GE161Fall2011

Printed:10/4/2011
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Time Value of Money - 1
Basic Principles and Formulas
2
Examples
Matsushita and Toray (Japan) will invest 180 billion yen ($1.46
billion) to build a plasma display panel (PDP) plant, increasing
production by 6 million panels/yr.
Cargill (USA) announced a $20 million investment to increase
capacity of liquid chocolate and a production line for chocolate
flakes, drops and chunks in Mouscron, Belgium.
Good decisions???
GE161Fall2011
Printed:10/4/2011
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Time Value
Easy decisions if value of money over time = constant
(Interest rate = 0)
Interest > 0 typically
Interest : Accumulation of value (paid or accrued) as a
percentage of the principal at the end of a time period
Where does interest come from??
4
Interest
Contractual agreement between parties
Simple interest paid on the principal only
Compound interest accumulation interest, as the
interest is added to principal, forming an exponential
relationship
Einstein the most powerful force in the universe is
compound interest.
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Cash Flow diagrams
Cash receipts or disbursements
(Cash in or cash out)
At a specific time
From a specific standpoint
Receipt: positive
Disbursement: negative
Time line
Arrows = Cash flows
Up: Receipts
Down: Disbursements
8
Time
time
period
6
Cash Flow Diagram Example
Receiving a loan
Making a loan
Savings and withdrawal
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Cash Flow Terms
P = Present sum of money (relative)
F = Future sum of money (relative)
A = a uniform series of sums of money at the end of a time
period
i = interest rate per period
n = number of periods
Convention With the exception of P all cash flows are
made at the end of a time period
8
Simple Interest
Interest is paid on the principal only
No interest is paid on previously unpaid interest
Example: You borrow $1000 at 10% simple annual interest and pay
back a lump sum after 5 years. What is your lump-sum payment?
P =1000
F =??
5
| |
| |
( )( )( ) 1 ( )( )
1000 1 (0.5)(5)
1500
F P P i n P i n
F
F
= + = +
= + +
=
Total interest paid = F P = 1500 1000 = 500
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MARR
Engineering alternatives are evaluated based on a reasonable
rate of return (ROR).
The minimum ROR acceptable ROR is referred to as the
minimum acceptable rate of return (MARR)
The MARR is higher than the interest that must be paid to borrow
the money.
ROR MARR CostofCapital > >
10
Equivalence
Sums of money or Cash Flows at different times which
have equal economic value
Cash flow
Time
Interest rate
Example: At 10% interest annual interest,
$100 today = $110 in one year = $121 in two years
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Equivalence Formulas
Single-payment compound-amount factor
(1 ) F P i = +
1 P
F=?
One Year
(1 )(1 ) F P i i = + +
2 P
F=?
Two Years
n
P
F=?
n Years
(1 )(1 )...(1 )
(1 )
n
F P i i i
F P i
= + + +
= +
F=P(F/P,i,n)
(F/P,i,n)= f(i,n)
Single-payment compound-amount factor
12
Example
Put $100 in the bank for 8 years at 10% per year,
interest compounded annually. What is it worth in 8
years?
P=100
F=??
8
Equivalence Formulas
Single-payment compound-amount factor
8
(1 )
100(1 0.1)
100(2.1436) 214.36
n
F P i
F
F
= +
= +
= =
F=100(F/P,i,n)
F=100(F/P,0.1,8)
F=100(2.1436) = 214.36
Compound Interest Factor
Page 174 in Text
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Printed:10/4/2011
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14
Equivalence Formulas
Single-payment present-worth factor
n
P=?
F n Years
(1 )
1
(1 )
n
n
F P i
P F
i
= +
(
=
(
+

Solve for P
P=F(P/F,i,n)
(P/F,i,n) = f(i,n)
Single-payment present-worth factor
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Equivalence Formulas
Single-payment present-worth factor
5
P=?
F=100
5
1
(1 )
1
100
(1 0.1)
100(.6209)
62.09
n
P F
i
P
P
P
(
=
(
+

(
=
(
+

=
=
P= F(P/F,0.1,5)
P= 100(.6209)
P= 62.09
Example: What is the present value of a future payment of $100 five
years from today, if the interest rate is 10% compounded annually?
Compound Interest Factor
Page 174 in Text
16
Equivalence Formulas
Uniform-series compound-amount factor
n
F=??
1 2
1
(1 ) (1 ) ... (1 )
(1 ) (1 ) (1 ) ... (1 )
(1 ) (1 ) 1
(1 ) 1
n n
n n
n n
n
F A i A i A i A
F i A i A i A i
Fi A i A A i
i
F A
i

= + + + + + + +
+ = + + + + + +
( = + = +

( +
=
(

A is given
0
Treat each cash flow A as a
single cash flow P and
find the future value for each
using
(1 )
n
F P i = +
Multiply both sides by (1+i)
(1)
(2)
Subtract equation (1) from (2)
F= A(F/A,i,n)
(F/A,i,n) = f(i,n)
Uniform-series
compound-amount factor
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Example: What is the future value of 5 end-of-period payments of
$100 each, at the end of the 5
th
period at 10% per period?
Equivalence Formulas
Uniform-series compound-amount factor
n
F=??
F= A(F/A,0.1,5)
F= 100(6.1051)
F= 610.51
A is given
0
5
(1 ) 1
(1 0.1) 1
100
0.1
100(6.1051)
610.51
n
i
F A
i
F
F
F
( +
=
(

