Engineering Economics

IV-Time Value of Money and Interest

Date: 07/10/2017

1
 Money
• In early primitive civilizations, trade and business were based on a
direct exchange of goods (Barter system).

• As civilizations developed, money was introduced to facilitate the

exchange of goods and services.

• Money has value only when it is spent. It would be of little use to an

individual on a desert island.

• Money is only received on the understanding that it can be passed on

again in exchange for something else.

2
 Time value of Money
Which would you rather have ??
$1,000 today or $1,000 in 5 years?

Obviously, $1,000 today.

Time Value of Money: means that money

has different value tomorrow than
it has today.

Money received sooner rather than later allows one to use

the funds for investment or consumption purposes.
This concept is referred to as the TIME VALUE OF MONEY!!

Remember, one CANNOT compare numbers in different time

periods without first adjusting them using an interest rate.

3
 Part I - Interest

4
Outcome of Today’s Lecture

 After completing this lecture…

 The students should be able to:

 Understand interest and rate of return
 Define and provide examples of the time values of money
 Distinguish between simple and compound interest, and use
compound interest in engineering economic analysis

5
Terminology and Symbols
 P= value or amount of money at present ,Also referred as present worth
(PW), present value (PV), net present value, discounted cash flow and
Capital Cost
 F=Value or amount of money at future time. Also F is called future worth
(FW) and future value (FV)
 A= Series of consecutives, equal, end of period amounts of money
(Receipts/disbursement)
 n= Number of interest period; years, months or days
 i= interest rate per time period; percent per year
 t=time, stated in periods; years, months or days

0 1 2 3 4 5 6 n=6

A
6 P
 Interest Rate and Rate of Return

Interest Interest

Interest rate Rate of return

Interest and profit are being interchangeably used !!

Interest: is a measure of the increase between the original sum borrowed or invested and the final
amount owed or accrued. It is the growth in value with time.
Interest
 1. Simple interest
 Simple interest is computed only on original sum (principal), not on prior
interest earned and left in the account.
 A bank account, for example, may have its simple interest every year: in
this case, an account with $1000 initial principal and 20% interest per year
would have a balance of $1200 at the end of the first year, $1400 at the end of
the second year, and so on.

 2. Compound Interest
 Compound interest arises when interest is added to the principal of a
deposit or loan, so that, from that moment on, the interest that has been added
also earns interest.This addition of interest to the principal is called
compounding.
 A bank account, for example, may have its interest compounded every
year: in this case, an account with $1000 initial principal and 20% interest per
year would have a balance of $1200 at the end of the first year, $1440 at the
end of the second year, and so on.

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Simple Interest Rate
 Interest is paid when a person/organisation borrowed money and repays a
larger amount over time

Interest =Amount to be returned – Principle (original amount)

Interest =F-P

 interest rate on borrowed fund is determined using the original amount

(called Principal) as

interest incurred per unit time

Interest Rate(%) 
Principal100

 Time unit of interest paid is called interest period.

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Simple Interest Rate

 If the interest rate, i, is given then;

interest  Pi n
 And at the end of n years the total amount of money due, F, would equal
the amount of the loan, P, plus the total interest, P.i.n, as given by;

F  P  P(i)(n)

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 Simple Interest Rate
 Example1: An employee at Laser kinetics.com borrows $10,000 on
May 1 and must repay a total of $10,700 exactly 1 year later.
Determine the interest amount and the interest rate paid.
 Solution:
 Amount to be paid= $10,700
 Original amount=$10,000

 Interest=Amount to be paid-Original amount=10700-10000=$700

interest incurred per unit time

Interest Rate(%)  100
Prinicipal

700
Interest Rate(%) 100  7% /
 10000 year
9

Ref. Engineering Economy By Leland Blank & Anthony

Simple Interest Rate
 Example 2: Stereographic, Inc., plans to borrow $20000 from a bank for 1
year at 9% interest for new recording equipment.
 Compute the interest and total amount due after 1 year.

 Solution:
 Original (Principal) amount=$20,000
 Interest rate=9% annual

interest incurred per year interest  20000  0.09

9 100 OR
20000 1
Interest  $1800
 1800
 Total due amount after a year=20000+1800=$21800

12
Ref. Engineering Economy By Leland Blank & Anthony
Tarquin
Simple Interest Rate
 Example 3: Calculate the amount deposited 1 year ago to have
$1000 now at an interest rate of 5% per year.
 Calculate the amount of interest earned during this period.

