Time Value of Money

Time Value of Money

 Interest: The Cost of Money
 Economic Equivalence
 Interest Formulas – Single Cash Flows
 Equal-Payment Series
 Dealing with Gradient Series
Decision Dilemma—Take 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?

3
 Option A Option B
(Lump Sum) (Installment
Plan)
0 $104 M
1 $7.92 M
2 $7.92 M
3 $7.92 M

25 $7.92 M
4
What Do We Need to Know?
 To make such comparisons, 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 money-a
cost to the borrower and an
earning to the lender
 Account Value Cost of Refrigerator

Case 1: N = 0 $100 N = 0 $100

Inflation
exceeds N = 1 $106 N = 1 $108
earning power
(earning rate =6%) (inflation rate = 8%)
Case 2: N = 0 $100 N = 0 $100
Earning power
exceeds N = 1 $106 N = 1 $104
inflation
(earning rate =6%) (inflation rate = 4%)
Delaying Consumption

8
Delaying Consumption
Elements of Transactions involve Interest
1. Initial amount of money in transactions involving debt or
investments is called the principal (P).
2. The interest rate (i) measures the cost or price of money and is
expressed as a percentage per period of time.
3. A period of time, called the interest period (n), determines
how frequently interest is calculated.
4. A specified length of time marks the duration of the
transactions and thereby establishes a certain number of
interest periods (N).
5. A plan for receipts or disbursements (An) that yields a
particular cash flow pattern over a specified length of time.
[monthly equal payment]
6. A future amount of money (F) results from the cumulative
effects of the interest rate over a number of interest periods.
Example: Paying back a loan
 You get a loan of $20000 from a bank at a 9%
annual interest rate. You also pay a $200 loan
origination fee when the loan commences
(begins). The bank offers two repayment plans.
 Plan 1: Equal payments at the end of every year
for the next 5 years
 Plan 2: Single payment at the end of the loan
period (5 years)

11
Which Repayment Plan?
End of Year Receipts Payments

Plan 1 Plan 2
Year 0 $20,000.00 $200.00 $200.00
Year 1 5,141.85 0
Year 2 5,141.85 0
Year 3 5,141.85 0
Year 4 5,141.85 0
Year 5 5,141.85 30,772.48
The amount of loan = $20,000, origination fee = $200, interest rate = 9% APR (annual
percentage rate)
Cash Flow Diagram
Represent time by a horizontal line marked off with the number of interest periods
specified. Cash flow diagrams give a convenient summary of all the important
elements of a problem.
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 Beginning Interest Ending
 i = Interest rate Year Balance earned Balance
0 $1,000
 N = Number of
interest periods 1 $1,000 $80 $1,080
 Example: 2 $1,080 $80 $1,160
 P = $1,000
3 $1,160 $80 $1,240
 i = 8%
 N = 3 years
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 the practice of charging an
interest rate to an initial sum and to any previously accumulated
interest that has not been withdrawn.
 P = Principal
amount End of Beginning Interest Ending
 i = Interest rate Year Balance earned Balance

 N = Number of 0 $1,000
interest
periods 1 $1,000 $80 $1,080

 Example: 2 $1,080 $86.40 $1,166.40

 P = $1,000
3 $1,166.40 $93.31 $1,259.71
 i = 8%
 N = 3 years
Compounding Process

$1,080

$1,166.40
0 $1,259.71
1

$1,000
2
3
$1,080
$1,166.40
 $1,259.71

0 1 2

F  $1, 000(1  0.08)3

$1,000
 $1, 259.71
Compound Interest Formula

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

0 1 2 3 4 5 6 7 8 9 10

$100(1  0.10)10  $100(2.59)  $259

$200(1  0.10)8  $200(2.14)  $429
$100
$200 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?

