Time Value of Money

Hakimul Batih
MTE 0101 Ekonomi Energi Ketenagalistrikan dan Efisiensi

Magister Teknik Elektro

Institut Teknologi PLN (IT PLN)
Newman, D.G., et.al. Engineering Economic Analysis, Oxford University Press.
Would you rather: (1) receive $1000 today or (2) receive $1000 ten
years from today?
Time value of money
• We often find that the monetary consequences of any alternative occur over a
substantial period of time-say, a year or more.
• When monetary consequences occur in a short period of time, we simply add
up the various sums of money and obtain a net result.
• But can we treat money this way when the time span is greater?
• Money is quite a valuable asset-so valuable that people are willing to pay to
have money available for their use.
• Money can be rented in roughly the same way one rents an apartment, only
with money, the charge is called interest instead of rent.
• The importance of interest is demonstrated by banks and savings institutions
continuously offering to pay for the use of people's money to pay interest
Time value of money
• If the current interest rate is 9% per year, and you put $100 in to the bank
for one year, how much will you receive back at the end of the year?
• You will receive your original $100 together with $9 interest, for a total of
$109
• This example demonstrates the time preference for money, we would
rather have $100 today than the assured promise of $100 one year hence;
but we might well consider leaving the$100 in a bank if we knew it would
be worth $109 one year hence.
• This is because there is a time value of money in the form of the willingness
of banks, businesses, and people to pay interest for the use of various sums.
Simple Interest
• Simple interest is interest that is computed only on the original sum and
not on accrued interest.
• Thus if you were to loan apresent sum of money P to some one at a simple
annual interestrate i (stated as a decimal) for aperiod of n years,the amount
of interest you would receive from the loan would be:
Total interest earned = P x i x n = Pin
• At the end of n years the amount of money due you, F, would equal the
amount of the loan P plus the total interest earned. That is, the amount of
money due at the end of the loan would be:
F = P + Pin = P(1+in)
Compound Interest
• In practice, interest is computed using the compound interest
method.
• For a loan, any interest owed but not paid at the end of the year is
added to the balance due. Thus, the next year's interest is calculated
based on the unpaid balance due ,which includes the un paid interest
from the preceding period. In this way, compound interest can be
thought of as interest on top of interest. This distinguishes compound
interest from simple interest.
Compound Interest

𝒏
𝑭𝒖𝒕𝒖𝒓𝒆 𝒔𝒖𝒎=( 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒔𝒖𝒎 ) ∙(𝟏+ 𝒊)

𝒏
𝑭 = 𝑷 ∙ (𝟏 +𝒊 )

i = interest rate per interest period. In the equations the interest rate is stated as a decimal (that is,9% interest is
0.09)
n = number of interest periods.
P =a present sum of money.
F = a future sum of money.
The future sum F is an amount, n interest periods from the present, that is equivalentto P with interest rate i.
Single Payment Coumpond Interest
• Single payment compound amount formula and is written in
functional notation as
F = P (F/P, i, n)
• The notation in parentheses (F /P, i, n) 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”
Uniform Series Compound Interest Formulas

• Many times we will find uniform series of receipts or disbursements.

Automobile loans, house payments, and many other loans are based
on a uniform payment series.

F = P (F/P, i, n)
Uniform Series Compound Interest Formulas
Uniform Series Compound Interest Formulas
Uniform Series Compound Interest Formulas
Uniform Series Compound Interest Formulas