me Relationships & EquivalenceMoney-Time Relationships & Equivalence The term capital refers to wealth in the form of money or property that can be used to produce more wealth. The majority of engineering economy studies involves commitment of capital for extended periods of time, so the effect of time must be considered. In this regard, it is recognized that a dollar today is worth more than a dollar one or more years from now because of the interest (or profit) it can earn. Therefore, money has a time value. It has been said that often the riskiest thing a person can do with money is nothing! Money has value, and if money remains uninvested (like in a large bottle), value is lost. Money changes in value not only because of interest rates—inflation (or deflation) and currency exchange rates also cause money to change in valueSimple Interest est rate are said to be simple. Simple interest 's not used frequently in modern commercial practice. When simple interest is applicable, the total interest, /, earned or paid may be computed Using the formula L=(P)\(N)(i). (4-1) Where P= principal amount lent or borrowed; N= number of interest periods (e.g., years) 1= interest rate per interest Period.Simple Interest The total amount repaid at the end of NV interest periods is P+/. Thus, if $1,000 were loaned for three years at a simple interest rate of 10% per year, the interest earned would be T= $1,000 x 3 x 0.10 = $300. The total amount owed at the end of three years would be $1,000 + $300 = $1,300. Notice that the cumulative amount of interest owed is a linear function of time until the principal (and interest) is repaid (usually not until the end of period N)Compound Interest Whenever the interest charge for any interest period (a year, for example) is based on the remaining principal amount plus any accumulated interest charges up to the beginning of that period, the interest is said to be compound. In short, compounding amounts to earning money on your reinvested earnings as well as your original savings. The effect of compounding of interest can be seen in the following table for $1,000 loaned for three Periods at an interest rate of 10% compounded each period. 1,000 $100 Si.100 $1,100 S110 $1,210 $1210 sto S131Simple vs Compound InterestThe Concept of Equivalence How can alternatives for providing the same service or accomplishing the same function be compared when interest is involved over extended periods of time? We should consider the comparison of alternative options, or proposals, by reducing them to an equivalent basis that is dependent on (1) the interest rate, (2) the amounts of money involved, and (3) the timing of the monetary receipts or expenses To better understand the mechanics of interest and to explain the concept of equivalence, suppose you have a $17,000 balance on your credit card. “This has got to stop!” you say to yourself. So you decide to repay the $17,000 debt in four months. An unpaid credit card balance at the beginning of a month will be charged interest at the rate of 1% by your credit card company. For this situation, we have selected three plans to repay the $17,000 principal plus interest owed.* These three plans are illustrated in Table 4. 1, and we will demonstrate that they are equivalent (i.e., the same) when the interest rate is 1% per month on the unpaid balance of principalPlan 1 Pay interest due at end of each month and principal at end of fourth month 1 $17,000 $170 $17.170 so $170 17.000 170 17.170 0 170 17,000 170 17.170 0 170 4 17,000 170 17.170 17,000 17.170 68,000 S-mo. $680 (total interest) Plan 2. Pay off the debt in four equal end-of-month installments (principal and interest) 1 $17,000 $170 $17,170 $4,187.10 $4,357.10 2 12,812.90 128.13 12,941.03 4,228.97 4,357.10 3 8,583.93 85.84 8,669.77 4,271.26 4,357.10 4 4,312.67 43.13 4,355.80 4.313,97Notation & Cash-Flow Diagrams & Tables 6 sof End of F = $1769027 Month I Cash-Flow Diagram for Plan 3 of Table 4-1 (Credit Card Company's Viewpoint) 0 2 3 4=N End of Month 1 = 1% per Month P = 17000Notation & Cash-Flow Diagrams & Tables aeMoney-Time Relationships & Equivalence Problem 1. Cash Flow Diagram t juating the Be Corporation insists that its ¢ prcee Money-Time Relationships & Equivalence @ | Solution Problem1.Cash 4, jown in the