Warm-Up Review

Time Value of Money

Calculation of Future Value
Calculation of Current Value
Simple interests and

compound interests
Continuous compounding

Basics of Time Value of Money

Interest rate

reward for use of capital$

usually expressed in % per year

Simple Interest (self-study)

Only the principal earns interest

Interest amount =P i n

Future value = P + P i n = P (1 + i n)

Basics of Time Value of Money

Compound Interest

Interest on interest
dependant on compounding period
(yearly, semi-annually, monthly)
For 2 years:
Future value = P ( 1+i) + i P (1+i) = P (1+ i)2

For n years:
Future value = P (1+ i)n
see column 2 of interest tables

What is Time Value?

We say that money has a time

value because that money can be

invested with the expectation of
earning a positive rate of return
In other words, a dollar received
today is worth more than a dollar
to be received tomorrow
That is because todays dollar can
be invested so that we have more
than one dollar tomorrow
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Compound Interest
Note from the example that the future value is
increasing at an increasing rate
In other words, the amount of interest earned each year
is increasing
Year 1: $10
Year 2: $11
Year 3: $12.10
The reason for the increase is that each year you are
earning interest on the interest that was earned in
previous years in addition to the interest on the original
principle amountchange

Interest Formulation
Simple Interest

Compound Interest

I (iP)N
F P I P(1 iN)

P(1 i) i[P(1 i)]

P(1 i)(1 i)
P(1 i) 2
After N periods, the total accumulated value F will grow to

F P(1 i) N

F
P
N
(1 i )

Continuous Compounding

There is no reason why we need to stop increasing the

compounding frequency at daily
We could compound every hour, minute, or second
We can also compound every instant (i.e.,
continuously):

Here, F is the future value, P is the present value, r is the

annual rate of interest, t is the total number of years, and e
is a constant
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Topics Today
Cash Flow Diagrams
Equivalent Issues
Engineer Decision

Cash Flow- expenses and receipts

Engineering projects generally have economic

consequences that occur over an extended period of
time
For example, if an expensive piece of machinery is
installed in a plant were brought on credit, the
simple process of paying for it may take several
years
Each project is described as cash receipts or expenses
at different points in time
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Categories of Cash Flows

The expenses and receipts due to engineering

projects usually fall into one of the following
categories:

First cost: expense to build or to buy and install

Operations and maintenance (O&M): annual expense,
such as electricity, labor, and minor repairs
Salvage value: receipt at project termination for sale or
transfer of the equipment (can be a salvage cost)
Revenues: annual receipts due to sale of products or
services
Overhaul: major capital expenditure that occurs during
the assets life
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Examples of Cash Inflows & Outflows

Receipts from customers--operating

activity
Loans made to other firms--investing
activity
Dividend payments--financing activity
Payments to investing activity
Payments of taxes--operating activity

Slide 14.8

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Types of Cash Flows

Single cash flow
Uniform series
Linear gradient series
Geometric gradient series
Irregular series

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Cash Flow Diagrams

The costs and benefits of engineering

projects over time are summarized on a

cash flow diagram.
Cash flow diagram illustrates the size,
sign, and timing of individual cash
flows, and forms the basis for
engineering economic analysis
Tool! To show expenses and receipts
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Cash Flow Diagrams

Pictorial representation of

engineering economic problem

incomes and expenditures
time period
interest rate

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Cash Flow diagrams--How

A cash flow diagram

is created by first
drawing a segmented time-based
horizontal line, divided into appropriate
time unit. Each time when there is a
cash flow, a vertical arrow is added
pointing down for costs and up for
revenues or benefits. The cost flows are
drawn to relative scale

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Cash Flow Diagrams

P-Pattern
F-Pattern
A-Pattern
G-Pattern

present
future
annual
gradient

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Cash Flow Diagrams

$15,000
$2000
$13,000 is net positive cash flow

Positive net Cash flow

(receipts)
1

Time (# of interest periods)

Negative net Cash Flow

(payments)

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Single Cash Flow

F
Compounding Process

P
Discounting Process

F P(1 i)

P=Present equivalent value

F
(1 i) N

A=Annual equivalent value

F= Future equivalent value

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Example: Value and Interest

The value of money depends on the amount

and when it is received or spent.