 Solution:

Interest=amount owned now-original deposit IFP IPF

Interest + original deposit=amount owned now
Pin  P  F F  Pin 1
Interest rate (original deposit) no. of interest period + 1000  P0.05 1
original deposit=amount owned now
(Interest rate x no. of interest period+1) original P  952.38
deposit = 1000
Original deposit=1000/(1.05)=$952.38

 Thus
 Interest = 1000-952.38= $47.62

13 Ref. Engineering Economy By Leland Blank & Anthony

Simple interest
 Example 4: You have agreed to loan a friend $5000 for 5 years at a simple
interest rate of 8% per year. How much interest will you receive from the
loan. How much will your friend pay you at the end of 5 years.
 Solution
Sr. # Principal at which interest Interest owed at Due at the end of
is computed end of year n year n
1 5000 400 5400
2 5000 400 5800
3 5000 400 6200
4 5000 400 6600
5 5000 400 7000

Total interest  Pi n

OR 8
Total interest  5000  5
2000 100
14
Total amount due at end of loan  5000  2000 
7000
Compound Interest Rate
 Compound interest arises when interest is added to the principal of a
deposit or loan, so that, from that moment on, the interest that has been
added also earns interest.
 Using notation, P, F, n, & I, compound interest calculations assuming
single payment at the end of loan period are given by

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Single payment compound interest formula

 Compound interest arises when interest is added to the principal of a

deposit or loan, so that, from that moment on, the interest that has been
added also earns interest.

 Future sum, F, using compound interest with single payment at the end
of loan period thus becomes as;

F  P1 in

This is called single payment compound interest formula.

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Compound interest
 Example 5: You have agreed to loan a friend $5000 for 5 years at a
compound interest rate of 8% per year. How much interest will you
receive from the loan.
How much will your friend pay you at the end of 5 years.
 Solution
Sr. # Principal at which interest Interest owed at Due at the end of
is computed end of year n year n
1 5000 5000x0.08=400 5000+400=5400
2 5400 5400x0.08=432 5400+432=5832
3 5832 5832x0.08=467 5832+467=6299
4 6299 504 6803
5 6803 544 7347

Total amount due at end of loan  $7347

Recall: In case of simple interest total amount due at the end of 5
year was $7000
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Repaying a Debt
 To better understand the mechanics of interest, let say that €5000 is
owed and is to be repaid in years together (for 5 yrs) with 8% annual
interest.

 Lets use four specific plans to repay

 Plan 1: At end of each year pay €1000 principle plus interest due
 Plan 2: Pay interest at end of each year and principal at end of 5 years
 Plan 3: Pay in five equal end of year payments
 Plan 4: Pay principal and interest in one payment at end of 5 years

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Repaying a Debt

19
Repaying a Debt

20
Repaying a Debt

21
Repaying a Debt

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 Be careful and think wisely for your
business

Thank You

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 Part II - Economic Equivalence

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Outcome of Today’s Lecture

 After completing this lecture…

 The students should be able to:

 Equivalence of Cash flows
 Solve problems using the single payment compound interest
formulas

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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.

Illustration:

At 6% interest rate, $100 today (present time) is equivalent to

$106 one year from today

And $100 now is equivalent to 100/1.06=$94.34 one year ago

25
Ref. Engineering Economy By Leland Blank & Anthony
Tarquin
Economic Equivalence
 Lets recall example of repaying of debt
 To better understand the mechanics of interest, let say that €5000 is
owed and is to be repaid in 5 years together with 8% annual interest..

 Lets use four specific plans to repay

 Plan 1: At end of each year pay €1000 principle plus interest due
 Plan 2: Pay interest at end of each year and principal at end of 5 years
 Plan 3: Pay in five equal end of year payments
 Plan 4: Pay principal and interest in one payment at end of 5 years

 Are all payment plans are equivalent to each other and to

€5000 now at 8% interest rate ??

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Economic Equivalence

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Technique of equivalence
 We can determine an equivalent value at some point in time for any
plan, based on a selected interest rate not from cash flow.

 We can use concept of time value of money and computer money

year i.e., euro-year,

Ratio under the curve is constant and equal at 8% which

29
indicate that repayment plans are actually equivalent
Single payment compound interest formula
Compound interest arises when interest is added to the principal of a
deposit or loan, so that, from that moment on, the interest that has been
added also earns interest.

 Compound interest is computed with following formula;

interest  P i 1n

 The future sum, F, thus become as;

F  P1 in

This is called single payment compound interest formula

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Single payment compound interest formula
 The single payment formula in functional form can be written as

F  PF / P, i, n

 The notation in parenthesis can be read as follows: “To find a future

sum F, given a present sum, P, at an interest rate i per interest period and n
interest periods hence” OR simply Find F, given P, at I, over n

 Similarly functional form of determining present value, P, from

future sum, F at interest rate, i, over interest period, n, becomes

P  F P / F , i, F1 i n 
P
n
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Example 6
 If €500 were deposited in a bank saving account, how much would
be in the account 3 years hence if the bank paid 6% interest
compounded annually?

