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LECTURE 3

MONEY-TIME
RELATIONSHIPS AND
EQUIVALENCE
MONEY
• Medium of Exchange --
Means of payment for goods or services;
What sellers accept and buyers pay ;
• Store of Value --
A way to transport buying power from one time
period to another;
• Unit of Account --
A precise measurement of value or worth;
Allows for tabulating debits and credits;
CAPITAL
Wealth in the form of money or
property that can be used to
produce more wealth.
KINDS OF CAPITAL
• Equity capital is that owned by individuals who
have invested their money or property in a
business project or venture in the hope of
receiving a profit.
• Debt capital, often called borrowed capital, is
obtained from lenders (e.g., through the sale of
bonds) for investment.
Financing
Definition Instrument
Description
• Debt
financing
• Equity
financing
• Borrow
money
• Sell partial
ownership of
company;
• Bond
• Stock
• Promise to
pay
principle &
interest;
• Exchange
shares of
stock for
ownership of
company;
Financing
Definition Instrument
Description
• Debt
financing
• Equity
financing
• Borrow
money
• Sell partial
ownership of
company;
• Bond
• Stock
• Promise to
pay
principle &
interest;
• Exchange
shares of
stock for
ownership of
company;
Financing
Definition Instrument
Description
• Debt
financing
• Equity
financing
• Borrow
money
• Sell partial
ownership of
company;
• Bond
• Stock
• Promise to
pay
principle &
interest;
• Exchange
shares of
stock for
ownership of
company;
Exchange
money for
shares of
stock as
proof of
partial
ownership
INTEREST
• The fee that a borrower pays to a lender for
the use of his or her money.
INTEREST RATE
• The percentage of money being borrowed
that is paid to the lender on some time
basis.
SIMPLE INTEREST
• The total interest earned or charged is linearly
proportional to the initial amount of the loan
(principal), the interest rate and the number of
interest periods for which the principal is
committed.
• When applied, total interest “I” may be found by
• I = ( P ) ( N ) ( i ), where
– P = principal amount lent or borrowed
– N = number of interest periods ( e.g., years )
– i = interest rate per interest period
COMPOUND INTEREST
• Whenever the interest charge for any interest
period is based on the remaining principal amount
plus any accumulated interest charges up to the
beginning of that period.
Period Amount Owed Interest Amount Amount Owed
Beginning of for Period at end of
period ( @ 10% ) period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331
ECONOMIC EQUIVALENCE
• Established when we are indifferent between a
future payment, or a series of future payments,
and a present sum of money .
• Considers the comparison of alternative options,
or proposals, by reducing them to an equivalent
basis, depending on:
– interest rate;
 amounts of money involved;
 timing of the affected monetary receipts and/or
expenditures;
 manner in which the interest , or profit on invested
capital is paid and the initial capital is recovered.
ECONOMIC EQUIVALENCE FOR FOUR
REPAYMENT PLANS OF AN $8,000 LOAN
• Plan #1: $2,000 of loan principal plus 10% of BOY principal
paid at the end of year; interest paid at the end of each
year is reduced by $200 (i.e., 10% of remaining principal)
Year Amt. Owed Interest Total Tot. payment Total
B.O.Y. Accrued Principal principal payment
EOY + Interest EOY

1 $8,000 $800 $8,800 $2,000 $2,800
2 $6,000 $600 $6,600 $2,000 $2,600
3 $4,000 $400 $4,400 $2,000 $2,400
4 $2,000 $200 $2,200 $2,000 $2,200
Total interest paid ($2,000) is 10% of total dollar-years
($20,000)
ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT
PLANS OF AN $8,000 LOAN
• Plan #3: $2,524 paid at the end of each year; interest paid
at the end of each year is 10% of amount owed at the
beginning of the year.

