Time Value of Money

Chapter 2 Time Value of Money

Interest: The Cost of Money Economic Equivalence Interest Formulas Single Cash Flows Equal-Payment Series Dealing with Gradient Series Composite Cash Flows.

Power-Ball Lottery

Decision DilemmaTake a Lump Sum or Annual Installments

A suburban Chicago couple won the Power-ball. They had to choose between a single lump sum $104 million, or $198 million paid out over 25 years (or $7.92 million per year). The winning couple opted for the lump sum. Did they make the right choice? What basis do we make such an economic comparison?

Option A (Lump Sum) 0 1 2 3 25 $104 M

Option B (Installment Plan)

$7.92 M $7.92 M $7.92 M

$7.92 M

What Do We Need to Know?

To make such comparisons (the lottery decision problem), we must be able to compare the value of money at different point in time. To do this, we need to develop a method for reducing a sequence of benefits and costs to a single point in time. Then, we will make our comparisons on that basis.

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

Delaying Consumption

Account Value

Cost of Refrigerator

Case 1: Inflation exceeds earning power Case 2: Earning power exceeds inflation

N = 0 $100 N = 1 $106 N = 0 $100 N = 1 $106

N = 0 $100 N = 1 $108 N = 0 $100 N = 1 $104

(earning rate =6%) (inflation rate = 8%)

(earning rate =6%) (inflation rate = 4%)

Key terms

Principal (P) Interest rate (i) Interest period (n) Number of interest periods (N) A plan for receipt (An) Future amount of money (F)

Which Repayment Plan?

End of Year Receipts Payments Plan 1 $200.00 5,141.85 5,141.85 5,141.85 5,141.85 5,141.85 Plan 2 $200.00 0 0 0 0 30,772.48

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

$20,000.00

The amount of loan = $20,000, origination fee = $200, interest rate = 9% APR (annual percentage rate)

Cash Flow Diagram

End-of-Period Convention

Beginning of Interest period

End of interest period

Methods of Calculating Interest

Simple interest: the practice of charging an interest rate only to an initial sum (principal amount). Compound interest: the practice of charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn.

Simple Interest

P = Principal amount End of i = Interest rate Year N = Number of interest periods 0 Example:

Beginnin g Balance

Interest earned

Ending Balance

$1,000
$1,000 $1,080 $1,160 $80 $80 $80 $1,080 $1,160 $1,240

P = $1,000 i = 8% N = 3 years

1 2 3

Simple Interest Formula

F P (iP) N where P = Principal amount i = simple interest rate N = number of interest periods F = total amount accumulated at the end of period N
F $1, 000 (0.08)($1, 000)(3) $1, 240

Compound Interest

Compound interest: the practice of charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn.

Compound Interest

P = Principal amount End i = Interest rate of N = Number of Year interest periods 0 Example:

Beginning Balance

Interest earned

Ending Balance

$1,000
$1,000 $1,080 $1,166.40 $80 $86.40 $93.31 $1,080 $1,166.40 $1,259.71

P = $1,000 i = 8% N = 3 years

1 2 3

Compounding Process
$1,080

0 1
$1,000

$1,166.40

$1,259.71

2 3 $1,080

$1,166.40

$1,259.71

2 3

F $1, 000(1 0.08)3

$1,000

$1, 259.71

Compound Interest Formula

n 0: P n 1: F1 P(1 i ) n 2 : F2 F1 (1 i ) P(1 i ) n N : F P(1 i )
N 2

Some Fundamental Laws

F V E m i R m a c
2

The Fundamental Law of Engineering Economy

F P(1 i )

Compound Interest

The greatest mathematical discovery of all time, Albert Einstein

Practice Problem: Warren Buffetts Berkshire Hathaway

Went public in 1965: $18 per share Worth today (August 22, 2003): $76,200 Annual compound growth: 24.58% Current market value: $100.36 Billion If he lives till 100 (current age: 73 years as of 2003), his companys total market value will be ?

Market Value

Assume that the companys stock will continue to appreciate at an annual rate of 24.58% for the next 27 years.

F $100.36(1 0.2458) $37.902 trillions

27

EXCEL Template
In 1626 the Indians sold Manhattan Island to Peter Minuit Of the Dutch West Company for $24. If they saved just $1 from the proceeds in a bank account that paid 8% interest, how much would their descendents have now? As of Year 2003, the total US population would be close to 275 millions. If the total sum would be distributed equally among the population, how much would each person receive?

Excel Solution
P $1 i 8% N 377 years

FV(8%,377,0,1) = $3,988,006,142,690
$3,988, 006,142, 690 A 275, 000, 000 $14,502

Excel Worksheet
A 1 P 1 B C

2
3 4 5

i
N FV

8%
377

FV(8%,377,0,1) = $3,988,006,142,690

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?

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

Practice problem

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

3
$1,500

$1,210 0 1 2 $1,000 $1,000 $1,100 $1,000 $2,100 $2,310 -$1,210 $1,100 $1,210 + $1,500 $2,710 3 4

?
$1,500

$2,981

Solution
End of Period Beginning balance Deposit made Withdraw Ending balance

n=0
n=1

0
$1,000(1 + 0.10) =$1,100

$1,000
$1,000

0
0

$1,000
$2,100

n=2
n=3 n=4

$2,100(1 + 0.10) =$2,310

$1,100(1 + 0.10) =$1,210 $2,710(1 + 0.10) =$2,981

0
$1,500 0

$1,210
0 0

$1,100
$2,710 $2,981