IEDA 3230: Engineering Economy

Time Value of Money

Cash flow equivalence

0 1 2 3 … n-1 n
time

A cash flow includes a series of cash transactions incurred at

different time periods
Time is discretized by equal time intervals
Interest is compounded for each time interval
A cash flow can be converted into an equivalent flow, under a
given interest rate, in different forms
A single cash flow: P or F
A uniform cash flow: A
A uniform gradient cash flow: G

Terminology
F: Future value
P: Present value
A: Annuity
Present and Future equivalence

Notation
i: interest rate per interest period
N: number of compounding periods
P: present sum of money; the equivalent value of a cash
flow at a time reference point called present
F: future sum of money; the equivalent value of a cash
flow at a time reference point called future
A: end-of-period cash flow in a uniform series cash flow,
also called annuity
G: cash flow that changes in each period following an
arithmetic series (gradient flow)
Non-uniform cash-flows

0 1 2 3 4 5 6 7 8

100
200

400 400 400 400 400

500

What is the present equivalence at i = 20%?

P0 = 100(P/F,20%,1) + 200(P/F,20%,2) + 500(P/F,20%,3)
+ 400(P/A,20%,5)(P/F,20%,3)
=1,203.82

What is the annuity for an equivalent uniform cash flow?

A = P0(A/P,20%,8) = 1203.82(0.2606) = 313.73
Uniform Gradient Cash Flow
(N−1)G
(N−2)G

3G
2G

0 1 2 3 4 N-1 N

Cash flows increase at a constant amount G

G is known as the uniform gradient amount
Cash flow starts at the end of period 2
End-of-period cash flow for period k is (k-1)G
 Uniform gradient cash flow: Given G, Find P
(N−1)G
(N−2)G

3G
2G
G

0 1 2 3 4 N-1 N

(P/G, i%, N) (F/G, i%, N)

0𝐺 1𝐺 2𝐺 𝑁−2 𝐺 (𝑁−1)𝐺
P= + + + …+ +
(1+𝑖)1 (1+𝑖)2 (1+𝑖)3 1+𝑖 𝑁−1 (1+𝑖)𝑁
(𝑛−1)
= 𝐺 σ𝑁
𝑛=1 (1+𝑖)𝑛

Note: P is the sum of an arithmetic-geometric series.

 Uniform gradient cash flow: P/G

𝐺 0 1 2 (𝑁−1)
P= + + + …+
(1+𝑖) (1+𝑖)0 (1+𝑖)1 (1+𝑖)2 (1+𝑖)𝑁−1

arithmetic-geometric series with: a = 0, d = 1, n = N, r = 1/(1+i)

𝐺 0 −[0+ 𝑁−1 1]𝑟 𝑁 1𝑟( 1 − 𝑟 𝑁−1 )

= +
(1+𝑖) 1−𝑟 (1−𝑟 )2

𝐺 𝑟( 1 − 𝑟 𝑁−1 )
= 1−𝑁 𝑟𝑁 +
(1 + 𝑖)(1 − 𝑟) (1 − 𝑟 )
 Uniform gradient cash flow: P/G

𝐺 𝑟( 1 − 𝑟 𝑁−1 )
= 1−𝑁 𝑟𝑁 +
(1+𝑖)(1−𝑟) (1−𝑟 )

𝐺 𝑟( 1 − 𝑟 𝑁−1 )
= 1−𝑁 𝑟𝑁 +
𝑖 (1−𝑟 )

𝐺 (1−𝑁) ( 1 − 𝑟 𝑁−1 ) 𝐺 (1 − 𝑁) ( (1 + 𝑖)𝑁−1 −1)

= + = +
𝑖 (1+𝑖)𝑁 𝑖 𝑖 (1 + 𝑖)𝑁 𝑖(1 + 𝑖)𝑁−1

𝐺 𝑖 1 − 𝑁 + (1 + 𝑖)𝑁 −(1 + 𝑖) (1 + 𝑖)𝑁 − 𝑖𝑁 − 𝑖

= =𝐺
𝑖 𝑖(1 + 𝑖)𝑁 𝑖 2 (1 + 𝑖)𝑁

P = G( P/G, i%, N)
 Uniform gradient cash flow: Given G, Find F
(N−1)G
(N−2)G

3G
2G
G

0 1 2 3 4 N-1 N

(F/G, i%, N)

 (1  i ) N 1  1 (1  i ) N  2  1 (1  i ) 2  1 (1  i )1  1 
F  G   ...   

 i i i i 

G
i
 
(1  i ) N 1  (1  i ) N  2  ...  (1  i )1  1 
NG
i
G NG
 ( F / A, i %, N ) 
i i
(F/A, i %, N)
Uniform gradient cash flow: Given G, Find A

From A = F(A/F, i%, N), we have

G NG 
A   ( F / A, i %, N )  ( A / F , i %, N )
i i 
G NG
  ( A / F , i %, N )
i i
1 N 
 G  
 i (1  i )  1 
N

 G ( A / G, i %, N )

(A/G, i%, N ) values are given in the appendix of the textbook.

