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Engineering Economics

Dr. Karim

Chapter 2: Cash-Flow &Time Value of Money

C a s h

F l o w

Cash flow is the sum of money recorded


as

costs

or

revenues

in

projects

financial records.
Engineering projects generally have economic
consequences that occur over an extended
period of time
For example, if an expensive piece of machinery is
installed in a plant were brought on credit, the simple
process of paying for it may take several years
The resulting favorable consequences may last as
long as the equipment performs its useful function

Categories of Cash Flows


The costs and revenues due to engineering projects
usually fall into one of the following categories:
First cost: expense to build or to buy and install
Operations and maintenance (O&M): annual expense, such

as electricity, labor, and minor repairs


Salvage value: receipt at project termination for sale or

transfer of the equipment (can be a salvage cost)


Revenues: annual receipts due to sale of products or

services
Overhaul: major capital expenditure that occurs during the

assets life (e.g., renovation)

Cash Flow Diagrams


The costs and revenues of engineering projects
over time are summarized on a cash flow diagram
(CFD). Specifically, CFD illustrates the size, sign,
and timing of individual cash flows, and forms the
basis for engineering economic analysis
A CFD is created by first drawing a segmented
time-based

horizontal

line,

divided

into

appropriate time unit. Each time when there is a


cash flow, a vertical arrow is added pointing
down for costs and up for revenues or benefits.

Cash Flow Diagrams (Con)


Cash flows that occur within a time period (both
inflows and outflows), are added together and
represented with a single arrow at the end of the
period.
When space allows, arrow lengths are drawn
proportional to the magnitude of the cash flow.

When analyzing the economic feasibility of a


project or design, we will compare its cash flow
with the cash flow of other alternatives.

Cash-Flow DiagramExample
A grass mower will cost $600. Maintenance costs are
expected to be $180 per year. Income from mowing
grass is expected to be $720 a year. The salvage value
after 3 years is expected to be $175.

+$720 +$720 +$720

OR

+$540 +$540

+$715

+
$175
-$180 -$180 -$180
-$600

-$600

Simplified cash flow


diagram with net cashflow shown at the end
of each time period.

Cash-Flow DiagramPerspective

Cash flow diagrams are always from some perspective.

A transfer of money will be an inflow or outflow depending


on your perspective.

Consider a borrower that takes out a loan for $5,000 at 6%


interest. From the borrowers perspective, the amount borrowed is
an inflow. From the lenders perspective, it is an outflow.
+$5,000

+$5,300

-$5,300
Borrowers Perspective

-$5,000
Lenders Perspective

Time Value of Money


The process of calculating
values of cash flows is known
as time value of money.
Time value of money numeral
the sum of interest paid/earned
over a given amount of time.

Why an Engineer should Know About The


Time Value of Money?
As a project manager we will need to understandand
recognize the time value of money, which will help us
to understand a variety of financialdecisions such as:
how to put cash flows on an equivalent basis so we can
easily compare the economic utility of multiple options.

Time Value of Money


$100 received today is worth more than $100
received one year from now.
If you dont believe this, give me $100 and I will gladly
give you back $100 in one year.
That would be a bad deal for you because:
I could invest the money and keep the interest earned on your
money.
If there was inflation in the economy during the time I was
holding onto your money, the purchasing power of the $100 I
give back will be less than the $100 you gave me.
There is a risk I wont return the money.

For all these reasons, when discussing cash flows over


time you have to take into account the time value of

Interest
Because of the time value of money, whenever
money is loaned, the lender expects to get back
the money loaned plus interest.
Interest is the price paid for the use of borrowed
money.
As with any financial transaction, interest is either
something you pay (a disbursement) or something
you earn (a receipt) depending on whether you
are doing the borrowing or the lending.

Interest Rate
Interest rate Interest paid over a time
period expressed as a percentage of
principal:

Interest rate

Interest paid

Rate of return

Interest earned

Types of Interest

Simple Interest
Interest paid (earned) on only the
original amount, or principal,
borrowed (lent).

Compound Interest
Interest paid (earned) on any previous
interest earned, as well as on the
principal borrowed (lent).

Effective Interest Rate


The interest rate that is used in calculations
is known as the effective interest rate.
If compounding is once a year it is known
as the effective annual interest rate.
However, effective quarterly, monthly, or
daily interest rates are also used.

Discount Factors and 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?

