that
occur at different times is the use of an interest rate.
• This connects to the time value of money, our starting
point.

3
 9/10/2023

Time Value of Money

• When monetary consequences of an project we’re

considering doing will occur over a period of time into the
future, we can’t simply add up the various sums of money.
Why?

• Money
• It has value over time
• It is a valuable asset that people are willing to pay to have available
for use
• It can be rented in roughly the same way other things can (like an
apartment)
 The charge is called interest instead of rent

Value of money
Value of money: same now and future?
• Why?
• Implications? (benefits, costs)
Discounting
• method of comparing benefits and costs
at different times
• future benefits and costs are “discounted” at rate (r)
Present Value (PV)
• measures current worth of future benefits and costs
($n)
PV ($n) =
(1 + r)n

4
 9/10/2023

Example of present value

time period 0 1 2 3 4

interest
earned $ 10 $ 11 $ 12.10 $ 13.31
(10 %)
new account
balance $ 100 $ 110 $ 121 $ 133.10 $ 146.41

($n) $ 146.41
present value after 4 years = $ 100
= =
(PV4) (1 + r)n (1 + 0.1)4

Time Value of Money continued

• Our preference for having money now rather than money in

the future differs from person to person
• The preference for having money now rather than later has
nothing to do with inflation
• The bank expresses the time value it puts on money by
publishing the interest rate that it charges to borrow money

5
 9/10/2023

2.1 Interest and Interest Rates (1 of 4)

• Interest (I) is compensation for giving up the use of
money.
– The difference between the amount loaned and the
amount repaid.
• An amount of money today, P, can be related to a future
amount, F, by the interest amount I, or interest rate i:

F = P + I = P + Pi = P (1 + i )

2.1 Interest and Interest Rates (2 of 4)

• The right to P at the beginning is exchanged for the right
to F at some future time, where F = P(1+ i)
• i → interest rate, P → present worth of F
• F → future worth of P, base period → interest period

6
 9/10/2023

2.1 Interest and Interest Rates (3 of 4)

• The dimension of an interest rate is
(dollars/dollars)/time.
– i.e., if $1 is lent at a 9% interest rate, then $0.09/year
would be paid in interest per time period.
• Period over which interest calculated is the interest
period.
• The longer the interest period, the higher the interest rate
must be to provide the same return.
• When you are given an interest rate without a specified
period, assume it is annual (per year).

2.1 Interest and Interest Rates (4 of 4)

CLOSE‐UP 2.2 Interest Periods

Interest Period Interest Is Calculated:

Semiannually Twice per year, or once every six months
Quarterly Four times a year, or once every three months
Monthly 12 times per year
Weekly 52 times per year
Daily 365 times per year
Continuous For infinitesimally small periods

7
 9/10/2023

2.2 Compound and Simple Interest (1 of 5)

Compound Interest

• If amount P is lent for one period at interest rate, i

– then amount repaid at the end of the period is
F = P(1 + i).
• If it’s more than one period, interest is
compounded.
– At end of each period, interest is added to principal
that existed at the beginning of that period

2.2 Compound and Simple Interest (2 of 5)

Compound Interest
• If an amount P is borrowed for N periods at interest rate i, the
amount that must be repaid at the end of N periods is:

F = P (1 + i ) N

• This method of computing interest is called compounding.

– Compounding assumes there are N sequential one-period
loans.
– At the end of each period, the amount borrowed plus
interest added in that period is borrowed for the next
period.
▪ See Table 2.1 for compound interest computations

8
 9/10/2023

2.2 Compound and Simple Interest (3 of 5)

Compound Interest

• Total interest on a loan over N periods is:

I C = F  P = P (1 + i ) N  P

• IC is referred to as compound interest.

• Interest period used with the compound interest
method is called the compounding period.

2.2 Compound and Simple Interest (4 of 5)

Compound Interest
Example 2.2
• If you were to lend $100 for … (see Example 2.2 in ch.2)
F = P(1 + i)N = 100(1 + 0.10)3 = $133.10
IC = F − P = $133.10 − $100.00 = $ 33.10
The amount owed is $133.10. The interest owed is $33.10.
• What is the amount owed at each year end?
(See Table 2.2 for yearly accrual.)