Interest rates..

So far, we have examined cases where:

Interests are compounded at the end of each period

Interest rate is constant
Interest rate is given for each interest period

What happens if:

- Interest rates vary from period to period?

- Interest is compounded at time periods different from

the cash flow periods?
Varying, deterministic interest rates

If interest rates for different periods are different, then

the computations of P, F, … are done by handling
each period separately.

7000 F0 = P 0
5000 6000
4000
4.06% 3.42% 5.23% 6.03%
-4 -3 -2 -1 0 1 2 3 … 20
A

A student took loans in each of four past years as

shown. If he wants to switch his total debt into a 20-
year annuity at fixed 5% pa, what is A?
 Varying, deterministic interest rates
7000 F0 = P 0
5000 6000
4000
4.06% 3.42% 5.23% 6.03%
-4 -3 -2 -1 0 1 2 3 … 20
A
Note: the interest rate for each period in the past was set at the start of the period.

F-4 = 4000
F-3 = 4000(1.0406) + 5000 = 9162.4
F-2 = 9162.4(1.0342) + 6000 = 15475.75
F-1 = 15475.75(1.0523) + 7000 = 23285.13
F0 = 23285.13(1.0603) = 24689.22
0.05(1.05)20
A = 24689.22 (A/P,5%,20) = 24689.22 = 1980.08
(1.05)20 −1
Nominal and Effective interest rates

In practice, interest rate is informally stated as per period,

say per annum, but the real interest is compounded with a
different period, say, per month.

Example:
Nominal interest rate of 12% compounded semi-annually
actually means actual interest rate is calculated by using
6%, compounded every 6 months

 Real yearly interest rate = (1+ 0.06)2 − 1 = 12.36%

 Effective rate: 12.36%

Nominal and Effective interest rates..

Nominal rate: r per annum, compounded

M times per annum
Effective rate: I

 Interest rate for each compounding period = r/M

 i = (1 + r/M)M − 1 = (F/P, r/M, M) −1

Given annual effective interest rate i, the interest rate

for each compound period is:
r/M = (1 + i)1/M − 1
Nominal and Effective interest rates, Example

Suppose $100 is invested to a 10-year project at the

nominal interest rate of 6% compounded quarterly.

How much is it worth at the end of the 10th year?

4 quarters in one year  M = 4, and

totally 10*4 = 40 periods
Real interest rate = 6/4 = 1.5% per quarter.

F = 100 (1 + 0.015)40 = 181.40 = 100 (F/P, 1.5%, 40)

Continuous time compounding

What happens to the effective interest rate if the

compounding periods become smaller and smaller?

In the discrete time model

Effective interest rate depends on
- the nominal rate r
- the number of compounding periods M

i = (1 + r/M)M − 1

Given r, the effective interest rate increases with M

Continuous time compounding

Nominal interest rate per annum: r

Compounding: M times per anum
 interest rate per period = r/M
Annual effective interest rate i = (1 + r/M)M − 1
𝑟 𝑀
𝐿𝑖𝑚𝑀→∞ [(1 + ) − 1] = 𝑒 𝑟 − 1
𝑀
 Future value, F of amount, P, after 1 year is
F = P(1 + i) = Per

Similarly, for a period of N years, the effective

continuous interest rate is:
𝑟 𝑁𝑀
i = 𝐿𝑖𝑚𝑀→∞ [ 1 + − 1] = 𝑒 𝑟𝑁 − 1
𝑀
 The effect of continuous time compounding
Compounding Nominal interest rate
periods
M 1.0000% 3.0000% 5.0000% 10.0000% 20.0000% 100.0000%
1 1.0000% 3.0000% 5.0000% 10.0000% 20.0000% 100.0000%
2 1.0025% 3.0225% 5.0625% 10.2500% 21.0000% 125.0000%
3 1.0033% 3.0301% 5.0838% 10.3370% 21.3630% 137.0370%
4 1.0038% 3.0339% 5.0945% 10.3813% 21.5506% 144.1406%
6 1.0042% 3.0378% 5.1053% 10.4260% 21.7426% 152.1626%
12 1.0046% 3.0416% 5.1162% 10.4713% 21.9391% 161.3035%
52 1.0049% 3.0446% 5.1246% 10.5065% 22.0934% 169.2597%
365 1.0050% 3.0453% 5.1267% 10.5156% 22.1336% 171.4567%
1000 1.0050% 3.0454% 5.1270% 10.5165% 22.1378% 171.6924%
Infinity 1.0050% 3.0455% 5.1271% 10.5171% 22.1403% 171.8282%

 The effect of continuous compounding increases with

the nominal rate r
Summary

- We saw various different types of cash flows, and how to model them
- Derived equivalence formulae for different cash flows types

Acknowledgements:
1. Most of the lecture notes for this course are adapted from those of Prof Xiangtong Qi
2. Course text: Engineering Economy by Sullivan, Wicks, Koelling

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