ENGINEERING ECONOMY

Seventeenth Edition

Chapter 4
PRINCIPLES OF
MONEY-TIME
RELATIONSHIPS
The Time Value of Money

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Objectives Of This Chapter
· Describe the return to capital in the form of interest
· Illustrate how basic equivalence calculation are made
with respect to the time value of capital in Engineering
Economy
Capital
• Wealth in the form of money or property that can be
used to produce more wealth
• Types of Capital
– Equity capital
• Owned by individuals
– Debt capital
• Obtained from lenders
Time Value of Money
• Money can “make” money if invested
• Change in the amount of money over a
given time period is called the time value
of money
• Most important concept in engineering
economy
Interest and Interest Rate

• Interest - The Amount Paid To Use

Money
– Rental Fee Paid For The Use Of Someone
Else's Money
• Interest Rate - Interest Per Time Unit
INTEREST PER TIME UNIT
INTEREST RATE 
ORIGINAL AMOUNT
Simple and Compound Interest
•Two “types” of interest calculations
• Simple Interest
• Compound Interest
•Compound Interest is more common
Simple Interest
•Total interest earned or charged is linearly
proportional
•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
Compound Interest

• Interest charge is based on the remaining principal

amount plus any accumulated interest charges

Period Amount Owed Interest Amount Amount Owed at

Beginning of for Period (@10%) end of Period
Period

1 $1000 $100 $1100

2 $1000 $110 $1210
3 $1000 $121 $1331
Illustration of Simple versus Compound Interest

Initial Investment 1000

Interest rate 10%
Time period 30
Simple 4000
Compunded $17,449.40
EQUIVALENCE
•You travel at 68 miles per hour
•Equivalent to 110 kilometers per hour
•Thus:
• 68 mph is equivalent to 110 kph
• Using two measuring scales
•Is “68” equal to “110”?
•No, not in terms of absolute numbers
•But they are “equivalent” in terms of the two measuring
scales
Economic Equivalence

• Established when we are indiff erent between a future

payment and a present sum of money
• Considers the comparison of alternative options, or proposals
– interest rate;
– amounts of money involved;
– timing of the aff ected monetary receipts and/or
expenditures;
– manner in which the interest , or profi t on invested
capital is paid and the initial capital is recovered
Cash Flow Diagramming
• Engineering Economy has developed a
graphical technique for presenting a
problem dealing with cash flows and their
timing.
• First, some important TERMS . . . .
Cash Flow Diagram / Table Notation

• i = eff ective interest rate per interest period

• N = number of compounding periods
• P = present sum of money; equivalent value of one or more
cash fl ows at present time
• F = future sum of money; equivalent value of one or more
cash fl ows at a future time
• A = end-of-period cash fl ows in a uniform series continuing
for a specifi ed number of periods
• G = uniform gradient amounts -- used if cash fl ows increase
by a constant amount
Interest Formulas Relating Present and Future
Equivalent Values of Single Cash Flows
• Finding F when given P:
• Finding future value when given present value

• F = P ( 1+i ) N
– (1+i) N single payment compound amount factor
– functionally expressed as F = P ( F / P, i%,N )
Interest Formulas Relating Present and Future Equivalent
Values of Single Cash Flows
• Finding P when given F:
• P = F [1 / (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.
An Example

• How much would you have to deposit now into an account

paying 10% interest per year in order to have $1,000,000 in
40 years?
• Assumptions: constant interest rate; no additional deposits or
withdrawals
Solution:
P= 1000,000 (P/F, 10%, 40)=$22,100
Appendix C of text- annuity tables
Relating A Uniform Series (Ordinary Annuity) To
Present And Future Equivalent Values
• Finding F given A:
• Future equivalent value given a series of uniform equal
payments
 (1  i ) n
 1
F=A  
 i 

• u n i f o rm s e r i e s c o m p o u n d a m o u n t f a c t o r
• f u n c t i o n a l l y ex p re s s e d a s F = A ( F / A , i % , N )
• p re d e t e rm i n e d v a l u e s a re i n c o l u m n 4 o f A p p e n d i x C o f t ex t
Relating a Uniform Series (Ordinary Annuity) To Present and
Future Equivalent Values
• Finding P given A:
• Finding present equivalent value given a series of uniform equal receipts
 (1  i ) n  1 
P A  n  for i 0
 i (1  i ) 

