Chapter 2

Time Value of Money

 Interest: The Cost of
Money
 Economic
Equivalence
 Development of
Interest Formulas
 Unconventional
Equivalence
Calculations

1
 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?
2
 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
3
What Do We Need to Know?
 To make such comparisons (the lottery
decision problem), we must be able to
compare the value of money at
different points 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. 4
 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
5
Delaying Consumption
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%)
6
Delaying Consumption

7
Notation for interest
calculations
 An :A discrete payment or receipt occurring at the
end of some interest period
 i: Interest rate per period
 N: Total number of interest periods
 P: A sum of money at a time chosen for purposes of
analysis as time zero – present value/worth
 F: A future sum of money at the end of the analysis
period

8
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)
9
 Repayment Plans
End of Year Receipts Payments
Plan 1 Plan 2
Year 0 $20,000.00 $200.00 $200.00
Year 1 A=?
Year 2 A=?
Year 3 A=?
Year 4 A=?
Year 5 A=? F=?
10
 Repayment Plans
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
P = $20,000, A = $5,141.85, F = $30,772.48 11
Cash Flow Diagram

12
 End-of-Period Convention
Important simplifying
assumption: All cash
flows are placed at the
0
end of an interest period. 1

Beginning of End of interest

Interest period period

0 1
13
 Methods of Calculating
Interest
 Simple interest: the practice of charging
an interest rate only to an initial sum
(principal amount) – even though you do
not withdraw it
 Compound interest: the practice of
charging an interest rate to an initial sum
and to any previously accumulated
interest that has not been withdrawn.
14
 Simple Interest
 P = Principal End of Beginning Interest Ending
Year Balance earned Balance
amount 0 $1,000
 i = Interest rate
1 $1,000 $80 $1,080
 N = Number of
2 $1,080 $80 $1,160
interest periods
 Example: 3 $1,160 $80 $1,240

P = $1,000


 i = 8%
I = Pi N
 N = 3 years F = P + I = P (1 + iN )
15
 Compound Interest
 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:
 P = $1,000
2 $1,080 $86.40 $1,166.40

 i = 8% 3 $1,166.40 $93.31 $1,259.71

 N = 3 years

16
 Compounding Process
$1,080

$1,166.40
0 $1,259.71
1

$1,000
2
3
$1,080

$1,166.40
17
 Compound Interest
 End of 1st period: F = P(1 + i )
End of 2nd period:
2
 F = P (1 + i )
 End of 3rd period: F = P(1 + i )3
 At the end of N
periods:

F = P (1 + i ) N

The Fundamental Law of Engineering Economy

18
 Economic Equivalence
 Economic equivalence exists between cash
flows that have the same economic effect and
could therefore be traded for one another.
 Even though the amounts and timing of the
cash flows may differ, the appropriate interest
rate makes them equal.
 Economic equivalence refers to the fact that a
cash flow (which can either be a single
payment or a series of payments) can be
converted to an equivalent cash at any point in
time.
19
Economic Equivalence

 The compound interest formula

F = P(1+i)N

expresses the equivalence between some

present amount P and future amount F for
given i and N.
 Equivalent cash flows are equivalent at any
common point in time.

20
 Economic Equivalence
F
 If you deposit P dollars
today for N periods at i,
you will have F dollars
F = P(1+i) N

at the end of period N. 0

 F dollars at the end of N
period N is equal to a
single sum P dollars P = F (1+ i)− N
now, if your earning P
power is measured in
terms of interest rate i.
21
 Typical Repayment Plans for a Bank
Loan of $20,000

Repayments

Plan 1 Plan 2 Plan 3

Year 1 $5,141.85 0 $1,800.00

Year 2 5,141.85 0 1,800.00
Year 3 5,141.85 0 1,800.00
Year 4 5,141.85 0 1,800.00
Year 5 5,141.85 $30,772.48 21,800.00
Total of $25,709.25 $30,772.48 $29,000.00
payments
Total interest $5,709.25 $10,772.48 $9,000.00
paid 22
Equivalence Between Two Cash
Flows
 You are offered the alternative of receiving
either $3000 at the end of 5 years or P
dollars today. You have no current need for
the money, you would deposit the P dollars in
an account paying 8% interest. What value of
P would make you indifferent to your choice
between P dollars today and the promise of
$3000 at the end of 5 years?

