Money Has Time Value

(we measure that with

interest)

ENGR 301
Principles of Project Management and Economics
Dr. Schmitt
TIME VALUE OF MONEY
 Our Refrain
• If you learn one thing in this course
– Money has time value!
• What does that mean?
– Simple interest
– Compound interest
• Can use these concepts to calculate equivalence
• Using
– Single payment compound interest formulas

3
 Time Value of Money
• Which would you rather have
– $1000 now?
or
– $1000 5 years from now?
• Why?

• Two reasons
– Inflation
– Opportunity cost
Two related concepts that we will cover later in the course

RELATED ECONOMIC CONCEPTS

 Inflation
• Amount of goods and services you can purchase with an
amount of money changes over time
− Usually, the amount you get with the same amount of
money decreases
• Inflation
− If the amount you get with the same amount of money
increases
• Deflation
 Opportunity Cost
• What you would be doing if you weren’t doing what you
are doing
• If you had $1000 now, you could do something with that
money that you can’t do for the next 5 years
 Back to Time Value of Money
• Which would you rather have
– $1000 now?
or
– $1000 5 years from now?
• Why?
 Time Value of Money
• Which means:
– $1000 now
Is not the same as
– $1000 5 years from now
• The value of the dollar amount changes over time
• Usually express this as a percentage over a period of time
– Interest
 Interest
• How much corporations and individuals are willing to
accept not to have access to money
• How much corporations and individuals are willing to pay
to have access to money
 Lecture Summary
2.1 Interest and Interest Rates
2.2 Compound and Simple Interest
2.2.1 Compound Interest
2.2.2 Simple Interest
2.3 Effective and Nominal Interest Rates
2.4 Continuous Compounding
2.5 Cash Flow Diagrams
2.7 Equivalence
 Interest and Interest Rates
• Money has time value
• Interest:
– money paid for using borrowed money
• i
– Interest Rate
– ratio between the interest payable at the end of a period
and the money borrowed at the beginning of the period
– P present value (here the money borrowed)
– I the total amount of interest payable

i = I/P I = Pi
 Total Interest
• compensation for giving up the use of the money for the
duration of the loan
𝐹 =𝑃+𝐼
• P principal
– the amount the money is worth today
– Present Worth of F 𝐼
• F: Future amount 𝑃
1
𝑃
F
period
– Future Worth of P
Interest rate
• I: interest amount (i)

– interest 𝐼
– can be expressed as an interest rate “i” with respect to P
– 𝐼 = 𝑃𝑖 so, 𝐹 = 𝑃 + 𝑃𝑖 = 𝑃(1 + 𝑖)
 Types of Interest
• Simple Interest
– Interest accrues only on the original sum
– Never calculated on outstanding interest
• Compound Interest
– Interest accrues on original sum and outstanding interest
– Standard
 Simple Interest
• Interest is earned (paid) in each period only on the initial
principal
• Interest is earned (paid) every period, accumulated, and
paid only at the end of a term of n periods
 Simple Interest Calculation
• Where
– F is the future sum
– P is the present sum
– n is the number of time periods
– i is the interest rate/period
– I is the total interest charges
• 𝐼 = 𝑃𝑖𝑁 → 𝐹 = 𝑃 + 𝐼 → 𝐹 = 𝑃(1 + 𝑖×𝑁)

• Total interest charges

F = P + Pin F = P(1 + in)

I = Pin
 Types of Interest
• Simple Interest
− Interest accrues only on the original sum
− Never calculated on outstanding interest
• Compound Interest
− Interest accrues on original sum and outstanding interest
− Standard
 Compound Interest
• The standard interest calculation
• Simple interest is not used unless specifically stated
otherwise
• Interest is calculated on the accumulated amount and not
simply on the original amount
• ‘Interest on top of interest’
 The difference...
• Calculate compound interest for multiple periods (not
just one)
• Consider a single period loan (n=1). In this case, the
same formula applies
F = P(1 + in) = P(1 + i ×1) = P(1 + i )
• Now, suppose we extend the loan to two periods.
How much will the future value be?
F = P(1 + i ) + iP(1 + i )
• This is because the future value is also calculated on
outstanding interest from the first period.
When are simple and compound interest the same?

