IEDA 3230: Engineering Economy

Time Value of Money

Some motivating examples

A bank offers the following interest rates for fixed

deposit (term deposit) accounts.
Assuming no change in rates, how much will US$
1000 in a 6 month deposit be worth after 6 months?
In 12 months?

Which of these deposits is the best (in terms of HK$)?

Some motivating examples

The following shows the finance charge on the unpaid

debt for the Hang Seng Visa Credit card.

Suppose a student spends $5000 per month, but only

repays $4000 each month for the duration of his
studies (4 years). How much will he owe when he
graduates?
Some motivating examples

The following data relates to a 3-year premium, 8-

year maturity Insurance/Investment plan offered by
Manulife™.

What is the guaranteed annualized return rate?

How does it compare with the 10-year USD treasury rate of 2.8%?
Some motivating examples

Suppose that you start a consulting services company

together with two friends, supported by the HKUST
Entrepreneurship Center.

After graduation, you want to sell your share of the company

because you got a job offer from McKinsey™. How will you
compute the value of your share, given the current assets and
expected yearly income of your company?
Agenda

We shall learn how to evaluate the value of some

flow of money over time, at a specified time
We will learn how to compare two (or more) such
flows
under..
- Fixed interest rates
- Discrete time vs continuous time
- Varying (but deterministic) interest rates
- Randomly varying interest rates
Simple interest

Interest is the amount that you can earn (or pay) after
a given time for an amount of money borrowed from
you (called the principal).

It is expressed as a proportion (or per-cent) of the

principal

Simple interest = r p n
r = (percent) interest rate per period
p = principal
n = number of periods
Simple interest, example

What is the simple interest earned on a deposit of $5000 at the

end of 1 year at 10% per annum (10% pa)

r = 10/100 = 0.1
p = 5000
n=1
 simple interest = 0.1 x 5000 = 500

How much can you get if you withdraw the interest each
month?

r = 0.1
p = 5000
n = 1/12
 simple interest = 0.1 x 5000 x (1/12) = 41.67
Compound interest

Compound interest is the interest earned on a loan if

the principal for each subsequent period includes the
interest from the earlier period(s)

Amount at the end of..

1 period = p + rp = p(1+r)
2 periods = p(1+r) + rp(1+r) = p(1+r)(1+r) = p(1+r)2
3 periods = p(1+r)2 + r p(1+r)2 = (p + rp)(1+r)2 = p(1+r)3
…
n periods = p(1+r)n
Compound interest, example

In 1626, the Manhattan Island in NY was bought for $24 from the
'Indians'.

At simple interest of 8% (r = 0.08), n = 2018-1626 = 392

 total value = p + pnr = 24 + 24*0.08*392 = 24 + 752.64 = 776.64

At 8% compound interest, current value = 24(1+ 0.08)392 = 3.036 x 1014

[Estimated value of Manhattan Island in 2000 ~= $1*1012
 Compounding methods and examples

I borrow $8000 for 4 years at annual interest rate of 10%

There are different ways to repay the principal and interests.
They are all equivalent provided that the interest rate does not change

Plan 1. Pay nothing until the end of year 4

Interests incurred at different time: 800; 880; 968; 1065
The amount of debt at different time: 8800; 9680; 10648; 11713
Final payment: 11713

Plan 2. Pay the interest generated at the end of each year

Interests incurred (and paid) at different time: 800; 800; 800; 800
The amount of debt at different time: 8000; 8000; 8000; 8000
Total payment: 8000+3200=11200 (Meaning?)

Plan 3. Pay in four Equal End-of-Year payments

Pay $2524 at the end of each year:
End of Year 1 balance:
End of Year 2 balance:
End of Year 3 balance:
End of Year 4 balance:
8000*1.1-2524 = 6276
6276*1.1-2524 = 4380
4380*1.1-2524 = 2294
2294*1.1-2524 = 0
Series and summations

Before we explore the various issues in our agenda,

let us review briefly some facts about series of
numbers and their summation

Arithmetic series: a, a+d, a+2d, …, a+(n-1)d

Sum of series (to n terms) = Sn = n(a + a+(n-1)d)/2

𝑛
 Sn = (2𝑎 + 𝑛 − 1 𝑑)
2
Series and summations..

Geometric series: a, ar, ar2, …, arn-1

(1 − 𝑟 𝑛 )
Sum of series (to n terms) = Sn = 𝑎
(1−𝑟)

Is this sum well defined if we have infinite terms?

Zeno's paradox… can the hare ever catch the tortoise?
How about the series where a = 1, r = -1 
1, -1, 1, -1, …
Sn = ??

Sn is defined only if the series converges, i.e. |r| < 1

𝑎
in which case, 𝑆∞ =
(1−𝑟)
Cash flow diagrams

When comparing alternatives, we may try (if possible) to reduce them such
that they achieve the same purpose/result  equivalent

A graphical method to do so is the cash flow diagram

11713
Plan 1
1 2 3 4
8000

800 800 800 8800

1 2 3 4
Plan 2 8000

2524
2524 2524 2524

Plan 3
1 2 3 4
8000
Cash flow diagrams

Time is the end-of-period time point

A downward arrow represents cash outflow,

An upward arrow represents cash inflow.