9
 9/10/2023

2.2 Compound and Simple Interest (5 of 5)

Compound Interest
Example 2.2
• Check first Spreadsheet Savvy feature in
MyLab for an Excel spreadsheet corresponding
to Table 2.2.

2.2 Compound and Simple Interest (5 of 5)

Simple Interest
• Simple Interest – interest without compounding (interest is
not added to principal at end of period).
IS = P i N
• Compound and simple interest amounts equal if N = 1.
• As N increases, difference between accumulated interest
amounts for the two methods increases exponentially.
• The conventional approach for computing interest is the
compound interest method.
• Simple interest is rarely used today.

10
 9/10/2023

2.2 Compound and Simple Interest (7 of 7)

Figure 2.1

Copyright © 2022 Pearson Canada Inc. 2 - 22

2.3 Effective and Nominal Interest Rates (1 of 4)

• Interest rates are stated for some period, usually a year.
• Computation is based on shorter compounding sub‐
periods.
• In this section we consider the relation between:
– The nominal interest rate stated for the full period.
– The effective interest rate that results from the
compounding based on the sub‐periods.

11
 9/10/2023

2.3 Effective and Nominal Interest Rates (2 of 4)

• Unless otherwise noted, rates are nominal annual rates.
– Calculated by multiplying the interest rate per
compounding period by the number of compounding
periods per year.
• Suppose: r is a nominal rate stated for a period (1 year)
consisting of m equal compounding periods (sub‐periods).
• The interest rate for each sub‐period is calculated as: is =
r/m

2.3 Effective and Nominal Interest Rates (3 of 4)

• An effective interest rate is the actual (but not usually
stated) interest rate, found by:
– converting a given interest rate with an arbitrary
compounding period (normally less than a year) to an
equivalent interest rate with a one‐year compounding
period.

ie = (1 + is ) m  1
• is: interest rate over a compounding sub‐period,
• ie: effective interest rate over a longer period, ie,
• m: number of sub‐periods in the longer period.

12
 9/10/2023

2.3 Effective and Nominal Interest Rates (4 of 4)

Example 2.6
• The Cardex Credit Card Co. charges a nominal 24%
interest … (see Example 2.6 in ch.2)
Assuming 365 days per year, we can calculate the
interest rate per year using is = r/m
where is = r/m = 0.24/365 = 0.0006575
then ie = (1 + iS)m − 1 = (1 + 0.0006575)365 − 1 = 0.271
• The effective interest rate is 27.1%

2.4 Continuous Compounding (1 of 5)

• Suppose that the nominal interest rate is 12% and interest is
compounded semi‐annually.
• We compute the effective interest rate as follows:
where r = 0.12, m = 2
is = r/m = 0.12/2 = 0.06
ie = (1 + iS)m − 1 = (1 + 0.06)2 − 1 = .1236 (12.36%)
• What if interest were compounded monthly?
ie = (1 + iS)m − 1 = (1 + 0.01)12 − 1 = 0.1268 (12.68%)
• Daily? ie = 0.127475 or about 12.75%
• More than daily? Continuous Compounding

13
 9/10/2023

2.4 Continuous Compounding (2 of 5)

• Compounding can be done yearly, quarterly, monthly, or
daily.
• Compounding periodically is referred to as discrete
compounding.
• For periods that are infinitesimally small, we say that
interest is compounded continuously.

2.4 Continuous Compounding (3 of 5)

• The effective interest rate under continuous
compounding is: ie = er − 1
Figure 2.2

14
 9/10/2023

2.4 Continuous Compounding (4 of 5)

Example 2.7
• Cash flow at the Artic Oil Company is continuously
reinvested. An investment in a new data logging system is
expected to return a nominal interest of 40 percent …
(see Example 2.7 in ch.2)

2.4 Continuous Compounding (5 of 5)

Example 2.7 (cont.)
The nominal interest rate is given as r = 0.40
ie = er − 1 = 1.492 – 1 ≅ 0.492 or 49.2%

15
 9/10/2023

2.5 Cash Flow Diagrams (1 of 6)

• Cash flow diagram is a graphical summary of the timing
and magnitude of a set of cash flows.

