CHAPTER4

Moneytime Relationships and Equivalence

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page1

Objective
The objective of Chapter 4 is to explain time value of money calculations

and to illustrate economic equivalence.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page2

Money
Medium of Exchange

Means of payment for goods or services;

What sellers accept and buyers pay;

Store of Value

A way to transport buying power from one time period to another;

Unit of Account

A precise measurement of value or worth;

Allows for tabulating debits and credits;

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page3

Capital
Capital refers to wealth in the form of money or property that can be

used to produce more wealth.

Engineering economy studies involve the commitment of capital for

extended periods of time.

A dollar today is worth more than a dollar one or more years from now

(for several reasons)

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page4

Cashflowcomparisons
Gives information about magnitude and timing of costs and benefits.
Needed for all kinds of decision making
We compare cash flows to decide which cash flow is better for us.
Example: Buying a car alternatives:
$18,000 now, or
$600 per month for 3 years (= $21,600 total)

Which is better?
It depends!
Issue: how much is money now worth compared to money in the future?
In other words: it depends on the interest rate at the moment.

This leads to idea of Time value of money!

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page5

Timevalueofmoney
Would you rather have:
$100 today, or
$100 a year from now?

Basic assumption:
Given a fixed amount of money, and
A choice of having it now or in the future,

Most people would prefer to have it sooner rather than later because:
Security
Interests
Currency strength
Uncertainty
Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page6

Whatthismeansforus
In this chapter, we will learn methods to:
Compare different cash flows over time

Using the interest rate or discount rate:

How much more a dollar today is worth, compared to a dollar in one year

For example, if the interest rate is 5%:

Then $1 today is worth as much as $1.05 next year

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page7

WhyConsiderReturntoCapital?
Return to capital in the form of interest and profit is an essential

ingredient of engineering economy studies.

Interest and profit pay the providers of capital for forgoing its use during

the time the capital is being used.

Interest and profit are payments for the risk the investor takes in letting

another use his or her capital.

Any project or venture must provide a sufficient return to be financially

attractive to the suppliers of money or property.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page8

Interest
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.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page9

SimpleInterest
When 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, the interest and interest rate are said to be simple.
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

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page10

SimpleInterest
If $1,000 were loaned for three years at a simple interest rate of 10%

per year, the interest earned would be

I=(P)(N)(i)
I = 1,000 x 3 x 0.1 = $ 300

So, the total amount repaid at the end of three years would be the

original amount ($ 1,000) plus the interest ($ 300)

$ 1,000 + $ 300 = $ 1,300

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page11

CompoundInterest
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 AmountOwed
Beginningof
period

Interestamount
forperiod@10%

AmountOwedat
theendofperiod

$1,000

$100

$ 1,100

$1,100

$110

$1,210

$1,210

$121

$ 1,331

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page12

SimpleandCompoundInterest

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page13

ConceptofEquivalence
Economic equivalence allows us to compare alternatives on a common

basis.
Established when we are indifferent between a future payment, or a

series of future payments, and a present sum of money .

Each alternative can be reduced to an equivalent basis depending on:
interest rate;
amounts of money involved;
timing of the affected monetary receipts and/or expenditures;

Using these elements we can move cash flows so that we can

compare them at particular points in time

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page14

ConceptofEquivalence
Suppose you have a $17,000 balance on your credit card. So you decide

to repay the 17,000 debt in four months. An unpaid credit card balance
at the beginning of a month will be charged interest at the rate of 1% by
your credit card company. For this situation, we have three plans to
repay the $17,000 principle plus interest owed.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

(1)
Month

Page15

(2)
(3)=1%x(2)
Amountowedatthe InterestAccruedfor
Begining ofmonth
month

(4)=(2)+(3)
Totalowedatthe
endofmonth

(6)
Totalendofmonth
payment

Plan 1:Payinterestdueatendofeachmonthandprincipleatendoffourthmonth
1

17,000

170

17,170

170

17,000

170

17,170

170

17,000

170

17,170

170

17,000

170

17,170

17,170

17,170

4,357.10

Total

680

Plan2:Payoffthedebtinfourequalendofmonthinstallements
1

17,000

12,812.90

128.13

12,941.03

4,357.10

8,583.93

85.84

8,669.77

4,357.10

4,312.67

43.13

4,355.80

4,357.10

Total

170

427.10

Plan3:Payprincipalandinterestinonepaymentatendoffourmonth
1

17,00

170

17,170

17,170

171.70

17,341.70

173.42

17,515.12

175.15

17,690.27

17,690.27

3
4
Total

Dr.Sadiq Abdelall17,341.70
AssistantProfessor
17,515.12
IndustrialEngineeringDepartment
IslamicUniversityofGaza

690.27

Page16

CashFlowDiagrams/TableNotation
Notation used in formulas for compound interest calculations.
i = Effective interest rate per interest period
N = Number of compounding (interest) periods
P = Present Worth: present sum of money equivalent value of one or more cash

flows at a reference point in time; the present

F = Future Worth: future sum of money: equivalent value of one or more cash

flows at a reference point in time; the future

A = Annual Worth: endofperiod cash flows in a uniform series continuing for a

certain number of periods, starting at the end of the first period and continuing
through the last

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page17

CashFlowDiagram
A cash flow diagram is an indispensable tool for clarifying and visualizing

a series of cash flows.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page18

CashFlowDiagram
Example 4.1

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page19

CashFlowTable
Example 4.2

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page20

10

FindingF whenGivenP
Finding future value when given present value
F = P ( 1+i )N
(1+i)N single payment compound amount factor
functionally expressed as F = ( F / P, i%, N )
predetermined values of this are presented in column 2 of Appendix C of text.

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page21

FindingF whenGivenP
Example 4.3
Exercise 4.11

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page22

11

FindingP whenGivenF
Finding present value when given future value
P = F (1+i)N
(1+i)N single payment present worth factor
functionally expressed as P = F ( P / F, i%, N )
predetermined values of this are presented in column 3 of Appendix C of text;

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page23

FindingP whenGivenF
Example 4.4
Exercise 4.14

Dr.Sadiq Abdelall
AssistantProfessor
IndustrialEngineeringDepartment
IslamicUniversityofGaza

Page24

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