None of the options is superior under the


assumptions given. If you choose the first
option, you will immediately place $100 into a
5% account, and in two years the account will
have grown to $110.25.
In fact, the account will contain $110.25 at
the end of two years regardless of which
option

you

choose.

Therefore,

these

alternatives are said to be equivalent


( have equal in economic value).

Economic

equivalence

combination of

is

interest rate

time value of money

and

to determine

the different amounts of money at


different points in time that are
equal in economic value.
The procedure for determining the
equivalent
discounting.

amount

is

known

as

Single Payment Equivalence

How much a known


investment earning
simple interest will be
worth in the future ,

Cash Flow Diagram

Simple Interest Formula


Formula
SI:
P0 :

SI = P0(i)(n)
Simple Interest
Deposit today (t=0)

i: Interest Rate per Period


n: Number of Time Periods

Simple Interest Example


Assume that you deposit $1,000 in
an account earning 7% simple
interest for 2 years. What is the
accumulated interest at the end of
the 2nd year?

= P0(i)(n)
SI
$1,000(.07)(2)

=
= $140

Simple Interest (FV)


What is the Future Value (FV) of the
deposit?
FV = P0 + SI
=
$1,000 + $140
= $1,140
Future Value is the value at some future
time of a present amount of money, or a
series of payments, evaluated at a
given interest rate.

Simple Interest (PV)


What is the Present Value (PV) of the
previous problem?
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given
interest rate.

Single-Payment Compound-Amount

How much a known


investment earning
compound interest will be
worth in the future ,
assuming an interest rate

Cash Flow Diagram

Single
Single Deposit
Deposit Future
Future Value
Value
(Compound
(Compound Interest)
Interest)
FV1 = P0(1+i)1
FV2 = P0(1+i)2
etc ..

Single Deposit Future Value Formula:


FVn = P0 (1+i)n = P0 (FVIFi,n) -- See
Table I

Accordingly,

FV2

= $1,000 (FVIF7%,2)
= $1,000 (1.145)
= $1,145 [Due to Rounding]

Table I: FVIFi,n

Project Example
We are considering a project that will require a $300,000
investment. A viable alternative that must be considered
is to do nothing and bank the money that would have
been invested in the project. What is the value of
$300,000 after 8 years assuming an interest rate of 6%?
In shorthand notation:
Using the formula derived earlier:
FVn = P0 (1+i)n = $300,000 * (1+.06)8 = $478,154
If our 8 year project is expected to return less
than $478,140 (and there arent any intangibles

Single-Payment Present-Worth

How much do we
need to invest today in
order to have a certain
known sum in the future
, assuming an interest
rate of (i)%?

Cash Flow Diagram

Table II: PVIFi,n = 1 / (1+ i)n

Uniform Series
Equivalence
The previous formulas dealt with the
time value of one-time payments.
The next formulas deal with the time
value of a series of equal payments
(A n n u i t i e s ).

Examples of Annuities

Student Loan Payments


Car Loan Payments
Insurance Premiums
Mortgage Payments
Retirement Savings

Equal-Payment-Series CompoundAmount

How much we will have after


(n) periods (year/month/etc) if
we invest a known amount
every period for (n) periods,
assuming an interest rate of
(i)% ?

Cash Flow Diagram

Va
Vallu
ua
attiio
on
n U
Ussiin
ng
g Ta
Tab
blle
e IIIIII

Future Value of an Ordinary Annuity:


FVAn = R [
] = R (FVIFAi%,n)
Where:
iis the interest rate per compounding period;
nare the number of compounding periods; and
Ris the fixed periodic payment.
Accordingly, FVA3 = $1,000 (FVIFA7%,3)
= $1,000 (3.215)
= $3,215

Table III: (FVIFAi%,n)

Example: Future Value of an Ordinary Annuity


Mr A deposited $700 at the end of each month of calendar year 2010
in an investment account of 9% annual interest rate. Calculate the
future value of the annuity on Dec 31, 2011. Compounding is done
on monthly basis.

Solution
We have,
Periodic Payment
Number of Periods
Interest Rate
Future Value
=

R = $700
n = 12
i = 9%/12 = 0.75%
FV = $700 {(1+0.75%)^12-1}/1%
$700 {1.0075^12-1}/0.01
$700 (1.0938069-1)/0.01
$700 0.0938069/0.01
$700 9.38069
$6,566.48

Valuation Using Table III


Future Value of an Annuity Due:
FVADn = R [
%,n)(1+i)

](1+i) = R (FVIFAi

Where:
iis the interest rate per compounding
period;
nare the number of compounding
periods; and
Ris the fixed periodic payment.