If needed, the viewpoint should be indicated

e.g. previous example is from the lender’s point of view
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
Discrete compounding and Discrete Cash Flow

Discrete compounding: interest is compounded at the end of a

time period
Discrete cash flow: cash transactions occur at the end of a
time period

To Find Given Notation for interest factor

For single cash flows
F P (F/P, i %, N)
P F (P/F, i %, N)
For uniform series
F A (F/A, i %, N)
P A (P/A, i %, N)
A F (A/F, i %, N)
A P (A/P, i %, N)
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
Given P, find F

F is to be found

1 2 … N
P is given

F = P(1+i)N

The term (1+i)N , denoted by (F/P, i%, N), is called

single payment compound amount factor

ref: (F/P, i%, N) table in the appendix of the textbook

Example, F/P, i%, N

Suppose I borrow $8,000 at the annual interest rate of 10%,

promising to repay at the end of the 4th year. How much do I
need to repay?

P=8000, i = 0.1, N = 4  F=8000(1+0.1)4=$11713

(if you are lazy )

From the table, we get (F/P,10%,4)=1.4641
F=P(F/P,10%,4)= 8000* 1.4641 = $11713
P, F and A relationship tables
Given F, find P

F is given

1 2 … N
P is to be found

P = F(1+i)-N

The term (1+i)-N , denoted by (P/F, i%, N), is called

single payment present worth factor

ref: (P/F, i%, N) table in the appendix of the textbook

Example, P/F, i%, N

An investor has an option to buy a tract of land that

will be worth $10,000 in 6 years. If the value of the
land increases at 8% each year, how much should the
investor be willing to pay now for this property?

P = F/(1+i)N = 10000/(1.08)6 = 6301.69

(alternatively, using tables)

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

P =10000 (P/F, 8%, 6) = 10000*0.6302=$6302

Given A, Find F (future value of an annuity)

A A A A A A

0 1 2 3 4 N-1 N

F
F  A( F / P, i, N  1)  A( F / P, i, N  2)  ...  A( F / P, i,1)  A( F / P, i,0)
 A((1  i ) N 1  (1  i ) N  2  ...  (1  i )1  (1  i ) 0 )
(1  i ) N  1
A
i

F = A(F/A, i%, N)

ref: (F/A, i%, N) table in the appendix of the textbook

Given F, Find A

0 1 2 … N-1 N

A A A A A A A A

A = F(A/F, i%, N)
𝑖
𝐴=𝐹 [How?]
(1 + 𝑖)𝑁 −1
Given F, Find A

A = F(A/F, i%, N)

A student plans to have $1,000,000 when she is at age 65. She

is 20 years old now. If the interest rate is 7%, what equal end-
of-year amount must she save to accomplish her goal?

A = 1000000 (0.07/(1.0745 – 1)) = $3500

Or, using the tables:

A= 1000000(A/F,7%,45)
=1000000*0.0035
= $3500
Given A, Find P
A A A A A A

0 1 2 3 4 N-1 N

𝐴 𝐴 𝐴
𝑃= + 2
+ …+
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑁

(1 + 𝑖)𝑁 −1
=𝐴 [How?]
𝑖(1 + 𝑖)𝑁

P = A(P/A, i%, N)
ref: (P/A, i%, N) table in the appendix of the textbook
Example, P/A, i%, N

If a machine undergoes a major overhaul now, its output

rate can be increased, which translates into additional
cash flow of $20,000 at the end of each year for 5 years.
What is the maximum we should pay to overhaul the
machine today if we use i=15% per year?

what we pay now ≤ total savings in the future

The cash flow: annuity, A = 20,000, i = 15%, and N = 5.

P = 20000(P/A,15%,5) = 20000*3.3522 = $67,044

Given P, Find A

A A A A A A

0 1 2 3 4 N-1 N

A= P(A/P, i%, N)

𝑖(1 + 𝑖)𝑁
𝐴=𝑃
(1 + 𝑖)𝑁 −1
A/P, Example

A = P(A/P, i%, N)

If I borrow $8000 at annual interest rate 10%, and

repay the loan by an equal end-of-year plan for 4 year,
how much should I pay each year?

A = 8000 ( 0.1*1.14)/(1.14 - 1) = 8000 * 0.31547 = 2523.76

A = 8000 (A/P, 10%, 4)

= 8000*0.3155
= $2524
Deferred Annuities

A A A
?
0 1 2 … J J+1 …
N-1 N
0 1 N-J-1 N-J

An annuity is deferred by J periods if the first

transaction occurs at the end of period J+1.

To get P for a J-period deferred annuity

Step 1: Compute PJ = value of annuity at time = J
Step 2: Compute present value of PJ at time = 0
PJ = A(P/A, i%, N−J)
P0=PJ(P/F, i%, J) = A(P/A, i%, N−J) (P/F, i%, J)
Example, deferred annuities
A A A A

0 1 2 … 17 18 19 21
20
?

A father, on the day his son is born, wants to give his

son $2000 for his 18th,19th,20th, and 21st birthday.
Suppose the bank interest is 12% per year. How
much should the father deposit now?

 the annuity is deferred J=17 periods.

P17 = A(P/A, 12%, 21−17) = 2000*3.0373 = $6074.60
P0=P17(P/F, 12%, 17) = 884.46
Summary

- We learnt several different types of uniform cash flows and

- How to convert a given cash flow into a different, equivalent one

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

Next: non-uniform & more complex cash flows