Chapter 4: Time Value of Money

© 2013 INSTITUTE OF TECHNOLOGY PETRONAS SDN BHD

All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means (electronic, mechanical, photocopying, recording or otherwise) without the permission of the copyright owner.
Chapter 4: Time Value of Money

Semester 2/2023

By :
Dr. Mysara Eissa Mohyaldinn
(mysara.eissa@uto.edu.my)
Tel No : 05 368 7057
Room No : 12.03.38
 CHAPTER LEARNING OUTCOMES

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

❑ Estimate the present and future value of money

❑ Determine economic equivalence of alternative capital

options.

❑ Apply cash flow diagram to describe inflow and outflow cash

variation with time.

 CHAPTER OUTLINES
• Simple Interest • Summary of Interest
• Compound Interest Formulas and
• The Concept of Equivalence Relationships for Discrete
Compounding
• Notation and Cash-Flow
Diagrams and Tables
• Relating Present and Future
Equivalent Values of Single
Cash Flows
• Relating a Uniform Series
(Annuity) to Its Present and
Future Equivalent Values
 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

UTP offers you a

discount of 5% if
you pay your 4-
years fees. What
do you need to
think about?

Go to
 TIME VALUE OF MONEY

Money at present worth more than the same amount at future due to three

reasons:

❑ Opportunity: can be invested now and grows (with a given interest rate)

❑ Risk: money owned now is more guaranteed, it is not certain to receive

money in future

❑ Inflation: inflation reduces money value over time (the price of a specific

product increases with time).

 TIME VALUE OF MONEY
Money has a time value because it can earn moremoneyovertime(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.

 METHOD 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.
CALCULATING SIMPLE INTEREST
EXAMPLE 1: SIMPLE INTEREST
CALCULATING COMPOUND INTEREST
EXAMPLE 2: COMPOUND INTEREST
SIMPLE VS COMPOUND INTEREST
 USING EXCEL
Refer to https://www.automateexcel.com/formulas/compound-
interest-calculate-excel/
To create your own
 USING EXCEL
Or download www.vertex42.com tool
 ECONOMIC EQUIVALENCE

Economic equivalence is a combination of interest rate and time value of

money to determine the different amounts of money at different points in time

that are equal in economic value.

Assuming interest rate of 9%, a $1000 today is equivalent to:

$1090 after one year (future equivalence)
1000/1.09=$917.43 one year before.
ECONOMIC EQUIVALENCE
ECONOMIC EQUIVALENCE
 ECONOMIC EQUIVALENCE

Assume that you will have no need

for money during the next two
years, and any money you receive
will immediately go into your
account and earn a 5% effective
annual interest rate. Which of the
following options -
would be more desirable to you?
option a: receive $100 now
option b: receive $105 after 1 year.
option a: receive $110.25 after 2
years
 ECONOMIC EQUIVALENCE

EE refers to the fact that a cash flow-whether a single payment

or a series of payments-can be converted to an equivalent cash

flow at any point in time

Dr. Sam C. M. Hui, Department of Mechanical Engineering, The University of Hong Kong
 ECONOMIC EQUIVALENCE

Or

Dr. Sam C. M. Hui, Department of Mechanical Engineering, The University of Hong Kong
 ECONOMIC EQUIVALENCE

Dr. Sam C. M. Hui, Department of Mechanical Engineering, The University of Hong Kong
 ECONOMIC EQUIVALENCE

At 9% interest, what is the equivalent worth of $3500 now 5

years from now?
ECONOMIC EQUIVALENCE
Finding F when given P
Finding F when given P
Finding P when given F
Finding P when given F
Finding P when given F
Finding i when given P , F and N
 CASH FLOW DIAGRAM

❑ Graphical presentation of monetary value with time (x-time (e.g.,

year)), y (monetary value)

❑ Monetary value: benefits (upward arrow) and cost (downward

arrows).

