Week 02

The Time Value of Money

Introduction
• The term capital refers to wealth in the form of money or property
that can be used to produce more wealth.
• It is recognized that a dollar today is worth more than a dollar one or
more years from now because of the interest (or profit) it can earn.
• Therefore, money has a time value.
Simple Interest
• When the total interest earned or charged is linearly proportional to
the initial amount of the loan (principal), the interest rate, and the
number of interest periods for which the principal is committed, the
interest and interest rate are said to be simple.
• When simple interest is applicable, the total interest, I , earned or
paid may be computed using the formula
Simple Interest… p/2
• The total amount repaid at the end of N interest periods is P + I. Thus, if
$1,000 were loaned for three years at a simple interest rate of 10% per
year, the interest earned would be

• The total amount owed at the end of three years would be $1,000 + $300 =
$1,300.
• Notice that the cumulative amount of interest owed is a linear function of
time until the principal (and interest) is repaid (usually not until the end of
period N).
Compound Interest
• Whenever the interest charge for any interest period (a year, for
example) is based on the remaining principal amount plus any
accumulated interest charges up to the beginning of that period, the
interest is said to be compound.
• The effect of compounding of interest can be seen in the following
table for $1,000 loaned for three periods at an interest rate of 10%
compounded each period:
Compound Interest… p/2
Compound Interest… p/3
• A graphical comparison of simple interest and compound interest is
given in figure below.
Compound Interest… p/4
• The difference is due to the effect of compounding, which is
essentially the calculation of interest on previously earned interest.
• This difference would be much greater for larger amounts of money,
higher interest rates, or greater numbers of interest periods.
• Thus, simple interest does consider the time value of money but does
not involve compounding of interest.
• Compound interest is much more common in practice than simple
interest.
Notation and Cash-Flow Diagrams and Tables
• The following notation is utilized in formulas for compound interest
calculations:
Notation and Cash-Flow Diagrams and Tables… p/2
• The use of cash-flow (time) diagrams or tables is strongly recommended for
situations in which the analyst needs to clarify or visualize what is involved
when flows of money occur at various times.
• The difference between total cash inflows (receipts) and cash outflows
(expenditures) for a specified period of time (e.g., one year) is the net cash
flow for the period.
• Cash flows are important in engineering economy because they form the
basis for evaluating alternatives.
• Indeed, the usefulness of a cash-flow diagram for economic analysis
problems is analogous to that of the free-body diagram for mechanics
problems.
Notation and Cash-Flow Diagrams and Tables… p/3

Example of Cash-Flow Diagram

Notation and Cash-Flow Diagrams and Tables… p/4
• The cash-flow diagram employs several conventions:
• The horizontal line is a time scale, with progression of time moving from left
to right. The period (e.g., year, quarter, month) labels can be applied to
intervals of time rather than to points on the time scale.
• The arrows signify cash flows and are placed at the end of the period. If a
distinction needs to be made, downward arrows represent expenses
(negative cash flows or cash outflows) and upward arrows represent receipts
(positive cash flows or cash inflows).
Example 1 - Cash-Flow Diagramming
Before evaluating the economic merits of a proposed investment, the
XYZ Corporation insists that its engineers develop a cash-flow diagram
of the proposal. An investment of $10,000 can be made that will
produce uniform annual revenue of $5,310 for five years and then have
a market (recovery) value of $2,000 at the end of year (EOY) five.
Annual expenses will be $3,000 at the end of each year for operating
and maintaining the project. Draw a cash-flow diagram for the five-
year life of the project. Use the corporation’s viewpoint.
Example 1 - Solution
Relating Present and Future Equivalent Values
of Single Cash Flows
Finding F when Given P
• If an amount of P dollars is invested at a point in time and i % is the
interest (profit or growth) rate per period, the amount will grow to a
future amount of P + Pi = P(1+i) by the end of one period; by the end
of two periods, the amount will grow to
P(1 + i)(1 + i) = P(1 + i)(2);
by the end of three periods, the amount will grow to
P(1 + i)(2)(1 + i) = P(1 + i)(3);
and by the end of N periods the amount will grow to
Example 2 - Future Equivalent of a Present Sum
Suppose that you borrow $8,000 now, promising to repay the loan
principal plus accumulated interest in four years at i = 10% per year.
How much would you repay at the end of four years?
Example 2 - Solution
Finding F when Given P… p/4
• The quantity (1 + i)N is commonly called the single payment
compound amount factor.
• We shall use the functional symbol (F/P, i%, N) for (1 + i)N.
• Hence, Equation can be expressed as

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

where the factor in parentheses is read “find F given P at i% interest

per period for N interest periods.”
Finding F when Given P… p/5
Numerical values for this factor are given in the second column from the left in the
tables of Appendix C for a wide range of values of i and N.
Finding F when Given P… p/7
• Let’s look at Example 2 again. Using Equation (4-3) and Appendix C,
we have