Year Amt. Owed Interest Total Tot. payment Total
B.O.Y. Accrued Principal principal payment
EOY + Interest EOY
1 $8,000 $800 $8,800 $1,724 2,524
2 $6,276 $628 $6,904 $1,896 $2,524
3 $4,380 $438 $4,818 $2,086 $2,524
4 $2,294 $230 $2,524 $2,294 $2,524
Total interest paid ($2,096) is 10% of total dollar-years
($20,950)
• PLan #2: $0 of loan principal paid until end of fourth year;
$800 interest paid at the end of each year
Year Amt. Owed Interest Total Tot. payment Total
B.O.Y. Accrued Principal principal payment
EOY + Interest EOY
1 $8,000 $800 $8,800 $0 $800
2 $8,000 $800 $8,800 $0 $800
3 $8,000 $800 $8,800 $0 $800
4 $8,000 $800 $8,800 $8,000 $8,800
Total interest paid ($3,200) is 10% of total dollar-years
($32,000)
ECONOMIC EQUIVALENCE FOR FOUR
REPAYMENT PLANS OF AN $8,000 LOAN
ECONOMIC EQUIVALENCE FOR FOUR REPAYMENT
PLANS OF AN $8,000 LOAN
• Plan #4: No interest and no principal paid for first three
years. At the end of the fourth year, the original principal
plus accumulated (compounded) interest is paid.
Year Amount Owed Interest Accrued Total Principal Total end
at beginning for Year Money Payment of Year
of Year owed at Payment (
BOY ) end
of Year
1 $8,000 $800 $8,800 $0 $0
2 $8,800 $880 $9,680 $0 $0
3 $9,680 $968 $10,648 $0 $0
4 $10,648 $1,065 $11,713 $8,000 $11,713
Total interest paid ($3,713) is 10% of total dollar-years
($37,128)
Notation
• i = interest rate (per time period)
• N = # of time periods
• P = money at present
• F = money in future
– After n time periods
– Equivalent to P now, at interest rate i
• A = payment at end of each time period
– E.g., annual
Assumptions
• Assume all cash flow occurs at the end of each time
period
– For example, all year 1 payments are due on December 31
of year 1
• The present is the end of period 0
1
8
Cash flows
• Cash flows describe income and outflow of
money over time
• Disbursements =outflows “-”
• Receipts =inflows “+”
• Beginning of first year is traditionally defined
as “Time 0”
1
9
Equivalence
• Translating cashflows over time into common
units

• Present values of future payments
• Future value of present payments
• Present value of continuous uniform
payments
• Continuous payments equivalent to present
payment
2
0
Single Payment Compound Interest
• P= (P)resent sum of money
• i= (i)nterest per time period (usually years)
• MARR=Minimal Acceptable Rate of Return
• n= (n)umber of time periods (usually years)
• F= (F)uture sum of money that is equivalent to
P given an interest rate i for n periods

• F=P(1+i)
n
P=F(1+i)
-n
• F=P(F/P,i,n) P=F(P/F,i,n)
Overview
• Converting from P to F, and from F to P
• Converting from A to P, and from P to A
• Converting from F to A, and from A to F
• (No gradient methods!)
• Sensitivity analysis
Present to Future,
and Future to Present
Converting from Present to
Future
• To find F given P:
P
0
F
n
n
………….
Compound forward in time
Derive by Recursion
• Invest an amount P at rate i:
– Amount at time 1 = P (1+i)
– Amount at time 2 = P (1+i)
2
– Amount at time n = P (1+i)
N
• So we know that F = P(1+i)
N
– (F/P, i%, n) = (1+i)
N

– Single payment compound amount factor
F
n
= P (1+i)
N
F
n
= P (F/P, i%, N)
Example—Present to Future
• Invest P=$1,000, n=3, i=10%
• What is the future value, F?
0 1 2 3
P = $1,000
F = ??
i = 10%/year
F
3
= $1,000 (F/P, 10%, 3) = $1,000 (1.10)
3
= $1,000 (1.3310) = $1,331.00
EX2: If $1000 is borrowed at 10% per year
simple interest, the total amount due at the
end of five years is nearest to:
Interest = Pin = (1000) (0.10) (5) = $500
Total amount due = _____________
EX3: The amount of money five years ago that is
equivalent to $1000 now at 10% per year
compound interest is nearest to:$1,611


1. What is the future value in 10 years of
$1,500 payments received at the end of each
year for the next 10 years? Assume an
interest rate of 8%.
Converting from Future to
Present
• To find P given F:
– Discount back from the future
P
F
n
n
………….
Bring a single sum in future
back to the “present”
Illustration of Discounting
0
20
40
60
80
100
0 2 4 6 8
1
0
1
2
1
4
1
6
1
8
2
0
Time
P
r
e
s
e
n
t

V
a
l
u
e
0
0.01
0.05
0.1
0.2
0.3
Converting from Future to Present
• Amount F at time n:
– Amount at time N-1 = F/(1+i)
– Amount at time N-2 = F/(1+i)
2
– Amount at time 0 = F/(1+i)
N
• So we know that P = F/(1+i)
N

– (P/F, i%, N) = 1/(1+i)
N

– Single payment present worth factor
Example—Future to Present
• Assume we want F = $100,000 in 9 years.
• How much do we need to invest now, if the interest rate i
= 15%?
0 1 2 3 8 9
…………
F
9
= $100,000
P= ??
i = 15%/yr
P = $100,000 (P/F, 15%, 9) = $100,000 [1/(1.15)
9
]
= $100,000 (0.1111) = $11,110 at time t = 0
1. You wish to deposit a certain quantity of
money now so that you will have $500 at the
end of 5 years. Assume an interest of 6%.
The amount you need to deposit now is
approximately..

