Chapter 3

Time Value of Money
Lecture No.4
Chapter 3
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition 2007
Time Value of Money
Money has a time value

because it can earn more
money over time (earning
power).
Money has a time value
because its purchasing
power changes over time
(inflation).
Time value of money is
measured in terms of
interest rate.
Interest is the cost of
moneya cost to the
borrower and an earning to
the lender
This a two-edged sword whereby earning

grows, but purchasing power decreases
(due to inflation), as time goes by.

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The Interest Rate

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Practice Problem
Problem Statement
If you deposit $100 now (n = 0) and $200 two
years from now (n = 2) in a savings account
that pays 10% interest, how much would you
have at the end of year 10?

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Solution
F
10
$100(1+ 0.10)10 = $100(2.59) = $259

$100
$200
$200(1+ 0.10)8 = $200(2.14) = $429

F = $259 + $429 = $688

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Practice problem
Problem Statement
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn a 10% interest, what would be the
balance at the end of 4 years?
$1,210
0
4
2
$1,000 $1,000
3
$1,500

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$1,210
0
3
2
$1,000
$1,000
$1,500
$1,100
$1,000
$2,100
$2,310
$1,210
-$1,210
+ $1,500
$1,100
$2,710

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$2,981
Solution
End of
Period
Beginning
balance
Deposit
made
Withdraw
Ending
balance
n=0
$1,000
$1,000
n=1
$1,000(1 + 0.10)
=$1,100
$1,000
$2,100
n=2
$2,100(1 + 0.10)
=$2,310
$1,210
$1,100
n=3
$1,100(1 + 0.10)
=$1,210
$1,500
$2,710
n=4
$2,710(1 + 0.10)
=$2,981
$2,981

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Economic Equivalence
Lecture No.5
Chapter 3
Copyright 2006
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Economic Equivalence
Economic equivalence exists between cash

flows that have the same economic effect
and could therefore be traded for one
another.
Even though the amounts and timing of the
cash flows may differ, the appropriate interest
rate makes them equal.

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Equivalence from Personal Financing

Point of View
F
If you deposit P dollars

today for N periods at
i, you will have F
dollars at the end of
period N.
P F
F = P(1+i)N
0
N

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Alternate Way of Defining Equivalence

P
F dollars at the end of

period N is equal to a
single sum P dollars
now, if your earning
power is measured in
terms of interest rate i.
N
F
N
P = F (1+ i)
0
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Practice Problem
At an 8% interest, what is the equivalent worth
of $2,042 now in 5 years?
If you deposit $2,042 today in a savings
account that pays an 8% interest annually.
how much would you have at the end of
5 years?
$2,042
33
=
0
5
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Solution
F = $2,042(1+ 0.08)
= $3,000

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Interest Formulas for Single

Cash Flows
Lecture No.6
Chapter 3
Copyright 2006
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Types of Common Cash Flows in Engineering

Economics

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Equivalence Relationship Between P and

F

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Single Cash Flow Formula- Compound-Amount

Factor
Single payment
compound amount
factor (growth factor)
Given:
i = 12%
N = 8 ye a rs
P = $5, 000
F = P(1 + i)
F = P( F / P, i, N)
N
0
N
Find: F
F = $5, 000(1 + 0.12)8
= $5, 000( F / P ,12%,8)
= $12, 380
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Practice Problem
If you had $2,000 now and invested it at

10%, how much would it be worth in 8
years?
F=?
i = 10%
0
8
$2,000
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Solution
G iv e n :
P = $2,000
i = 10%
N = 8 ye a rs
F in d : F
F = $ 2 , 0 0 0 (1 + 0 . 1 0 ) 8
= $ 2 , 0 0 0 ( F / P ,1 0 % , 8 )
= $ 4 , 2 8 7 .1 8
E X C E L com m and:
= F V (1 0 % ,8 ,0 ,2 0 0 0 ,0 )
= $ 4 ,2 8 7 .2 0
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Single Cash Flow Formula PresentWorth Factor
Single payment
present worth factor
(discount factor)
Given:
i = 12%
P = F(1 + i) N
P = F(P / F, i, N)
0
N = 5 y e a rs
F = $ 1,0 0 0
Find:
P = $1, 000 (1 + 0 .12 )
= $1, 000 ( P / F ,12% ,5 )

= $567.40
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Practice Problem
You want to set aside a lump sum amount

today in a savings account that earns 7%
annual interest to meet a future expense in
the amount of $10,000 to be incurred in 6
years. How much do you need to deposit
today?