 Solution:

 P= € 500,
 i=6%=0.06
 n=3
F  P1 in
Cash Flow Diagram
F  5001 0.06 3

 595.50

32
Example 6
 Alternate Solution:
 P= €500, Lets use Appendix B, to find F given P,
 i=6%=0.06 look in the first column, which is headed
“single payment”, compound amount
 n=3
factor of F/P for n=3 we find = 1.191
F  PF / P, i, n
F  500F / P,6%,3 F  5001.191 
595.50
Lets plot now cash flow diagram from Bank’s Point of
view

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Example 7
 If you wish to have € 800 in a saving account at the end of 4 years
and 5% interest will be paid annually, how much should you put
into saving account now?
 Solution

33 Cash Flow Diagram

Example 7
 Alternate Solution

From compound interest table

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Example 8
 How much do you need to deposit today to withdraw $25,000
after 1 year, $3,000 after 2 yrs, and $5,000 after 4 yrs, if your
account earns 10% annual interest?

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  P  F1 in  P  F1 i n  P  F1 i n
 250001  30001  50001
1
 22727.27
0.1 0.12 0.14
 2479.34  3415.07
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37
Example 9

Also

P  400112 /1003  600112 /1005

P  625.16

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Appendix B

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Outcome of Today’s Lecture

 After completing this lecture…

 The students should be able to:
 Understand uniform series compound interest formulas

41
More interest Formulas
 Uniform Series
 Arithmetic Gradient
 Geometric Gradient
 Nominal and Effective
Interest
 Continuous Compounding

42
Uniform Series
 Previously (i.e., interest and equivalence), we dealt with single payments
compound interest formula:

Algebraic Equivalent Functional Notation

 Examples:
 _
_
_
43
Uniform Series
 Quite often we have to deal with uniform (equidistant and equal-valued)
cash flows during a period of time:

 Remember: A= Series of consecutives, equal, end of period amounts of

money (Receipts/disbursement)
 Examples:


44
Deriving Uniform Series Formula
 Let’s compute Future Worth, F, of a stream of equal, end-of-
period cash flows, A, at interest rate, i, over interest period, n
Recall

0 1 2 n-1 n
F A A
Let n=4 F1  A1 i3 F2  A1 i2
= +
0 0 0 1 2 3 4
1 2 3 4 1 2 3 4
F F F
1 2
A A
F=F1+F2+F3+F4 F3  A1 i1 F4  A1 i 0

+ +
0 0 1 2 3 4
7 1 2 3 4
F F
3 4
 Deriving Uniform Series Formula
F=F1+F2+F3+F
A F 4
F1  A1 + F2  A1 +
F = i3 i2
+
0 1 2 3 4 F3  A1 F4  A1
F  Ai1
1 i  A1 i 
3
i0 A1 i 
21

A
For general case, we can write that

F  A1 in1  A1 in2  A1 in3 ...  A F  A 1

i
n1
 1 i n2
 1 i n3
 ... 1  Eq.
(1)

Multiplying both sides with (1+i)

F1 i  A1 in  A1 in1  A1 in2 ...  A1
i Eq.

F1 i  A 1 i  1 i

n n1
 1 i n2
 ...  1
(2)
Deriving Uniform Series Formula
 Eq. (2)-Eq. (1)
F1 i  A 1 i  1 i  1 i  ...  1 i
n n1 n2 Eq.
(2)
-
F  A1 i  1 i  1 i  ...
n1 n2 n3
Eq.
(1)
1
iF  A 1 i n
Eq.


(3)
1 in
1 1
  AF / A, i
Eq.
F  A
i (4)
%, n
 
 1  in 
Where   is called uniform series compound
1 i 

amount factor and has notation F / A, i%,

47 n
Deriving Uniform Series Formula
 Eq. (4) can also be written as

 i 
AF   F A / F , i%, Eq.
 1 i 1 
n
(5)
n
 i 
Where   is called uniform series sinking
  1  i
n
  
1 fund
factor and has notation A / F , i%,
n

 Find n
, %,
 given i 

48
Example 10

49
Example 11

 i 
AF 
 1 i n
1
50
Example 11

51
Deriving Uniform Series Formula
 If we use the sinking fund formula (Eq. 5) and substitute the single
payment compound amount formula, we obtain
 i  n
  i P1
    F  P1
 1
 Fi 1   1 i 1 
n n
A
i i n
 i1 i n
   PA / P, i%, Eq.