• Expenses for water treatment at a state park
are expected to be $60,000 now, $25,000 in
year one, and $10,000 per year thereafter
forever. At an interest rate of 8% per year, the
capitalized cost of the treatment is nearest to:
• P = 60,000 + 25,000(P/F, 8%, 1) +
10,000/0.08(P/F, 8%, 1)
= 60,000 + 25,000(0.9259) + 125,000(0.9259)
= $198,885
Annual to Present,
and Present to Annual
Converting from Annual to
Present
• Fixed annuity—constant cash flow
$A per period
P = ??
0
…………..
n 1 2 3 .. .. n-1
Converting from Annual to
Present
• We want an expression for the present
worth P of a stream of equal, end-of-period
cash flows A
0 1 2 3 n-1 n
A is given
P = ??
Converting from Annual to
Present
• Write a present-worth expression for each year
individually, and add them
1 2 1
11 1 1
..
(1)(1) (1)(1)
n n
PA
i i i i
÷
(
= +++ +
(
++ + +
¸ ¸
The term inside the brackets is a geometric progression.
This sum has a closed-form expression!
Converting from Annual to
Present
• Write a present-worth expression for each
year individually, and add them
1 2 1
11 1 1
..
(1)(1) (1)(1)
n n
PA
i i i i
÷
(
= +++ +
(
++ + +
¸ ¸
(1) 1
0
(1)
n
n
i
PA fori
i i
(

= =
(
+
¸ ¸
Converting from Annual to
Present
• This expression will convert an annual cash flow
to an equivalent present worth amount:
– (One period before the first annual cash flow)
(1) 1
0
(1)
n
n
i
PA fori
i i
(

= =
(
+
¸ ¸
 The term in the brackets is (P/A, i%, n)
 Uniform series present worth factor
Converting from Present to Annual
• This is how mortgages and car loans work:
– The bank gives you an amount P today
– You pay equal amounts A until you have paid the loan plus
interest
– In the first year, you pay mainly interest, and little of the
principal
– In the last year, you pay mainly the principal, and little
interest (since little of your original loan amount P is still
owed)
Converting from Present to
Annual
• Given the P/A relationship:
(1) 1
0
(1)
n
n
i
PA fori
i i
(

= =
(
+
¸ ¸
(1 )
(1 ) 1
n
n
i i
AP
i
(
+
=
(
+ ÷
¸ ¸
We can just solve for A in terms of P, yielding:
Remember: The present is
always one period before
the first annual amount!
 The term in the brackets is (A/P, i%, n)
 Capital recovery factor
Converting from Present to Annual
• How is it possible to calculate a constant amount to repay, and
have the total be exactly equivalent to P?
– It is sort of like magic!
• The calculations would be easier if you paid an equal fraction
of the principal P every year, plus whatever interest is owed
on the unpaid portion of the principal:
– But in that case almost nobody could afford to get a mortgage,
because the payments would be very high in the first few years!
EX1: A small manufacturing company is considering
purchasing a maintenance contract for its air
conditioning systems. Since all of its systems are new,
the company plans to begin the contract in year four
and continue through year ten. The cost of the
contract is $3,200 per year and the company's
minimum attractive rate of return is 12% per year.
• P = 3200(P/A, 12%, 7)(P/F, 12%, 3)
= 3200(4.5638)(0.7118)
= $10,395.24
• Ten annual deposits of $1,125 each are placed in a
savings account yielding 5% interest. Approximately
how much money has accumulated in the account
immediately following the tenth deposit?
• The correct answer was: c. $14,150.
• An individual wants to withdraw $15,000 from her
savings account at the end of every year for 6 years
starting at the end of this year. It is the beginning of
the year now. Approximately how much should be
deposited now to provide for these six withdrawals?
Assume an interest rate of 6%.
• The correct answer was: b. $73,755.
Future to Annual,
and Annual to Future

Converting from Future to
Annual
• Find the annual cash flow that is equivalent to a
future amount F
0
$A per period??
$F
The future amount
$F is given!
0
…………..
n 1 2 3 .. .. n-1
Converting from Future to
Annual
• Take advantage of what we know
• Recall that:


and

1
(1 )
n
P F
i
(
=
(
+
¸ ¸
(1 )
(1 ) 1
n
n
i i
AP
i
(
+
=
(
+ ÷
¸ ¸
Substitute “P” and
simplify!
Converting from Future to
Annual
• First convert future to present:
– Then convert the resulting P to annual