• This, of course, is the same result obtained in Example 2 since

(F/P, 10%, 4) = (1 + 0.10)(4) = 1.4641.
Finding P when Given F
• From Equation (4-2), F = P(1 + i)N. Solving this for P gives the
relationship

• The quantity (1 + i)−N is called the single payment present worth

factor. Numerical values for this factor are given in the third column
of the tables in Appendix C.
• We shall use the functional symbol (P/F, i%, N) for this factor. Hence,
Finding P when Given F… p/2
• Based on Equations (4-2) and (4-4), the following three simple rules
apply when performing arithmetic calculations with cash flows:
o Rule A. Cash flows cannot be added or subtracted unless they occur at the
same point in time.
o Rule B. To move a cash flow forward in time by one time unit, multiply the
magnitude of the cash flow by (1 + i), where i is the interest rate that reflects
the time value of money.
o Rule C. To move a cash flow backward in time by one time unit, divide the
magnitude of the cash flow by (1 + i).
Finding the Interest Rate Given P, F, and N
• There are situations in which we know two sums of money (P and F)
and how much time separates them (N), but we don’t know the
interest rate (i) that makes them equivalent.
• We can easily solve Equation (4-2) to obtain an expression for i.
Example 3 - The Inflating Price of Gasoline
The average price of gasoline in 2005 was $2.31 per gallon. In 1993, the
average price was $1.07. What was the average annual rate of increase
in the price of gasoline over this 12-year period?
Example 3 - Solution
Finding N when Given P, F, and i
• Sometimes we are interested in finding the amount of time needed
for a present sum to grow into a future sum at a specified interest
rate.
• We can use the equivalence relationship given in Equation (4-2) to
obtain an expression for N.
Example 4 - When Will Gasoline Cost $5.00 per Gallon?

In Example 3, the average price of gasoline was given as $2.31 in 2005.

We computed the average annual rate of increase in the price of
gasoline to be 6.62%. If we assume that the price of gasoline will
continue to inflate at this rate, how long will it be before we are paying
$5.00 per gallon?
Example 4 - Solution
Relating a Uniform Series (Annuity) to Its Present
and Future Equivalent Values
• Figure 4-6 shows a general cash-flow diagram involving a series of uniform (equal) receipts, each
of amount A, occurring at the end of each period for N periods with interest at i% per period.
• Such a uniform series is often called an annuity.
• It should be noted that the formulas and tables to be presented are derived such that A occurs at
the end of each period, and thus,
Relating a Uniform Series (Annuity) to Its Present
and Future Equivalent Values… p/2
1. P (present equivalent value) occurs one interest period before the
first A (uniform amount),
2. F (future equivalent value) occurs at the same time as the last A,
and N periods after P, and
3. A (annual equivalent value) occurs at the end of periods 1 through
N, inclusive.
Finding F when Given A
• If a cash flow in the amount of A dollars occurs at the end of each
period for N periods and i%is the interest (profit or growth) rate per
period, the future equivalent value, F, at the end of the Nth period is
obtained by summing the future equivalents of each of the cash
flows. Thus,
Finding F when Given A… p/2
• The bracketed terms comprise a geometric sequence having a
common ratio of (1 + i)−1. Recall that the sum of the first N terms of a
geometric sequence is

where a1 is the first term in the sequence, aN is the last term, and b is
the common ratio. If we let b = (1 + i)−1, a1 = (1 + i)N−1, and aN = (1 + i)0,
then
Finding F when Given A… p/3

The quantity {[(1 + i)N − 1]/i} is called the uniform series compound
amount factor.
Finding F when Given A… p/4
• Numerical values for the uniform series compound amount factor are
given in the fourth column of the tables in Appendix C for a wide
range of values of i and N.
• We shall use the functional symbol (F/A, i%, N) for this factor.
• Hence, Equation (4-8) can be expressed as

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

Example 5 - Future Value of a College Degree
A recent government study reported that a college degree is worth an
extra $23,000 per year in income (A) compared to what a high-school
graduate makes. If the interest rate (i) is 6% per year and you work for
40 years (N), what is the future compound amount (F) of this extra
income?
Example 5 - Solution
• The viewpoint we will use to solve this problem is that of “lending”
the $23,000 of extra annual income to a savings account (or some
other investment vehicle).
• The future equivalent is the amount that can be withdrawn after the
40th deposit is made.
Example 5 - Become a Millionaire by Saving $1.00 a Day!

• To illustrate further the amazing effects of compound interest, we

consider the credibility of this statement: “If you are 20 years of age
and save $1.00 each day for the rest of your life, you can become a
millionaire.”
• Let’s assume that you live to age 80 and that the annual interest rate
is 10% (i = 10%).

• Thus, the statement is true for the assumptions given!