❑ All cash flows at a single point of time are combined together into a

single value.
 CASH FLOW DIAGRAM

https://nitsri.ac.in/Department/Civil%20Engineering/LECTURES_11-15_WRS--PDF.pdf

https://www.webpages.uidaho.edu/~mlowry/Teaching/economic/FE_Ch._51.
pdf
CASH FLOW DIAGRAM
 CASH FLOW DIAGRAM
Relating a Uniform Series (Annuity) to Its Present
and Future Equivalent Values
CASH FLOW DIAGRAM
CASH FLOW DIAGRAM
CASH FLOW DIAGRAM
 Chapter 5: Evaluating a Single
Project
© 2013 INSTITUTE OF TECHNOLOGY PETRONAS SDN BHD
All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any
means (electronic, mechanical, photocopying, recording or otherwise) without the permission of the copyright owner.
 CHAPTER LEARNING OUTCOMES

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

❑ Discuss and critique contemporary methods for determining

project profitability

❑ Evaluate the economic profitability of a single proposed

problem solution
 Case Study – WalMart Stock

 In October 1,1970, when Wal-

Mart Stores, Inc. went public, an
investment of 100 shares cost
$1,650.
 That investment would have been
worth $15,384,576 on September
30, 2014, after nine times stock
splits for 2 for 1. What would be
the rate of return on this
investment?
 The unit price of Walmart shares
now closed at more than $100 as
compared to $80 in 2014. What
is the estimated present worth of
the original 100 shares today?
 Capital Evaluation

Proposed capital projects can be evaluated in several ways.

• Present worth (PW)

• Future worth (FW)
• Annual worth (AW)
• Internal rate of return (IRR)
• External rate of return (ERR)
• Payback period (generally not appropriate as a
primary decision rule)
To be attractive, a capital project must provide a return that exceeds a
minimum level established by the organization. This minimum level is
reflected in a firm’s Minimum Attractive Rate of Return (MARR).
 Rate of Return

What it is...
❑ Interest earned on your invested capital, or
commonly known as internal rate of return
(IRR)
Example...
❑ The interest earned on your savings account is
the rate of return on your deposits

Many elements contribute to determining the MARR.

• Amount, source, and cost of money available

• Number and purpose of good projects
available
• Perceived risk of investment opportunities
• Type of organization
 Case Study – WalMart Stock

Rate of Return
 Given:
 P = $1,650
 F = $15,384576

 N = 44 years

 Find: i
 Formula to Use
 F = P(1 + i)N

 $15,384,576 = $1,650(1 + i)44

$15,384,576
 i = 23.09%

2014

$1,650
 Case Study – WalMart Stock
If you took out $1,650 from your savings
account and invested in Wal-Mart stock,
you could have
 $15,384,576
 Or the equivalent to earning 23.09%
interest each year on your savings
account over 44 years.
If you did not invest $1,650 in Wal-
Mart stock, what could you use your
money for?
 If the best you could do was to leave
the money in a savings account to earn
6% interest over 44 years, you would
have $21,426.
 What is the meaning of 6% interest?
This will be your opportunity cost rate
or minimum return required for any
investment.
 Case Study – WalMart Stock
❑ In 1970, as long as you could earn more than a 6% interest in another
investment opportunity, you would take that investment.
❑ Therefore, that 6% is viewed as a minimum attractive rate of return (or
required rate of return). This is the interest rate commonly used in NPW
analysis.
❑ So to see if the proposed investment is a good one, you adopt the
following decision rule:

ROR (23.09%) > MARR(6%)

 Present Worth
The most-used method is the present worth method.

The present worth (PW) is found by discounting all cash inflows

and outflows to the present time at an interest rate that is generally
the MARR.
A positive PW for an investment project means that the project is
acceptable (it satisfies the MARR).
 Present Worth
The most-used method is the present worth method.

❑ Principle: Compute the equivalent

net surplus at n = 0 for a given
interest rate of i.
❑ For Single Project Evaluation:
Accept the project if the net
surplus is positive.
❑ For Comparing Multiple
Alternatives: Select the
alternative with the largest net
present worth.
 Example 1-Present Worth
Consider a project that has an initial investment of $50,000 and that
returns $18,000 per year for the next four years. If the MARR is 12%,
is this a good investment?