• Simplifying, we get:


1 (1)
(1) (1) 1
n
n n
i i
AF
i i
( ( +
=
( (
+ +÷
¸ ¸¸ ¸
(1 ) 1
n
A
i
i
F =
(
(
+ ÷
¸ ¸
 The term in the brackets is (A/F, i%, n)
 Sinking fund factor (from the year 1724!)
Example 1
• How much money must Carol save each year
(starting 1 year from now) at 5.5%/year:
– In order to have $6000 in 7 years?
Example 3.1
• Solution:
– The cash flow diagram fits the A/F factor (future
amount given, annual amount??)
– A= $6000 (A/F, 5.5%, 7) = 6000 (0.12096) = $725.76
per year
– The value 0.12096 can be computed (using the A/F
formula), or looked up in a table
Converting from Annual to Future
• Given


• Solve for F in terms of A:
(1 ) 1
n
i
AF
i
(
=
(
+ ÷
¸ ¸
)
=A
(1 1
F
n
i
i
(
+ ÷
(
¸ ¸
 The term in the brackets is (F/A, i%, n)
 Uniform series compound amount factor

Converting from Annual to Future
• Given an annual cash flow:
0
$A per period
$F
Find $F, given the $A
amounts
0
…………..
n 1 2 3 .. .. n-1
More Numerical Examples
How Fast Does Our Money Grow?
• Invest $1000 now for 64 years at 6%:
– F = P (1+i)
n
= $1000 (1.06)
64
= $41,647
• Things get big over time!
• Invest $1000 each year for 64 years at 6%:
– F = A [(1+i)
n
- 1]/i
• = $1000 [(1.06)
64
- 1]/.06 = $677,450
• This is really big!
EX3: A company plans to start a sinking fund so that it
will have money to purchase a new 18-wheeler ten
years from now. The cost of the truck is expected to
be $200,000 and the company uses an interest rate
of 10% per year. If the company makes the first
deposit three years from now, how much must each
one be in order to have the money at the end of year
ten?
• A = 200,000(A/F, 10%, 8)
= 200,000(0.08744)
= $17,488.50

• At a 10% interest rate, what uniform annual amount
should be deposited each year in order to
accumulate $1,000,000 at the time of the twentieth
annual deposit?
• The correct answer was: a. $17,500.
• If $175 is deposited in a savings account at the
beginning of each year for 15 years, and the account
earns interest at 6%, compounded annually, the
value of the account at the end of 15 years is
approximately
• The correct answer was: c. $4,318.
EX4: An expenditure for maintaining a bridge occurs in
five-year cycles. If the cost is $100,000 now and
$100,000 every five years forever, the capitalized cost
of this expenditure at 10% per year is nearest to:
• Annual worth of 100,000 every 5 years =
100,000(A/F, 10%, 5)
= 100,000 (0.1638)
= $16,380
• P = 100,000 + 16,380/0.10
= $263,800

Non-Equal, Non-Annual Payments
• Same basic ideas still work
• Assume that you plan to invest:
– $2000 in year 0
– $1500 in year 2
– $1000 in year 4
• How much will you have in year 10?
– $2000 (1+i)
10
+ $1500 (1+i)
8
+ $1000 (1+i)
6

A More Complicated Example
• How much to invest (at 5%) to get:
– $1200 in year 5
– $1200 in year 10
– $1200 in year 15
– $1200 in year 20
• Convert each future amount to present:
– According to P = F/(1+i)
n

– Invest $1200/(1.05)
5
+ $1200/(1.05)
10
+ $1200/(1.05)
15
+
$1200/(1.05)
20
= $2706
Sensitivity Analysis

