ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 2 TIME VALUE OF MONEY

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 2.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, McGraw Hill, 2005, Chapters
2,3,4.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapters 2, 3.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 3, 4.

2.1 Interest and time value of money

Case 1: Manhattan Island purchase (1626, Peter Minuit, Dutch West India Company)
Year Value of $24 investment compounded at 6% per year
1626 $24.00
1676 $442.00
1726 $8,143.25
1776 $149,999.92
1826 $2,763,021.69
1876 $50,895,285.85
1926 937,499,017.25
1976 $17,268,876,530.40
1996 $55,383,626,485.92

a. Simple interest
F=P+PiN=P(1+iN)
F= future sum of money
P= present amount or principal
i= interest rate per period
N= number of interest periods (usually years)

b. Compound interest rates

N
FN=P(1+i)

c. Effective interest rates

r
ieff  (1  )m  1 r= nominal interesting rate
m

d. Continuous compounding
r
i  lim (1  )m  1  r  1
m  m

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2.2 Time-value equivalence

If a mount of money is used as a capital for an investment, its value will grow up along the
time according to an agreed (or contracted) interest rate. If ignoring the inflation, a capital
will equal to its present value to plus its time value (or interest) in the end of the investment.
In a reverse way, we can also discount a capital in the end of the investment term back to its
present worth by reducing its added time-values. To discount a capital or a cash flow from
its value in the end of an investment term back to its present worth is the economic concept
called time-value equivalence.

a. Simple capital
Case 2: By 10% compound interest rate, what is the P (principal) for $1000 in two years?
$1000
Solution: P=  $826.45
(1  0.10)2
Hence: $826.45 equals $1000 in two years by 10% interest rate.

b. Instalments
Case 3: If we assume 10% compound interest rate, to pay for a goods in two years by $500
instalment per year, what is the cash price for the goods now?
Solution: Year 1: 500/(1.10)=$455,
Year 2: 455  500 /(1.01) 2  $868
The present cash price is $868, or $868 equals two $500 annual instalments.

c. Cash flow
 Cash flow diagrams
The net cash flow of receipts and payments over time can be represented by a cash
flow diagram. Net receipts are indicated by an upward arrow, net payments by a
downward arrow. The height of the arrow is proportional to net amount received or
paid. Arrow is placed on time scale at END of period. The amounts are net amounts
which are obtained by totalling up the receipts and payments during any period.
Money

$1000 Positive or benefit

$500 $500
$200

0 Time
1 2 3 4 5 6 7 9

-$200 -$200 Negative or cost

-$500
-$700

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Figure 2.1 A cash flow diagram.

Case 4: If a fixed 6% compound interest is agreed on a $1000 loan and you have the
following three different plans to return the principle and interest, what are the
relevant payments?
1) Return the principle and interest in the end of 10 years.
2) Return the principle and interest by the equal annual amount (or annuity)
within the next 5 years.
3) Return the principle and interest by the annuity within 5 years but start to pay
at the end of year 6.
Solution:
1) F=$1000(1+6%)10=$1791
1000(1.06)5 1338
2) A    237.4
1  1.06  1.062  1.063  1.064 5.6371
1000(1.06)10 1791
3) A  2 3 4
  317.7
1  1.06  1.06  1.06  1.06 5.6371
Hence:
$1000 equals $1791 in the end of year 10, $237.4 in the end of each of the next 5
years, or $317.7 in the end of years 6, 7, 8, 9 and 10.

2.3 Compound-interest factors

a. Notations and data tables
N
 Compound interest: FN=P(1+i) can be written as (F/P, i, N)
N
 The ratio (or compound-amount factor under single payment) (1+i) can be found
according to i and N from tables in Appendix C for Steiner (1996) or D for Riggs et
al. (1997).

b. Present-worth factor (single payment)

1 1
P  FN [ ] then (P/F, i, N)=
(1  i ) N (1  i) N

c. Sinking fund factor (uniform series)

A fund established to accumulate a given future amount through the collection of a
uniform series of payments is called a sinking fund.
i i
A  FN [ N
] then (A/F, i, N)=
(1  i )  1 (1  i ) N  1

d. Series compound-amount factor (uniform series)

(1  i ) N  1 (1  i ) N  1
FN  A[ ] then (F/A, i, N)=
i i

e. Capita recovery factor (uniform series)

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Case 5: If we borrow $3993 from a bank by 8% fixed compound interest rate and we are
going to return the principle and interest within 5 years. What is the annuity (or
annual mortgage)?
Solution:
Let P=$3993, i=8%, A= annuity
Year annuity (A) Return to the principle
1 A A-Pi
2 A (A-Pi)(1+i)
3 A (A-Pi)(1+i)2
4 A (A-Pi)(1+i)3
5 A (A-Pi)(1+i)4
(A-Pi)[1+(1+i)+(1+i)2+(1+i)3+(1+i)4]=P (1)
Multiply both sides of Eq. (1) by (1+i) to get
(A-Pi)[(1+i)+(1+i)2+(1+i)3+(1+i)4+(1+i)5]=P(1+i) (2)
Eq. (2) - Eq. (1),
(A-Pi)[(1+i) 5-1]=Pi (3)
5 N
i (1  i ) i (1  i )
Hence A  P[ ] or A  P[ ]
5
(1  i )  1 (1  i ) N  1
i (1  i ) N
then (A/P, i , N)=
(1  i ) N  1
A=$1000.

