ENG2000

Time Value of Money (part 2)

Previously

We considered the purpose of engineering economics

We also discussed the time value of money
this is not the time equals money cliche!
We examined how to determine the present and future values of
money
Today:
We will see how to draw a cash flow diagram
And arrive at some basic assumptions used in the rest of the
course
the issue of equivalence

Equations to remember!

Future value F = P(1+i)N

Effective rate ie = (1+r/m)m -1 where r = nominal rate, m = compounding
period
What if m-> infinity?

Continuous compounding

The limit of compounding is continuous compounding

where the compounding period is infinitesimally small
this is getting more practical with automated calculation
Now the effective interest rate is found by letting m get infinitely large:

r m
ie lim 1 1
m
m
er 1

However the difference between continuous and monthly compounding

is not large

Cash flow diagram

A tool that we will use a lot later is the cash flow diagram
this displays graphically the inflow and outflow of cash as a function of time period

positive cash flows

length of arrow indicates magnitude

cash flow

start of period 1
end of period 1;
start of period 2

time periods

negative (outgoing) cash flows

length of arrow indicates magnitude

Equivalence

The purpose of all this future/present worth calculation is to allow a fair

comparison of the costs of various options
Hence we need to establish an equivalence of values occurring at
different times
mathematical equivalence, resulting from algebraic formulation
decisional equivalence, resulting from a lack of importance of the
calculation results to the decision-maker
market equivalence, arising when one cash flow scheme can be
replaced by another at zero cost

Mathematical equivalence

If we have a present worth Pt at time t

and a future worth Ft + N at time t + N
then these are equivalent, with respect to the interest rate, i, if F t + N =
Pt(1 + i)N
Also, if Ft + N + M is equivalent to Pt
Then Ft + N + M = Pt(1 + i)N + M
And Ft + N + M = Ft + N(1 + i)M

Decisional equivalence

If a decision-maker does not care which of two cash flow

options is chosen, the options show decisional
equivalence

Exercise #2 Decisional Equivalence

Should Ms. Kehl accept Alpure's offer?

What are the circumstances that she should consider?
What would be a basis for her decision?
In common engineering economics exercise, we assume that decisional
equivalence is based purely on financial grounds. How does this
assumption apply to this scenario?
Is this a valid assumption?

Market equivalence

The basis of market equivalence is that there is a way of exchanging

future cash flow for present cash flow
F P is called borrowing
P F is called lending
However, borrowing typically costs more than borrowing yields
so, for individuals, market equivalence is typically not possible
Large organisations, however, have many ways to achieve market
equivalence
internal or external investments or transfers
if transactions are small compared with assets, borrowing and
lending occur at similar rates

Assumptions

For the rest of the notes we make two assumptions

1. Assume market equivalence holds
2. Assume decisional equivalence is based purely on financial
grounds
Both tend to lead to reasonable predictions while maintaining simplicity
Under these assumptions, mathematical equivalence (or lack thereof)
becomes the key factor

In-class exercise #2

At the end of four years, you would like to have $5000 in a bank account
with which to buy a used car
How much should you deposit in the account now in order to achieve
this?
account pays daily interest
assume 365 days per year
consider interest rates varying from 5% to 15%

 Use

F P1 i N

where F = $5000
N = 365 x 4

Hence P = 5000/(1 +
i)N
Interest
Necessary
4500
rate (%)

deposit ($)

0.05

4114

0.06

3957

0.07

3805

0.08

3660

0.09

3520

0.1

3385

0.11

3256

0.12

3131

0.13

3011

0.14

2896

0.15

2785

4000

Necessary
deposit

3500
3000
2500
2000
0.05 0.07 0.09 0.11 0.13 0.15

Conclusions

We now have a basis for comparing the costs of projects when there are
choices about when and how to make payments
this will de developed further in the next section
See also
http://www.getobjects.com/Components/Finance/TVM/concepts.htm
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