Engineering Economics

Time Value of Money

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

The Time Value of Money

Money itself is a commodity. Like other goods that are bought and sold, i.e. money costs money Over time money can earn more money, or interest Interest: way to measure the cost of money The way interest operates reflects the fact that money has a time value A dollar received today has a greater value than a dollar received at some future time Money has both earning power and purchasing power over time (i.e., it can be put to work, earning more money for its owner)

The Time Value of Money

Your money $106 Cost of a fridge $108

Net loss $2
$100

$106
Net gain $2

$104

Elements of Transactions Involving Interest

1. Principal (P): The initial amount of money invested or borrowed in transactions is called the. 2. The interest rate (i): measures the cost or price of money and is expressed as a percentage per period of time. 3. The interest period (n): A period of time determines how frequently interest is calculated.
Yearly (most common), daily, monthly, quarterly, semiannually

Elements of Transactions Involving Interest

4. Number of interest periods (N): a specified length of time marks the duration of the transaction. 5. A plan for receipts or disbursements (A) that yields a particular cash flow pattern over a specified length of time. (For example, we might have a series of equal monthly payments that repay a loan.) 6. A future amount of money (F) results from the cumulative effects of the interest rate over a number of interest periods.

Methods of Calculating Interest

Money can be loaned and repaid in many ways, and equally, money can earn interest in many different ways The two computational schemes: Simple interest: Total earned Interest: I = iPN Total amount: F = P + iPN = P(1 + iN) Compound interest: After 1st period: P + iP = P(1+i) After 2nd period: P(1+i) + P(1+i)i = P(1+i)2 After 3rd period: P(1+i)2 + P(1+i)2i = P(1+i)3 . After Nth period: P(1+i)N-1 + P(1+i)N-1i = P(1+i)N
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Simple vs. Compound Interest

Suppose you deposit $1,000 in a bank savings account that pays interest at a rate of 8% per year. Assume that you don't withdraw the interest earned at the end of each period (year), but instead let it accumulate. (a) How much would you have at the end of year three with simple interest? (b) How much would you have at the end of year three with compound interest?
Simple: Compound: F = P(1 + iN) = 1,000(1 + 0.08*3) = 1,240 F = P(1 + i)N = 1,000(1 + 0.08)3 = 1,259.71

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

Definition and Simple Calculations

Economic equivalence exists between cash flows that have the same economic effect and could therefore be traded for one another in the financial marketplace For example, that we invest $1,000 at 12% annual interest for five years. At the end of the investment period, our sums grow to F = 1000(1+0.12)5 = $1,762.34 we can say that at 12% interest, $1,000 received now is equivalent to $1,762.34 received in five years

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Definition and Simple Calculations

Suppose you are offered the alternative of receiving either $3,000 at the end of five years or P dollars today. With 8% interest, what value of P would make you indifferent to your choice between P dollars today and the promise of $3,000 at the end of five years? F = P(1+i)N or
p F 3,000 $2,042 N 5 (1 i) (1 0.08)

As you may have already guessed, at a lower interest rate, P must be higher in order to be equivalent to the future amount. For example, at i = 4%, P = $2,466.

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Equivalence Calculations
To compare the value of alternative cash flows present time: yields the present worth Some point in the future: yields their future worth Consider the cash flow series given in Figure below. Compute the equivalent lump sum amount at n = 3 at 10% annual interest.
200 150 100

120
80

100

5
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Given: The cash flows given in Figure 2.6, and i = 10%. Find: V3 (or equivalent worth at n = 3). We find the equivalent worth at n = 3 in two steps. Step 1: Find the equivalent lump-sum payment of the first four payments at n = 3:
100(1 + 0.10)3+ 80(1 + 0.10)2+ 120(1 + 0.10)1 + 150 = 511.90

Step 2: Find the equivalent lump-sum payment of the remaining two payments at n = 3:
200(1 + 0.10)-1 + 100(1 + 0.10)-2 = 264.46

Step 3: Find V3. the total equivalent value:

V3 = 511.90 + 264.46 = 776.36

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

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Compound-Amount Factor
To calculate the future worth: F = P(1 + i)N . (1 + i)N is called compound-amount factor or single-payment compound-amount factor express that factor in a functional notation as (F/P. i, N), which is read as "Find F, given i, and N F = P(F/P, i, N) process of finding F is often called the compounding process To find F in any of three ways: Use calculator: F = P(1 + i)N Use interest table: F = P(F/P. i, N) Using a computer: F = FV(i,N,0,P).
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Present-Worth Factor
The present worth: p F[ 1 N] (1 i) Factor 1/(1+i)N single-payment present-worth factor and is designated (P/F, i, N)