– uniform series present worth factor

– functionally expressed as P = A ( P / A,i%,N )
– predetermined values are in column 5 of Appendix C of text
Lotto Example
• If you win $5,000,000 in the California lottery, how much will
you be paid each year? How much money must the lottery
commission have on hand at the time of the award? Assume
interest = 3%/year.
• Given: Jackpot = $5,000,000, N = 19 years (1st payment
immediate), and i = 3% year
• Solution:
• A = $5,000,000/20 payments = $250,000/payment (This is the
lottery’s calculation of A
P = $250,000 + $250,000(P/A, 3%, 19)
P = $250,000 + $3,580,950 = $3,830,950
Relating A Uniform Series (Ordinary Annuity) To Present And
Future Equivalent Values
• Finding A given F:
• Finding amount A of a uniform series when given the equivalent future value
 i 
A F  n 
 (1  i )  1 
sinking fund factor
– functionally expressed as A = F ( A / F,i%,N )
– predetermined values are in column 6 of Appendix C of textbook
Relating A Uniform Series (Ordinary Annuity) To Present
And Future Equivalent Values
• Finding A given P:
• Finding amount A of a uniform series when given the equivalent present value
 i (1  i ) n 
A P  n 
 (1  i )  1 
– capital recovery factor
– functionally expressed as A = P ( A / P,i%,N )
– predetermined values are in column 7 of Appendix C of textbook
Example - Uniform Series Capital Recovery Factor

• Suppose you fi nance a $10,000 car over

60 months at an interest rate of 1% per
month. How much is your monthly car
payment?
• Solution:
A = $10,000 (A | P, 1%, 60) = $222 per
month
Example: Uniform Series Compound Amount
Factor
• Assume you make 10 equal annual deposits of
$2,000 into an account paying 5% per year. How
much is in the account just after the 10th deposit?
• Solution:
• F= $2,000 (F/A, 5%, 10) = $25,156
Another Example:
You want to have one million dollars 40 years from
now
• What uniform annual deposit for 40 years would
also make you a millionaire?
• Solution:
• A = $1,000,000 (A | F, 10%, 40) = $2,300
COMBINING FACTORS
• IF cash fl ows that are combinations of series and other single
cash fl ows
• Shifted Series
• Solve for the series present worth values then move to t =
0
• Shifted Single Amounts
• Solve for the PW at t = 0 for the single cash fl ows
• Shifted Series and Single Amounts
• Solve for the series present worth values then move to t =
0
• Solve for the PW at t = 0 for the single cash fl ows
• Add the equivalent PW’s at t = 0
Example:
Consider:
0 1 2 3 4 5 6 7 8

A = -$500/year
P0 P2

PW of this series is at t = 2 (P2 or F2)

P2 = $500(P/A,i%,4) or, could refer to as F2
P0 = P2(P/F,i%,2) or, F2 (P/F,i%,2)
P0 = $500(P/A,i%,4)(P/F,i%,2)
Shifted Series and Single Amounts
F4 = $300

• Consider: A = $500

0 1 2 3 4 5 6 7 8

i = 10%

F5 = -$400

•Find the PW at t = 0 and FW at t = 8

The PW Points are:
F1 or P1 F4 = $300

A = $500

1 2 3
0 1 2 3 4 5 6 7 8

i = 10%

F5 = -$400
• P1 of shifted series at t1

• P1(P/F, i%, 1) or $500 (P/A, i%, 3)(P/F, i%, 1)

Write the Equivalent Statement
• P=$500(P/A, 10%, 3)(P/F, 10%, 1)+300 (P/F, 10%, 4)-
400(P/F, 10%, 5)
• Substituting the factor values into equivalence
expression and solving…
• P = $500( 2.4869 )( 0.9090 ) $1,130.30
+
$300( 0.6830 ) $204.90

