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Lecture 2

The document discusses the Time Value of Money, emphasizing that money today is worth more than the same amount in the future due to its earning potential. It explains the concepts of simple and compound interest, detailing how interest is calculated and the differences in total amounts owed over time. Examples illustrate the calculations for both simple and compound interest, highlighting the advantages of compound interest in accumulating wealth.

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MH Moin
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20 views13 pages

Lecture 2

The document discusses the Time Value of Money, emphasizing that money today is worth more than the same amount in the future due to its earning potential. It explains the concepts of simple and compound interest, detailing how interest is calculated and the differences in total amounts owed over time. Examples illustrate the calculations for both simple and compound interest, highlighting the advantages of compound interest in accumulating wealth.

Uploaded by

MH Moin
Copyright
© © 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
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Lecture 2

Time Value of Money

HUM 2107
Engineering Economy
Zahid Hasan Shuvo
Industrial and Production Engineering
Department of MPE
Time Value of Money
 Change in the amount of money ones a given
time period is called the time value of money.
 The idea that a currency today is worth more
than a currency in the future because the
currency received today can earn interest.
 The economic value of a sum depends on
when it is received. Because money has both
earning as well as purchasing power over
time.
 Purchasing power is the value of a currency
expressed in terms of the amount of goods
or services that one unit of money can buy.

2
Simple Interest
 When More than one interest period is involved, the term simple
interest must be considered.
 Simple interest is interest earned on only the principal amount
during each interest period.
 With simple interest, the interest earned during each interest
period does not earn additional interest in the remaining periods,
even though you do not withdraw it.
 for a deposit of P dollars at a simple interest rate of i for N
periods, the total earned interest would be 𝐼 = 𝑖𝑃 𝑁
 The total amount available at the end of N periods thus would be
𝐹 = 𝑃(1 + 𝑖𝑁)
 Here i= Interest rate, P= Principal, N= No. of period
3
Simple Interest (Cont.)
If you borrow $1000 for 3 years at 14% per year of simple interest
rate, how much money will you owe at the end of 3 years?

Solution:
Interest per year = 1000 × 0.14 = 140
For 3 years total interest = 1000 × 0.14 × 3 = 420
Total amount after 3 years = 1000 + 420 = 1420

4
Compound Interest
 When More than one interest period is involved, this term must be considered too.
 Compound Interest for an interest period is calculated on the principal plus the
total amount of interest accumulated in previous periods.
 i (interest amount) = Principal + Total amount of interest accumulated in
previous periods
 This total amount includes the original principal plus the accumulated interest that
has been left in the account.
 In general, if you deposited (invested) P dollars at interest rate i, you would have
𝑃 + 𝑖𝑃 = 𝑃(1 + 𝑖) dollars at the end of one period. If the entire amount (principal
and interest) is reinvested at the same rate i for another period, at the end of the
second period you would have

5
Compound Interest (Cont.)
Continuing, we see that the balance after the third period is

This interest-earning process repeats, and after N periods the total


accumulated value (balance) F will grow to-

6
Compound Interest (Cont.)
If you borrow $1000 for 3 years at 14% per year of compound
interest rate, how much money will you owe at the end of 3 years?
Solution:
Interest Total after
𝑌𝑒𝑎𝑟 1 = 1000 × 0.14 = 140 Year 1 = 1140

𝑌𝑒𝑎𝑟 2 = 1140 × 0.14 = 159.60 Year 2 = 1299.60

𝑌𝑒𝑎𝑟 3 = 1299.60 × 0.14 = 181.94 Year 3 = 1481.54

Time value of money is especially recognized in compound interest.


Thus with compound interest the original $1000 would accumulated
an extra 1481.54-1420 = 61.54 compared with simple interest.
7
Compound Interest (Cont.)
Suppose you deposit $1,000 in a bank savings account that pays
interest at a rate of 10% compounded annually. Assume that you don’t
withdraw the interest earned at the end of each period (one year),
but let it accumulate. How much would you have at the end of year 3?

8
Compound Interest (Cont.)
The total interest earned is $331, which is $31 more than was
accumulated under the simple-interest method. We can keep track of
the interest accruing process more precisely as follows:

9
Comparing Simple with Compound Interest
In 1626, Peter Minuit of the Dutch West India Company paid $24 to
purchase Manhattan Island in New York from the Indians. In
retrospect, if Minuit had invested the $24 in a savings account that
earned 8% interest, how much would it be worth in 2007?
Solution:

10
Interest Calculation
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑎𝑐𝑐𝑢𝑚𝑢𝑙𝑎𝑡𝑒𝑑 – 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑤𝑒𝑑 – 𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑙𝑜𝑎𝑛
 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑛𝑜. 𝑜𝑓 𝑃𝑒𝑟𝑖𝑜𝑑 × 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑡𝑖𝑚𝑒
 𝑃𝑒𝑟𝑐𝑒𝑛𝑡 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = × 100%
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐴𝑚𝑜𝑢𝑛𝑡

11
Interest Calculation (Cont.)
“A” Company invest $ 1,00,000 on May-1 and withdrew a total of $
1,06,000 exactly one year later. Compute - (a) Interest (b) Interest
Rate.
Solution:
𝑎 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = $ 1,06,000 – $1,00,000 = $6000

6,000 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟


𝑏 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = × 100%
1,00,000
= 6% (𝑝𝑒𝑟 𝑦𝑒𝑎𝑟)

12
Interest Calculation (Cont.)
“A” Company plans to borrow $ 20,000 for 1 year at 15% interest
rate. Compute - (a) Interest (b) Total amount due after 1 year.

(𝑎) 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = $ 20,000 × (0.15) = $ 3,000

(𝑏) 𝑇𝑜𝑡𝑎𝑙 𝑑𝑢𝑒 𝑎𝑓𝑡𝑒𝑟 𝑜𝑛𝑒 𝑦𝑒𝑎𝑟 = $ 20,000 + $ 3,000


= $ 23,000
𝑇𝑜𝑡𝑎𝑙 𝑑𝑢𝑒 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 (1 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)
= $ 20,000 (1 + 0.15)
= $ 23,000

13

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