The Time Value of Money

• The term capital refers to wealth in the form of money or

property that can be used to produce more wealth.

• The majority of engineering economy studies involve

commitment of capital for extended periods of time, so the
effect of time must be considered.
• it is recognized that a dollar today is worth more than a
dollar one or more years from now because of the interest
(or profit) it can earn. Therefore, money has a time value.
 Why Consider Return to Capital?
- Return to capital in the form of interest and profit is an
essential ingredient of engineering economy studies
1. interest and profit pay the providers of capital for forgoing
its use during the time the capital is being used.
2. interest and profit are payments for the risk the investor
takes in permitting another person, or an organization, to use
his or her capital.
3. Any project or venture must provide a sufficient return to be
financially attractive to the suppliers of money or property.
Simple Interest
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 for which the principal is
committed, the interest and interest rate are said to be simple (not
used frequently in modern commercial practice) .

ḻ = (P)(N)(i),
Where
ḻ = total interest , earned or paid
P = principal amount lent or borrowed;
N = number of interest periods (e.g., years);
i = interest rate per interest period.

The total amount repaid at the end of N interest periods is P + ḻ

 Example
If $1,000 were loaned for three years at a simple interest
rate of 10% per year, find
1. The total interest earned
2. The total amount owed at the end of three years
Compound Interest
Whenever the interest charge for any interest period (a
year, for example) is based on the remaining principal
amount plus any accumulated interest charges up to the
beginning of that period, the interest is said to be
compound.
 Example
If $1,000 were loaned for three periods at an interest rate of
10% compounded each period, find
1. The total interest earned
2. The total amount owed at the end of three Periods
Simple interest does consider the time value of money but
does not involve compounding of interest. Compound interest
is much more common in practice than simple interest

Illustration of Simple versus Compound Interest

The Concept of Equivalence
• Economic equivalence allows us to compare alternatives
on a common basis.

• Each alternative can be reduced to an equivalent basis

dependent on
– interest rate,
– amount of money involved, and
– timing of monetary receipts or expenses.

• Using these elements we can “move” cash flows so that

we can compare them at particular points in time.
We Need Some Tools to Find
Economic Equivalence.

Notation Used in Formulas for

Compound Interest Calculations.
The following notation is utilized in formulas for compound
interest calculations:
i = effective interest rate per interest period;
N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more
cash flows at a reference point in time called the present;
F = future sum of money; the equivalent value of one or more
cash flows at a reference point in time called the future;
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.
• The use of cash-flow (time) diagrams or tables is
strongly recommended for situations in which the
analyst needs to clarify or visualize what is involved
when flows of money occur at various times.
• The difference between total cash inflows (receipts)
and cash outflows (expenditures) for a specified
period of time (e.g., one year) is the net cash flow for
the period.
• Cash flows are important in engineering economy
because they form the basis for evaluating
alternatives.
A cash flow diagram is an indispensable tool for
clarifying and visualizing a series of cash flows.
Cash inflow
The horizontal (lender)
line is a time
scale, the
numbers
represent time
periods

Cash outflow
(lender) The arrows signify cash
flows and are placed at
the end of the period
Example: Cash-Flow Diagramming
Before evaluating the economic merits of a proposed investment,
the XYZ Corporation insists that its engineers develop a cash-flow
diagram of the proposal. An investment of $10,000 can be made
that will produce uniform annual revenue of $5,310 for five years
and then have a market (recovery) value of $2,000 at the end of
year (EOY) five. Annual expenses will be $3,000 at the end of
each year for operating and maintaining the project. Draw a cash-
flow diagram for the five-year life of the project. Use the
corporation’s viewpoint.
Relating Present and Future
Equivalent Values
of Single Cash Flows
• We can apply compound interest formulas to
“move” cash flows along the cash flow
diagram.
 Finding F when Given P
If an amount of P dollars is invested at a point in time and i% is
the interest (profit or growth) rate per period, the amount will
grow to a future amount of P + Pi = P(1+i) by the end of one
period; by the end of two periods, the amount will grow to P(1
+ i)(1 + i) = P(1 + i)2; by the end of three periods, the amount
will grow to P(1 + i)2(1 + i) = P(1 + i)3; and by the end of N
periods the amount will grow to
F = P(1 + i)N.
 Example: Future Equivalent of a
Present Sum
Suppose that you borrow $8,000 now, promising
to repay the loan principal plus accumulated
interest in four years at i = 10% per year. How
much would you repay at the end of four years?
It is common to use standard notation for interest factors.

