Ch02: Time Value of Money

• And that is even before we consider the effects of inflation!

• The reason for this surprising result is the time value of money; the
earlier a sum of money is received, the more it is worth because over
time money can earn more money via interest.
• Interest: The Cost of Money
• Most of us have a general appreciation of the concept of interest.
• We know that money left in a savings account earns interest so that
the balance over time is higher than the sum of the deposits.
• The cost of money is established and measured by an interest rate, a
percentage that is periodically applied and added to an amount (or to
varying amounts) of money over a specified length of time.
• When money is loaned or invested , the interest earned is the
lender's gain for providing a good to another person.
• Interest, then. may be defined as the cost of having money available
for use.
The Time Value of Money
• The time value of money seems like a sophisticated concept. yet it is
one that you encounter every day.
• Should you buy some thing today or buy it later?
• Example
• Pretend you have $ 100 and you want to buy a $100 refrigerator for
your dorm room.
• If you buy it now. you encl up broke. But if you invest your money al
6% annual interest, the n in a year you can still buy the refrigerator,
and you will have $6 left over.
• Clearly, you need to ask yourself whet her the inconvenience of not
having the refrigerator in your own room for a year can be
compensated by the financial gain in the amount of $6.
Figure 2.1: Gains achieved or losses incurred by delaying consumption.
• If the price of the refrigerator increases at an annual rate of 8% due to
inflation, then you will not have enough money (you will be $2 short)
to buy the refrigerator a year from now (Case 1 in Figure 2. 1 ).
• In that case, you probably are better off buying the refrigerator now.
• If the inflation rate is running at only 4%, then you have $2 left over if
you buy the refrigerator a year from now (Case 2 in Figure 2.1 ).
• What this example illustrates is that we must connect earning power
and purchasing po1ver to the concept of time.
• The way interest operates reflects the fact that money has a time
value.
• This is why amounts of interest depend on lengths of time; interest
rates, for example, are typically given in terms of a percentage per
year.
• We may define the principle of the time value of money as follows:-
the economic value of a sum depends on when the sum is received.
• Because money has both earning power and purchasing power over
time, a dollar received today has a higher value than a dollar received
at some future time.
Elements of Transactions Involving Interest

1. The initial amount of money invested or borrowed in transactions 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. (Note that, even though the
4. A specified length of time marks the duration of the transaction 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. (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.
• In Plan 1, the principal amount, P, is $20,000, and the interest rate. i, is 9%.
• The interest period, n, is one year, and the duration of the transaction is five years,
• The receipts and disbursements planned over the duration of this transaction yield
a cash flow pattern of five equal payments A of $5,141.85 each. paid at year end
during years one through five.
• Plan 2 has most of the elements of Plan 1, except that instead of five equal
repayments, we have a grace period followed by a single future repayment F of
$30.772.48.
Figure 2.2 Cash Flow Diagram
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 for calculating this earned interest
yield either simple interest or compound interest.
• Engineering economic analysis uses the compounded-interest scheme
exclusively, as it is most frequently practiced in the real world.
• In general, for a deposit of P dollars at a simple interest rate of i for N
periods, the total earned interest I would be
• Under a compound-interest scheme, the interest earned in
each period is calculated based on the total amount at the end
of the previous period.
Simple versus Compound Interest

• This interest-earning process repeats, and after N periods, the total

accumulated value (balance) F will grow to
Practice

(b) Compound interest: Applying Eq. (2.3) to our three-year, 8% case,

we obtain
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, which we assume to exist.
• Economic equivalence 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.
• The important fact to remember about the present value of future cash
flows is that the present sum is equivalent in value to the future cash
flows.
• It is equivalent because if you had the present value today, you could
transform it into the future cash flows simply by investing it at the
interest rate, also referred to as the discount rate.
• Economic equivalence exists between cash flows that have the same
economic effects 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.
Practice
Equivalence Calculations Require a Common Time Basis for
Comparison
• We commonly use either the present time, which yields what is called the present
worth of the cash flows, or some point in the future, which yields their future
worth.
• Solving for i
• 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?
• Single Amounts: Find N, Given P, F, and i?
• 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).
Present Values of an Uneven
Example:
• 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?
Present Values of an Uneven cash flow

• Given: Uneven cash flow; i = 10% per year.

• Find: P.
• 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.
Equal Payment Series: Find F, Given i, A, 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.
• Results
• F = $5,000(5.6371)= $28,185.46.
• The term within the brackets is called the equal-payment-series
sinking-fund factor, or just sinking-fund factor,
• 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.
Sinking-Fund Factor: Find A, Given F, i, and N

• Given: i = 7% per year, and N = 8 years.

• Find: A.
• Using the sinking-fund factors, we obtain
• A = $100,00O(A/F, 7%, 8)
• = $9,746.78.
• Thanks