0 1
$1,210

4
?
2 3

$1,000 $1,000 $1,500

Solution
End of Beginning Deposit Withdraw Ending
Period balance made balance
n=0 0 $1,000 0 $1,000

n=1 $1,000(1 + 0.10) $1,000 0 $2,100

=$1,100

n=2 $2,100(1 + 0.10) 0 $1,210 $1,100

=$2,310

n=3 $1,100(1 + 0.10) $1,500 0 $2,710

=$1,210

n=4 $2,710(1 + 0.10) 0 0 $2,981

=$2,981
 $1,210 ?
0 1 3
2 4

$1,000 $1,000
$1,500
$1,100
$1,000
$1,210 $2,981
$2,100 $2,310
-$1,210 + $1,500

$1,100 $2,710
Economic Equivalence
 What do we mean by “economic equivalence?”

 Why do we need to establish an economic

equivalence?

 How do we establish an economic

equivalence?
 Economic Equivalence (EE)
 Economic equivalence exists between cash flows that
have the same economic effect and could therefore be
traded for one another.
 EE refers to the fact that a cash flow-whether a
single payment or a series of payments-can be
converted to an equivalent cash flow at any point
in time.
 Even though the amounts and timing of the cash flows
may differ, the appropriate interest rate makes them
equal.
Economic Equivalence (EE)
Equivalence from Personal Financing
Point of View
F

 If you deposit P
F  P(1  i) N
dollars today for N
periods at i, you 0
N
will have F dollars
at the end of period
N.
PF P
Alternate Way of Defining
Equivalence
P
 F dollars at the end
of period N is equal
to a single sum P 0 N
dollars now, if your
earning power is = F

measured in terms P  F (1  i ) N

of interest rate i.
0 N
Practice Problem
At 8% interest, what is the equivalent worth
of $2,042 now 5 years from now?

$2,042 If you deposit $2,042 today in a savings

account that pays 8% interest annually.
how much would you have at the end of
5 years?

0 1 2 33 4 5
F

=
0 5
Solution

5
F  $2,042(1  0.08)
 $3,000
Example 2.2
At what interest rate
would these two amounts be equivalent?

$2,042
i=? $3,000

0 5
 Equivalence Between Two Cash Flows

 Step 1: Determine the

$2,042 $3,000
base period, say, year
5.
 Step 2: Identify the
interest rate to use.
0 5
 Step 3: Calculate
equivalence value. i  6%, F  $2,042(1  0.06) 5  $2,733
i  8%, F  $2,042(1  0.08) 5  $3,000
i  10%, F  $2,042(1  0.10) 5  $3,289
Example - Equivalence
Various dollar amounts that will be economically
equivalent to $3,000 in 5 years, given an interest
rate of 8%.
$3,000
P 5
 $2, 042
(1  0.08)

P F
$2,042 $2,205 $2,382 $2,572 $2,778 $3,000
0 1 2 3 4 5
Example 2.3

$200 V
=
$150
$120
$100 $100
$80

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

Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.

Approach
V

$200

$150
$120

$100 $100
$80

0 1 2 3 4 5
 V3  $511.90  $264.46 V
 $776.36

$200
$200(1  0.10) 1  $100(1  0.10) 2
$150  $264.46
$120
$100 $100
$80

0 1 2 3 4 5

100(1  0.10)3  $80(1  0.10) 2  $120(1  0.10)  $150

 $511.90
Practice Problem
2P
 How many years would it
take an investment to
double at 10% annual
0
interest?
N=?

P
Solution

2P
F  2 P  P (1  0.10) N
N
2  1.1
log 2  N log1.1
0
log 2
N=? N
P
log1.1
 7.27 years
Practice Problem
$1,000
$500
Given: i = 10%,
A

Find: C that makes the 0 1 2 3

two cash flow streams
to be indifferent C C

0 1 2 3
 Approach
$1,000
 Step 1: Select the base
period to use, say n = $500
2. A
 Step 2: Find the 0 1 2 3
equivalent lump sum
value at n = 2 for both
A and B. C C
 Step 3: Equate both B
equivalent values and
solve for unknown C. 0 1 2 3
Solution
 For A: $1,000

2 1
$500
V2  $500(1  0.10)  $1,000(1  0.10)
 $1,514.09 A
0 1 2 3
 For B:
V2  C (1  0.10)  C
C C
 2.1C
 To Find C: B
2.1C  $1, 514.09
0 1 2 3
C  $721
Practice Problem
$1,000
$500
At what interest rate
would you be A

indifferent between the 0 1 2 3

two cash flows?
$502 $502 $502

0 1 2 3
 Approach
 Step 1: Select the base period $1,000
to compute the equivalent
value (say, n = 3) $500
A
 Step 2: Find the net worth of 0 1 2 3
each at n = 3.