-
$400( 0.6209 ) $248.36

= $1086.84
Arithmetic Gradient Cash Flows

• Receipts or expenses that are projected to

increase or decrease by a uniform amount
each period
• Modeled as a uniform gradient of cash fl ows
Deviating Gradient Factor

• Arithmetic Cash Flow can be broken into two cash fl ows diagrams

• Recall the P/A that was already explained

• Develop a closed form formula for the second part
• Note of timing cash fl ows on which the interest formulas can be
derived
Interest Formulas Relating A Uniform Gradient of Cash
Flows To Future Equivalents

• Find the future equivalent value when given the

uniform gradient amount
• F=G(F/A, i%, N-1)+G((F/A, i%, N-2)+…+G(F/A, i%,
2)+G(F/A, i%, 1)
Interest Formulas Relating A Uniform Gradient of Cash Flows To Annual
and Present Equivalents

• Find the annual equivalent value when given the uniform gradient amount

• Functionally represented as A = G ( A / G, i%,N )

• Presented in column 9 of Appendix C (represented in the above pranthetial
expression)
 Interest Formulas Relating A Uniform Gradient of Cash Flows To Annual and
Present Equivalents

• Find the present equivalent value when given the uniform gradient amount
G  (1  i ) N  1 N 
P=   
i  i (1  i ) N (1  i ) N 
• Functionally represented as P = G ( P / G, i%,N )
• Presented in column 8 of Appendix C (represented in the above
parenthetical expression).
Arithmetic Gradient Example
• Consider the following cash flow

$500
$400
$300
$200
$100

0 1 2 3 4 5
Present Worth Point is here!
And the G amt. = $100/period
Find the present worth if i = 10%/yr; n = 5 yrs
 Gradient Example – Base annuity
$500
$400
$300
$200
$100

0 1 2 3 4 5

• First, the Base Annuity of $100/period

• P of the base annuity = $100 (P/A, 10%, 5)
• P = $100 (3.7908) = 379.08
• Note Finished: we need the P of the gradient component and
then add that value to the $379.08 amount
 $500
$400
$300
$200
$100

0 1 2 3 4 5

$400
$300
$200
$100
$0

0 1 2 3 4 5

• We desire the P of the Gradient Component at t = 0

• P= G(P/G,10%,5) = $100(P/G,10%,5)=$686.18
Gradient Example: Final Result
• PBase Annuity = $379.08

•PGradient Component= $686.18

•Total P= $379.08 + $686.18 = $1065.26

•Note: The two sums occur at t =0 and can be added together –
concept of equivalence
Two Common Forms of Quotation

• Two types of interest quotation

• 1. Quotation using a Nominal Interest Rate
• 2. Quoting an Eff ective Periodic Interest
Rate
• Both are common in business, fi nance, and
engineering economy
• Each must be understood
Nominal Interest Rate

• A Nominal Interest Rate, r, is an interest Rate that

does not include any consideration of compounding
• Mathematically
r = (interest rate per period)(No. of Periods)
If interest period is the same as compounding period,
then Nominal Interest Rate=Eff ective Interest Rate
r=Ie
Examples – Nominal Interest Rates

• 1.5% per month for 24 months

– S ame a s : ( 1 . 5 % ) ( 2 4 ) = 3 6 % p e r 2 4 mo n th s
• 1.5% per month for 12 months
– S ame a s ( 1 . 5 % ) ( 1 2 mo n t h s ) = 1 8 % /y e ar
• 1.5% per 6 months
– S ame a s : ( 1 . 5 % ) ( 6 m o n th s ) = 9 % /6 mo n t h s o r s e mi an n u al p e r i o d
• 1% per week for 1 year
– S ame a s : ( 1 % ) ( 5 2 w e e k s ) = 5 2 % p e r y e ar
• A nominal rate does not reference the frequency of compounding
• Need an alternative way to quote interest rates
The Effective Interest Rate

• Eff ective interest rate is a true, periodic interest rate

• Applies for a stated period of time
• Example: “12 % compounded monthly”
• Pick this statement apart:
– 12% is the nominal rate
– “compounded monthly” conveys the frequency of the
compounding throughout the year
– 12 compounding periods within a year
Nominal and Effective Interest Rates

• i e =(1+r/M) M -1
• M = the number of compounding periods within
the year
• r= Nominal
• Annual Percentage Rate (APR) – Percentage per
period plus overhead
Example:

• Example: Interest is 8% per year compounded quarterly”.

