Engineering Economics

Time Value of Money

Time Value of Money

Engineering decisions frequently involve tradeoffs among costs

and benefits occurring at different times
Typically, invest in project today to gain benefits in future
For example, if you borrow money on your credit card, you
have to pay (exorbitant) interest
i.e. it costs you extra to buy your Eminem album now,
rather than waiting until pay-day
Conversely, if you invest the same money now, you can
afford more than just the album at a future date
In engineering projects, the sums of money can be large,
so it makes a big difference how something is paid for

Time Value of Money (Contd)

qThe time value of money discusses economic methods

used to compare benefits and costs occurring at different
times
q The essence of the problem is therefore how do we
compare options when we consider the time value of
money?
qThe key to making these comparisons is the use of interest
rates.

Interest and Interest Rate

Why are there interest rates?

because the lender could have done something of value
with the money that you now have
so it costs them to lend you the money
interest is therefore the compensation that the borrower
pays to the lender for the loss of use of their money
q The value lost may be investments, new equipment, pleasure,
whatever
q Hence money has both a present worth and a future worth
or a dollar today is worth more than a dollar at a future time
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Present WorthFuture Worth

An amount of money today, P, can be related to a future

amount, F, by the interest amount I, or interest rate i:

F = P + I = P + Pi = P(1 + i)
i interest rate, P present
worth of F
F future worth of P, base
period interest period
Source: Engineering Economics, 5th edition, by Fraser Pearson

Example 2.1

Samuel bought a one-year guaranteed investment certificate

(GIC) for $5000 from a bank on 15 May 2002. The bank
was paying 10% on one year GICs at that time. On 15 May
2003, he will cash the GIC for.?

Interest Period

The dimension of an interest rate is currency/currency/time period.

For example: a 9% interest rate means that for every dollar lent,
0.09 dollars (or other unit of money) is paid in interest for each time
period.
q The value of the interest rate depends on the length of the time
period. Period over which interest calculated is interest period.

Compound Interest

If number of periods is greater than one, interest usually

compounded (at the end of each period, interest is added to
principal that there was at the beginning of that period).
Example 2.2: If you were to lend $100 to your friend for three years
at 10% per year, how much would you get back?

Compound Interest Computation

F = P(1 + i)N

IC = F - P = P(1 + i)N - P

From the previous example: F=$133.1 and Ic = $100(1 + 0.1)3 - $100 = $33.10
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Compound InterestSimple Interest

q Simple Interest interest without compounding (interest is

not added to principal at end of each period). i.e.

IS = P i N
Linear

IC = P(1 + i)N - P
Exponential

Compound and simple interest amounts equal if N = 1!

As N increases, difference between accumulated interest
amounts for the two methods increases exponentially.
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Compound InterestSimple Interest

In 1993, a couple in Nevada presented

the government with a state bond
for $1000 with a demand that it be honored
The bond carried an annual interest of
24%
And was issued in 1865!
The compounded interest would be
$1000(1 + 0.24)128 = $9.07 x 1014
In contrast, simple interest would have
made the bond worth a mere
$31,720

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NominalEffective Interests Rates

Nominal Interest Rate: The standard method for expressing an annual

interest rate. e.g. a nominal interest rate of 18% per year, compounded
monthly, is the same as 18/12 = 1.5% per month
q Generally, the sub-period interest rate is can be given by is = r/m, where
r is the nominal rate and m is the number of sub-periods.
q Note that 18% compounded annually is not the same as 1.5% per
month compounded. The real interest rate cab be given as:
(1 + 0.015)12 = 1.196, so this gives ~20% real interest rate. This is known
as the effective interest rate

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Effective Interest Rate

q We know that F = P(1 + is)m

If we want the effective interest rate for the whole period then
P(1 + is)m = P(1 + ie)
q Giving
ie = (1 + is)m 1 = (1 + r/m)m 1
q So what, for example, is the annual rate of interest compounded
annually is equivalent of 1% per month, compounded monthly?
is = 0.01, m = 12, so
ie = (1 + 0.01)12 1 = 12.7%

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Example 2.6

vCardex Credit Card Co. charges a nominal 24 percent

interest on overdue accounts, compounded daily. What is
the effective interest rate?

