IE 305 Spring08 Chapter 3

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IE 305 Spring08 Chapter 3

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You are on page 1of 28

th

edition 2007

Time Value of Money

Chapter 3-1

Contemporary Engineering Economics

Copyright 2006

Contemporary Engineering Economics, 4

th

edition 2007

Chapter Opening Story Take a Lump Sum or

Annual Installments

Mrs. Louise Outing won a

lottery worth $5.6 million.

Before playing the lottery,

she was offered to choose

between a single lump sum

$2.912 million, or $5.6

million paid out over 20

years (or $280,000 per

year).

She ended up taking the

annual installment option,

as she forgot to mark the

Cash Value box, by

default.

What basis do we compare

these two options?

Contemporary Engineering Economics, 4

th

edition 2007

Year Option A

(Lump Sum)

Option B

(Installment Plan)

0

1

2

3

19

$2.912M $283,770

$280,000

$280,000

$280,000

$280,000

Contemporary Engineering Economics, 4

th

edition 2007

What Do We Need to Know?

To make such comparisons (the lottery

decision problem), we must be able to

compare the value of money at different point

in time.

To do this, we need to develop a method for

reducing a sequence of benefits and costs to

a single point in time. Then, we will make our

comparisons on that basis.

Contemporary Engineering Economics, 4

th

edition 2007

Time Value of Money

Money has a time value

because it can earn more

money over time (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.

Interest is the cost of

moneya cost to the

borrower and an earning to

the lender

This a two-edged sword whereby earning

grows, but purchasing power decreases

(due to inflation), as time goes by.

Contemporary Engineering Economics, 4

th

edition 2007

The Interest Rate

Contemporary Engineering Economics, 4

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edition 2007

Cash Flow Transactions for Two Types of Loan

Repayment

End of Year Receipts Payments

Plan 1 Plan 2

Year 0 $20,000.00 $200.00 $200.00

Year 1 5,141.85 0

Year 2 5,141.85 0

Year 3 5,141.85 0

Year 4 5,141.85 0

Year 5 5,141.85 30,772.48

The amount of loan = $20,000, origination fee = $200, interest rate = 9% APR

(annual percentage rate)

Contemporary Engineering Economics, 4

th

edition 2007

Cash Flow Diagram for Plan 2

Contemporary Engineering Economics, 4

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edition 2007

End-of-Period Convention

Contemporary Engineering Economics, 4

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edition 2007

Methods 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.

Contemporary Engineering Economics, 4

th

edition 2007

Simple Interest

P = Principal amount

i = Interest rate

N = Number of

interest periods

Example:

P = $1,000

i = 10%

N = 3 years

End of

Year

Beginnin

g

Balance

Interest

earned

Ending

Balance

0 $1,000

1 $1,000 $100 $1,100

2 $1,100 $100 $1,200

3 $1,200 $100 $1,300

Contemporary Engineering Economics, 4

th

edition 2007

Simple Interest Formula

( )

where

= Principal amount

= simple interest rate

= number of interest periods

= total amount accumulated at the end of period

F P iP N

P

i

N

F N

$1, 000 (0.10)($1, 000)(3)

$1, 300

F

th

edition 2007

Compound Interest

P = Principal amount

i = Interest rate

N = Number of

interest periods

Example:

P = $1,000

i = 10%

N = 3 years

End

of

Year

Beginning

Balance

Interest

earned

Ending

Balance

0 $1,000

1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

Contemporary Engineering Economics, 4

th

edition 2007

Compounding Process

$1,000

$1,100

$1,100

$1,210

$1,210

$1,331

0

1

2

3

Contemporary Engineering Economics, 4

th

edition 2007

0

$1,000

$1,331

1

2

3

3

$1, 000(1 0.10)

$1, 331

F

Contemporary Engineering Economics, 4

th

edition 2007

Relationship Between Simple Interest and

Compound Interest

Contemporary Engineering Economics, 4

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edition 2007

Compound Interest Formula

1

2

2 1

0:

1: (1 )

2: (1 ) (1 )

: (1 )

N

n P

n F P i

n F F i P i

n N F P i

Contemporary Engineering Economics, 4

th

edition 2007

Some Fundamental Laws

2

F m a

V i R

E m c

(1 )

N

F P i

Contemporary Engineering Economics, 4

th

edition 2007

Compound Interest

The greatest mathematical discovery of

all time,

Albert Einstein

Contemporary Engineering Economics, 4

th

edition 2007

Practice Problem: Warren Buffetts

Berkshire Hathaway

Went public in 1965: $18

per share

Worth today (June 22,

2006): $91,980

Annual compound growth:

23.15%

Current market value:

$115.802 Billion

If his company continues to

grow at the current pace,

what will be his companys

total market value when

reaches 100? ( lives till 100

(76 years as of 2006)

Contemporary Engineering Economics, 4

th

edition 2007

Market Value

Assume that the companys stock will continue to

appreciate at an annual rate of 23.15% for the

next 24 years.

24

$115.802 (1 0.2315)

$17.145 trillions

F M

th

edition 2007

EXCEL Template

In 1626 the Indians sold Manhattan Island to Peter Minuit

of the Dutch West Company for $24.

If they saved just $1 from the proceeds in a bank account

that paid 8% interest, how much would their descendents

have now?

As of Year 2006, the total US population would be close to

300 millions. If the total sum would be distributed equally

among the population, how much would each person receive?

Contemporary Engineering Economics, 4

th

edition 2007

Excel Solution

380

$1

8%

380 years

$1(1 0.08) $5, 023, 739,194, 020

P

i

N

F

=FV(8%,380,0,1)

= $5,023,739,194,020

$5, 023, 739,194, 020

Amount per person

300, 000, 000

$16, 746

th

edition 2007

Practice Problem

Problem Statement

If you deposit $100 now (n = 0) and $200 two

years from now (n = 2) in a savings account

that pays 10% interest, how much would you

have at the end of year 10?

Contemporary Engineering Economics, 4

th

edition 2007

Solution

0 1 2 3 4 5 6 7 8 9 10

$100

$200

F

10

8

$100(1 0.10) $100(2.59) $259

$200(1 0.10) $200(2.14) $429

$259 $429 $688 F

Contemporary Engineering Economics, 4

th

edition 2007

Practice problem

Problem Statement

Consider the following sequence of deposits

and withdrawals over a period of 4 years. If

you earn a 10% interest, what would be the

balance at the end of 4 years?

$1,000

$1,500

$1,210

0

1

2

3

4

?

$1,000

Contemporary Engineering Economics, 4

th

edition 2007

$1,000

$1,500

$1,210

0 1

2

3

4

?

$1,000

$1,100

$2,100 $2,310

-$1,210

$1,100

$1,210

+ $1,500

$2,710

$2,981

$1,000

Contemporary Engineering Economics, 4

th

edition 2007

Solution

End of

Period

Beginning

balance

Deposit

made

Withdraw Ending

balance

n = 0

0 $1,000 0 $1,000

n = 1

$1,000(1 + 0.10)

=$1,100

$1,000 0 $2,100

n = 2

$2,100(1 + 0.10)

=$2,310

0 $1,210 $1,100

n = 3

$1,100(1 + 0.10)

=$1,210

$1,500 0 $2,710

n = 4

$2,710(1 + 0.10)

=$2,981

0 0 $2,981

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