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Solution
$10,000
0
6
P = $10, 000(1 + 0.07) 6

= $10, 000( P / F , 7%, 6)
= $6, 663
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Solving for i

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Solution
EXCEL Solution using RATE Function
$20 = $10(1 + i ) 5
2 = (1 + i )
i = 14.87%
5
=RATE(5,0,-10,20)=14.87%

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Rule of 72 Number of Years Required

to Double Your Investment

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Solution Analytical Approach
2P
F = 2 P = P(1 + 0.20) N
2 = 1.2
log 2 = N log1.2
log 2
N=
log1.2
= 3.80 years
N
0
N=?
P

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Solution - Rule of 72
Approximating
how long it will
take for a sum of
money to double
72
N
interest rate (%)
72
=
20
= 3.6 years

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Number of Years Required to Double an Initial

Investment at Various Interest Rates

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Uneven Payment Series
$25,000
$5,000
$3,000
0
1
How much do you need

to deposit today (P) to
withdraw $25,000 at n
=1, $3,000 at n = 2,
and $5,000 at n =4, if
your account earns
10% annual interest?

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$25,000
Uneven
Payment Series
$5,000
$3,000
0
1
P
$25,000
$5,000
$3,000
0
1
0
1
P2
= $22, 727
P4
P1
P1 = $25, 000( P / F ,10%,1)
P2 = $3, 000( P / F ,10%, 2)

= $2, 479
P = P1 + P2 + P4 = $28, 622
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P4 = $5, 000( P / F ,10%, 4)

= $3, 415
Interest Formulas Equal

Payment Series
Lecture No.7
Chapter 3
Copyright 2006
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Equal Payment Series

F
0
A
P
0
N
0

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Equal Payment Series Compound Amount

Factor
F
A
0
2
N
A
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Process of Finding the Equivalent Future

Worth, F
A(1+i)N-2
A
A
A(1+i)N-1
(1
+
i
)
1
N 1
N 2
F = A(1+ i) + A(1+ i) +"+ A = A

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Another Way to Look at the Compound

Amount Factor

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Equal Payment Series Compound Amount

Factor (Future Value of an Annuity)
F
0
3
N
(1 + i ) N 1
F=A
i
= A( F / A, i , N )
Example:
Given: A = $5,000, N = 5 years, and i = 6%
Find: F
Solution: F = $5,000(F/A,6%,5) = $28,185.46
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Validation
$5,000(1+ 0.06) = $6,312.38
F =?
$5,000(1+ 0.06)3 = $5,955.08

$5,000(1+ 0.06) = $5,618.00
2
i = 6%
0
$5,000(1+ 0.06)1 = $5,300.00

$5,000(1+ 0.06) = $5,000.00
$28.185.46
0
$5,000 $5,000 $5,000 $5,000 $5,000

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Finding an Annuity Value

F
0
3
N
A=?
i
A= F
N
(1 + i) 1
= F ( A / F , i, N )
Example:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
Solution: A = $5,000(A/F,7%,5) = $869.50
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Handling Time Shifts in a Uniform Series

F=?
First deposit occurs at n = 0
i = 6%
0
$5,000 $5,000 $5,000 $5,000 $5,000

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Annuity
Due
F5 = $5,000(F / A,6%,5)(1.06)
= $29,876.59
Excel
Solution
Beginning period
=FV(6%,5,5000,0,1)

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Sinking Fund Factor

F
0
i
L
O
A = FM
P
(
1
)
1
+
i
N
Q
N
3
N
= F( A / F, i, N)
Example: College Savings Plan

Given: F = $100,000, N = 8 years, and i = 7%
Find: A
Solution:
A = $100,000(A/F,7%,8) = $9,746.78
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Excel Solution
Given:
F = $100,000
i = 7%
N = 8 years
$100,000
Current age: 10 years old
Find:
0
1
=PMT(i,N,pv,fv,type)
=PMT(7%,8,0,100000,0)
=$9,746.78
A=?

