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4 - Time Value of Money

1. Capital investment in oil projects is used for fixed capital like machinery and equipment, and working capital for operating costs like raw materials, wages, and utilities. Fixed capital is depreciable while working capital is not. 2. Interest is compensation for borrowed capital, typically charged at the prime rate. Simple interest charges the same rate on the original principal, while compound interest adds accrued interest to the principal each period. 3. Effective interest rates factor in compounding periods less than one year, yielding a higher return than the stated nominal annual rate. The effective annual rate can be calculated from the nominal rate and compounding periods.

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41 views22 pages

4 - Time Value of Money

1. Capital investment in oil projects is used for fixed capital like machinery and equipment, and working capital for operating costs like raw materials, wages, and utilities. Fixed capital is depreciable while working capital is not. 2. Interest is compensation for borrowed capital, typically charged at the prime rate. Simple interest charges the same rate on the original principal, while compound interest adds accrued interest to the principal each period. 3. Effective interest rates factor in compounding periods less than one year, yielding a higher return than the stated nominal annual rate. The effective annual rate can be calculated from the nominal rate and compounding periods.

Uploaded by

Kaoru Amane
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Principles, Methods, and Techniques

of Engineering Economics Analysis


Capital Investment

 Money invested in oil projects is used for the following


purposes:
1. To purchase and install the necessary machinery,
equipment, and other facilities. This is called fixed
capital investment. This investment is depreciable.
2. To provide the capital needed to operate an oil field or a
refinery as well as the facilities associated with them.
This is what is called working capital. Principally it is
capital tied up in raw material inventories in storage,
process inventories, finished product inventories, cash
for wages, utilities, etc. This is a non-depreciable
investment.
Interest

 Interest may be defined as the compensation paid for


the use of borrowed capital.
 The recognized standard is the prime interest rate,
which is charged by banks to their customers.
Types of Interest

 Interest may be described as simple or compound.


 Simple interest, as the name implies, is not
compounded; it requires compensation payment at a
constant interest rate based only on the original
principal.
 In compound interest, the interest on the capital due at
the end of each period is added to the principal;
interest is charged on this converted principal for the
next time period. Most oil economics are based on
compound interest.
Interest Calculation

 If P represents the principal (in dollars), n the


number of time units (in years), and i the interest
rate based on the length of one interest period,
then:
 Using simple interest: the amount of money to be paid
on the borrowed capital P, is given by: (P) (i) (n).
 Hence the sum of capital plus the interest due after n
interest periods will be denoted by:

where F is the future value of the capital P.


 Using compound interest: the amount due after any
discrete number of interest periods can be calculated as
follows:

 Thus the general equation is given by:


Example 4.1

A sum of $1,000 is deposited into an account where the


interest rate is 10% compounded annually; compare the
future values of the deposit for the two cases of simple
and compound interest after 4 years.
Solution to Example 4.1
Effective Interest

 The discrete compounding interest can be further


classified as effective or nominal depending on the time
period at which money is compounded.
 In other words, if the length of the discrete interest
period is 1 year, the interest rate is known as the
effective one, while if other time units less than 1 year
are used, the interest rate is described as nominal.
 In common engineering practice, 1 year is assumed as
the discrete interest period; however, there are many
cases where other time units are employed.
 For instance, the future value after 1 year of $1,000
compounded annually at 6% is $1,060, while if
compounding is done quarterly (every 3 months), the
return will be $1,061 (i.e., 1.5% four times a year).
 A rate of this type would be referred to as “6 percent
compounded quarterly.” This is known as the nominal
interest rate.
 The effective interest rate in this case is definitely
greater than 6%, since we are making more money
(compare $61 to $60).
 The effective interest rate, “ie” is related to the
nominal interest rate “i” as follows:
 If “i” is the nominal interest rate stated under the
conditions for “m” compounding time periods per year,
then the interest rate for one period is given by i/m.
Hence the future value after 1 year is

 The future value F1 can be expressed at the same time


in an alternate form as
 The effective interest rate “ie” is related to i and m as
given by:

 To find the future worth after n years using the nominal


interest rate:
Example 4.2

Assume that a short-term loan for 1 year only could be


arranged for an oil company in temporary distress. The
company needs $100,000 for immediate working capital at
either a nominal rate of 12% compounded monthly or a
nominal rate of 15% compounded semiannually. The oil
company wants to know which arrangement would provide
the oil company with the lower debt at the end of the
short-term loan period.
Solution to Example 4.2

 On a nominal 12% rate compounded monthly:

 On a nominal 15% rate, compounded semiannually:

 The loan at 12% compounded monthly has the lower


effective interest rate
Annuities and Periodic
Payments
 An annuity is a series of equal payments occurring at
equal time intervals, normally at the end of the period.
 The amount of an annuity is the sum of all payments
plus interest if allowed to accumulate at a definite rate
of interest during the annuity term.
 Assume that the amount of annuity at the end of n years
is F, while A is the uniform yearly periodic payment to
be invested at i interest yearly rate.
 By the end of the annuity term:
 Finally the sum of all payments will be F, where

 Hence it can be shown that

 The above factor [(1 + i)n – 1]/i is known as the


compound amount factor or sinking fund factor.
 A is related to this value of F by:

 Substituting

 Solving for A

 where [i(1 + i)n/(1 + i)n – 1] is known as the capital


recovery factor.

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