Example: What amount must be paid to settle a
current debt of $1000 in two years at an interest
rate of 8% ?
Solution: $1000 (1 + 0.08) (1 + 0.08) = $1166
$1000
1

2
$1166

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An Example of Cash Flow Diagram

Boney (right) borrowed

$1,000 from a bank at 8%

interest. Two end-of-year
payments: at the end of the
first year, he will repay half of
the $1000 principal plus the
interest that is due. At the end
of the second year, he will
repay the remaining half plus
the interest for the second
year.

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An Example of Cash Flow Diagram

Cash flow for this problem is:

End of year
0
1
2

Cash flow
+$1000
-$580 (-$500 - $80)
-$540 (-$500 - $40)

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Cash Flow Diagram

$1,000

Time (# of interest periods)

$580

$540

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Uneven Payment Series

Find the present worth of any uneven stream of
payments by calculating the present value of each
individual payment and summing the results
Future worth can then be calculated by using the
interest formula
P1
P0
0

P2

P5
P3

P4

P6

F
(1 i) N

Years

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Equal Payment Series

F
0

2
A

A
F A(1 i)

N 1

N-1

3
A

A(1 i)

N2

......A(1 i) A

F A A(1 i) A(1 i)2 ..... A(1 i) N 1

2
N
(1 i)F A(1 i) A(1 i) .... A(1 i)
Subtracting two above equations from each other yields:

F(1 i) F - A A(1 i)

N
(1 i) 1

FA

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Linear Gradient Series

(N-1)G

A1

2G
G

Uniform Series

0
1

N-1

(1 i) N iN 1
P G
i 2 (1 i) N

Composite Series: uniform series + linear gradient

Find P, given A1, G, I, N
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Geometric Gradient Series

Particularly relevant to construction costs
Cash flows increase by a constant %(g); compound growth
Example: price changes due to inflation
A1(1+g)N-1
A1

A1(1+g)

2 3
g>0

Pn A n (1 i) n A 1 (1 g) n 1 (1 i) n
(1 g) n 1
P A1
n 1
(1 i) n
N

0
1

Present Worth, Pn, of any Cash Flow An

N-1 N

PA
1
Find P, given A1, g, i, N

If i=g, then P=?

1(1g)N (1i)N
....i g
i g

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Principal Uses of A Statement of Cash Flows

Evaluate a businesss ability to produce positive

cash flows in the future.
Determine whether a company can satisfy its
financial obligations.
Identify sources of differences between a
businesss net income and its related (net) cash
flow from revenue and expense transactions.
Analyze the impact on a businesss financial
condition of its major investing and financing
transactions.

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Cash-Flow Data Can Be Used to Address

Will a company generate
sufficient cash to retire a longterm debt that matures soon?
Why doesnt a companys
record profits translate into
positive cash flows?
Is a company likely to suspend
(or increase) its dividend
payments?
How does the composition of a
companys cash flows compare
to that of its competitors?

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Three Major Types of Business Activities

Operating activities: those

transactions and events
related to the production
and delivery of goods
services.

and

Investing activities: include

the making and collecting of
loans, the acquisition and disposal of PP&E
assets, and the purchase and sale of
securities other than trading securities and
cash equivalents.

Financing activities:
involve obtaining cash from lenders and
repaying those amounts and obtaining cash
from investors and providing them with a
return of and a return on their investments.
Slide 14.7

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Economic Equivalence
Which one would you prefer?
$20,000 today
$50,000 ten years from now
$ 8,000 each year for the next ten years
We need to

compare their economic worth!

Economic equivalence exists between cash flows if

they have the same economic effect.
Convert cash flows into an equivalent cash flow at
any point in time
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Equivalence Principles
1

Use a common time basis

Equivalent cash flows are equivalent at any

common point in time
Use the present time = present worth
Use some future point in time = future worth

Equivalence depends on interest rate

Changing the interest rate destroys

equivalence
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Equivalence Principles
Requires conversion
of multiple payment
cash flows to a
single cash flow
4 Equivalence is
maintained
regardless of the
point of view
3

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The Decision Making Process

Define problem
Choose objectives
Identify alternatives
Evaluate consequences
Select the best
Implement
Audit results

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Making Decisions
Preferences

Politics

People

Expert
opinion

Market
research

Costs

Facts

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Example: buying a car

57 Chevy

97 Neon

93 Mercedes

Purchase

$12,000

$7,000

$20,000

Operation

200/mth

50/mth

150/mth

Resale

$13,000

$5,000

$20,000
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Modeling
Real World

Analysis

The Model

Information
for decision
making

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