Figure 2.3

2.5 Cash Flow Diagrams (2 of 6)

Close‐Up 2.3 Beginning and Ending of Periods
• As illustrated in a cash flow diagram (see Figure 2.3), the
end of one period is exactly the same point in time as the
beginning of the next period (see Figure 2.4).
• Now is time 0, which is the end of period –1 and, also the
beginning of period 1.
• The end of period 1 is the same as the beginning of
period 2, and so on.
• N years from now is the end of period N and the
beginning of period (N + 1).

16
 9/10/2023

2.5 Cash Flow Diagrams (3 of 6)

Figure 2.4

Assumptions:
• Cash flows occur at the ends of periods.
• End of time period 1 = beginning of time period 2…
• Time 0 = “now”

2.5 Cash Flow Diagrams (4 of 6)

Example 2.8
• Consider Ashok, a recent University graduate trying to
summarize typical cash flows for each month. His monthly
income is $3500, received at the end of each month. Out
of this he pays for rent, food, entertainment, cell and
internet charges, and a … (see Example 2.8 in ch.2)

17
 9/10/2023

2.5 Cash Flow Diagrams (5 of 6)

Example 2.8 (cont.)
Figure 2.5 Cash Flow
Diagram for Example 2.8

• Each arrow represents a cash flow, labelled with the

amount of the receipt or disbursement.

2.5 Cash Flow Diagrams (6 of 6)

Example 2.8 (cont.)
Figure 2.6 Cash Flow Diagram for
Example 2.8 in Summary Form

• When two of more cash flows occur in the same time

period, the amounts may be shown individually or in
summary form.

18
 9/10/2023

Assumptions in Solving Economic Analysis

Problems
• End-of-Year Convention
• All cash flow amounts are calculated as amounts at the end of
each period:
 Now = end of period 0 (beginning of period 1)
 Future amounts happen at the end of the period specified

31 Dec

• No Sunk Costs
• Only the current situation and the potential future is considered.

2.7 Equivalence (1 of 6)
• Engineering Economics utilizes “time value of money” to
compare certain values at different points in time.
• Equivalence is a condition that exists when:
– The value of a cost at one time is equivalent to the value
of the related benefit at a different time.

19
 9/10/2023

2.7 Equivalence (2 of 6)
• Three concepts of equivalence are useful for comparing
costs and benefits at different times:

1. Mathematical Equivalence
2. Decisional Equivalence
3. Market Equivalence

2.7 Equivalence (3 of 6)
• Mathematical Equivalence:
– A consequence of the mathematical relationship
between time and money.
– Decision‐makers exchange P dollars now for F
dollars N periods from now using rate i and the
mathematical relationship: F = P(1 + i)N

20
 9/10/2023

Example of present value: Equivalence

time period 0 1 2 3 4

interest
earned $ 10 $ 11 $ 12.10 $ 13.31
(10 %)
new account
balance $ 100 $ 110 $ 121 $ 133.10 $ 146.41

($n) $ 146.41
present value after 4 years = $ 100
= =
(PV4) (1 + r)n (1 + 0.1)4

2.7 Equivalence (4 of 6)
• Decisional Equivalence:
– Happens when a decision maker judges available choices
to be equally good.
– Two cash flows, Pt at time t and Ft1N at time t + N, are
equivalent if the individual is indifferent between the
two.
– Implied interest rate relating to Pt and Ft1N can be
calculated from the decision that the cash flows are
equivalent.
– In mathematical equivalence, the interest rate
determines whether the cash flows are equivalent.

21
 9/10/2023

2.7 Equivalence (5 of 6)
• Market Equivalence:
– Arises due to the availability of a market to exchange one
cash flow for another at zero cost.

2.7 Equivalence (6 of 6)
• For the remainder of this text, we assume:
1. Market equivalence holds.
2. Decisional equivalence can be expressed in monetary
terms.
• If these two assumptions are reasonably valid, then
mathematical equivalence can be used as accurate model
of costs/benefits relationship.