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)
PW = $4,671.40 → This is a good investment!
 Future Worth
Future Worth (FW) method is an alternative to the PW method.

• Looking at FW is appropriate since the primary objective is to maximize

the future wealth of owners of the firm.
• FW is based on the equivalent worth of all cash inflows and outflows at
the end of the study period at an interest rate that is generally the MARR.
• Decisions made using FW and PW will be the same.
 Future Worth

Future Worth (FW) method is an alternative to the PW method.

$47,309

❑ Given
Cash flows and MARR (i)
❑ Find
The net equivalent worth at a $35,560 $37,360 $31,850 $34,400
specified period other than
0
the “present,” commonly at 1 3
2
the end of the project life
❑ Decision Rule
Accept the project if the
$76,000
equivalent worth is positive.
Project life
 Future Worth
Future worth example.

A $45,000 investment in a new conveyor system is projected to improve

throughput and increasing revenue by $14,000 per year for five years.
The conveyor will have an estimated market value of $4,000 at the end of
five years. Using FW and a MARR of 12%, is this a good investment?

FW = -$45,000(F/P, 12%, 5)+$14,000(F/A, 12%, 5)+$4,000

FW = -$45,000(1.7623)+$14,000(6.3528)+$4,000
FW = $13,635.70 → This is a good investment!
 Annual Worth
Annual Worth (AW) is another way to assess projects.
• Annual worth is an equal periodic series of dollar amounts that is
equivalent to the cash inflows and outflows, at an interest rate that is
generally the MARR.
• The AW of a project is annual equivalent revenue or savings minus annual
equivalent expenses, less its annual capital recovery (CR) amount.
❑ By knowing the annual equivalent worth, we can:
o Seek consistency of report format.
o Determine the unit cost (or unit profit).
o Facilitate the unequal project life comparison.
 Capital Recovery
Capital recovery reflects the capital cost of the asset.
• CR is the annual equivalent cost of the capital invested.
• The CR covers the following items.
– Loss in value of the asset.
– Interest on invested capital (at the MARR).
• The CR distributes the initial cost (I) and the salvage value (S) across
the life of the asset.
 Capital (Ownership) Cost
Capital recovery reflects the capital cost of the asset.
 Def: Owning equipment
associated with two
transactions— S
(1) its initial cost (I), and 0
(2) its salvage value (S). N
 Capital costs: Taking these
items into consideration, we I
calculate the capital costs as:
0 1 2 3 N
CR(i) = I(A / P , i , N) − S(A / F , i , N)
= (I − S)(A / P , i , N) + iS CR(i)
 Example 6 – Annual Worth
An off grid solar project requires an initial investment of $45,000, has a
salvage value of $12,000 after six years, incurs annual expenses of $6,000,
and provides an annual revenue of $18,000. Using a MARR of 10%,
determine the AW of this project.

Since the AW is positive, it’s a good investment.

 Rate of Return
Rate of return can be defined in a number of ways.
• Interest rate earned on the unpaid (outstanding) balance of an
installment loan.
• The break-even interest rate which equates the present worth of a
project’s cash outflows to the present worth of its cash inflows
• the interest rate earned on the unrecovered project balance of the
investment such that when the project terminates, the unrecovered
project balance will be zero
 Example 7 – Loan Repayment
A bank lends $10,000 and receives an annual repayment of $4,021 over 3 years. The bank is
said to earn a return of 10% on its loan of $10,000.
A = $10,000 (A/P, 10%, 3)
= $4,021

Unpaid Loan Return on Payment Unpaid Loan

Balance at Unpaid Received Balance at
Beginning of Year Balance (10%) from Borrower End of Year
n
0 $0 $0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 $0

A return of 10% on the amount still outstanding at the beginning of each

year
 Internal Rate of Return

• The internal rate of return (IRR) method is the most widely used rate of
return method for performing engineering economic analysis.
• It is also called the investor’s method, the discounted cash flow method,
and the profitability index.
• If the IRR for a project is greater than the MARR, then the project is
acceptable.
 Internal Rate of Return
How the IRR works
• The IRR is the interest rate that equates the equivalent worth of an
alternative’s cash inflows (revenue, R) to the equivalent worth of
cash outflows (expenses, E).
• The IRR is sometimes referred to as the breakeven interest rate.

