HM-202

Engineering Economics

How Time and Interest Affects Money

NFC Institute of Engineering & Technological

Training, Multan
 Recap
Cash Flows
Estimated inflows (revenues) and outflows (costs)
Interest owed
= amount owed now original amount
Interest rate (%) = ??
Interest earned
= total amount now original amount
Rate of return (%) = ??
ROR ~ Return on Investment (ROI
 Interest
Simple
Compound
Interest earns interest
Interest period
Time unit for rate of return. The most common
period is 1 year
 Inflation
Represents a decrease in the value of a
currency over a period of time
Reduction in purchasing power of the currency
Increase in the consumer price index (CPI)
Increase in the future costs (Ex. Maintenance)
Increase in salaries (Ex. Minimum hourly rate)
Reduction in real rate of return on investments
Inflation and investments
Currency A: ROR 4%, Inflation 3%
Currency B: ROR 3.5%, Inflation 2%
 Economic Equivalence
$100 now and $110 a year later when rate
of interest is 10% per year.

Equivalence between different sums of

money at different points in time by taking
into account the time value of money
Simple vs. Compound Interest
Simple Interest
Calculated using the principal amount only
Total Simple Interest
= Principal * Number of Periods * Interest Rate
Compound Interest
Interest is calculated on principal plus interest
accumulated in all previous periods
Compound Interest per period
= (principle + all accrued interest) * Interest Rate
PS: Interest Rate is expressed in decimal form (10% = 0.10)
 Compound Interest
Example:
Principle = $1000; Interest Rate = 10%; Time = 2yrs
SI (Total) = 1000*2*0.1 = $200
CI (yr 1) = 1000*0.1 = $100
CI (yr 2) = 1100*0.1 = $110
CI (Total) = $210

CI (Total)
= Principle*(1+interst rate) number of years-Principle
CI (Total) = 1000 *(1.1)2 1000 = $210
 Commonly Used Notation
P: Value of money at a designated time or at
time 0 (present time).
F: Value of money at some future time.
A: Series of consecutive, equal, end of
period amounts of money.
n: Number of interest periods
i: Interest rate or rate of return per time
period
T: Time, stated in periods.
 Using Excel
Appendix A
Commonly used Excel Functions:
PV (i%, n, A, F): To find present value
FV (i%, n, A, P): To find future value
PMT (i%, n, P, F): To find value A
NPER (i%, A, P, F): To find n
RATE (n, A, P, F): To find i (assuming CI)
IRR (first_cell:last_cell): To find i (assuming CI)
NPV (i%, second_cell:last_cell)+first_cell: To find present value
P of any series
 Minimum Attractive Rate of Return
MARR is the minimum rate of return for
selecting an alternative.
aka Hurdle rate
Higher than the rate expected from a bank
or some safe investment (Why?)
ROR >= MARR > cost of capital
It is selected and not computed
 Capital
Capital (money) is required to finance decisions
Two ways to obtain capital:
Equity Financing
Use ones own funds
Cost of Capital is the interest being currently earned (Ex.
Bank savings rate of return)
Debt Financing
Borrow from outside sources
Responsible for paying interests and principal as per
schedule
Cost-of-Capital is the interest rate
 End of Period Convention
End of period refers to end of interest
period and NOT end of calendar year
All cash flows are assumed to occur at the
end of an interest period
If there are multiple cash flows in an
interest period, net cash flow is assumed
to occur at the end of the interest period
 Cash Flow Diagram

Year Year
1 5

0 1 2 3 4 5
Time
+
Cash Flow,

0 1 2 3 Time
$

-
 Doubling Time: Rule of 72
Time required for an initial single amount
to double in size with compound interest is
approximately:
72/i
 Chapter#02 Objective
Understand cash flows
Compute present values (PV) and future
values (FV) from given cash flows
Simplifications
Using Excel !!
 Cash Flow - Example
Buying and maintaining a car
Down Payment: $5000
Gas + Insurance + Annual Payments
(Yr 1-Yr 5): $4000
Gas + Insurance + Maintenance
(Yr 6- Yr 8): $2500
Sell off: $5000
 Cash Flow - Example
$5000

0 1 2 3 4 5 6 7 8

-$4000 -$4000 -$4000 -$4000 -$4000 - -$2500 -$2500

-$5000 $2500

PV??
Another car??
 Cash Flow Models
Single Payments
Given Future Value compute Present Value
Interest rate and Number of periods
Notation: (P/F, i, n)
Excel Function: PV(i%,n,,F)
Given Present Value compute Future Value
Interest rate and Number of periods
Notation: (F/P, i, n)
Excel Function: FV(i%,n,,P)
 SPCAF and SPPWF
Single payment compound amount factor
(SPCAF) or F/P factor:
F P(1 i ) n
Single payment present worth factor
(SPPWF) or P/W factor:

1
P F n
(1 i )
Table 1 Table 29
 Example

0 1 2 3 4 5 6 7 8
$100

$200
$250

$400

P = 200+100(P/F,10%,2)+400(P/F,10%,3)+250(P/F,10%,6)

F = P(F/P,10%,8)
 Cash Flow Models
Uniform-Series
Given uniform series of cash flows, find
present worth
Notation: (P/A,i,n)
Excel function: PV(i%,n,A)
For a given present work, find an equivalent
uniform series
Notation: (A/P,i,n)
Excel function: PMT(i%,n,P)
 USPWF and CRF
Uniform series present worth factor (USPWF)
or P/A factor:
(1 i ) n 1
P A n
,i 0
i (1 i )
Capital recovery factor (CRF) or A/P factor:

i (1 i ) n
A P ,i 0
(1 i ) 1
n
 Example
A = 100
i = 10%
n=5
P = ??
F = ??
 SFF and USCAF
Sinking fund factor (SFF) or A/F factor:
Notation: (A/F,i,n); Excel function:FV(i%,n,A)
i
A F ,i 0
(1 i ) 1
n

Uniform series compound amount factor or

F/A factor:
Notation: (F/A,i,n); Excel function:PMT(i%,n,F)

(1 i ) n 1
F A ,i 0
i
 Interpolation

x1 x2
f(x1) f(x2)

x x1
f ( x) f ( x1) ( f ( x 2) f ( x1))
x 2 x1