23
 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.
 Step 3: Calculate 0 5
equivalence value.
i = 6% , F = $2, 042 (1 + 0 .06 ) 5 = $2, 733
P = F (1+ i)− N
i = 8% , F = $2, 042 (1 + 0 .08 ) 5 = $3, 000
i = 10% , F = $2, 042 (1 + 0 .10 ) 5 = $3,289
24
 Practice problem
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

25
Practice problem

26
Practice Problem 2P

 How many years

would it take an 0
investment to
N=?
double at 10%
annual interest? P

27
 Solution
2P
F = 2 P = P (1 + 0.10) N

2 = 1.1N
0 log 2 = N log1.1
N=? log 2
N=
P log1.1
= 7.27 years

28
 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

29
 Approach
$1,000
$500
 Step 1: Select the base
period to compute the A
equivalent value (say, n 0 1 2 3
= 0)
 Step 2: Find the net
$502 $502 $502
worth of each at n = 0.
B

0 1 2 3
30
31
 Types of Cash Flows

(a) Single cash flow

(b) Equal (uniform)
payment series
(c) Linear gradient
series
(d) Geometric
gradient series
(e) Irregular payment
series
32
Single Cash Flow Formula
F
 Single payment
present worth factor P = F(1 + i)− N
(discount factor) P = F(P / F, i, N)
0
 Given: i = 1 2 %
N = 5 y e a rs N
F = $ 1,0 0 0
P
 Find: P = $1, 000 (1 + 0 .12 ) − 5
= $1, 000 ( P / F ,12% ,5 )
= $567.40
34
 Uneven Payment Series
 Wilson Technology wishes to set aside money now to
invest over the next 4 years. The company can earn 10%
on a lump sum deposited now. The money will be
withdrawn in the following increments:

 Year 1: $25000 to purchase computer hardware and

software
 Year 2: $3000 for additional hardware
 Year 3: no expenses
 Year 4: $5000 for software upgrades

How much must be deposited now?

35
 Uneven Payment Series

P1 = $25,000( P / F,10%,1)
P2 = $3,000( P / F,10%,2)
P4 = $5,000( P / F,10%,4)
P = P1 + P2 + P4
= $28,622

36
Equal Payment Series

0 1 2 3 4 5 N-1 N
F

P N −1 N −2
F = A(1 + i ) + A(1 + i ) + + A
37
 Equal Payment Series Compound Amount
Factor

F
(1 + i ) − 1
N
0 1 2 3 F=A
N i
A
= A( F / A, i , N )
Example 4.13:
 Given: A = $3,000, N = 10 years, and i = 7%

 Find: F

 Solution: F = $3,000(F/A,7%,10) =
$41,449.20
38
 Sinking Fund Factor

F
i
A= F
0 1 2 3 (1 + i) N − 1
N

A = F ( A / F , i, N )
Example 4.15:
 Given: F = $5,000, N = 5 years, and i = 7%

 Find: A

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

39
Handling Time Shifts in a Uniform Series
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

F5 = $5, 000( F / A, 6%,5)(1.06)

= $29,876.59
40
 Capital Recovery Factor

P
i(1 + i) N
A= P
1 2 3 (1 + i) N − 1
0 N

A
= P( A / P, i, N )
Example 4.16:
 Given: P = $250,000, N = 6 years, and i =
8%
 Find: A

 Solution: A = $250,000(A/P,8%,6) = $54,075

41
 Equal Payment Series Present Worth Factor

P
(1 + i ) − 1
N
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

42
Example 2.13 Deferred Loan Repayment Plan

 You borrowed $21061.82 to finance educational

expenses. The loan will be paid with five payments.
You want to defer the first payment until the end of
year 2, but still desire to make five annual equal
installments. With 6% interest, what are the annual
payments?

43
Example 2.13 Deferred 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’ 44
Two-Step Procedure

P ' = $21, 061.82( F / P, 6%,1)

= $22,325.53
A = $22,325.53( A / P, 6%,5)
= $5,300
45
 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 46
Option 1 – Early Savings Plan
?

