Beirut Arab University

Faculty of Engineering
Industrial Engineering and Engineering Management

Time Value Of Money:

Simple Interest, Compound Interest, and Annuities

Chapter 2
The objective of Chapter 2 is to explain time value of
money calculations and to illustrate economic
equivalence.
 Simple and Compound Interest: Objectives

Simple Interest

Compound Interest

Notation and Cash-Flow Diagrams

Relating Present and Future Equivalent Values of Single Cash Flows

• Finding F when Given P
• Finding P when Given F
• Finding the Interest Rate Given P, F, and N
• Finding N when Given P, F, and

Nominal and Effective Interest Rates

The Concept of Equivalence
Annuities
 Time Value of Money: Introduction

 Money has a time value

 Capital refers to wealth in the form of money or property
that can be used to produce more wealth.
 Engineering economy studies involve the commitment of
capital for extended periods of time.
 A dollar today is worth more than a dollar one or more
years from now (for several reasons).
 Time Value of Money: Introduction

 Return to capital in the form of interest and profit is an

essential ingredient of engineering economy studies.
 Interest and profit pay the providers of capital for forgoing
its use during the time the capital is being used.
 Interest and profit are payments for the risk the investor
takes in letting another use his or her capital.
 Any project or venture must provide a sufficient return to
be financially attractive to the suppliers of money or
property.
 Simple Interest

Simple interest is used infrequently

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, the
interest and interest rate are said to be simple.
 Simple Interest : Computation of simple interest

The total interest, I, earned or paid may be computed

using the formula below.

P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period
The total amount repaid at the end of N interest
periods is P + I.
 Simple Interest: Concept and Computation

Example1:
If $1,000 were invested for three years at a simple interest rate of 10% per year, what
would be the interest earned and the total amount owed at the end of three years?

Example2:
What is the interest on $200 at 12% per year for:
- 3years
- two months
 Compound Interest: Concept and Computation

Compound interest reflects both the remaining principal and any accumulated
interest. For $1,000 at 10%…

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed at Interest amount for Amount owed at
Period beginning of period period end of period
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

Compound interest is commonly used in personal and professional financial

transactions.
 Compound Interest: Concept and Computation

Example3:

What are the compound amount and the compound interest at the end of 3 years if
$1,000 is borrowed at 10% annual interest rate?
 Cash Flow Diagrams

A cash flow diagram is an indispensable tool

for clarifying and visualizing a series of cash
flows.
 Cash Flow Diagrams

Example4:
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 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.
 Compound Interest: Concept and Computation

We can apply compound interest formulas to “move”

cash flows along the cash flow diagram.
Using the standard notation, we find that a present
amount, P, can grow into a future amount, F, in N
time periods at interest rate i according to the
formula below.

In a similar way we can find P given F by

 Notation used in formulas for compound interest
calculations.
 i = effective interest rate per interest period
 N = number of compounding (interest) periods
 P = present sum of money; equivalent value of one or
more cash flows at a reference point in time; the present
 F = future sum of money; equivalent value of one or
more cash flows at a reference point in time; the future
 Compound Interest: Concept and Computation

It is common to use standard notation for interest

factors.

This is also known as the single payment

compound amount factor. The term on the right is
read “F given P at i% interest per period for N
interest periods.”

is called the single payment present worth factor.

 Compound Interest: Concept and Computation
Applications:

Example5:
Suppose that you borrow $8,000 now, promising to repay the loan principal plus
accumulated interest in four years at 10% per year. How much would you repay at
the end of four years?
 Compound Interest: Concept and Computation

Example6:
An investor has an option to purchase a tract of land that will be worth $10,000 in six
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?
 Compound Interest: Concept and Computation

Example7:
If we want to turn $500 into $1000 over a period of 10 years, at what interest rate
would we have to invest it?

Example8:
How long would it take for $500 invested today at 15% interest per year to be worth
$1,000?
Pause and solve

Betty will need $12,000 in five years to pay for a major

overhaul on her tractor engine. She has found an
investment that will provide a 5% return on her invested
funds. How much does Betty need to invest today so she
will have her overhaul funds in five years?
 Nominal and Effective Interest Rates

 More often than not, the time between successive

compounding, or the interest period, is less than
one year (e.g., daily, monthly, quarterly).
 The annual rate is known as a nominal rate.
 A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.
 The more frequent the compounding the greater
the effective interest.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year.
r
iM 
M
We can find, iy, the effective interest per year by
using the formula below.

r M
(1  i y )  (1  iM )  (1  )
M

M
 Compound Interest: Concept and Computation

Example9:
If 12% nominal interest rate is quoted with interest compounded monthly, what is the
effective interest rate per month? The effective interest rate per year?

Example10:
Find the effective annual interest if money is worth 6% compounded monthly on the
investment market.