SIMPLE VERSUS COMPOUND

INTEREST
Fig: Simple & Compound Interest at 24% per year Comparison, Fraser et al, 2016
 Compounding longer
• We’ll extend this calculation for more periods

Year Amount at Beginning Interest for Amount at

of Interest Period Period End of
Interest
Period
1 P +iP =P(1+i)
2 P(1+i) +iP(1+i) =P(1+i)2
3 P(1+i)2 +iP(1+i)2 =P(1+i)3
Suppose true for k periods
k P(1+i)k-1 +iP(1+i)k-1 =P(1+i)k
k+1 P(1+i)k +iP(1+i)k =P(1+i)k+1
n P(1+i)n-1 +iP(1+i)n-1 =P(1+i)n
 Compound Interest
• For a given duration
– n periods
• Interest is calculated and paid at the end of every period
– Interest you earn in one period earns you more interest in
the next period

F = P(1 + i) n
 Compound Interest
• Consider a $25,000 loan at 10% per year:
Year Total in Year Interest Amount
accumulated at accumulated at
end of year end of year

1 $25000.00
P
2
3
4
 Compound Interest
• Consider a $25,000 loan at 10% per year:
Year Total in Year Interest Amount
accumulated at accumulated at
end of year end of year

1 $25000.00 $2500.00 $27500.00

P +iP =P(1+i)
2 $27500.00 $2750.00 $30250.00
P(1+i) +iP(1+i) =P(1+i)2
3 $30250.00 $3025.00 $33275.00
P(1+i)2 +iP(1+i)2 =P(1+i)3
4 $33275.00 $3327.50 $36602.50
P(1+i)3 +iP(1+i)3 P(1+i)4
 Single Payment Compound Interest
Formulas
• Notation:
– i = interest rate per period
– n = number of interest periods
– P = a present sum of money
– F = a future sum of money
 Compound Interest
• If the interest rate’s period is in years:
• After one year the future amount at the end of year one
would be:
– F = P(1+i)
• After two years, the future amount at the end of year two
would be the additional interest on year one’s total:
– F = P(1+i)+iP(1+i)
• Rearranging:
– F = P(1+i)(1+i) = P(1+i)2
 Single Payment Compound Interest
Formulas
• Generalizing the previous slide:
– F = P(1+i)n
• Single payment compound amount formula
• Functional notation
– F = P(F/P, i, n)
– Future sum ‘F’, given present sum ‘P’ at
interest rate ‘i’ per interest period for ‘n'
periods
– Functional notation is written algebraically
– F = P(F/P) so, F = F
 Calculating a Future Value
• $3000.00 deposited in a bank account at 7% per year
interest would be how much after four years?
Draw the Cash Flow
Compound Interest Factors
Compound Interest Factors
Compound Interest Factors
 Answer
• $3000.00 deposited in a bank account at 7% per year
interest would be how much after four years?
– F = P(F/P, 7%, 4)
– F = 3000(1+0.07)4
– F=3000*(1.311)
 Finding Equivalence for a Future Value
• F = P(1+i)n
– Rearranging:
– P = F/(1+i)n = F(1+i)-n
• Present value or present worth
– An equivalent notation:
– P = F(P/F, i, n)
• Functional notation
• A better way to write this would be:
– P= F x f(P/F, i, n)
 Calculating a Present Value
• If you want to have $3000.00 in the bank after four years
at 7% per year interest, what would you have to deposit
now?
Draw the Cash Flow
Compound Interest Factors
Compound Interest Factors
Compound Interest Factors
 Answer
• If you want to have $3000.00 in the bank after four years
at 7% per year interest, what would you have to deposit
now?
• Two ways to solve
• Compound Interest Factors (use tables)
– F(P/F, 7%, 4)
– P = 3000(.7629)
• Single Payment Compound Interest Formula
– P = F(1+i)-n
– P = 3000(1+0.07)-4
 Compounding
• Interest can be compounded over different periods
• If we say 5% interest without specifying a period, we
assume this is for a one-year period
• But interest can be compounded over any period
– Semiannually Twice per year/every six months
– Quarterly 4 times per year/every 3 months
– Monthly 12 times per year
– Weekly 52 times per year
– Daily 365 times per year
– Continuous infinitesimally small period
 Nominal Interest Rate
• Nominal Interest Rate (for a sub-period) 𝒊𝒔
#
• Annual interest rate: 𝑟 = 𝑖" ×𝑚 ⇒ 𝑖" = $
where:
– r= Nominal interest rate for the full period,
– 𝑖! = interest rate for each sub-period, and
– m= number of (equal sub-periods)
 Effective Interest Rate
• Effective Interest Rate 𝒊𝒆 : the actual but not usually
stated interest rate, found by converting a given interest
rate with an arbitrary compounding period (normally less
than a year) to an equivalent interest rate with a one-year
compounding year