F10 = $2,000( F / A,8%,10)

Option 1: Early Savings Plan
= $28,973
0 1 2 3 4 5 6 7 8 9 10

F44 = $28,973( F / P,8%,34) 44

$2,000
= $396,645

Age 31 65

47
Option 2: Deferred Savings
Plan

F44 =$2,000(F / A,8%,34)

Option 2: Deferred Savings Plan

=$317,233 0 11 12
44

$2,000

48
 $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 49
 Present Value of Perpetuities
 Perpetuity: stream of cash flows that continues
forever

 (1 + i ) N − 1
P = A N 
= A( P | A, i, N )
 i (1 + i ) 
A
As N → ∞, P =
i

50
Present Value of Perpetuities

A=1000


1 2 3 4 5 6 7 8 N∞

i = 10 %
P=10000

51
Linear Gradient Series

(1+ i)N −iN −1

P = G 2 
 i (1+ i)
N

= G(P | G, i, N)

52
Linear Gradient Series

G 2G ( N − 1)G
P = 0+ 2
+ 3
++
(1 + i ) (1 + i ) (1 + i ) N

N
= G  ( n − 1)(1 + i ) −n

n =1 53
Linear Gradient Series

G 2G ( N − 1)G
P = 0+ 2
+ 3
++
(1 + i ) (1 + i ) (1 + i ) N
1
=x
1+ i
P = 0 + Gx 2 + 2Gx 3 +  + ( N − 1)Gx N
2
[ 2
P = Gx 1 + 2 x + 3 x  + ( N − 1) x N −2
]
Arithmetic-Geometric Series
Let S be the sum
54
 Linear Gradient Series

S = 1 + 2 x + 3 x 2 +  + ( N − 1) x N − 2
Sx = x + 2 x 2 + 3 x 3  + ( N − 1) x N −1
S − Sx = 1 + x + x 2 + x 3 +  + x N − 2 − ( N − 1) x N −1

Geometric Series

1 − x N −1 T = 1 + x + x 2 +  + x N −2
S − Sx = − ( N − 1) x N −1
1− x Tx = x + x 2 +  + x N −1
1 − x N −1 ( N − 1) x N −1 T − Tx = 1 − x N −1
S = 2
−
(1 − x ) (1 − x ) 1 − x N −1
T=
1 − Nx N −1 + ( N − 1) x N 1− x
S =
(1 − x ) 2
55
 Linear Gradient Series
N −1
2 1 − Nx + ( N − 1) x N
P = Gx 2
(1 − x )
Letting x=1/(1+i)

(1 + i ) N − Ni − 1
P =G
i 2 (1 + i ) N
Gradient Series
Present Worth Factor

P = G ( P | G , i, N )
56
Gradient Series as a Composite
Series

57
 Example

$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% annual interest, if
you want to withdraw the annual
P =? series as shown in the figure?
58
 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
$1,750(P/F, 12%, 4) = $1,112.16
$2,000(P/F, 12%, 5) = $1,134.85
P =?
$5,204.03
59
 Method 2:

P1 = $1,000(P / A,12%,5)
= $3,60480
.

P2 = $250(P / G,12%,5)
= $1,599.20

P = $3,604.08 + $1,59920
.
= $5,204
60
Geometric Gradient Series

1− (1+ g) N (1+ i)− N

A , if i ≠ g
P= 1 i−g
NA1 / (1+ i), if i = g
=(P|A1,g,i,N)
61
Geometric Gradient Series

Pn = An (1 + i ) − n = A1 (1 + g ) n −1 (1 + i ) − n
N N
P =  Pn =  A1 (1 + g ) n −1
(1 + i ) −n

n =1 n =1
n
A1 N
1 + g 
P= 
1 + g n =1  1 + i  62
Geometric Gradient Series
1+ g A1
Let x= and a=
1+ i 1+ g
P = a( x + x 2 +  + x N )
Px = a ( x 2 + x 3 +  + x N +1 )
P − Px = a ( x − x N +1 )
a ( x − x N +1 )
P=
1− x
 1 − (1 + g ) N (1 + i ) − N 
 A1   if i ≠ g
  i−g 
P=
 NA1 if i = g
 (1 + i )
n
A1 N 1 + g 
P= 
1 + g n =1  1 + i  63
 Geometric Gradient:
Find P, Given A1,g,i,N
 Given:
g = 7%
i = 12%
N = 5 years
A1 = $54,440
 Find: P
. )−5
. )5 (1+ 012
1− (1+ 007
P = $54,440
. − 007
012 .
= $151,109