$502 $502 $502

B

0 1 2 3
Establish Equivalence at n = 3
3
Option A : F3  $500(1  i)  $1, 000
Option B : F3  $502(1  i) 2  $502(1  i)  $502

 Find the solution by trial and error, say i = 8%

Option A : F3  $500(1.08) 3  $1, 000

 $1, 630
Option B : F3  $502(1.08) 2  $502(1.08)  $502
 $1, 630
Single Cash Flow Formula

 Single payment F
N
compound amount factor F  P(1  i )
(growth factor) F  P( F / P, i, N )
0
 Given: i  10%
N  8 years N
P  $2,000
. )8
F  $2,000(1  010 P
 Find: F  $2,000( F / P,10%,8)
 $4,28718
.
Practice Problem

 If you had $2,000 now and invested it at 10%,

how much would it be worth in 8 years?

F=?
i = 10%
0
8
$2,000
Solution
Given:
P  $2, 000
i  10%
N  8 years

Find: F

F  $2, 000(1  0.10)8

 $2, 000( F / P,10%, 8)
 $4, 287.18
EXCEL command:
=FV(10%,8,0,2000,0)
=$4,287.20
Single Cash Flow Formula

 Single payment present P  F(1  i)  N F

worth factor (discount
factor) P  F ( P / F , i, N )
 Given:
i  12% 0
N  5 years N
F  $1,000
 Find: P
5
P  $1,000(1  0.12 )
 $1,000( P / F,12%,5)
 $567.40
Practice Problem
 You want to set aside a lump sum amount today
in a savings account that earns 7% annual interest
to meet a future expense in the amount of $10,000
to be incurred in 6 years. How much do you need
to deposit today?
Solution $10,000

P
P  $10, 000(1  0.07) 6
 $10, 000( P / F , 7%, 6)
 $6, 663
Multiple Payments
 How much do you need to
deposit today (P) to
$25,000 withdraw $25,000 at n =1,
$3,000 at n = 2, and $5,000
$3,000 $5,000
0 at n =4, if your account
1 2 3 4 earns 10% annual interest?

P
 $25,000

Uneven $3,000 $5,000

Payment Series
0
1 2 3 4

$25,000

$3,000 $5,000
0 0 0

1 2 3 4
+ 1 2 3 4
+ 1 2 3 4

P2
P4
P1
P1  $25, 000( P / F ,10%,1) P2  $3, 000( P / F ,10%, 2) P4  $5, 000( P / F ,10%, 4)
 $22, 727  $2, 479  $3, 415

P  P1  P2  P3  $28, 622
Check
0 1 2 3 4
Beginning 0 28,622 6,484.20 4,132.62 4,545.88
Balance
Interest 0 2,862 648.42 413.26 454.59
Earned
(10%)
Payment +28,622 -25,000 -3,000 0 -5,000

Ending $28,622 6,484.20 4,132.62 4,545.88 0.47

Balance

Rounding error
It should be “0.”
Equal Payment Series: Find equivalent P or F
A

0 1 2 3 4 5 N-1 N
F

P
Equal Payment Series – Compound
Amount Factor
F

0 1 2 N
A A A

0 1 2 N

0 1 2
N

A A A
Compound Amount Factor
F

A(1+i)N-2
A A A

A(1+i)N-1

0 1 2 N 0 1 2 N

N 1 N 2
F  A(1  i )  A(1  i )  A
 Equal Payment Series Compound Amount Factor
(Future Value of an annuity)