$
𝑖& = 1 + 𝑖" −1
• where:
– 𝑖" = effective interest rate for the full period,
– 𝑖! = interest rate for the sub-period,
– m= the number of sub-periods (in the longer period)
 Effective Interest Question
• What is the annual effective interest rate equivalent to a
nominal rate of 12% per year compounded monthly?
• The nominal interest rate
– r = 12 per year
• the number of corresponding periods per year is
– m = 12
• Meaning
– r/m = 0.12/12 = 0.01
• Calculating effective interest
– ie = (1+is)m – 1 = (1+ 0.01)12 -1 = 0.127 or 12.7%
 Upshot
• an interest rate of 1% per month, compounded
monthly, is equivalent to an effective rate of
approximately 12.7% per year compounded
yearly)
 Loan Shark: Nominal Rate
• You can borrow money at a rate of 5% per week.
• What is the nominal interest rate for these loans?
• Nominal interest rate
• 𝑟 = 𝑖" ×𝑚
• 𝑟 = 5% * 52 weeks
• 𝑟 = 260%
• (recall that nominal interest rates are usually expressed on
a yearly basis)
 Loan Shark: Effective Rate
• You can borrow money at a rate of 5% per week.
• What is the effective annual interest rate?
• Effective annual interest rate
– ie = (1+is)m – 1
– ie = (1 + 0.05)52 – 1
– ie = 11.64
– (meaning: Effective annual interest rate of about
1164%)
 Credit Card Interest
• Your credit card has a nominal 20% interest on overdue
accounts, compounded daily. What is the effective interest
rate?
• This is r=20%
• is =r/m
• is =20%/365
• is =0.00054795
• ie = (1+is)m – 1
• ie =(1+ 0.00054795)365 – 1
• ie =22.13%
 Interest, Equivalence & Time
• Money has time value!
• Equivalence calculation requires an interest rate
– F = P(1+i)n = P(F/P, i, n)
– P = F/(1+i)-n = F(1+i)-n = F(P/F, i, n)
• (More generally: any meaningful calculation we do in
this class requires an interest rate)
• Can calculate present or future value using formulas
• Or notation factors
– Appendix B, page 576-606
 Equivalence
• Equivalence with respect to the ‘time value of
money’ implies that:
– A sum of money in one time period may have
the same value as a different sum in another
time period with respect to an interest rate.
or
– $x today is worth the same as $y in the
future
• How to determine?
– Compound interest formulas
 Check for Equivalence
• Claim: a and b are equivalent to $1000
– (a) $1050 one year from now at 5% per year
– (b) $1102.50 two years from now at 5% per year
• How to confirm?
• F=P(1+i)n
• F=P(F/P, i, n)
 Are (a) and (b) Equivalent?
• Check using F=P(1+i)n
– (a) F=1000(1+.05) 1=1000(1.05)=1050
• $1050 in one year at 5% interest
– (b) F=1000(1+.05) 2=1000(1.1025)=1102.50
• $1102 two years from now at 5% per year
 Checking with Present Value
• So far, have calculated Future Value
F=P(1+i)n
• Can also calculate Present Value
• Turn formula around
F * P-1 =P(1+i)n * P-1
F/P = (1+i)n
F (1+i)-n = P
• Or more generally,
P =F (1+i)-n
 Are (c) and (d) Equivalent?
• Claim:
– c and d are equivalent to $1000
• (c) $1100 one year from now at 10% per year
• (d) $1210 two years from now at 10% per year
– How to check?
– P=F(1+i)-n
or
– P=F(P/F, i,n)
 Are (c) and (d) Equivalent?
• Claim:
– c and d are equivalent to $1000
• (c) $1100 one year from now at 10% per year
• (d) $1210 two years from now at 10% per year
– Check using P=F(1+i)-n
• (c) 1100(1+.1)-1=1100/1.1=1000
• (d) 1210(1+.1)-2=1210/1.21=1000
 Equivalence Example?
• Demonstrated equivalence for $1000:
• (a) $1050 one year from now at 5% per year
• (b) $1102.50 two years from now at 5% per year
• (c) $1100 one year from now at 10% per year
• (d) $1210 two years from now at 10% per year
– What about:
• $1050 one year from now at 10% interest?
 Equivalence Example?
• Demonstrated equivalence for $1000:
• (a) $1050 one year from now at 5% per year
• (b) $1102.50 two years from now at 5% per year
• (c) $1100 one year from now at 10% per year
• (d) $1210 two years from now at 10% per year
– What about:
• $1050 one year from now at 10% interest?
– P=F(1+i)-n
• 1050(1+.1)-1=1050/1.1=954.50
– NOT Equivalent
• Why?
 Types of Questions
• What is the future value of this present value?
• What is the present value of this future value?
• What interest would make this equivalent?