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120 16 Chapter 17 TimeValueofMoney

The document discusses concepts related to time value of money, including: 1) Money has time value - a dollar today is worth more than a dollar in the future due to interest earned or paid. 2) Discounting future cash flows allows project alternatives to be evaluated on a comparable present value basis. 3) The basic time value of money formula relates present value (PV) to future value (FV) based on the interest rate (i) and number of periods (n): PV = FV / (1+i)n. 3) Examples demonstrate how interest compounds over time, making a dollar received in the future worth less today, and vice versa when moving money from the future to

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Hrvoje Eror
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60 views12 pages

120 16 Chapter 17 TimeValueofMoney

The document discusses concepts related to time value of money, including: 1) Money has time value - a dollar today is worth more than a dollar in the future due to interest earned or paid. 2) Discounting future cash flows allows project alternatives to be evaluated on a comparable present value basis. 3) The basic time value of money formula relates present value (PV) to future value (FV) based on the interest rate (i) and number of periods (n): PV = FV / (1+i)n. 3) Examples demonstrate how interest compounds over time, making a dollar received in the future worth less today, and vice versa when moving money from the future to

Uploaded by

Hrvoje Eror
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 12

5/17/2021

Chapter 17
Project Selection and Portfolio
Management, Time Value of Money

Project Management for Business,


Engineering, and Technology

Basic Concepts
Time-value of Money

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Time-value of Money

◼ All Projects involve a cash stream of some


sort
❑ It is usually a combination of both income and
expenses
❑ If the net is positive the project “made money”;
otherwise, it “lost money”
◼ One way to sort out project alternatives is
through engineering economy

The General Concepts


◼ Money, besides being a measure of value, is a
commodity, just like gold, wheat…
◼ It is can be bought, sold, borrowed, loaned,
saved, consumed, and stolen
◼ When money is borrowed the “rent” is called
interest.
❑ If you loan money you earn interest; If you borrow
money you pay interest
◼ Because the amount of interest is a function of
time, the value of an amount of money varies as
a function of time

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Interest

◼ Simple interest vs. compound interest:


❑ Simple interest is a certain % of the money loaned
◼ Time may, or may not, be a factor
❑ Compound interest is a relatively new invention
(1700’s?) and is essentially, interest on interest

Discounting
◼ When interest rates are greater than zero,
$$-amounts can only be summed at the
same point in time
◼ Usually, this means that all future $$
amounts are converted to a present value
before they are summed
◼ This is called “discounting” the cash flow
◼ Almost every commercial project is
evaluated and compared based upon some
“discounted cashflow” – stocks, bonds,
projects, real estate…

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Other Points …

◼ When interest rates are zero $$-amounts can


summed independent of time
◼ Money is more valuable now than it is some
time in the future – (See 2nd law)
◼ Unless specifically told otherwise, always
assume compound interest
Law 1: Show me the money

The Basic Formula

PV = FV/(1+i%)n
❑ PV or P is present value
❑ FV or F is some amount in the future
❑ i%= the interest rate per period (years, months,
weeks, …)
❑ n = the number of periods

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Example # 1 – Single Amount


◼ Question: What is the PV (the value now)
of $10,000 that you expect to receive 2
years from now, if current interest rates are
10% compounded annually?
◼ Answer: PV=$10,000/1.12 = $8,264
FV=$10,000
PV=$8,264
Cash Flow Diagram

Time = 0 Time = 2
1
(or now) Years (or 2-years from now)

Remember!
◼ The time the money is loaned or borrowed is
broken into even time intervals (or, periods) –
years, quarters, months, days.
◼ All cash-flow events occur at the ends of the
time intervals and the interest rate per period
is constant.
◼ Interest rates are generally expressed as
nominal annual (per year =12%) but must be
adjusted to fit the compounding period (per
month =1%, per quarter =3%).
A very common exam mistake

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$1,000 now is equivalent to $8,916 12-years in the


future at 20% interest
Period 20% $8,916 =F =P(1+%)n =$1,000(1.2)12
0 $1,000
1 $1,200
Present Money Grows
2 $1,440
3 $1,728

Future Value of $1,000


$10,000
4 $2,074 $8,000
5 $2,488 $6,000
6 $2,986 $4,000
7 $3,583 $2,000
8 $4,300 $0
9 $5,160 0 1 2 3 4 5 6 7 8 9 10 11 12
10 $6,192 Years
11 $7,430
12 $8,916
Law 2: Get the Money Up-Front!
Brute Force

$10,000 12-years in the future at 20% is equivalent


to $1,122 now
Period 20% $1,122 =P =F(1+%)-n =$10,000(1.2)-12
12 $10,000
11 $8,333
10 $6,944
Future Money Shrinks
9 $5,787
8 $4,823 $12,000
Present Value of

7 $4,019 $10,000
$10,000

6 $3,349 $8,000
$6,000
5 $2,791 $4,000
4 $2,326 $2,000
3 $1,938 $0
2 $1,615 12 11 10 9 8 7 6 5 4 3 2 1 0

1 $1,346 Years

0 $1,122

Brute Force Law 3: Take the Money and Run!

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Summarizing with Q&A

Net Present Value

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Net Present Value


◼ One way to evaluate projects, stocks,
bonds, etc. is by discounted cash flow
◼ Amounts of money scattered at various
points in time can only be summed at the
same point in time – usually now
◼ The relationship: PV=FV/(1+i%)n
is used to “move” money from one point in
time to another
◼ Other evaluation methods: B/C and IRR

Some Commonly Used Terms


◼ P, PV, and NPV – all mean Present
Value or the value of the money Now

◼ F and FV stand for future value

◼ A, AE, and PMT all stand for the


periodic amount in a uniform series
or “annual equivalent” or equal
installment payment, etc.

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Derivation of F=P(1+i)n

Years Start Interest End


First P iP P(1+i)
Second P(1+i) iP(1+i) P(1+i)2
Third P(1+i)2 iP(1+i)2 P(1+i)3
n-th P(1+I)n-1 iP(1+I)n-1 P(1+i)n

QED, F=P(1+i)n OR P=F(1+i)-n

Derivation of F=A*(F/A,i,n)
=

(1) F=A(1+i)n-1+…A(1+i)2+ A(1+i)1+A


Multiply by (1+i)

(2) F+Fi = A(1+i)n+A(1+i)n-1…A(1+i)2+A(1+i)1


Subtracting (1) from (2), you get. Fi=A(1+i)n-A

F=A[((1+i)n-1)/i], and
P=A[((1+i)n-1)/i(1+i)n]

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Single Value Problem


The relationships between equivalent
amounts of money ($5,000 now) at different
points in time are shown below.
P F
A

1. P= $5,000, i=12% 0 5

2. F= $5,000(1.12)5 = $8,811.71
3. A= $8,811.71*.12/(1.125-1) = $1,387.05
4. P= $1,387.05*(1.125-1)/(.12*1.125) = $5,000

Summarizing with Q&A

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Class Exercise
NPV

Exercise

◼ You borrow $10,000 at 12% per year for 5-years


to purchase a car. What are your monthly
payments?
P=A[((1+i)n-1)/i(1+i)n]

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Summarizing with Q&A

12

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