figure below, the initial investment of $10,000 and annual expenses of $3,000 are cash outflows, while annual revenues and the market value are eash Flow Diagram inflowsPresent and Future Equivalent ValuesPresent and Future Equivalent Values Finding F when given P fan amount of P dollars is invested at a point in time and i% is the interest (profit or growth) rate per period, the amount will grow to a future amount of P+Pi=P(1+i) by the end of one period; by the end of two periods, the amount will grow to P(a+i(1+i)=P( + i)? by the end of three periods, the amount will grow to p(L+i2(1+i)=P(1 + i)3; and by the end of N periods the amount will grow to F=P+i)%Present and Future Equivalent Values F=P(+i)* (4-2) Equation (4-2) can be represented using the functional symbol (F/P, i%, N) for (1 + i) Hence, Equation (4-2) can be expressed as F = P(F/P,i%,N). (4-3) where the factor in parentheses is read “find F given P at i% interest per period for N interest periods.” Note that the sequence of F and P in F/P is the same as in the initial part ‘of Equation (4-3), where the unknown quantity, F, is placed on the left-hand side of the equation. This sequencing of letters is true of all functional symbols to make them easy to remember.Money-Time Relationships & Equivalence @ Problem 2. Future Equivalent of a Present Sum Suppose that you borrow $8,000 now, promising to repay the loan principal plus accumulated interest in four years at /= 10% per year. How much would you repay at the end of four years?Present and Future Equivalent Values Finding P when given F While (1 + i)" is commonly called the single payment compound amount factor, (1 + i)~" is referred to as the single payment present worth factorMoney-Time Relationships & Equivalence Problem 3. Present Equivalent of a Future SumMoney-Time Relationships & Equivalence Problem 3. Present Equivalent of a Future Sum P =§$10,000(P/F, 8%, 6) P = $10,000(0.6302) = $6,302Present and Future Equivalent Values Based on Equations (4-2) and (4-4), the following three simple rules apply when performing arithmetic calculations with cash flows. Rule A. Cash flows cannot be added or subtracted unless they occur at the same point in time Rule B. To move a cash flow forward in time by one-time unit, multiply the magnitude of the cash flow by (1 +), where jis the interest rate that reflects the time value of money. Rule C. To move a cash flow backward in time by one-time unit, divide the magnitude of the cash flow by (1 + i)Present and Future Equivalent Values Finding the interest rate given P, F, and N i= YF/P-1 While (1 + ()” is commonly called the single payment compound amount factor, (1 + 17" Is referred to as the single payment present worth factor eMoney-Time Relationships & Equivalence Problem 4. Finding i given P, F, & N The average price of gasoline in 2005 was $2.31 per gallon. In 1993, the average price was $1.07. What was the average annual rate of increase in the price of gasoline over this 12-year period?Money-Time Relationships & Equivalence Problem 4. Finding i given P, F, & NPresent and Future Equivalent Values Finding N when given P, F, &i F=P +i)" (1+i)* =(F/P) Using logarithms N log(| +1) = log(F/P) and _ logt/P) ~ logit +)Money-Time Relationships & Equivalence Problem 5. Finding N when given P, F, & iRelating a Uniform Series (Annuity) to Its Present and Future Equivalent Values The figure shows a general cash-flow diagram involving a series of uniform (equal) receipts, each of amount A, occurring at the end of each period for NV periods with interest at i% per period, Such a uniform series is often called an annuity. It should be noted that the formulas and tables to be presented are derived such that A occurs at the end of each period, and thus 1. P (present equivalent value) occurs one interest period before the first A (uniform amount), 2. F (future equivalent value) occurs at the same time as the last A, and N periods after P, and 3. A (annual equivalent value) occurs at the end of periods 1 through N, inclusive Be cictionshio tr 1 = Uniform Amounts (Given) PA, and F can be observed In the figure. Four formulas relating A to F and P will be 3 Number developed End of Period of Interest Period: Interest Rate per Period i P= Present Equivalent (Find) F = Future Equivalent (Find)