Example11:
Find the amount of $1500 invested at 12% compounded quarterly and due at the end
of 5 years.
 Compound Interest: Concept and Computation

 When interest rates vary with time different

procedures are necessary.
 Interest rates often change with time (e.g., a variable
rate mortgage).
 We often must resort to moving cash flows one
period at a time, reflecting the interest rate for that
single period.
 Compound Interest: Concept and Computation

Example13:
If the principal is $500 and the interest rate is 6% compounded semiannually for the
first five years and 8% compounded quarterly for the next six years, what is the
compound amount at the end of the 11th year?
 Compound Interest: Concept and Computation

Example14:

If $1000 is due five years from now and money is worth 4% compounded quarterly, find its
present value and the compound discount.
 Concept of Equivalence

 Economic equivalence allows us to compare

alternatives on a common basis.
 Each alternative can be reduced to an equivalent basis
dependent on
 interest rate,
 amount of money involved, and
 timing of monetary receipts or expenses.
 Using these elements we can “move” cash flows so that
we can compare them at particular points in time.
 Compound Interest: Concept and Computation

Example15:

A debt of $200 is due at the end of four years. If money is worth 6% compounded quarterly,
what is the value of the debt when it is paid :
- at the end of one year?
- at the end of six years?

Example16:

A man owes a) $300 due in three years and b) $400 due in eight years. He and his creditor have
agreed to settle the debts by two equal payments in five and six years, respectively. Find the
size of each payment if money is worth 6% compounded semiannually.

Example17:

John borrowed some money from Mary as follows: $100 due in one year, $300 due in two
years, and $400 due in two years and one-half years. If money is worth 4% compounded
semiannually, when can John discharge all his debts by a single payments of $800?
 Compounding Continuously

 Interest can be compounded continuously.

 Interest is typically compounded at the end of discrete
periods.
 In most companies cash is always flowing, and should
be immediately put to use.
 We can allow compounding to occur continuously
throughout the period.
 The effect of this compared to discrete compounding
is small in most cases.
Compounding Continuously

We can use the effective interest formula to

derive the interest factors.

As the number of compounding periods gets larger (M

gets larger), we find that
 Compound Interest: Concept and Computation

Example18:

Find the compound amount and the compound interest when $10,000 is invested at 5%
compounded continuously for:
- one year
- two years
Annuities: Definition

An annuity is a series of periodic payments, usually

made in equal amounts. The payments are computed by
the compound interest method and are made at equal
interval of times, such as annually, semiannually,
quarterly, or monthly.
 Annuities: Definition

Term of an annuity

Origin A = Uniform Amounts =Periodic Payments

A A A A A

0 1 2 3 N-1 N

Payment Interval
P= Present Equivalent F= Future Equivalent
 Annuities: Amount of an annuity –
Finding F Given A

Example19:
How much will you have in 40 years if you save $3,000 each year and your account
earns 8% interest each year?
Annuities: Present Value of an annuity –
Finding P Given A

Example20:
How much would is needed today to provide an annual amount of $50,000 each year for 20
years, at 9% interest each year?
 Annuities: Finding A Given F

Example21:
How much would you need to set aside each year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25 years?
 Annuities: Finding A Given P

Example22:
If you had $500,000 today in an account earning 10% each year, how much could you
withdraw each year for 25 years?
Pause and solve

Arison Company purchased a new pump for $75,000. They borrowed the
money for the pump from their bank at an interest rate of 0.5% per month and
will make a total of 24 equal, monthly payments. How much will Arison’s
monthly payments be?
 Annuities: Applications

It can be challenging to solve for N or i.

 We may know P, A, and i and want to find N.

 We may know P, A, and N and want to find i.
 We may know F, A, and N and want to find i.
 Annuities: Applications

Example23:
Geneco borrowed $100,000 from a local bank, which charges them an interest rate of 7% per
year. If Geneco pays the bank $8,000 per year, how many years will it take to pay off the loan?

So,

This can be solved by using the interest tables and

interpolation, but we generally resort to a computer
solution.
 Annuities: Applications

Example24:
An annuity of 5 payments of size $1,000 each has an amount of $8,000. Determine i.

So,

Again, this can be solved using the interest tables

and interpolation, but we generally resort to a
computer solution.
 Annuities: Applications

There are specific spreadsheet functions to find N

and i.
The Excel function used to solve for N is
NPER(rate, pmt, pv), which will compute the number of
payments of magnitude pmt required to pay off a present
amount (pv) at a fixed interest rate (rate).