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i = 8%
Example 3.15 Combination of a Uniform Series

and a Single Present and Future Amount

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Solution: A Two-Step Approach
Step 1: Find the required

savings at n = 5.
Step 2: Find the required

annual contribution (A)
over 5 years.
FC =$500(F/ P,7%,5) =$701.30

FRequired Savings =$5,000$701.30 =$4,298.70
A= $4,298.70(A/ F,7%,5)
= $747.55

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Comparison of Three Different

Investment Plans Example 3.16

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Solution:
Investor A:
Balance at the end of 10 years

F65 = $2,000(F / A,9.38%,10)(1.0938)(F / P,9.38%,31)

$33,845
= $545,216
Investor B:
F65 = $2,000( F / P,9.38%,31) (1.0938)

$322,159
= $352,377
Investor C:
F65 = $2, 000( F / P,9.38%, 41) (1.0938)

$820,620
= $897,594
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How Long Would It Take to Save $1

Million?

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Loan Cash Flows

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Capital Recovery Factor

P
i(1 + i)
A= P
N
(1 + i) 1
= P( A / P, i, N )
N
A=?
Example: Paying Off an Educational Loan

Given: P = $21,061.82, N = 5 years, and i = 6%
Find: A
Solution: A = $21,061.82(A/P,6%,5) = $5,000
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Example 3.17 Loan Repayment

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Solution:
Using Interest Factor:

A = $250,000( A/ P,8%,6)
= $250,000(0.2163)
= $54,075
Using Excel:
= PMT(i, N, P)
= PMT(8%,6, 250000)
= $54,075
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Example 3.18 Deferred Loan

Repayment

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A Two-Step Procedure
P ' = $250, 000( F / P,8%,1)

= $270, 000
A ' = $270, 000( A / P,8%, 6)
= $58, 401
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Present Worth factor Find P, Given A,

i, and N
(1+i) 1
P= A
N
i(1+i)
= A(P/ A,i, N)
N
P=?

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Example 3.19 Louise Outings Lottery

Problem
Given:
A = $280,000
i = 8%
N = 19
Find: P
Using interest factor:
P =$280,000(P/A,8%,19)
= $2,689,008
Using Excel:
=PV(8%,19,-280000)
= $2,689,008
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Interest Formulas
(Gradient Series)
Lecture No.8
Chapter 3
Copyright 2006
Linear Gradient Series
L
i(1+ i) iN 1O
P = GM
P
N i (1+i) Q
N
= G(P / G, i, N)
Gradient Series as a Composite Series of a Uniform

Series of N Payments of A1 and the Gradient Series of
Increments of Constant Amount G.
Example Present value calculation for a

$2,000
gradient series
$1,000
$1,250 $1,500
$1,750
0
1
P =?
How much do you have to deposit

now in a savings account that
earns a 12% annual interest, if
you want to withdraw the annual
series as shown in the figure?
Method 1: Using the (P/F, i, N) Factor

$2,000
$1,000
$1,250 $1,500
$1,750
0
1
P =?
$1,000(P/F, 12%, 1) = $892.86

$1,250(P/F, 12%, 2) = $996.49
$1,500(P/F, 12%, 3) = $1,067.67
$1,750(P/F, 12%, 4) = $1,112.16
$2,000(P/F, 12%, 5) = $1,134.85
$5,204.03
Method 2: Using the Gradient Factor

P1 = $1,000(P / A,12%,5)
.
= $3,60480
P2 = $250(P / G,12%,5)
P = $3,604.08 + $1,59920
.
= $5,204
= $1,599.20
Gradient-to-Equal-Payment Series
Conversion Factor, (A/G, i, N)
Example 3.21 Find the Equivalent

Uniform Deposit Plan
Solution:
Given: A1 =$1,000,G=$300,i =10%,and, N =6

Find: A
A=$1,000+$300(A/ G,10%,6)
=$1,000+$300(2.22236)
=$1,667.08
Example 3.22 Declining Linear Gradient

