Engineering Economy

Chapter 4: The Time Value of Money

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Key Concepts
Cash Flow Diagram: the financial description (visual) of a project Time Value of Money: the value of money changes with time
Money provides utility (value) when spent Value of money grows if invested Value of money decreases due to inflation

Interest: used to move money through time for comparisons

Time Value of Money

Money has value because it gives us utility. Generally, money is preferred now, as opposed to later (same amount)
One can spend it now and get utility One can invest it and watch it grow with interest for greater future utility One can put it under the mattress and watch it lose purchasing power

Time Value of Money

To describe the same amount of money at different periods of time requires the use of an interest rate. With a positive rate:
Money grows (compounds) into larger future sums in the future. Money is smaller (discounted ) in the past.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Money has a time value.

Capital refers to wealth in the form of money or property that can be used to produce more wealth. Engineering economy studies involve the commitment of capital for extended periods of time. A dollar today is worth more than a dollar one or more years from now (for several reasons).
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Return to capital in the form of interest and profit is an essential ingredient of engineering economy studies.
Interest and profit pay the providers of capital for forgoing its use during the time the capital is being used. Interest and profit are payments for the risk the investor takes in letting another use his or her capital. Any project or venture must provide a sufficient return to be financially attractive to the suppliers of money or property.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Cash Flow
Movement of money in (out) of a project Inflows: revenues or receipts Outflows: expenses or disbursements Net Cash Flow:

Cash Flow Analysis

Given that any investment opportunity can be drawn by a cash flow diagram, how can we select the best? Transform all cash flow diagrams into something similar for comparison.
Use a Common Interest Rate Use Time Value of Money Calculations

Cash Flows
Discrete: Movement of cash to or from a project at a specific point in time. Continuous: Rate of cash moving from or to a project over some period of time.

Cash Flow Diagram

Financial representation of a project. Describes type, magnitude and timing of cash flows over some horizon. Can describe any investment opportunity. Typical investment:

Cash Flow Diagram

Describes type, magnitude and timing of cash flows over some horizon
500K 200K 0 1 2 50K 100K 500K 200K 3 200K 4 5

Cash Flow Diagram

Continuous cash flows define a rate of movement of cash over time.
500K 200K 0 1 2 3 200K 4 5

500K

While good for analysis, not used often.

Cash Flow Diagram

Net Cash Flow Diagram
98.0M 97.2M 96.4M
0 1 2 3

89.5M
9 10

113M

490M

Interest
Interest Rate comprised of many factors Example: Home Mortgage: 7.5%
Prime Rate : (Banks borrow money at this rate from the Federal Reserve banks when needed) 5% Risk Factor : 1% Administration Fees : 0.5% Profit : 1%

May inflate more for higher risk client.

Interest
Cost of Money
Rental amount charged by lender for use of money In any transaction, someone earns and someone pays interest

Savings Account: Home/Auto Loan:

bank pays you; 1.5% fee to depositor borrower pays bank; 7.5% fee to bank

Simple Interest: infrequently used

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, the interest and interest rate are said to be simple.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Computation of simple interest

The total interest, I, earned or paid may be computed using the formula below.

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 + I.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

If $5,000 were loaned for five years at a simple interest rate of 7% per year, the interest earned would be

So, the total amount repaid at the end of five years would be the original amount ($5,000) plus the interest ($1,750), or $6,750.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Compound interest reflects both the remaining principal and any accumulated interest. For $1,000 at 10%
(1) (2)=(1)x10% Interest Amount owed at beginning of amount for period period $1,000 $100 $1,100 $1,210 $110 $121 (3)=(1)+(2) Amount owed at end of period $1,100 $1,210 $1,331

Period 1 2 3

Compound interest is commonly used in personal and professional financial transactions.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Figure 4-1
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

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.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

We need some tools to find economic equivalence.

Notation used in formulas for compound interest calculations.
i = effective interest rate per interest period N = number of compounding (interest) periods P = present sum of money; equivalent value of one or more cash flows at a reference point in time; the present F = future sum of money; equivalent value of one or more cash flows at a reference point in time; the future A = end-of-period cash flows in a uniform series continuing for a certain number of periods, starting at the end of the first period and continuing through the last
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Figure 4-5
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Figure 4-6
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Cash flow tables are essential to modeling engineering economy problems in a spreadsheet

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

We can apply compound interest formulas to move cash flows along the cash flow diagram.
Using the standard notation, we find that a present amount, P, can grow into a future amount, F, in N time periods at interest rate i according to the formula below. In a similar way we can find P given F by
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

It is common to use standard notation for interest factors.

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. is called the single payment present worth factor.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

We can use these to find economically equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six years if the interest rate is 8% per year?

$3,000 at the end of year seven is equivalent to how much today (time zero) if the interest rate is 6% per year?
Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

There are interest factors for a series of end-of-period cash flows.

How much will you have in 40 years if you save $3,000 each year and your account earns 8% interest each year?

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding the present amount from a series of end-of-period cash flows.

How much would is needed today to provide an annual amount of $50,000 each year for 20 years, at 9% interest each year?

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding A when given F.

How much would you need to set aside each year for 25 years, at 10% interest, to have accumulated $1,000,000 at the end of the 25 years?

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding A when given P.

If you had $500,000 today in an account earning 10% each year, how much could you withdraw each year for 25 years?

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

It can be challenging to solve for N or i.