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Solving for Time and Interest Rates

Suppose you buy a share of stock for $10 and sell it for $20; your profit is thus $10. If that happens within a year, your rate of return is an impressive 100% ($10/$10 = 1). If it takes five years, what would be the rate of return on your investment? Given: P = $10, F = $20, and N = 5. Find: i

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Solving for Time and Interest Rates

You have just purchased 100 shares of General Electric stock at $30 per share. You will sell the stock when its market price doubles. If you expect the stock price to increase 12% per year, how long do you expect to wait before selling the stock Given: P = $3,000, F = $6,000, and i = 12% per year. Find: N (years).

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

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Uneven-Payment Series
A common cash flow transaction involves a series of disbursements or receipts When there is no clear pattern over the series: the transaction is called an uneven cash flow series The present worth of any uneven stream of payments can be found by calculating the present worth of each individual payment and summing the results. Once the present worth is found, we can make other equivalence calculations

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Present Values of an Uneven Series by Decomposition into Single Payments

Wilson Technology, a growing machine shop, wishes to set aside money now to invest over the next four years in automating its customer service department. The company can earn 10% on a lump sum deposited now, and it wishes to withdraw the money in the following increments: Year 1: $25,000 to purchase a computer and database software designed for customer service use; Year 2: $3,000 to purchase additional hardware to accommodate anticipated growth in use of the system; Year 3: No expenses: and Year 4: $5,000 to purchase software upgrades. How much money must be deposited now in order to cover the anticipated payments over the next four years?

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Present Values of an Uneven Series by Decomposition into Single Payments

Equivalent to: the present value of each single cash flow of the future expense stream of ($25,000, $3,000, $0, $5,000) We sum the individual present values as follows: P = $25,000(P/F. 10%. I ) + $3,000(P/F, 10%. 2) + $5.000(P/F, 10%,4) = $28,622

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Present Values of an Uneven Series by Decomposition into Single Payments

Recheck the calculation: 1. let's calculate the balance at the end of each year. 2. If you deposit $28,622 now, it will grow to (1.10)($28,622), or $31,484, at the end of year one. 3. From this balance, you pay out $25.000. The remaining balance, $6,484, will again grow to (1.10)($6,484), or $7.132, at the end of year two. 4. Now you make the second payment ($3,000) out of this balance, which will leave you with only $4,132 at the end of year two. 5. Since no payment occurs in year three, the balance will grow to $(1.10)2($4.132), or $5,000, at the end of year four. 6. The final withdrawal in the amount of $5,000 will deplete the balance completely

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

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Compound-Amount Factor: Find F, Given A, i, and N

Find F of a fund to which A amount contributed each period at interest rate of i per period. The contributions are made at the end of each of the N periods.

(1i)N 1] A(F/A, i, N) F A[ i
The bracketed term is called the equal-payment-series compound amount factor, or the uniform-series compoundamount factor; Factor notation is (F/A, i, N)

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Compound-Amount Factor: Find F, Given A, i, and N

Suppose you make an annual contribution of $5,000 to your savings account at the end of each year for five years. If your savings account earns 6% interest annually, how much can be withdrawn at the end of five years Given: A = $5.000, N = 5 years. and i = 6% per year. Find: F

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Compound-Amount Factor: Find F, Given A, i, and N

Using the equal-payment-series compound-amount factor, we obtain F = $5,000(F/A, 6%, 5) = $5,000(5.6371) = $28,185.46. To obtain the future value of the annuity on Excel, we may use the following financial command: F = FV(6%,5,5000,0).

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Handling Time Shifts in a Uniform Series

In previous example, the first deposit of the five-deposit series was made at the end of period one, and the remaining four deposits were made at the end of each following period. Suppose that all deposits were made at the beginning of each period instead. How would you compute the balance at the end of period five?

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Handling Time Shifts in a Uniform Series

Each payment has been shifted one year earlier; thus, each payment is compounded for one extra year Previous balance can earn interest for one additional year F5 = 28,185.46(1.06) = 29,876.59 Excel: FV(6%,5,5000,,1) By adding the $5,000 deposit at period zero to the original cash flow and subtracting the $5,000 deposit at the end of period five

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Sinking-Fund Factor: Find A, Given F, i, and N

1 A F[ ] F(A/F,i, N) (1i)N 1
The term within the brackets is called the equal-paymentseries sinking-fund factor, or just sinking-fund factor Referred to with the notation (A/F, i, N)

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College Savings Plan: Find A, Given F, N, and i

You want to set up a college savings plan for your daughter. She is currently 10 years old and will go to college at age 18. You assume that when she starts college, she will need at least $100,000 in the bank. How much do you need to save each year in order to have the necessary funds if the current rate of interest is 7%? Assume that end-of-year payments are made. Using the sinking-fund factors, we obtain A = $100,00O(A/F, 7%, 8) = $9,746.78.