22
 9/10/2023

Computing $ Flows – extra notes

• Not every benefit or cost will involve a real change to the
physical system you’re making choices about
• Example: tax consequences of depreciation
• Not every benefit or cost will involve cash flow
• Example: avoided environmental damages,
depreciation of assets
• We’ll handle how tax implications are included in analysis in
the second half of the course, and how societally-based
analyses (which include broader impacts on society) late in
the first half

Equivalence and Sustainability

• The formulas and methods we use give reasonable results
when applied to time spans of less than a century, but can be
misleading when applied to longer time periods
• Many of the problems humanity currently faces require us
to plan on a time scale of centuries or longer

23
 9/10/2023

Long-term implications: example

years from 0 100 Total sum

now

Cost or
benefit - $ 100M

Present
value - $ 100M

Long-term implications: example

years from 0 100 Total sum

now

Cost or
benefit - $ 100M $ 10,000M

Present
value - $ 100M $ 29M

$ 10,000M
present value after 100 years = = $ 29M
(1 + 0.06)100

24
 9/10/2023

Long-term implications: example

years from 0 100 Total sum

now

Cost or
benefit - $ 100M $ 10,000M

Present
value - $ 100M $ 29M -$ 71M

$ 10,000M
present value after 100 years = = $ 29M
(1 + 0.06)100
discount rate

Other perspectives: First Nations

“In our every deliberation, we must consider the impact of our decisions on
the next seven generations.”

The Constitution of the Iroquois Nation (The Great Binding Law) explains “seventh
generation” philosophy as follows: “The thickness of your skin shall be seven
spans — which is to say that you shall be proof against anger, offensive actions
and criticism. Your heart shall be filled with peace and good will and your mind
filled with a yearning for the welfare of the people of the Confederacy. With endless
patience you shall carry out your duty and your firmness shall be tempered with
tenderness for your people. Neither anger nor fury shall find lodgement in your
mind and all your words and actions shall be marked with calm deliberation. In all
of your deliberations in the Confederate Council, in your efforts at law making, in
all your official acts, self interest shall be cast into oblivion. Cast not over your
shoulder behind you the warnings of the nephews and nieces should they chide
you for any error or wrong you may do, but return to the way of the Great Law
which is just and right. Look and listen for the welfare of the whole people and
have always in view not only the present but also the coming generations, even
those whose faces are yet beneath the surface of the ground — the unborn of the
future Nation.”

53

25
 9/10/2023

Other perspectives: First Nations

Bioregion

Community

Resource
Inventory Capital and
Repair Surplus Purchase of
Identification Outside
Harvest Goods and
Services
Self-reliance
Production

Export of Surplus Surplus Raw

Self-reliance Profit Material Export
Production

54

Other perspectives: First Nations

• Implications on decision making frameworks and analyses?

55

26
 9/10/2023

How Do Electricity Rates Work?

• Covering this because the textbook explanations and

problems aren’t correct.

Example Electricity Pricing Structure

• Small, medium and large general service rates (12xx):

Price per Price $8.02

kWh 8.16¢ per kW

3.93¢ $4.18

First Usage (kWh) 35 115 Demand (kW)

14,800/mo

• CBL rate (1823):

Price per Price per kW
kWh
7.36¢ $5.581
2.817¢

90% of last yr’s use Usage (kWh) Demand (kW)

As of Apr 2010

27
 9/10/2023

How accounts are charged: hypothetical

example

Elec Use
1000
Peak demand =
900 900 kW
800

700 Total energy use = 72,600

kWh
600
kW

500

400

300
200

100
0

One hypothetical month

Example Electricity Pricing Structure

𝑡𝑜𝑡𝑎𝑙 𝑢𝑠𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑑𝑒𝑚𝑎𝑛𝑑 𝑐ℎ𝑎𝑟𝑔𝑒 𝑐𝑜𝑠𝑡

𝑏𝑙𝑒𝑛𝑑𝑒𝑑 𝑟𝑎𝑡𝑒
𝑢𝑠𝑎𝑔𝑒 𝑎𝑚𝑜𝑢𝑛𝑡 𝑘𝑊ℎ

– Can be calculated over any time period of interest

– Consequent cost per kWh is a “blended” rate that
accounts for all variable costs
– Note that fixed administrative costs are not included
(although they can be significant), because they won’t
change if a project increases energy use or (peak)
demand.

28