1 i 
n
1  n (6)
 It means we can determine
A  P the values of A when the present sum P
is known

 i1 
 
in1 i 1 
Where n is called uniform series
capital
recovery factor and has notation PA / P, i%,
n
52
Deriving Uniform Series Formula
 Eq. (6) can be rewritten as
 1 in
   AP / A ,i %, n
1i1
n
 Eq.
(7)
 P iA present sum P when the value of A is
It means we can determine
known

1 in 1

 n 
 i1
Where is called uniform series present

i and has notation
worth factor AP / A, i%, n

15
Example 12

54
Example 13

55
Example 13

56
Example 13

57
Example 14

0 1 2 3
4

58
Example 15
 Determine n based on 3.5% interest rate?

Solution:
P = A (P/A, 3.5%, n)
$1,000 = $50 (P/A, 3.5%, n)

(P/A, 3.5%, n) = 20

From the 3.5% interest table, n = 35.

59
Example 16
 A sum of money is invested at 2% per 6 month period (semi-annually)
will double in amount in approximately how much years?

P = $1 n = unknown number of i = 2% F=2

semiannual periods

F = P (1 + i)n
2 = 1 (1.02)n
2 = 1.02n
n = log (2) / log (1.02)
= 35

Therefore, the money will double in 17.5 years.

60
More interest Formulas
 Uniform Series
 Arithmetic Gradient
 Geometric Gradient
 Nominal and Effective
Interest
 Continuous Compounding

61
Arithmetic Gradient Series
 It’s frequently happen that the cash
flow series is not constant amount.
 It probably is because of operating
costs, construction costs, and
revenues to increase of decrease
from period to period by a
constant percentage

62
Arithmetic Gradient Series
 Let the cash flows increase/decrease by a uniform fixed amount G
every subsequent period
Recall

F  G1 in2  2G1 in3 ...  (n  2)G1 i1  (n 1)G(1

i)0 Eq.
(1)
FG 1 i n2
 21 i n3 1

...  (n  2)1 i  (n 1)
63
Arithmetic Gradient Series
 Multiplying Eq. (1) with (1+i), we get
1 iF  G1 i n1
 21 in2 ...  (n  2)1 i2  (n 1)(1 i)1  Eq.
 Eq. (2)-Eq. (1) (2)
1 iF  G1 i n1
 21 in2 ...  (n  2)1 i2  (n 1)(1 i)1
- 

F  G 1 in2  21 in3 ...  (n  2)1 i1  (n 1) 

iF  G 1 in1  1 in2 ...  1 i2  1 i1  n

1
iF  G1 i n1

 1 in2 ...  1 i2  1 i1 1  Eq.
(3)
nG

iF  G 1 i n
1  nG
 i 
G 1 in 1  1 in 1 ni 
F  
 n  G i 2
i  i   
 1 in  in Arithmetic
F  G 2    GF / G, i%, gradient future Eq.
29 i 1
  n worth factor (4)
 iF1 i  G 1 i  1 i
n n1

 ...  1 i3  1 i2  1 i 

- nG1 i
 
iF  G 1 in1  1 in2  ...  1 i2  1 i1 1  nG
 
iiF  G 1 in 1 
nGi 
iF  G 1 i   nG
n

  i
1 

30
Arithmetic Gradient Series
 Substituting F from single payment compound formula, we can
write
Eq.(4) Recal
as  1 in in 1 l
P  G   GP / G, i%,
 1 i
n

i 2 n  Eq.
(5)
 (P/G ,i%, n) is known as Arithmetic gradient present worth factor

 Now substituting value of F from uniform series compound amount

factor, we can write Eq. (4) as
 1 in  in 1  1 in
F  G 
  A i
1 i2   
  i1 
n

1 i  in
i n


F  A 
  

A  G 1 i
 
n

1 
A  GA / G, i%, n
1i 2

31 (A/G,i%, n) is known as Arithmetic gradient uniform

series factor
Arithmetic Gradient Series

67
Example 17
 Suppose you buy a car.You wish to set up enough money in a bank
account to pay for standard maintenance on the car for the first five
years.You estimate the maintenance cost increases by G = $30 each
year.The maintenance cost for year 1 is estimated as $120. i = 5%.
Thus, estimated costs by year are $120, $150, $180, $210,
$240.

68
Example 18

69
Example 19
 Maintenance costs of a machine start at $100 and go up by $100
each year for 4 years.What is the equivalent uniform annual
maintenance cost for the machinery if i= 6%.

A=?

70
Example 19

71
Example 20

72
Example 20

73
Exercise 4-18 Newmann

(Hint: look for differences in time

axis.)

74
 Thank
You

75