Engineering Economics

IV-Time Value of Money and Interest

Date:07/10/2016

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.

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!!

3Remember, one CANNOT compare numbers in different time

periods without first adjusting them using an interestrate.
 Part I-Interest

4
Outcome of Todays 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
F

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

7
Interest and profit are being interchangeably used !!
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.
8
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(%) 100
Principal

Time unit of interest paid is called interest period.

9
Simple Interest Rate
If the interest rate, i, is given then;

interest Pi 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)

10
Simple Interest Rate
Example1: An employee at Laserkinetics.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%/ year
10000

9
Ref.Engineering Economy By Leland Blank &AnthonyTarquin
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

9
interest incurred per year interest 20000 0.09
20000 OR 1
100
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 PF

Interest + original deposit=amount owned now
Pin P F F Pin
Interest rate (original deposit) no. of interest period+ 1
original deposit=amount owned now
(Interest rate x no. of interest period+1)original 1000 P0.051
deposit = 1000 P 952.38
Original deposit=1000/(1.05)=$952.38

Thus
Interest = 1000-952.38= $47.62
13
Ref.Engineering Economy By Leland Blank &AnthonyTarquin
Example 4 (Simple interest)
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 owed Due at the end of
interest is computed at 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 Pi 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

15
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 P1 in

This is called single payment compound interest formula.

16
Example 5 (Compound interest)
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 owed Due at the end of
interest is computed at 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
17
Repaying a Debt
To better understand the mechanics of interest, let say that 5000 is
owed and is to be repaid in 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

18
Repaying a Debt

19
Repaying a Debt

20
Repaying a Debt

21
Repaying a Debt

22
 Be careful and think wisely for your business

Thank You

23
 Part II-Economic
Equivalence

24
Outcome of Todays Lecture

After completing this lecture

The students should be able to:

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

25
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
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 ??

27
Economic Equivalence

28
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 1n

The future sum, F, thus become as;

F P1 in

This is called single payment compound interest formula

30
Single payment compound interest formula
The single payment formula in functional form can be written as

F PF / 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, n F1 i n P

31
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 P1 in
Cash Flow Diagram
F 5001 0.06 3

595.50
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 PF / P, i, n
F 500F / P,6%,3 F 5001.191
595.50
Lets plot now cash flow diagram from Banks Point of view

33
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

35
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?

36
 P F1 in P F1 i n P F1 i n
250001 30001 50001
1
22727.27
0.1 0.12 0.14
2479.34 3415.07
36
37
Example 9

Also

P 400112 /1003 600112 /1005

P 625.16

39
Appendix B

40
Outcome of Todays 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
Lets compute Future Worth, F, of a stream of equal, end-of-period
cash flows, A, at interest rate, i, over interest period, n
A
Recall

0 1 2 n-1 n
F A A
Let n=4
F1 A1 F2 A1
= i +
i2
3

0 0 0 1 2
1 2 3 4 1 4
2 3 3 4
F2
F F1
A A
F=F1+F2+F3+F4 F3 A1 F4 A1
+ + i0
i1 0
0 3 4 1 4
7
1 2 2 3
F3 F4
 Deriving Uniform Series Formula
F=F1+F2+F3+F4
A F
F1 A1 + F2 A1 +
=
F i3 i2
+
0 1 2 3 4 F3 A1 F4 A1
F A1
i 1 i A1 i 0A1 i A
3 2
i
1

For general case, we can write that

F A1 in1 A1 in2 A1 in3 ... A F

A1 i n1
1 in2 1 in3 ... 1 Eq. (1)

Multiplying both sides with (1+i)

F1 i A1 i n A1 i n1 A1 i n2 ... A1 i

F1 i A 1 i n 1 i n1 1 i n2 ... 1 i Eq. (2)
Deriving Uniform Series Formula
Eq. (2)-Eq. (1)
F1 i A 1 in
1 in1 1 in2 ... 1 i Eq. (2)
-

F A 1 i n1 1 i n2 1 i n3 ... 1 Eq. (1)

iF A 1 i n 1 Eq. (3)

1 in 1
F A AF / A, i%,n Eq. (4)
i

1 i n 1
Where is called uniform series compound
i
amount factor and has notation F / A,i%, n
47
Deriving Uniform Series Formula
Eq. (4) can also be written as

F A/ F,i%, n
i
AF Eq. (5)
1 i 1
n

i
Where is called uniform series sinking fund
1 i
n

1
factor and has notation A/ F,i%, n

Find
,
given i %, n

48
Example 10

49
Example 11

i
A F
1 i 1
n

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
AF P1i F P 1 i n
1 i 1 1 i 1
n n

i1 in
AP PA/ P,i%, n
1 i
n
1
Eq. (6)

It means we can determine the values of A when the present sum P

is known

i 1 i n

Where 1 in 1 is called uniform series capital

recovery factor and has notation PA/ P, i%, n

52
Deriving Uniform Series Formula
Eq. (6) can be rewritten as
1 i n 1
P A n
AP / A ,i%, n
i1i Eq. (7)

It means we can determine present sum P when the value of A is

known

1 i n 1
n
i1i
Where is called uniform series present

worth factor and has notation AP/ A,i%, n

15
Example 12

54
Example 13

55
Example 13

56
Example 13

57
Example 14

0 1 2 3 4

58
 Determine n based on 3.5% interest rate?

Problem

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
Problem
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
Its 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 G1 in2 2G1 in3 ... (n 2)G1 i1 (n 1)G(1

i)0 Eq. (1)

FG 1 i n2

21 in3 ... (n 2)1 i1 (n 1)
63
Arithmetic Gradient Series
Multiplying Eq. (1) with (1+i), we get
1 iF G1 in1 21 in2 ... (n 2)1 i2 (n 1)(1 i)1 Eq. (2)
Eq. (2)-Eq. (1)
1 iF G1 in1 21 in2 ... (n 2)1 i2 (n 1)(1
- i)1

F G 1 in2 21 in3 ... (n 2)1 i1 (n 1)

iF G 1 i n1 1 i n2 ... 1 i 2 1 i 1 n 1
iF G1 i n1

1 i n2 ... 1 i 2 1 i 1 1 nG Eq. (3)

1 i n 1
iF G nG
i
G 1 in 1 1 i n 1 ni
F n G 2

i i i
1in in 1 Arithmetic
29
F G 2 GF / G, i%, n gradient future Eq. (4)
i worth factor
 iF1 i G 1 i n

1 in1 ... 1 i3 1 i2 1 i
nG1 i
-

iF G 1 in1 1 in2 ... 1 i2 1 i1 1 nG

iiF G 1 i n 1 nGi
1 i n 1
iF G nG
i

30
Arithmetic Gradient Series
Substituting F from single payment compound formula, we can write
Eq.(4) as Recall
1in in 1
P G GP / G, i%, n
1 i
n
Eq. (5)
2
i
(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 1
F G 2 A
i i


i1
n

i 1 i in 1
n F A
1

A G

1 i
n

i

A GA/1 i2 n

G, i%,
31 (A/G, i%, n) is known asArithmetic gradient uniform series factor
Arithmetic Gradient Series

67
Example 15
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 15

69
Example 16
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 16

71
Example 17

72
Example 17

73
Example 17

(Hint: look for differences in time axis.)

74
 ThankYou

75