The IRR is the interest i'% at which

 Internal Rate of Return

Solving for the IRR is a bit more complicated than PW, FW, or AW
• The method of solving for the i'% that equates revenues and expenses
normally involves trial-and-error calculations, or solving numerically
using mathematical software.
• The use of spreadsheet software can greatly assist in solving for the IRR.
Excel uses the IRR(range, guess) or RATE(nper, pmt, pv) functions.
 Excel 1 – Present Value
❑ Find: Internal Rate of Return
A B C
Period 1 Period Cash Flow
Cash
(N) 2
Flow
3 0 -1000
0 -$1,000 4 1 -500
5 2 800
1 -500 6 3 1500
2 800 7 4 2000
8
3 1,500 9 IRR = 44%
10
4 2,000 11

=IRR(cell range, guess) =IRR(B3:B7,10%)

 Internal Rate of Return

Challenges in applying the IRR method.

• It is computationally difficult without proper tools.

• In rare instances multiple rates of return can be found.

• The IRR method must be carefully applied and interpreted when

comparing two more mutually exclusive alternatives (e.g., do not
directly compare internal rates of return).
 External Rate of Return
The ERR procedure
• Discount all the net cash outflows to time 0 at ε% per compounding period.
• Compound all the net cash inflows to period N at at ε%.
• Solve for the ERR, the interest rate that establishes equivalence between the two
quantities.

ERR is the i'% at which

where
Rk = excess of receipts over expenses in period k,
Ek = excess of expenses over receipts in period k,
N = project life or number of periods, and
ε = external reinvestment rate per period.
 Example 6– Cash Flow
Applying the ERR method
For the cash flows given below, find the ERR when the external reinvestment rate
is ε = 12% (equal to the MARR).

Year 0 1 2 3 4
Cash Flow -$15,000 -$7,000 $10,000 $10,000 $10,000

Expenses

Revenue

Solving, we find
 Payback Period
The payback period method is simple, but possibly misleading.

• The simple payback period is the number of years required for cash
inflows to just equal cash outflows.
• It is a measure of liquidity rather than a measure of profitability.

The payback period is the smallest value of θ (θ ≤ N) for which the

relationship below is satisfied.

For discounted payback future cash flows are discounted

back to the present, so the relationship to satisfy becomes
 Payback Period

Problems with the payback period method.

• It doesn’t reflect any cash flows occurring after θ, or θ'.
• It doesn’t indicate anything about project desirability except the
speed with which the initial investment is recovered.
• Recommendation: use the payback period only as supplemental
information in conjunction with one or more of the other methods in
this chapter.
 Example 7– Payback Period
Finding the simple and discounted payback period for a set of cash flows.
End of Net Cash Cumulative Cumulative
 The cumulative cash Year Flow PW at 0% PW at 6%
flows in the table were
0 -$42,000 -$42,000 -$42,000
calculated using the
formulas for simple and 1 $12,000 -$30,000 -$30,679
discounted payback.
2 $11,000 -$19,000 -$20,889

3 $10,000 -$9,000 -$12,493

 From the calculations θ =
4 years and θ' = 5 years. 4 $10,000 $1,000 -$4,572

5 $9,000 $2,153
 Summary

 Evaluation of project capital expenditure must use appropriate

methods of project worth and rate of return.

 Present worth, Future worth, Capital recoveries, minimum rate

of returns and payback period are methods/formulae to assist

in deciding worthiness of any project.
 THANK YOU
© 2013 INSTITUTE OF TECHNOLOGY PETRONAS SDN BHD
All rights reserved. No part of this document may be reproduced, stored in a retrieval system or transmitted in any form or by any means (electronic,
mechanical, photocopying, recording or otherwise) without the permission of the copyright owner.