Engineering economics

THE TIME VALUE OF MONEY

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• “Assets” are items or entities, which bring benefit or
positive value to an owner, and,
• therefore require careful and appropriate
measurement. Collectively, asset value represents
the wealth of an individual or organization and may
be used as parameter of performance.
• Three methods of evaluation will be considered,
namely:- Book Value, Market Value and Cash Flow.
• The Cash flow Method is considered to be the most
useful for project analysis
• Cash Flow considers the future of the asset in terms
of revenue and cost. The asset is used to generate
currency. 2
Majority of the petroleum economics studies
involve commitment of capital for extended
periods of time.

Therefore, the effect of time must be considered.

Money changes in value due to changes in the

interest rate, inflation (or deflation), and currency
exchange rates

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• The idea that money available at the present time is worth
more than the same amount in the future due to its potential
earning capacity.

• This core principle of finance holds that, provided money can

earn a return, the same amount of money is worth more the
sooner it is received.

Example:
For a 5% rate of return, $100 invested today will be worth $105
in one year ($100 multiplied by 1.05).
Similarly, $100 received one year from now is only worth $95.24
today ($100 divided by 1.05), considering a 5% return

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 Rate of Return
• In finance, return is a profit on an investment. It comprises any change in
value, and interest or dividends or other such cash flows which the investor
receives from the investment.

• return is also used to refer to a profit on an investment, expressed as a

proportion of the amount invested.

• A loss instead of a profit is described as a negative return.

• Rate of return is a profit on an investment over a period of time, expressed as

a proportion of the original investment. The time period is typically a year, in
which case the rate of return is referred to as annual return.

• Return, in the second sense, and rate of return, are commonly presented as a
percentage.

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• Rate of return refers to a value that indicates how much return is generated
based on the initial investment made, also called the capital. This rate is
expressed as a percentage and is based on the capital and the annual
return, which is the amount earned over the course of a year.

• The rate of return on an investment is the percentage of loss or gain

generated by an investment. This value is based on the initial investment,
or capital, and the amount regained over a certain period, such as one year
for an annual rate of return.

• The return of rate can be calculated by subtracting the capital from the
return, and then dividing this value by the capital to determine the rate.

Example:
Investment (capital) = $100
Return = $120 (in one year)
Growth = $20 (in a year)
This value is then divided by the capital, yield a return rate of 20%, which
indicates the return rate on that investment for one year.

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INTEREST
The fee that a borrower pays to a
lender for the use of his or her
money.
INTEREST RATE
The percentage of money being
borrowed that is paid to the
lender on some time basis.

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Interest
• An interest rate indicates the amount that has to be paid on a loan.
• It has nothing to do with any gain or loss made on an investment.
• When someone takes a loan (principal amount), he or she is typically
presented with the annual interest rate on that loan, which indicates
payment (interest amount) in addition to the actual principal that must be
paid.
• The interest rate on a loan can be determined by dividing the interest
amount paid on a loan over one year by the value of the principal.

Example:
Take a loan of $100
Pay back the loan amount ($100) in a year plus additional $25
Divide that 25 by 100 => interest rate of 0.25 or 25%.

NOTE: Rate of return and interest rate are expressed as percentages

Return rate is based on investments made . . . the return may be + or -
Interest is paid on a loan . . . fixed amount has to be paid
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 SIMPLE INTEREST
• The total interest earned or charged is linearly
proportional to the initial amount of the loan
(principal), the interest rate and the number of
interest periods for which the principal is
committed.
• When applied, total interest “I” may be found
by I = ( P ) ( N ) ( i ), where
– P = principal amount lent or borrowed
– N = number of interest periods ( e.g., years )
– i = interest rate per interest period
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 SIMPLE INTEREST
Jefferson University has recently received a bequest of
$1 million to establish a trust for providing annual
scholarships in perpetuity. The trust fund is deposited in
a bank that pays 7% interest per annum, and only the
annual interest will be spent for the designated purpose.
What is the annual amount that is available for
scholarships? Since the interest will be withdrawn at the
end of the interest period, the simple interest per
annum is ($l,000,000)(0.07) = $70,000
Note that at the end of each year, the trust fund
remains intact after the interest is withdrawn from the
bank. Thus, $70,000 is available annually for
scholarships 10
 COMPOUND INTEREST
• Whenever the interest charge for any interest
period is based on the remaining principal
amount plus any accumulated interest charges
up to the beginning of that period.
Period Amount Owed Interest Amount Amount Owed
Beginning of for Period at end of
period ( @ 10% ) period
(1) (2) = (1) * 10% (3) = (1) + (2)

1 $1,000 $100 $1,100

2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

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 Compound interest

• A sum of $l,000 is invested in a 2-year savings certificate

that pays 8% interest
• per year compounded annually. What is the total amount
to be received at the end of 2 years?
• The principal and interest at the end of each year for the 2
years are as
• follows:
• End of year (1) 1,000 + (l,000)(0.08) = 1,080.00
• End of year (2) 1.080 + (l,080)(0.08) = 1,166.40
• Hence, the total amount to be received at the end of two
years is $1,166.40.
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 ECONOMIC EQUIVALENCE
Equivalence factors are needed in engineering economy to make
cash flows (CF) at different points in time comparable.

For example, a cash payment that has to be made today cannot be

compared directly to a cash flow that must be made in 5 years.

Since the time value of money changes according to:

1.The interest rate,
2.The amount of money involved,
3.The timing of receipt or payment,
4. The manner in which interest is compounded,

We need a way to reduce CF's at different times to an equivalent basis.