Series
Solution:
F = F1 F2
Equivalent Present Worth at n = 0

= A1(F / A,10%,5) $200(P/ G,10%,5) (F / P,10%,5)
=$1,200(6.105) $200(6.862)(1.611)
=$5,115
Types of Geometric Gradient

Series
g > 0
Present Worth Factor
R|A L1(1+g) (1+i) O, if i g

P
P = S MN
i g
Q
|TNA /(1+i),
if i = g
N
Example 3.23 Annual Power Cost if

Repair is Not Performed
Solution Adopt the new compressed-air

system
1 (1 + 0.07)5 (1 + 0.12)5
POld = $54, 440
0.12 0.07
= $222, 283
PNew = $54, 440(1 0.23)( P / A,12%,5)
= $41,918.80(3.6048)
= $151,109
Example 3.24 Jimmy Carpenters

Retirement Plan Save $1 Million
What Should be the Size of his first

Deposit (A1)?
1 (1 + 0.06) (1 + 0.08)
= A1
0.08 0.06
= A1 (72.6911)
20
F20
= $1, 000, 000

$1, 000, 000
A1 =
72.6911
= $13, 757
20
Unconventional Equivalence
Calculations
Lecture No. 9
Chapter 3
Copyright 2006
Equivalent Present Worth Calculation Brute

Force Approach using Only P/F Factors
Equivalent Present Worth Calculation

Grouping Approach
$200
$150 $150 $150 $150
$100 $100 $100
$50
0
1
PG r o u p
= $ 5 0 ( P / F ,1 5 % ,1)
= $ 4 3 .4 8
PG r o u p
= $ 1 0 0 ( P / A ,1 5 % , 3 )( P / F ,1 5 % ,1)
= $ 1 9 8 .5 4
PG r o u p
= $ 1 5 0 ( P / A ,1 5 % , 4 )( P / F ,1 5 % , 4 )
= $ 2 4 4 .8 5
PG r o u p
= $ 2 0 0 ( P / F ,1 5 % , 9 )
= $ 5 6 .8 5
P = $ 4 3 .4 8 + $ 1 9 8 .5 4 + $ 2 4 4 .8 5 + $ 5 6 .8 5
= $ 5 4 3 .7 2
Unconventional Equivalence Calculations A

Personal Savings Problem
Situation 1: If you make
4 annual deposits of
$100 in your savings
account which earns a
10% annual interest,
what equal annual
amount (A) can be
withdrawn over 4
subsequent years?
Unconventional Equivalence Calculations

An Economic Equivalence Problem
Situation 2:
What value of A
would make the two
cash flow
transactions
equivalent if i =
10%?
Method 1: Establish the Economic

Equivalence at n = 0
Method 2: Establish the Economic

Multiple Interest Rates

F=?
Find the balance at the end of year 5.

6%
6%
5%
4%
4%
0
1
$400
$300
$500
Solution
n = 1:
$300( F / P , 5% ,1) = $315
n = 2:
$315( F / P , 6% ,1) + $500 = $833.90
n = 3:
$833.90( F / P , 6% ,1) = $883.93
n = 4:
$883.93( F / P , 4% ,1) + $400 = $1, 319.29
n = 5:
$1, 319.29( F / P , 4% ,1) = $1, 372.06
Cash Flows with Missing Payments

P=?
9 10
11 12 13
14 15
0
$100
i = 10%
Missing payment
Solution
P=?
$100
9 10
Add $100 to
offset the change
11 12 13
14 15
0
$100
i = 10%
Pretend that we have the 10th

Payment in the amount of $100
Approach
P=?
$100
9 10
11 12 13
0
$100
i = 10%
Equivalent Cash Inflow = Equivalent Cash Outflow
14 15
Equivalence Relationship
P+$100(P/ F,10%,10) = $100(P/ A,10%,15)

P+$38.55 = $760.61
P = $722.05
Unconventional Regularity in Cash Flow

Pattern
$10,000
i = 10%
1
10 11 12 13 14
0
C
Payments are made every other year
Approach 1: Modify the Original Cash

Flows
$10,000
i = 10%
1
10 11 12 13 14
A = $10, 000( A / P ,10%,14)

