The Time Value of Money

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
If you would know the value of money, go and try to borrow
some.
Benjamin Franklin

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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).
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Return to capital in the form of interest or
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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
If $5,000 were loaned for five years at a
simple interest rate of 7% per year, the
interest earned would be

So, the total amount repaid at the end

of five years would be the original
amount ($5,000) plus the interest
($1,750), or $6,750.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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 Interest Amount
at beginning of amount for owed at end
Period period period 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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We need some tools to find economic
equivalence.
• 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
– A = end-of-period cash flows in a uniform series
continuing for a certain number of periods, starting at the
end of the first period and continuing through the last

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
A cash flow diagram is an indispensable
tool for clarifying and visualizing a
series of cash flows.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can use these to find economically
equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six
years if the interest rate is 8% per year?

$3,000 at the end of year seven is equivalent to how

much today (time zero) if the interest rate is 6% per
year?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Appendix C
Interest and Annuity Tables for Discrete Compounding

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Solution
Betty’s required investment is

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Problem 1
Suppose you contribute $10 per week ($520 per year) into an
interest-bearing account that earns 6% a year (compounded once
per year). That’s probably one less pizza per week! But if you
contribute faithfully each week into this account, how much
money would you have saved through the compounding of
interest by the end of 15 years?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Problem 2

A lump-sum loan of $5,000 is needed by Chandra

to pay for college expenses. She has obtained small
consumer loans with 12% interest per year in the past
to help pay for college. But her father has advised
Chandra to apply for a PLUS student loan charging
only 8.5% interest per year. If the loan will be repaid in
full in five years, what is the difference in total interest
accumulated by these two types of student loans?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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There are interest factors for a series of
end-of-period cash flows.

How much will you have in 40 years if you

save $3,000 each year and your account
earns 8% interest each year?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Finding the present amount from a series
of end-of-period cash flows.

How much would is needed today to provide

an annual amount of $50,000 each year for
20 years, at 9% interest each year?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding A when given F.

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?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding A when given P.

If you had $500,000 today in an account

earning 10% each year, how much could you
withdraw each year for 25 years?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Pause and solve
Acme Steamer 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 Acme’s monthly payments be?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Solution
Acme’s monthly payments are

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Problem 3
It is estimated that a certain piece of equipment can save
$22,000 per year in labor and materials costs. The equipment
has an expected life of five years and no market value. If the
company must earn a 15% annual return on such investments,
how much could be justified now for the purchase of this piece
of equipment? Draw a cash-flow diagram from the company’s
viewpoint.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding N
Acme borrowed $100,000 from a local bank, which
charges them an interest rate of 7% per year. If Acme
pays the bank $8,000 per year, now many years will it
take to pay off the loan?

So,

This can be solved by using the interest tables and

interpolation.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding i
Jill invested $1,000 each year for five years in a local
company and sold her interest after five years for
$8,000. What annual rate of return did Jill earn?

So,

Again, this can be solved using the interest tables

and interpolation.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Problem 4
The value of an investment comes from its cash flows. Let’s say
you are intent on receiving $45,000 per year, starting at the end
of year one and continuing over 10 years. A lump-sum of
$380,000 invested now (year 0) will allow you to receive your
desired annual amount. What interest rate is required to make
this happen?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Pause and solve
Irene just purchased a new sports car and wants to
also set aside cash for future maintenance expenses.
The car has a bumper-to-bumper warranty for the first
five years. Irene 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 Irene 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?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Solution
Present value, at EOY 5, of maintenance expenses in
years 6-10, is

Now move this value to time zero

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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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 (albeit quite complicated) we can use to find
the present value, and a set of factors developed for
interest tables.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 We can also find A or F
equivalent to a uniform gradient
series.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an
2 3,000
annuity portion of the cash
flows and a gradient 3 4,000
portion. 4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Sometimes cash flows change by
a constant rate, ,each period--this
is a geometric gradient series.

This table presents a End of Year Cash Flows ($)

geometric gradient series. It
1 1,000
begins at the end of year 1
and has a rate of growth, , 2 1,200
of 20%. 3 1,440
4 1,728

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can find the present value of a
geometric series by using the appropriate
formula below.

Where is the initial cash flow in the series.

Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Pause and solve
Acme Miracle projects good things for their new weight
loss pill, LoseIt. Revenues this year are expected to
be $1.1 million, and Acme believes they will increase
15% per year for the next 5 years. What are the
present value and equivalent annual amount for the
anticipated revenues? Acme uses an interest rate of
20%.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Solution
Use the geometric gradient formula to find the present
value, then convert the present amount to an annual
amount.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 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.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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The present equivalent of a cash flow occurring at
the end of period N can be computed with the
equation below, where ik is the interest rate for the
kth period.

If F4 = $2,500 and i1=8%, i2=10%, and i3=11%, then

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 The effect of more frequent
compounding can be easily
determined.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year. We can
find, i, the effective interest by using the formula
below.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the
effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Pause and solve

A credit card company charges an interest rate of 1.375%

per month on the unpaid balance of all accounts. The
annual interest rate, they claim, is 12(1.375%) = 16.5%.
What is the effective rate of interest per year being charged
by the company?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Pause and solve
A light-duty pickup truck has a manufacturer’s suggested retail
price (MSRP) of $14,000 on its window. After haggling with the
salesperson for several days, the prospective buyer is offered
the following deal: “You pay a $1,238 down payment now and
$249 each month thereafter for 39 months and the truck will be
yours.” The APR at this dealership is 2.4% compounded
monthly. How good a deal is this relative to the MSRP?

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 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.
Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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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

Engineering Economy, Sixteenth Edition, Global Edition

© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Continuous compounding
interest factors.

The other factors can be found from these.

Engineering Economy, Sixteenth Edition, Global Edition
© Pearson Education Limited 2014
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.