• What is the true annual interest rate?
– Eff ective Interest Rate = (1 + 0.08/4) 4 – 1
– Effective Interest Rate = (1.02) 4 – 1 = 0.0824 = 8.24%/year
• Example: “18%/year, comp. monthly”
– 0.18/12 = 0.015 = 1.5% per month.
– 1.5% per month is an effective monthly rate.
• The effective annual rate is:
– (1 + 0.18/12) 1 2 – 1 = 0.1956 = 19.56%/year
Interest Problems with Cash Flows Less Than
Compounding Periods

• Reality:
– Compounding period and payment periods do not always
match up;
– May have monthly cash fl ows but…
– Compounding period diff erent that monthly
• Savings Accounts – for example;
– Monthly deposits with quarterly interest earned or paid;
– They don’t match!
• Make them match!
Example – Single Amounts

• “r” = 15%, c.m. (compounded monthly)

• Let P = $1500.00
• Find F at t = 2 years
• 15% c.m. = 0.15/12 = 0.0125 = 1.25%/month.
• n = 2 years OR 24 months
• Work in months or in years
Approach 1 – Work with Mounts

– Draw the CFD

– F 2 4 = $1,500(F/P,0.15/12,24);
– F 2 4 = $1,500(F/P,1.25%,24);
– F 2 4 = $1,500(1.0125) 2 4 =$2,021.03.
Approach 2- Work With Years

• N= 2 years and i/month =0.0125

• Eff ective Interest Rate= (1.0125) 1 2 – 1 = 0.1608 or 16.08%%
• F 2 = $1,500(F/P,16.08%,2)
• F 2 = $1,500(1.1608) 2 = $2,021.19
• Slight roundoff compared to approach 1
Continuous Compounding and Discrete Cash
Flows

• Occurs at discrete intervals, but compounding is

continuous throughout the interval
• Given nominal per year interest rate– r, compounding
per year – M one unit of principal = [1+(r/M)] M
• Given (M/r) = p [1+ (r/M)] M =[1+ (1/p)] rp
=
{[(1+(1/p)] r p } r
• (F/P, r%, N)= e r N
• I E ff e c t i v e = e r -1, e=2.71…..
Example of Continuous Compounding

• What is the true, eff ective annual interest rate if the

nominal rate is given as:
– r = 18%, compounded continuously
• Solution
• Solve e 0.18
-1=1.1972 -1 = 19.72%/year
Example

• Requires an eff ective return of at least 15% per year.

• What is the minimum annual nominal rate if interest on his
investment is compounded continuously?
• Solution:
– e r – 1 = 0.15
– e r = 1.15
– ln(e r ) = ln(1.15)
– r = ln(1.15) = 0.1398 = 13.98%
Continuous Compounding and Discrete Cash
Flows Single cash Flow

• Finding future equivalent value given present value

• F=P (e r N )
• Functionally expressed as (F/P, r%, N)
• e r N is continues compounding compound amount
• Predetermined values are in column 2 0f Appendix D of
text
 Hypothetical Cash Flow Financial model
Hypothetical Cash Flow Financial
model
Period/years 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Discount rate
(inflation+others) 5%
Growth rate 5%
Other events 500 500 500 200 100 -100 -200 -500 -1000 -2000
Cash Flow (CF) 1000 1050 1102.5 1157.625 1215.506 1276.282 1340.096 1407.1 1477.455 1551.328 1628.895 1710.339 1795.856 1885.649
Net CF 1000 1050 1102.5 1657.625 1715.506 1776.282 1540.096 1507.1 1477.455 1451.328 1428.895 1210.339 795.8563 -114.351
Discounted CF 952.381 952.381 952.381 1363.732 1344.144 1325.489 1094.517 1020.065 952.381 890.9896 835.4451 673.9622 422.0596 -57.755
Present value $ 13,674.55
Future value $ 28,428.41
Number of shares 100

Present value of
the Share price $ 136.75