= $1, 357.46
Relationship Between A and C

$10,000
i = 10%
1
10 11 12 13 14
0
C
$10,000
i = 10%
1
10 11 12 13 14
Solution
i = 10%
A =$1,357.46
A = $10,000( A/ P,10%,14)
= $1,357.46
C = A(F / P,10%,1) + A
=1.1A+ A
= 2.1A
= 2.1($1,357.46)
= $2,850.67
Approach 2: Modify the Interest Rate
Idea: Since cash flows occur every other

year, let's find out the equivalent compound
interest rate that covers the two-year period.
How: If interest is compounded 10%
annually, the equivalent interest rate for twoyear period is 21%.
(1+0.10)(1+0.10) = 1.21
Solution
$10,000
i = 21%
1
1
2
3
3
5
4
7
5
9
10 11 12 13 14
0
C
C = $10,000( A / P,21%,7)
= $2,850.67
Example 3.25 At What Value of C would

Make the Two Cash Flows Equivalent?
V1 = $100(F / A,12%,2) +$300(P/ A,12%,3) = $932.55

V2 = C(F / A,12%,2) +C(P/ A,12%,2)(P/ F,12%,1) = 3.6290C
3.6290C = $932.55
C = $256.97
Example 3.26 Establishing a College

Fund
Solution: Establish the Economic

Example 3.27 Calculating an Unknown

Interest Rate with Multiple Factors
Establish an economic Equivalence at n =7
Linear Interpolation to Find an Unknown

Interest Rate
Linear Interpolation
( F / A, i, 7 )
=1
( P / A , i ,1 3)
6%
( F / A, i, 7 )
( P / A , i ,1 3)
0 .9 4 8 2
?
7%
1 .0 0 0 0
1 .0 3 5 5
1 0 .9 4 8 2
i = 6 % + (7 % 6 % )
1 .0 3 5 5 0 .9 4 8 2
= 6 .5 9 3 4 %
Using the Goal Seek Function to Find the

Unknown Interest rate

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Time Value of Money

Time Value of Money

Money has a time value

This a two-edged sword whereby earning

Contemporary Engineering Economics, 4th

The Interest Rate

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

$100(1+ 0.10)10 = $100(2.59) = $259

$200(1+ 0.10)8 = $200(2.14) = $429

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

Economic equivalence exists between cash

Contemporary Engineering Economics, 4th

Equivalence from Personal Financing

If you deposit P dollars

Contemporary Engineering Economics, 4th

Alternate Way of Defining Equivalence

F dollars at the end of

Contemporary Engineering Economics, 4th

Interest Formulas for Single

Types of Common Cash Flows in Engineering

Contemporary Engineering Economics, 4th

Equivalence Relationship Between P and

Contemporary Engineering Economics, 4th

Single Cash Flow Formula- Compound-Amount

If you had $2,000 now and invested it at

Single Cash Flow Formula PresentWorth Factor

P = $1, 000 (1 + 0 .12 )

= $1, 000 ( P / F ,12% ,5 )

You want to set aside a lump sum amount

Contemporary Engineering Economics, 4th

P = $10, 000(1 + 0.07) 6

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

Rule of 72 Number of Years Required

Contemporary Engineering Economics, 4th

Solution Analytical Approach

Contemporary Engineering Economics, 4th

Contemporary Engineering Economics, 4th

Number of Years Required to Double an Initial

Contemporary Engineering Economics, 4th

Uneven Payment Series

How much do you need

Contemporary Engineering Economics, 4th

P2 = $3, 000( P / F ,10%, 2)

P4 = $5, 000( P / F ,10%, 4)

Interest Formulas Equal

Equal Payment Series

Contemporary Engineering Economics, 4th

Equal Payment Series Compound Amount

Process of Finding the Equivalent Future

Contemporary Engineering Economics, 4th

Another Way to Look at the Compound

Contemporary Engineering Economics, 4th

Equal Payment Series Compound Amount

$5,000(1+ 0.06)3 = $5,955.08

$5,000(1+ 0.06)1 = $5,300.00

$5,000 $5,000 $5,000 $5,000 $5,000

Contemporary Engineering Economics, 4th

Finding an Annuity Value

Handling Time Shifts in a Uniform Series