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Capital-Recovery Factor (Annuity Factor): Find A, Given P, i and N

i(1i)N ] P(A/P,i, N) A P[ (1i)N 1

The portion within the brackets: the equal-payment-series capital-recovery factor, or simply capital-recovery factor, which is designated (A/P, i, N). In finance, A/P factor is referred to as the annuity factor.

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Paying Off an Educational Loan: Find A, Given P, i, and N

You borrowed $21,061.82 to finance the educational expenses for your senior year of college. The loan will be paid off over five years. The loan carries an interest rate of 6% per year and is to be repaid in equal annual installments over the next five years. Assume that the money was borrowed at the beginning of your senior year and that the first installment will be due a year later. Compute the amount of the annual installments. Given: P = $21,061.82, i = 6% per year, and N = 5 years. Find: A.

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Paying Off an Educational Loan: Find A, Given P, i, and N

Using the capital-recovery factor, we obtain
A = $21,061.82(A/P, 6%, 5) = $21,061.82(0.2374) = $5,000.

The Excel solution using annuity function commands is as follows:

A = PMT(i,N,P) = PMT(6%,5, 21,061.82)

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Deferred Loan Repayment

Suppose in previous Example that you had wanted to negotiate with the bank to defer the first loan installment until the end of year two (but still desire to make five equal installments at 6% interest). If the bank wishes to earn the same profit as in previous Example, what should be the annual installment Given: P = $21,061.82, i = 6% per year, and N = 5 years, but the first payment occurs at the end of year two. Find: A.

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Deferred Loan Repayment

In deferring one year, the bank will add the interest accrued during the first year to the principal, i.e. we need to find the equivalent worth of $21,061.82 at the end of year 1, P':
P = 21,061.82(F/P,6%,1) = 22,325.53

Thus, you are borrowing $22,325.53 for five years. To retire the loan with five equal installments, the deferred equal annual payment, A', will be
A = 22,325.53(A/P, 6%, 5) = 22,325.53 (0.2374) = 5,300

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Present-Worth Factor: Find P, Given A, i, and N

(1i)N 1] A(P/A,i, N) P A[ i(1i)N

The bracketed term is referred to as the equal-paymentseries present-worth factor and is designated (P/A, i, N)

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Present-Worth Factor: Find P, Given A, i, and N

Lottery problem: a couple gave up the installment plan of $7.92 million a year for 25 years to receive a cash lump sum of $104 million. If the couple could invest its money at 8% annual interest, did it make the right decision? What is the lump-sum amount that would make the couple indifferent to each payment plan? Given: i = 8% per year, A = $7.92 million, and N = 25 years. Find: P. .

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Present-Worth Factor: Find P, Given A, i, and N

Tabular Solution:
P = $7.92(P/A, 8%, 25) = $7.92(10.6748) = $84.54 million.

Excel solution:
= PV(8%,25,7.92,,0) = $84.54 million..

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Start Saving Money as Soon as Possible

Composite Series that Requires Both (F / P ,i, N) and (F/A, i, N) Factors Consider the following two savings plans that you consider starting at the age of 21: Option I: Save $2,000 a year for 10 years. At the end of 10 years, make no further investments, but invest the amount accumulated at the end of 10 years until you reach the age of 65. (Assume that the first deposit will be made when you are 22.) Option 2: Do nothing for the first 10 years. Start saving $2,000 a year every year thereafter until you reach the age of 65. (Assume that the first deposit will be made when you turn 32.)
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Start Saving Money as Soon as Possible

Option I: Compute the final balance in two steps. First, compute the accumulated balance at the end of 10 years (when you are 31). F31 = 2,000(F/A,8%,10) = 28,973 Then use this amount to compute the result of reinvesting the entire balance for another 34 years. F65 = 28,973(F/P,8%,34) = 396,645 Option 2: Since you have only 34 years to invest, the resulting balance will be F65 = 2000(F/A,8%,34) = 317,253 With the early savings plan, you will be able to save 79,391 more.
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Present Value of Perpetuities

A perpetuity is a stream of cash flows that continues forever. A good example is a share of preferred stock that pays a fixed cash dividend each period (usually a quarter-year) and never matures You cannot compute the future value of its cash flows, because it is infinite We know how to calculate the present value for an equalpayment series with the finite stream:
Find P, Given A, i, and N

Take N : P = A / i

(1 i)N 1] P A[ i(1 i)N

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

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Linear Gradient Series

Sometimes cash flows will vary linearly They increase or decrease by a set amount, G, the gradient amount.