F
(1  i ) N  1
0 1 2 3 FA
N i
A
 A( F / A, i , N )
Example 2.9:
 Given: A = $5,000, N = 5 years, and i = 6%

 Find: F

 Solution: F = $5,000(F/A, 6%, 5) = $28,185.46

Validation

4 F =?
$5,000(1  0.06)  $6,312.38
$5,000(1  0.06)3  $5,955.08 i = 6%

2
$5,000(1  0.06)  $5,618.00 0 1 2 3 4 5

$5,000(1  0.06)1  $5,300.00

$5,000 $5,000 $5,000 $5,000 $5,000
0
$5,000(1  0.06)  $5,000.00
$28.185.46
Finding an Annuity Value

F
i
A F N
0 1 2 3 (1  i )  1
N

A=?  F ( A / F ,i, N )

Example:
 Given: F = $5,000, N = 5 years, and i = 7%

 Find: A

 Solution: A = $5,000(A/F, 7%, 5) = $869.50

Example 2.10 Handling Time Shifts in a Uniform Series

F5  $5, 000( F / A, 6%, 5)(1.06)

 $29,876.59 F=?
First deposit occurs at n = 0

i = 6%

0 1 2 3 4 5

$5,000 $5,000 $5,000 $5,000 $5,000

Sinking fund

(1) A fund accumulated by periodic deposits and

reserved exclusively for a specific purpose,
such as retirement of a debt.

(2) A fund created by making periodic deposits

(usually equal) at compound interest in order to
accumulate a given sum at a given future time
for some specific purpose.

67
Sinking Fund Factor
is an interest-bearing account into which a fixed sum is deposited each
interest period; The term within the colored area is called sinking-fund
factor. F
i
A F
0 1 2 3 (1  i ) N  1
N
A  F ( A / F ,i, N )
Example 2.11 – College Savings Plan:
 Given: F = $100,000, N = 8 years, and i = 7%
 Find: A
 Solution:
A = $100,000(A/F, 7%, 8) = $9,746.78

68
 OR

 Given: $100,000
 F = $100,000

 i = 7%
Current age: 10 years old
 N = 8 years

0
1 2 3 4 5 6 7 8

A=?

i = 8%
 Find: A
 Solution: A = $100,000(A/F, 7%, 8) = $9,746.78
 Capital Recovery Factor
(Annuity Factor)
 Annuity: (1) An amount of money payable to a
recipient at regular intervals for a prescribed period of
time out of a fund reserved for that purpose. (2) A
series of equal payments occurring at equal periods of
time.
(3) Amount paid annually, including reimbursement of
borrowed capital and payment of interest.

 Annuity factor: The function of interest rate and time

that determines the amount of periodic annuity that
may be paid out of a given fund.
70
 Capital Recovery Factor is the colored area which is designated (A/P, i, N). In finance, this A/P factor is referred to as the annuity factor.

P N
i (1  i )
A P N
1 2 3 (1  i )  1
0 N
 P( A / P, i , N )
A=?

Example 2.12: Paying Off Education Loan

 Given: P = $21,061.82, N = 5 years, and i = 6%
 Find: A
 Solution: A = $21,061.82(A/P,6%,5) = $5,000
Example 2.13 Deferred (delayed) Loan Repayment Plan
P =$21,061.82

i = 6%

0 1 2 3 4 5 6

Grace period
A A A A A

P’ = $21,061.82(F / P, 6%, 1)

i = 6%
0 1 2 3 4 5 6

A’ A’ A’ A’ A’
Two-Step Procedure

P '  $21, 061.82( F / P, 6%,1)

 $22,325.53
A  $22,325.53( A / P, 6%,5)
 $5,300
Present Worth of Annuity Series
The colored area is referred to as the equal-payment-series present-worth factor

P=?
(1  i ) N  1
P A
1 2 3 i (1  i ) N
0 N

A  A( P / A, i , N )

Example 2.14: Powerball Lottery

 Given: A = $7.92M, N = 25 years, and i = 8%
 Find: P
 Solution: P = $7.92M(P/A, 8%, 25) = $84.54M
Example 2.15 Early Savings Plan – 8% interest
?

Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10

44

$2,000 ?

Option 2: Deferred Savings Plan

0 1 2 3 4 5 6 7 8 9 10 11 12
44

$2,000
Option 1 – Early Savings Plan

?
F10  $2,000( F / A,8%,10)
 $28,973 Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10

F44  $28,973( F / P,8%,34) 44

 $396,645 $2,000

Age 31 65
Option 2: Deferred Savings Plan

?
F44  $2,000( F / A,8%,34)
 $317,233 Option 2: Deferred Savings Plan

0 11 12
44

$2,000
 $396,644

Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10

44

$2,000
$317,253

Option 2: Deferred Savings Plan

0 1 2 3 4 5 6 7 8 9 10 11 12
44

$2,000
Linear Gradient Series
Engineers frequently meet situations involving periodic payments
that increase or decrease by a constant amount (G) from period to
period.

N
i (1  i )  iN  1
PG 2 N
i (1  i )
 G( P / G, i, N )

79
Gradient Series as a Composite Series
Example – Present value calculation for a gradient
series $2,000
$1,750
$1,250 $1,500
$1,000

0
1 2 3 4 5

How much do you have to

deposit now in a savings
account that earns a 12%
P =? annual interest, if you want to
withdraw the annual series as
shown in the figure?
Method 1:
$2,000
$1,750
$1,250 $1,500
$1,000

0
1 2 3 4 5

$1,000(P/F, 12%, 1) = $892.86

$1,250(P/F, 12%, 2) = $996.49
$1,500(P/F, 12%, 3) = $1,067.67
P =? $1,750(P/F, 12%, 4) = $1,112.16
$2,000(P/F, 12%, 5) = $1,134.85
$5,204.03
Method 2:

P1  $1,000( P / A,12%,5)
 $3,604.80

P2  $250( P / G,12%,5)
 $1,599.20

P  $3,604.08  $1,599.20
 $5,204
 Example 2.16 Supper Lottery
$3.44 million
Cash Option

0 1 2 3 4 5 6 7 25 26

Annual Payment Option

$357,000
G = $7,000
$196,000
$189,000
$175,000

0 1 2 3 4 5 6 7 25 26
Equivalent Present Value of Annual
Payment Option at 4.5%

P  [$175, 000  $189, 000( P / A, 4.5%, 25)

$7, 000( P / G, 4.5%, 25)]( P / F , 4.5%,1)
 $3,818,363
Geometric Gradient Series
Many engineering economic problems, particularly those relating to construction
costs, involve cash flows that increase over time, not by a constant amount, but rather
by a constant percentage (geometric), called compound growth.

1  (1  g ) N (1  i )  N
A1 , if i  g
P ig
NA1 / (1  i ), if i  g
Present Worth Factor

1  (1  g ) N (1  i )  N
A1 , if i  g
P ig
NA1 / (1  i ), if i  g
Alternate Way of Calculating P

ig
Let g ' 
1 g
A1
P ( P / A, g ', N )
(1  g )
Example 2.17: Find P, Given A1, g, i, N

 Given:
g = 5%
i = 7%
N = 25 years
A1 = $50,000
 Find: P

1  (1  0.05) 25 (1  0.07) 25 

P  $50, 000  
 0.07  0.05 
 $940, 696
Required Additional Savings

P  $50, 000( P / A, 7%, 25)

 $582, 679
P  $940, 696  $582, 679
 $358, 017
 $200

Composite $150 $150 $150 $150

Cash Flows $100 $100 $100

$50

0
1 2 3 4 5 6 7 8 9

PGroup 1  $50( P / F ,15%,1)

 $43.48

PGroup 2  $100( P / A,15%,3)( P / F ,15%,1)

 $198.54
PGroup 3  $150( P / A,15%, 4)( P / F ,15%, 4)
 $244.85
PGroup 4  $200( P / F ,15%,9)
 $56.85
P  $43.48  $198.54  $244.85  $56.85
 $543.72