(1+i)N = (F/P,i,N)

This is also known as the single payment compound amount

factor. The term on the right is read “F given P at i% interest
per period for N interest periods.”

F = P(1 + i)N
F = P(F/P,i,N)

Numerical values for this factor are given in the second

column from the left in the tables of Appendix C for a wide
range of values of i and N
Example - Revisited
Suppose that you borrow $8,000 now, promising to repay the loan
principal plus accumulated interest in four years at i = 10% per year.
How much would you repay at the end of four years?
Example: $2,500 at time zero is equivalent to how much after six years
if the interest rate is 8% per year?
 Finding P when Given F
• From Equation F = P(1 + i)N. Solving this for P gives the
relationship

1

= =  1 +  
1+

• The quantity (1 + i)−N is called the single payment present

worth factor. Numerical values for this factor are given in the
third column of the tables in Appendix C for a wide range of
values of i and N.

(1+i)-N = (P/F,i,N)
P = F (P/F,i,N)
Example: Present Equivalent of a Future
Amount of Money
An investor (owner) has an option to purchase a
tract of land that will be worth $10,000 in six
years. If the value of the land increases at 8%
each year, how much should the investor be
willing to pay now for this property?
Example: $3,000 at the end of year seven is equivalent to how much
today (time zero) if the interest rate is 6% per year?
 Test Yourself
Betty will need $12,000 in five years to pay for a major
overhaul on her tractor engine. She has found an
investment that will provide a 5% return on her invested
funds. How much does Betty need to invest today so
she will have her overhaul funds in five years?
 Important Rules
Rule A. Cash flows cannot be added or subtracted unless they
occur at the same point in time.

Rule B. To move a cash flow forward in time by one time

unit, multiply the magnitude of the cash flow by (1 + i), where
i is the interest rate that reflects the time value of money.

Rule C. To move a cash flow backward in time by one time

unit, divide the magnitude of the cash flow by (1 + i).
 Finding the Interest Rate Given P, F,
and N
There are situations in which we know two sums of
money (P and F) and how much time separates them (N),
but we don’t know the interest rate (i) that makes them
equivalent.

 = /
 1
Example:
If we want to turn $500 into $1,000 over a period
of 10 years, at what interest rate would we have
to invest it?
 Example: The Inflating Price of
Gasoline
The average price of gasoline in 2005 was $2.31 per
gallon. In 1993, the average price was $1.07. What was
the average annual rate of increase in the price of
gasoline over this 12-year period?
 Finding N when Given P, F, and i

Sometimes we are interested in finding the amount of time

needed for a present sum to grow into a future sum at a specified
interest rate.
 =
1+ 

1+  = /

Using logarithms,
log 1 +  = log 

log 

=
log 1 + 
Example:
How long would it take for $500 invested today
at 15% interest per year to be worth $1,000?
 Example: When Will Gasoline Cost
$5.00 per Gallon?
In the previous example, the average price of gasoline was
given as $2.31 in 2005. We computed the average annual
rate of increase in the price of gasoline to be 6.62%. If we
assume that the price of gasoline will continue to inflate at
this rate, how long will it be before we are paying $5.00 per
gallon?
Examples
Example 1: What’s the FV of an initial $100 after 3 years if i
= 10%?
Example 2: What’s the PV of $100 due in 3 years if i = 10%?
Example 3: If sales grow at 8% per year, how long before
sales double?
Example 4: Your cousin want to buy a fancy watch with $425
, instead you suggest that she buy an inexpensive watch
with $25 and invest the difference (i.e. $400) for 40 years
with an interest of 9% per year how much she will get after
40 years ?
Example 5: How long dose it take for $1,000 to quadruple in
value when the interest rate is 8%?
Example 6: A person invested 100,000 JD with a 9% interest
for five years. How many did he have at the end of the fifth
year?
Example 7: How much will be the population of Jordan after
fifty years if the number now is ten million and the increase
rate is 3.5%
Example 8: A person borrowed 50 thousand JD for six years
at an annual interest rate of 15%. If he paid 50 thousand JD
at the end of the second year .How much he must paid at the
end of the sixth year?
Example 9: You deposited $100,000 in a bank giving annual
interest rate of 8%. At the end of the first year you deposited
$10,000 and at the end of the fourth year you withdrew $20,000
from the balance. At the end of the fifth year you withdrew
another $20,000. At the end of the seventh year, you deposited
$10,000 in your balance. How much will be in your balance at
the end of the twelfth year?