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Linear Gradient Series

Note: each payment is An = (n - 1)G. Note The series begins with a zero cash flow at the end of period zero. If G > 0: an increasing gradient series. If G < 0: a decreasing gradient series.

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Linear Gradient Series

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Linear Gradient Series

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Linear Gradient Series

Choosing how to receive your winning a SuperLotto Plus jackpot?! You have a choice: the entire jackpot in 26 annual graduated payments receiving one lump sum that will be less than the announced jackpot. What wouId these choices come out to for an announced jackpot of $7 million? Lump-sum cash-value option: Receive about 49.14%. or $3.44 million, in one lump sum (less tax withholdings).This cash value is based on average market costs determined by U.S. Treasury zero-coupon bonds with 5.3383% annual yield.
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Linear Gradient Series

Annual-payments option: Receive the jackpot in 26 graduated annual payments. Receive $175,000 as the first payment (2.5% of the total jackpot amount). The second payment would be $189,000. Over the course of the next 25 years these payments would gradually increase each year by $7,000 to a final payment of $357,000

If the U.S. Treasury zero-coupon rate is reduced to 4.5% (instead of 5.338%) at the time of winning. what would be the equivalent cash value of the lottery?
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Linear Gradient Series

Given: A1 = $175,000, A2 = $189,000, G = $7,000 (from payment periods 3 to 26), i = 4.5% per year, and N = 26 years Find: P

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Linear Gradient Series

Since the linear gradient series starts at period 2 for this example (i.e., is delayed by one period), we can calculate the present value in two steps: First compute the value at N = 1 and then extend it to N = 0
P = [175,00 + 189,000(P/A,4.5%,25) + 7,000(P/G,4.5%,25)](P/F,4.5%,1) P = 3,818,363

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Geometric Gradient Series

Cash flow varies by some fixed rate expressed as percentage Many engineering economic problems, particularly those relating to construction costs or maintenance costs, involve cash flows that increase or decrease over time by a constant percentage (geometric) That process is called compound growth. Price changes caused by inflation are a good example of such a geometric series.

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Geometric Gradient Series

An = A1(1 + g)n-1 n = 1, 2, 3, 4, N If g > 0 the series will increase if g < 0 the series will decrease

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Geometric Gradient Series

The present worth Pn of any cash flow An at an interest rate i Pn = An(1 + i)-n = A1(1 + g)n-1(1 + i)-n The present amount for the entire series

P = Pn = A1(1 + g)n-1(1 + i)-n

n=1 n=1

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Geometric Gradient Series

P= A1(P/A1,g,I,N) (P/A1,g,I,N): geometric-gradient-series present-worth factor Special case i=g: P = [A1/(1+i)]N

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Required Cost-of-Living Adjustment Calculation

Suppose that your retirement benefits during your first year of retirement are $50.000. Assume that this amount is just enough to meet your cost of living during the first year. However, your cost of living is expected to increase at an annual rate of 5%, due to inflation. Suppose you do not expect to receive any cost-of-living adjustment in your retirement pension. Then. some of your future cost of living has to come from your savings other than retirement pension. If your savings account earns 7% interest a year, how much should you set aside in order to meet this future increase in cost of living over 25 years
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Required Cost-of-Living Adjustment Calculation

Given: A1 = 50,000 g = 5%, i = 7%, N = 25 years Find: P - Find the equivalent amount of total benefits paid over 25 years Pincome - Find the equivalent amount of total cost of living with inflation Pcost-of-living - The required additional savings to meet the future increase in cost of living will be P = Pcost-of-living - Pincome

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Required Cost-of-Living Adjustment Calculation

- Find the equivalent amount of total benefits paid over 25 years: Pincome = 50,000(P/A,7%, 25) Pincome = 582,679 - Find the equivalent amount of total cost of living with inflation Pcost-of-living = Pcost-of-living = 940,696 - The required additional savings to meet the future increase in cost of living will be P = 940,696 582,679 = 358,017
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Home Work 02
Do end chapter problems: 2.6, 2.10, 2.20, 2.26, 2.31, 2.32, 2.37, 2.40, 2.41, 2.42 Each problem is worth 10 points. Total points of homework 02 = 100 points Any extra problem worth 10 bonus points Due at 11:50am th ba 20/07/2010 at class.

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