Equivalence factors allow us to do so. Established when we are
indifferent between a future payment, or a series of future payments, and
a present sum of money.
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CASH FLOW DIAGRAMS / TABLE NOTATION
i = effective interest rate per interest period
N = number of compounding periods (e.g., years)
P = present sum of money; the equivalent value of one or more
cash flows at the present time reference point
F = future sum of money; the equivalent value of one or more
cash flows at a future time reference point
A = end-of-period cash flows (or equivalent end-of-period values )
in a uniform series continuing for a specified number of periods,
starting at the end of the first period and continuing through the
last period
G = uniform gradient amounts --- used if cash flows increase by a
constant amount in each period

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 CASH FLOW DIAGRAM NOTATION

1
1 2 3 4 5=N

1 Time scale with progression of time moving from left to

right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.

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 CASH FLOW DIAGRAM NOTATION

1
1 2 3 4 5=N
P =$8,000 2
1 Time scale with progression of time moving from left to
right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.
2 Present expense (cash outflow) of $8,000 for lender.

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 CASH FLOW DIAGRAM NOTATION
A = $2,524 3
1
1 2 3 4 5=N
P =$8,000 2
1 Time scale with progression of time moving from left to
right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.
2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

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 CASH FLOW DIAGRAM NOTATION
A = $2,524 3
1
1 2 3 4 5=N
P =$8,000 2 4 i = 10% per year

1 Time scale with progression of time moving from left to

right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.
2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

4 Interest rate of loan. 18

 CASH FLOW DIAGRAM NOTATION
A = $2,524 3 5
1
1 2 3 4 5=N
P =$8,000 2 4 i = 10% per year

1 Time scale with progression of time moving from left to

right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.
2 Present expense (cash outflow) of $8,000 for lender.

3 Annual income (cash inflow) of $2,524 for lender.

4 Interest rate of loan. 5 Dashed-arrow line indicates

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amount to be determined.
RELATING PRESENT AND FUTURE EQUIVALENT
VALUES OF SINGLE CASH FLOWS

• Finding F when given P:

• Finding future value when given present value
• F = P ( 1+i ) N
– (1+i)N single payment compound amount factor

P
N=
0
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F=?
RELATING PRESENT AND FUTURE EQUIVALENT
VALUES OF SINGLE CASH FLOWS

Gretchen Boyd borrows $1,000 for 4 years and

agrees to pay 5% interest per
year compounded annually. What is the total
amount that she will repay the
debt at the end of 4 years?
Since P = $1,000, / = 5%, and n = 4, we get
from Eq. (3.1)
F = (l,000)(l + 0.05)4 = $1,215.51
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Future Equivalent of a Present Sum

Suppose you borrow $8,000 now, and promise

to pay back the loan principal plus accumulated
interest in four years at interest rate of 10% per
year. How much would you repay at the end of
the fourth year?

P = $8,000

0 4
i = 10% per year F=?

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 RELATING PRESENT AND FUTURE
EQUIVALENT VALUES OF SINGLE CASH
FLOWS
• Finding P when given F:
• Finding present value when given future value
• P = F [1 / (1 + i ) ] N
– (1+i)-N single payment present worth factor
–

F
0 N=

P=? 23
 Present Equivalent of Future Sum

• Andrew Burke wants to put aside a sum of money in

the bank now so that he can have $1,000 available 2
years from now. If the bank pays 1.5% interest per
quarter (every three months) compounded quarterly,
what is the amount P that he should deposit now?

• Since F = $1,000, i = 1.5%, n = (2)(4) = 8, we get

from Eq. (3.2)
• P = (l,000)(l + 0.015)"8 = $887.71

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Present Equivalent of Future Sum

An investor has an option to purchase a plot of

land that will be worth $25,000 in six years. If
the interest rate is 8% per year, how much
should the investor be willing to pay now for
this property?
F = $25,000

0 6
P=? i = 10% per year

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RELATING A UNIFORM SERIES (ORDINARY ANNUITY)
TO PRESENT AND FUTURE EQUIVALENT VALUES
• Finding F given A:
• Finding future equivalent income (inflow) value given
a series of uniform equal Payments
(1 + i )N - 1
• F=A
i
– uniform series compound amount factor in [ ]

F=?
1 2 3 4 5 6 7 8 26
A=
 RELATING A UNIFORM SERIES (ORDINARY
ANNUITY) TO PRESENT AND FUTURE EQUIVALENT
VALUES
• Finding P given A:
• Finding present equivalent value given a series of
uniform equal receipts
(1+i)N-1
• P=A
i(1+i)N
– uniform series present worth factor in [ ]

A= 1 2 3 4 5 6 7 8

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P=?
 RELATING A UNIFORM SERIES (ORDINARY
ANNUITY) TO PRESENT AND FUTURE EQUIVALENT
VALUES
• Finding A given F:
• Finding amount A of a uniform series when given the
equivalent future value
i
A=F
( 1 + i ) N -1
– sinking fund factor in [ ]

F=
1 2 3 4 5 6 7 8 28
A =?
 RELATING A UNIFORM SERIES (ORDINARY
ANNUITY) TO PRESENT AND FUTURE EQUIVALENT
VALUES
• Finding A given P:
• Finding amount A of a uniform series when given the
equivalent present value
i ( 1+i )N
A=P
( 1 + i ) N -1
– capital recovery factor in [ ]

P=
1 2 3 4 5 6 7 8 29
A =?