The effective interest rate is 27.1%

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Continuous Compounding

Suppose that the nominal interest rate is 12% and interest is

compounded semi-annually.
We compute the effective interest rate as follows: where r = 0.12,
m=2
is = r/m = 0.12/2 = 0.06
ie = (1 + iS)m - 1 = (1 + 0.06)2 - 1 = .1236 (12.36%)
What if interest were compounded monthly?
ie = (1 + iS)m - 1 = (1 + 0.01)12 - 1 = 0.1268 (12.68%)
Daily? ie = 0.127475 or about 12.75%
More than daily? Continuous Compounding
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Continuous Compounding (Contd)

q The effective interest rate

under continuous
compounding is
m

' r$
ie = lim %1 + " 1 = e r 1
m
& m#
q The effective interest rate for a
nominal interest rate of 12%
under continuous compounding:
ie =

er

-1=

e0.12

- 1 = 0.12750 = 12.75%

Growth of $1 at 30% interest for various

compounding periods

Source: Engineering Economics, 5th edition, by Fraser Pearson

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Cash Flow Diagram

Cash flow diagram is a graphical summary of the timing and

magnitude of a set of cash flows. This displays graphically
the inflow and outflow of cash as a function of time period

Source: Engineering Economics, 5th edition, by Fraser Pearson

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Cash Flow Diagram (Contd)

Beginning and Ending of Periods:

Assumptions:
v Cash flows occur at the ends of periods.
v End of time period 1 = beginning of time period 2,
etc.
v Time 0 = now

Source: Engineering Economics, 5th edition, by Fraser Pearson

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Equivalence

q The purpose of all this future/present worth calculation is to allow a fair

comparison of the costs of various options
q Hence we need to establish an equivalence of values occurring at different
times

If we have a present worth Pt at 0me t

$106,000 in one year
and a future worth Ft + N at 0me t + N
then these are equivalent, with respect to the
interest rate, i, if Ft + N = Pt(1 + i)N
0
Interest rate = 6% per
Also, if Ft + N + M is equivalent to Pt 1
year
Then Ft + N + M = Pt(1 + i)N + M
$100,000 now
And Ft + N + M = Ft + N(1 + i)M

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Example 1.17 (Blank)

A father wants to deposit an unknown lump-sum amount into

an investment opportunity 2 years from now that is large
enough to withdraw $4000 per year for university tuition for
5 years starting 3 years from now. If the rate of return is
estimated to be 7% per year, construct the cash flow
diagram.

Source: Engineering Economy, 2nd edition, by Leland Blank. Copyright McGraw-Hill

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Example 1.20 (Blank)

An electrical engineer wants to deposit an amount P now such

that she can withdraw an equal annual amount of A1=
$2000 per year for the first five years starting 1 year after
the deposit, and a difference annual withdraw of A2=$3000
per year for the following 3 years. How would the cash flow
diagram appear if i=5% per year?

Source: Engineering Economy, 2nd edition, by Leland Blank. Copyright McGraw-Hill

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Review Problem 2.1

Atsushi has had $800 stashed under his matters for 30 years.
How much money has he lost by not putting it in a bank
account at 8% annual compound interest all these years?

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Review Problem 2.2

You want to buy a new computer, but you are $1000 short of the amount
you need. Your aunt has agreed to lend you the amount you need
provided you pay her $1200 two years from now. She compounds
interest monthly. Or you may go to a bank and get a loan. However, a
loan processing fee of $20 is applied, which will be included in the loan
amount. The bank is expecting $1220 two years from now on monthly
compounded interest.
(a) What monthly rate is your aunt charging for the loan? What is the bank
charging?
(b) What effective annual rate is your aunt/ bank charging?
(c) Which option is better for you?

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Readings and End of Chapter

Problems
Reading: Chapters 1 and 2 (Fraser) or Chapter 1 (Blank)
Chapter-End Problems (Fraser):
2.1, 2.4, 2.8, 2.10, 2.16, 2.22, 2.31, 2.37, 2.38, 2.40, 2.43
Green: Key concept Blue: Applications Red: Challenging
Problem #

2.1

2.4

2.8

2.10

2.16

2.22

2.31

Answer

120

10%

18.75
%

Draw

9.14%,
8.76%

14.06%,
13.98%,
13.98%

Draw

Problem #

2.37

2.38

2.40

Answer

$600 982

B2 $51 less 16.08%,

$58 038,
13.75%

2.43
0.1/12
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