64
 Geometric Gradient:
Find A1, Given F,g,i,N
 Planning for retirement: accumulate $1000000 in 20 years
time
 Local bank account that pays 8% interest per year
 Expects that annual income will increase at 6% annually.
 Start with a deposit of A1 at the end of year 1.

A1 = $1M ( A1 | F , g , i, N )
A1 = 13757

65
 Unconventional Equivalence
Calculations
If you make 4
annual deposits of
$100 in your savings
account which earns
a 10% annual
interest, what equal
annual amount can
be withdrawn over 4
subsequent years?

66
67
Method 3:

A=100(F|P,10%,4)=146.41

68
Composite $200

Cash Flows $150 $150 $150 $150

$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
69
Multiple Interest Rates
Find the balance at the end of year 5. F=?

6% 6% 4% 4%
5%

0
2 4 5
1 3

$400
$300
$500

70
Solution
n = 1:
$300( F / P , 5% ,1) = $315
n = 2:
$315( F / P , 6% ,1) + $500 = $833.90
n = 3:
$833.90( F / P , 6% ,1) = $883.93
n = 4:
$883.93( F / P , 4% ,1) + $400 = $1, 319.29
n = 5:
$1, 319.29( F / P , 4% ,1) = $1, 372.06 71
 Cash Flows with Missing
Payments

P=?

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0

$100

i = 10% Missing payment

72
 Solution

P=? Add this cash flow to

$100 offset the change

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0

$100
Pretend that we have the 10th
i = 10% payment

73
 Approach

P=?
$100

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0

$100

i = 10%

Equivalent Cash Inflow = Equivalent Cash Outflow

74
 Equivalence Relationship

P+$100(P/ F,10%,10) = $100(P/ A,10%,15)

P+$38.55 = $760.61
P = $722.05

75
Unconventional Regularity in
Cash Flow Pattern
$10,000

i = 10%

1 2 3 4 5 6 7 8 9 10 11 12 13 14
0

C C C C C C C

Payment is made every other year

76
Approach 1: Modify the Original
Cash Flows
$10,000

i = 10%

1 2 3 4 5 6 7 8 9 10 11 12 13 14
0

A A A A A A A A A A A A A A

A = $10, 000( A / P ,10%,14)

= $1, 357.46
77
 Relationship Between A and C
$10,000

i = 10%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
0
C C C C C C C
$10,000

i = 10%
1 2 3 4 5 6 7 8 9 10 11 12 13 14
0

A A A A A A A A A A A A A A
78
Solution
A = $10,000( A/ P,10%,14)
= $1,357.46

≡ ≡
i = 10%

C C = A(F / P,10%,1) + A
=1.1A+ A
= 2.1A
A A
= 2.1($1,357.46)
A =$1,357.46 = $2,850.67
79
Approach 2: Modify the Interest
Rate
 Idea: Since cash flows occur every
other year, let's find out the equivalent
compound interest rate that covers the
two-year period.
 How: If interest is compounded 10%
annually, the equivalent interest rate for
two-year period is 21%.
(1+0.10)(1+0.10) = 1.21
80
 Solution
$10,000
i = 21%
1 2 3 4 5 6 7
1 2 3 4 5 6 7 8 9 10 11 12 13 14
0
C C C C C C C

C = $10,000( A / P,21%,7)
= $2,850.67
81
 Summary
 Money has a time value because of its
earning power and inflation rate.
 Economic equivalence exists between
individual cash flows and/or patterns of cash
flows that have the same value. Even though
the amounts and timing of the cash flows
may differ, the appropriate interest rate
makes them equal.
 The purpose of developing various interest
formulas was to facilitate the economic
equivalence computation.
82