One Excel function used to solve for i is

RATE(nper, pmt, pv, fv), which returns a fixed interest rate for an
annuity of pmt that lasts for nper periods to either its present value
(pv) or future value (fv).
Annuities: Deferred Annuities

 We need to be able to handle cash flows that do not

occur until some time in the future.
 Deferred annuities are uniform series that do not
begin until some time in the future.
 If the annuity is deferred J periods then the first
payment (cash flow) begins at the end of period J+1.
Annuities: Deferred Annuities

Finding the value at time 0 of a deferred annuity is a two-step

process:
1. Use (P/A, i%, N-J) find the value of the deferred annuity at the
end of period J (where there are N-J cash flows in the
annuity).
2. Use (P/F, i%, J) to find the value of the deferred annuity at time
zero.
Pause and solve

Mary just purchased a new sports car and wants to also set aside cash for future
maintenance expenses. Mary estimates that she will need approximately $2,000
per year in maintenance expenses for years 6-10, at which time she will sell the
vehicle. How much money should Mary deposit into an account today, at 8%
per year, so that she will have sufficient funds in that account to cover her
projected maintenance expenses?
When you take your first job, you decide to start saving right away for your
retirement. You put $5,000 per year into the company’s 401(k) plan, which
averages 8% interest per year. Five years later, you move to another job and
start a new 401(k) plan. You never get around to merging the funds in the two
plans. If the first plan continued to earn interest at the rate of 8% per year for
35 years after you stopped making contributions, how much is the account
worth?
We need to determine the value of F that will make the present equivalent of all loan
payments equal to the amount borrowed. (interest rate is 8% per year)
Two receipts of $1,000 each are desired at the EOYs 10 and 11. To make these
receipts possible, four EOY annuity amounts will be deposited in a bank at EOYs 2,
3, 4, and 5. The bank’s interest rate (i) is 12% per year.
(a) Draw a cash-flow diagram for this situation.
(b) Determine the value of A that establishes equivalence in your cash-flow
diagram.
Figure below depicts an example problem with a series of year-end cash flows
extending over eight years. The amounts are $100 for the first year, $200 for the
second year, $500 for the third year, and $400 for each year from the fourth
through the eighth.
These could represent something like the expected maintenance
expenditures for a certain piece of equipment or payments into a fund.
It is desired to find
(a) the present equivalent expenditure, P0;
(b) the future equivalent expenditure, F8;
(c) the annual equivalent expenditure, A of these cash flows if the annual interest
rate is 20%
 Uniform (Arithmetic) Gradient of Cash Flows

Sometimes cash flows change by a constant amount each

period.
We can model these situations as a uniform gradient of cash
flows. The table below shows such a gradient.

End of Period Cash Flows

1 0
2 G
3 2G
: :
N (N-1)G
 Uniform (Arithmetic) Gradient of Cash Flows

It is easy to find the present value of a uniform gradient

series.
Similar to the other types of cash flows, there is a
formula we can use to find the present value, and a set of
factors developed for interest tables.
 Uniform (Arithmetic) Gradient of Cash Flows

We can also find A or F equivalent to

a uniform gradient series.
The annual equivalent of this series End of Year Cash Flows ($)
of cash flows can be found by
considering an annuity portion of the 1 2,000
cash flows and a gradient portion.
2 3,000
3 4,000
4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000
 Geometric Sequences of Cash Flows

Sometimes cash flows change by a constant rate, f ,

each period-this is a geometric gradient series.

This table presents a geometric gradient

series. It begins at the end of year 1 and
End of Year Cash Flows ($)
has a rate of growth, f , of 20%. 1 1,000
2 1,200
3 1,440
4 1,728
 Geometric Sequences of Cash Flows

We can find the future value of a geometric series

by using the appropriate formula below.

(1  f ) N  (1  i ) N
FA
f i

N 1
F  NA(1  i)
Where A is the initial cash flow in the series.
Pause and solve

Miracle projects good things for their new weight loss pill, LoseIt. Revenues this
year are expected to be $1.1 million, and Miracle believes they will increase 15%
per year. Study period is 5 years. What are the present value and equivalent
annual amount for the anticipated revenues? Miracle uses an interest rate of
20%.
 Annuities

Example25:

What is the cash value of a car that can be bought for $1,000 down and $500 a month for 36
months if money is worth 12% compounded monthly?

Example26:

An ordinary annuity of 10 equal annual payments of $200 each is to be discharged by a single

payment of $1,800. when should this single payment be due if the yearly interest rate i =9%

Example27:

You borrowed $5,000 and you will repay the loan in 5 equal end-of year payments. The first
payment is due one year after you receive the loan. Interest rate of the loan is 8%. What is the
size of each of the 5 payments?
 Annuities

Example28:

Determine the present value and the amount in the following diagram. i=10%
P? 50 100 150

0 1 2 3 4 5 6

Example29:

The maintenance cost of a car is estimated to be $100, and it increases at the uniform rate per
year of 10%. Using 8% interest rate, calculate the present worth of cost of the first five years.
Continuous compounding interest factors.

The other factors can be found from these.