Table III: (FVIFAi%,n)

Example: Future Value of an Annuity Due


Calculate the future value of 12 monthly deposits of
$1,000 if each payment is made on the first day of the
month and the interest rate per month is 1.1%.

Solution
Periodic Payment
R = $1,000
Number of Periods n = 12
Interest Rate
Future Value
(1+1.1%)

i = 1.1%
= $1,000 {(1+1.1%)^12-1}/1.1%
= $1,000 {1.011^12-1}/0.011

(1+0.011)
=

$1,000 (1.140286-1)/0.011 1.011


$1,000 0.140286/0.011 1.011
$1,000 12.75329059 1.011
$12,893.58

Equal-Payment-Series SinkingFund
How much we need to set

aside in order to have a


known amount of money at
the end of the equal
payments , assuming an
interest rate of (i)%?

Cash Flow Diagram

V
Va
a ll u
ua
a tt ii o
on
n U
U ss ii n
ng
g Ta
Ta b
b ll e
e II V
V
Present Value of an Ordinary Annuity =

PVAn

RX

= R (PVIFAi%,n)

PVA3
= $1,000 (PVIFA7%,3)
=
$1,000 (2.624)
= $2,624
Where,
iis the interest rate per compounding period;
nare the number of compounding periods;
and
Ris the fixed periodic payment.

Ta b l e I V: (PVIFAi%,n)

Example: Present Value of an Ordinary Annuity


Calculate the present value on Jan 1, 2011 of an annuity of
$500 paid at the end of each month of the calendar year
2011. The annual interest rate is 12%.
Solution
We have,
Periodic Payment
Number of Periods
Interest Rate
Present Value

R = $500
n = 12
i = 12%/12 = 1%
PV = $500 (1-(1+1%)^(-12))/1%
= $500 (1-1.01^-12)/1%
$500 (1-0.88745)/1%
$500 0.11255/1%
$500 11.255
$5,627.54

V
Va
a ll u
ua
a tt ii o
on
n U
U ss ii n
ng
g Ta
Ta b
b ll e
e II V
V
Present Value of an Annuity Due =

RX

PVADn = R (PVIFAi%,n)(1+i)
PVAD3 = $1,000 (PVIFA7%,3)(1.07)
= $1,000 (2.624)(1.07)
= $2,808
Where,
iis the interest rate per compounding period;
nare the number of compounding periods;
and
Ris the fixed periodic payment.

Ta b l e I V: (PVIFAi%,n)

Example: Present Value of an Annuity Due


A certain amount was invested on Jan 1, 2010 such that it generated
a periodic payment of $1,000 at the beginning of each month of the
calendar year 2010. The interest rate on the investment was 13.2%.
Calculate the present value of the original investment.

Solution
Periodic Payment
R = $1,000
Number of Periods
n = 12
Interest Rate
i = 13.2%/12 = 1.1%
Original Investment
= PV of annuity due on Jan 1, 2010
= $1,000 (1-(1+1.1%)^(-12))/1.1%
(1+1.1%)
= $1,000 (1-1.011^-12)/0.011 1.011
$1,000 (1-0.876973)/0.011 1.011
$1,000 0.123027/0.011 1.011
$1,000 11.184289 1.011
$11,307.32

Equal-Payment-Series Capital Recovery

What are the yearly payments


on $p borrowed assuming (n)
payments and an interest rate
of i%?

Cash Flow Diagram

Example: Equal-Payment-Series
Capital Recovery

To get started in a new telecommuting position with AB Hammond


Engineers, Jane took out a $1000 loan at i = 10% per year for 4
years to buy home office equipment.
Solution
From the lenders perspective, the investment in this young engineer
is expected to produce an equivalent net cash flow of $315.47 for
each of 4 years.
= $1000

= $1000 (A/P,10%,4) =

$315.47

The term in brackets is called the

capital recovery factor

(CRF), or A/P factor or DISCOUNT FACTOR.

Discount Factors for Discrete Compounding

Steps to Solve Time Value of Money Problems

1. Read problem carefully


2. Create a time line
3. Put cash flows and arrows on time
line
4. Determine if it is a PV or FV
problem
5. Determine if solution involves a
single
CF or annuity stream(s)
6. Solve the problem
7. Check with financial calculator
(optional)