We may know P, A, and i and want to find N. We may know P, A, and N and want to find i. These problems present special challenges that are best handled on a spreadsheet.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding N
Acme borrowed $100,000 from a local bank, which charges them an interest rate of 7% per year. If Acme pays the bank $8,000 per year, now many years will it take to pay off the loan? So,

This can be solved by using the interest tables and interpolation, but we generally resort to a computer solution.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding i
Jill invested $1,000 each year for five years in a local company and sold her interest after five years for $8,000. What annual rate of return did Jill earn? So,

Again, this can be solved using the interest tables and interpolation, but we generally resort to a computer solution.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

There are specific spreadsheet functions to find N and i.

The Excel function used to solve for N is NPER(rate, pmt, pv), which will compute the number of payments of magnitude pmt required to pay off a present amount (pv) at a fixed interest rate (rate). One Excel function used to solve for i is RATE(nper, pmt, pv, fv), which returns a fixed interest rate for an annuity of pmt that lasts for nper periods to either its present value (pv) or future value (fv).
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

We need to be able to handle cash flows that do not occur until some time in the future.
Deferred annuities are uniform series that do not begin until some time in the future. If the annuity is deferred J periods then the first payment (cash flow) begins at the end of period J+1.
Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Finding the value at time 0 of a deferred annuity is a two-step process.

1. Use (P/A, i%, N-J) find the value of the deferred annuity at the end of period J (where there are N-J cash flows in the annuity). 2. Use (P/F, i%, J) to find the value of the deferred annuity at time zero.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Sometimes cash flows change by a constant amount each period.

We can model these situations as a uniform gradient of cash flows. The table below shows such a gradient.
End of Period 1 2 3 : N
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Cash Flows 0 G 2G : (N-1)G

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

It is easy to find the present value of a uniform gradient series.

Similar to the other types of cash flows, there is a formula (albeit quite complicated) we can use to find the present value, and a set of factors developed for interest tables.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

We can also find A or F equivalent to a uniform gradient series.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

The annual equivalent of this series of cash flows can be found by considering an annuity portion of the cash flows and a gradient portion. End of Year 1 2 3 4 Annuity ($) 2,000 2,000 2,000 2,000

End of Year 1 2 3 4

Cash Flows ($) 2,000 3,000 4,000 5,000

Gradient ($) 0 1,000 2,000 3,000

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Sometimes cash flows change by a constant rate, ,each period--this is a geometric gradient series.
This table presents a geometric gradient series. It begins at the end of year 1 and has a rate of growth, , of 20%. End of Year 1 2 3 4 Cash Flows ($) 1,000 1,200 1,440 1,728
Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

We can find the present value of a geometric series by using the appropriate formula below.

Where

is the initial cash flow in the series.

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

When interest rates vary with time different procedures are necessary.
Interest rates often change with time (e.g., a variable rate mortgage). We often must resort to moving cash flows one period at a time, reflecting the interest rate for that single period.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

The present equivalent of a cash flow occurring at the end of period N can be computed with the equation below, where ik is the interest rate for the kth period.

If F4 = $2,500 and i1=8%, i2=10%, and i3=11%, then

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Nominal and effective interest rates.

More often than not, the time between successive compounding, or the interest period, is less than one year (e.g., daily, monthly, quarterly). The annual rate is known as a nominal rate. A nominal rate of 12%, compounded monthly, means an interest of 1% (12%/12) would accrue each month, and the annual rate would be effectively somewhat greater than 12%. The more frequent the compounding the greater the effective interest.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

The effect of more frequent compounding can be easily determined.

Let r be the nominal, annual interest rate and M the number of compounding periods per year. We can find, i, the effective interest by using the formula below.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Finding effective interest rates.

For an 18% nominal rate, compounded quarterly, the effective interest is.

For a 7% nominal rate, compounded monthly, the effective interest is.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Effects of Compounding
18%Compoundedlessthen1year n 1 Ratepern 0.18000 Effectivei 18.000% PV $10,000 FV5years $22,877.58

0.09000

18.810%

$10,000

$23,673.64

0.04500

19.252%

$10,000

$24,117.14

12

0.01500

19.562%

$10,000

$24,432.20

360

0.00050

19.716%

$10,000

$24,590.50

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Figure 4-18
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Interest can be compounded continuously.

Interest is typically compounded at the end of discrete periods. In most companies cash is always flowing, and should be immediately put to use. We can allow compounding to occur continuously throughout the period. The effect of this compared to discrete compounding is small in most cases.
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

Interpolation
% N 5 5 Factor 0.7473 0.713

Find 6.5% for 5 years from the table. Find the incremental difference and add the appropriate amount to the low number Or For 6.5 add the factor for 7 and 6 then divide by 2! (.7473 +.713)/2 = .73015
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

6% 7%

0.0343 Subtract7%Factorfrom6%factor

Divideby10

0.00343

Multiplyby5

0.01715

AddtothelowerFactorfor6%=6.5%

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

0.73015

Interpolation
% N 5 5 Factor 0.7473 0.713

What about 6.9%?

6% 7%

0.0343 Subtract7%Factorfrom6%factor

Divideby10

0.00343

Multiplyby9

0.01372

AddtothelowerFactorfor6%=6.9%
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.

0.73358

Names
Engineering Economy
Present Worth (PW) Future Worth (FW) Future Value (FV) Annual Worth (AW) Internal Rate of Return (IRR) Minimum Acceptable Rate of Return (MARR)
Engineering Economy, Fourteenth Edition By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling

Finance
Net Present Value (NPV)
Present Value (PV)

Annuity (A) Internal Rate of Return (IRR)

Hurdle Rate

Discount Rate
Copyright 2009 by Pearson Education, Inc. Upper Saddle River, New Jersey 07458 All rights reserved.