Sensitivity Analysis
• So far, we have assumed that all of the numbers
and parameters are known with certainty:
• In reality, most of them will be estimates!
• We can use sensitivity analysis to assess the
impact of each input parameter on the output
variable of interest (present worth, internal rate
of return, etc.):
• Best performed using a spreadsheet!
• Vary the input parameters within ranges,
observe the change in the output variable
Sensitivity Analysis
• Perform “what-if” analysis on one or more input
parameters:
• Observe any changes in the output variable
• You can easily do this by hand in a spreadsheet
• Commercial Excel add-ins are also available:
• For example, Palisade Corporation’s TopRank
Sensitivity Analysis
• Varying one or more input parameters:
• Store the results of each change
• Plot the results as a function of input values
• If a small change in an input parameter leads to
a large change in the output:
• Then the output is “sensitive” to that input
• Either more effort should go into estimating that
parameter:
• Or you should choose a decision that is not
sensitive to that input!
Sensitivity Analysis
• If the output is not as sensitive to some input
parameters:
• Then not as much effort is required to
estimate those parameters!
• Because they do not have much impact on the
output variable of interest
Summary
Summary
• This lecture presented the fundamental time-
value-of-money relationships common to
most engineering economic analysis
calculations
• We learned how to convert:
– Present to future, and vice versa
– Annual to present, and vice versa
– Future to annual, and vice versa
• We saw that costs get big over time
• We learned about sensitivity analysis
Summary
• You must master these basic relationships in order to
use them in economic analysis and decision making:
– These relationships will be important to you, both
professionally and in your personal life!
– Make sure you have a good grasp of these concepts, so
you can use them correctly!
Practice Problems
1. The cost of a small flood control dam is expected to be
$40,000 now, $3,000 one year from now, $4,000 two years
from now and amounts increasing by $1,000 per year through
year ten, after which they will remain constant. At an interest
rate of 10% per year, the capitalized cost of the dam is nearest
to:
• For year 10 on the annual cost is $12,000. Find its capitalized
cost P/I in year 10 and use the P/F factor for its present worth.
• P
cap
= 40,000 + 3,000(P/A, 10%, 10) +1000(P/G, 10%, 10)
+(12,000/0.10)(P/F, 10%, 10)
= 40,000 + 3,000(6.1446) +1000(22.8913)
+(12,000/0.10)(0.3855)
= $127,585

2. A machine that has a five year life has a first
cost of $50,000, an operating cost of $4,000
per month and a $10,000 salvage value. At an
interest rate of 12% per year compounded
monthly, the capitalized cost of the machine is
nearest to: $498,800

• 3. An apartment complex wishes to establish a fund at the
end of 2004 that by the end of 2021, will grow to an amount
large enough to place new roofs on its 39 apartment units.
Each new roof is estimated to cost $ 2,500 in 2019, at which
the time 13 apartments will be roofed. In 2020, another 13
apartments will be roofed but the unit cost will be $ 2,625.
the last 13 apartments will be roofed in 2021 at a unit cost of
$ 2,750.
• The annual effective interest rate that can be earned on this
fund is 4%. How much money each year must be put aside
(saved) starting at the end of 2005 to pay for all 39 roofs?
• A = $ 4,490/year
• By doing annual updating of a certain
production line, a manufacturing company
can avoid spending $100,000 for a new
system ten years from now. At an interest rate
of 10% per year, the annual amount the
company could afford to spend beginning one
year from now is nearest to: $16,270
• At an interest rate of 10% per year, annual
deposits of $1,000 in years one through ten
would accumulate to how much immediately
after the last deposit?A)$6,145
• If a company wanted to make a single
investment now instead of spending $20,000
five years from now, how much would the
investment be at an interest rate of 10% per
year? P = 20,000(P/F, 10%, 5)
= 20,000(0.6209)
• If a company invests $25,000 in new packaging
equipment, by how much must it reduce its annual
costs if it expects to recover the investment in seven
years at an interest rate of 10% per year?A)$2,635
• In order to update a production process, a company
can spend money now or four years from now. If the
amount now would be $20,000, what equivalent
amount could the company spend four years from
now at an interest rate of 10% per year? $35,620
• If a small company invests its annual profits of
$150,000 in a stock fund which earns 18% per
year, the amount in the fund after ten years
will be nearest to:$2,153,000
• What is the equivalent amount in year ten of
an expenditure of $5,000 in year one, $6,000
in year two, and amounts increasing by
$1,000 per year through year ten?
• Assume the interest rate is 10% per year.
• A short-haul trucking company purchased a
used dump truck for $12,000. The company
paid $5,000 down and financed the balance at
an interest rate of 10% per year for five years.
The amount of its annual payment is nearest
to:B)$1,846
• In order to have money for their son's college
education, a young couple started a savings
plan into which they made intermittent
deposits. They started the account with a
deposit of $2,000 (in year zero) and then
added $3,000 in years two, five and six. The
amount they had in the account in year ten if
they earned interest at 12% per year was
nearest to:D)$23,647

• Payments of $1,000 in year two and $4,000 in
year five are equivalent to uniform payments
in years three through seven at an interest
rate of 10% per year nearest to:$985
• At an interest rate of 10% per year,
expenditures of $1,000 in years zero, three
and six could be replaced by a single
investment in year eight nearest to:$4964
• The number of years from now that an initial
investment of $1,000,000 would be recovered
from uniform receipts of $131,000 per year
beginning three years from now at an interest
rate of 10% per year is nearest to:24