( +
=
(

=
=
Compound Interest Factor
Page 174 in Text
18
Equivalence Formulas
Sinking-fund deposit factor
(1 ) 1
(1 ) 1
n
n
i
F A
i
i
A F
i
( +
=
(

(
=
(
+

Solve for A
A= F(A/F,i,n)
(A/F,i,n) = f(i,n)
Sinking-fund deposit factor
n
F is given
A =??
0
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Equivalence Formulas
Sinking-fund deposit factor
8
(1 ) 1
0.1
1000
(1 0.1) 1
1000(0.08744)
87.44
n
i
A F
i
A
A
A
(
=
(
+

(
=
(
+

=
=
Example: What amount must be deposited annually for 8 years to
yield $1000 when withdrawn in 8 years, with 10% interest
compounded annually?
A= F(A/F,0.1,8)
A= 1000(0.08744)
A= 87.44
Compound Interest Factor
Page 174 in Text
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F =1000
A =??
0
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Equivalence Formulas
Capital-recovery factor
n
P is given
A =??
(1 ) 1
(1 )
(1 )
(1 ) 1
n
n
n
n
i
A F
i
F P i
i i
A P
i
(
=
(
+

= +
( +
=
(
+

Knowing that
and
Substituting for F..
A= P(A/P,i,n)
(A/P,i,n) = f(i,n)
Capital-recovery factor
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Example: What is the required annual revenue amount needed for five
years, to equal an initial investment of $1000 if the interest rate is
10% per year compounded annually?
Equivalence Formulas
Capital-recovery factor
5
P = 1000
A =??
5
5
(1 )
(1 ) 1
0.1(1 0.1)
1000
(1 0.1) 1
1000(0.26380)
263.80
n
n
i i
A P
i
A
A
A
( +
=
(
+

( +
=
(
+

=
=
A= P(A/P,0.1,5)
A= 1000(0.26380)
A= 263.80
Compound Interest Factor
Page 174 in Text
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Equivalence Formulas
Uniform-series present-worth factor
n
P =??
A is given
P= A(P/A,i,n)
(P/A,i,n) = f(i,n)
Uniform-series present-worth factor
(1 )
(1 ) 1
(1 ) 1
(1 )
n
n
n
n
i i
A P
i
i
P A
i i
( +
=
(
+

( +
=
(
+

Solve for P
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Example: You can afford to make loan payments of $1000/year for 5
years. How much money can you borrow now at an interest rate of
10% per year?
5
P = ??
A =1000
5
5
(1 ) 1
(1 )
(1 0.1) 1
1000
0.1(1 0.1)
1000(3.7908)
3790.80
n
n
i
P A
i i
P
P
P
( +
=
(
+

( +
=
(
+

=
=
P= P(P/A,0.1,5)
P= 1000(3.7908)
P= 3790.80
Compound Interest Factor
Page 174 in Text
Equivalence Formulas
Uniform-series present-worth factor
24 Sample Problems
Simple vs. Compound Interest
You borrow $5000 at 6% per year
simple interest and repay in a
lump sum after 10 years. What is
your payment?
| |
| |
1 ( )( )
5000 1 (.06)(10)
5000(1.6)
8000.00
F P i n
F
F
F
= +
= +
=
=
You borrow $5000 at 6% per year
compound interest and repay in a lump
sum after 10 years. What is your
payment?
F = P(F/P,i,n)
F = 5000(F/P,0.06,10)
F = 5000(1.7908)
F = 8954.00
5
P = 5000
F =??
10
GE161Fall2011
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To build a new manufacturing facility you must pay the architectural
fee of $70,000 in one year, the building contractor installment of
$1,400,000 in 2 years, and the final contractor payment of
$2,600,000 in three years. What is the present cost of these future
payments at an annual interest rate of 7%?
Sample Problems
Multiple Cash Flows
3
P = ??
70K
1,400K
2,600K
P = 70,000(P/F,.07,1) + 1,400,000(P/F,.07,2) + 2,600,000(P/F,.07,3)
P = 70,000(0.9346) + 1,400,000(0.8734) + 2,600,000(.8163)
P = $ 3,410,562
26 Sample Problems
Finding a Factor Value
How long will it take to at least triple your money if the rate or return
is 15% per year compounded annually?
P
F = 3P
n = ?
i = 15%
Find n in table
n = 8 years
( / , , )
3 ( / , 0.15, )
( / , 0.15, ) 3
F P F P i n
P P F P n
F P n
s
s
>
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Shifted Cash Flows
10
P=??
A =100
1 4
i =10%
1. Find equivalent [P] at yr. 3
2. Find equivalent P at yr. 1
from [F] at year 3
[P]
[F]
Example: What is the present value of seven annual end of period
payments of $100 which begin in 4 years at 10% interest?
| |
| |
| |
( / , , )
100( / , 0.1, 7)
( / , 0.1, 3)
100( / , 0.1, 7)( / , 0.1, 3)
100(4.8684)(0.7513)
365.76
P A P A i n
P P A
P F P F
P P A P F
P
P
=
=
=
=
=
=