f. Series present-worth factor (uniform series)

(1  i ) N  1 (1  i ) N  1
P  A[ ] then (P/A, i, N)=
i (1  i ) N i (1  i ) N

g. Arithmetic gradient uniform series (to uniform series)

1 N
By given G, to find A, A= G[  ]  G ( A / G, i, N )
i (1  i) N  1
h. Arithmetic gradient present worth
(1  i) N  iN  1
By given G, to find P, P= G[ ]  G ( P / G, i, N )
i 2 (1  i) N
Case 6: A loan of $1000 is made today under an agreement that $1400 will be received in
payment sometime in the future. When should the $1400 be received if the loan is to
earn interest at a rate (or nominal rate) of 8 percent compounded quarterly?
Solution:
0.08 4
P=$1000, FN=$1400, ieff  (1  )  1  0.082 , N=?
4

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1400
(1400)/(1000)=  ( F / P,8.2%, N )  (1  0.082) N
1000
Ln1.4
N  4.27 years
Ln1.082

Case 7: A numerically controlled milling machine that can be purchased for $8065 is
estimated to reduce production costs annually by $2020. The machine will operate
for 5 years, at which time it will have no resale value. What rate of return will be
earned on the investment? (Alternative statement of the problem: At what interest
rate will a cash flow of $2020 per year for 5 years equal a present value of $8065?)
Solution:
P $8065
  3.993  ( P / A, i,5) , Hence i=8%.
A $2020

Case 8: If you borrowed $60,000 from a bank on a fixed compound interest rate 9.4% and
you would like to pay all the debt within 6 years, what is your monthly mortgage?
Solution:
P=$60,000, N=126=72 months, i  12 1  0.094  1  0.0075  0.75%
A=(A/P,i,N)P=(A/P,0.75,72) $60,000=0.0180$60,000=$1080.
Your monthly mortgage is $1080.

Case 9: If you save $1000 from the end of year 1, and then increase this amount by $200 for
each of the following 5 years. How much would be equivalent if you decide to save
the same amount each year for the next 6 years? How much in total you will receive
in the end of year 6? Assume you have a very good annual interest rate of 8%.
Solution:
A=1000+200(A/G,8%,6)=1000+200X2.2763=$1455.26
F=A(F/A,8%,6)= 1455.26X7.3359=$10,675.64.

2.4 Tutorial questions

a. Problem 1
If your willingness to give up present consumption in order to have more future
consumption is measured by an interest rate of 15 percent and you have $8000 in
total at this moment, what would be an equivalent amount in the end of 3 years?

b. Problem 2
Draw a cash diagram to show an amount at year 0 of $1500 at the next 5 years with
interest at 8 percent.

c. Problem 3
1) If you deposit $20,000 in a bank account which pays 6 percent interest
compounded annually, how much will be in the account after 8 years if you
make no withdraws?
2) What is the present worth of $100,000 which you will receive at the end of 12

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years if your personal minimum attractive rate of return is 14 percent?

3) A used car which costs you $1,500. The dealer will accept five payments at
the end of each of 5 years. He postulates an interest rate of 15 percent. How
much will you need to pay him in five equal payments? Interest will be
computed on the declining capital balance.
4) You will receive an annuity of $80,000 each year for the next 20 years. For
how much would you be willing to sell the right to this annuity if you believe
that your marginal attractive rate of return is 20 percent annually?

d. Problem 4
A drill press for a small machine shop has a first cost of $2,000, a prospective life of
20 years, and no salvage value. If the opportunity cost of capital for this shop is 20
percent before income taxes, what is the annual capital cost of the drill press?

e. Problem 5
A used car you are considering buying is offered for sale for $6,800. The bank will
lend you $5,700 on the car at 15 percent nominal interest, compounded monthly, for
36 months. The bank manager tells you that the payments will be $276.03 per
month, but he seems unsure of his figures. Is the bank manager correct in his
estimate of your monthly payments? If not, what is the correct figure?

Answers to tutorial questions

Problem 1: $12,167.
Problem 2:
$1500(1.08)5
$1500(1.08)4
$1500(1.08)3
$1500(1.08)2

$1500(1.08)
$1500

0 1 2 3 4 5
Problem 3: 1) $31,876; 2) $20,760; 3) $447.48; 4) 389,600
Problem 4: $410.8.
Problem 5: A=$197.79 per month.

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