TIME VALUE OF MONEY

CHAPTER 2
 Time Value of Money
 The Cost of Money is established and measured by an
interest rate, a percentage that is periodically applied
and added to an amount of money over a specified
length of time.

 Economic Equivalence

 Interest Formulas – Single Cash Flows

 Equal-Payment Series

 Dealing with Gradient Series

 Composite Cash Flows.

 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 having money available for use -

a cost to the borrower and an earning to the lender
 Elements of Transactions involve Interest
1. Initial amount of money in transactions involving debt or
investments 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.

4. A specified length of time marks the duration of the transactions

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. [monthly equal
payment]

6. A future amount of money (F) results from the cumulative effects

of the interest rate over a number of interest periods.
 EXAMPLE OF INTEREST TRANSACTION

 Suppose that you apply for an education loan of

$30,000 from a bank at a 9% annual interest rate. In
addition you pay a $300 loan origination fee when
the loan begins.

 The bank offers two repayment plans, one with equal

payments made at the end of every year for the next
five years (installment plan) and the other with a
single payment made after the loan period of five
years (deferment plan).
 Which Repayment Plan?
Table 2.1 Repayment plan offered by the lender

End of Year Receipts Payments

Plan 1 Plan 2
Year 0 $30,000.00 $300.00 $300.00

Year 1 $7,712.77 0

Year 2 $7,712.77 0

Year 3 $7,712.77 0

Year 4 $7,712.77 0

Year 5 $7,712.77 46,158.72

The amount of loan = $30,000 & origination fee = $300 &

interest rate = 9% APR
F = P (1 + i )N = P (1+0.09)5 = $30,000 x (1.09)5 = $46,158.72
Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example
  i (1  i ) N   0.09(1  0.09) 5  =
( A / P, i, N )  A P  N  A P (30,000)  5 
 (1  i )  1  (1  0.09)  1  $7,712.77

 i 
( A / F , i , N )  A F    0.09  =
N
 (1  i )  1 A $46,158.72 5 
 (1  0.09)  1 $7,712.77

Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example
 Methods of Calculating Interest

 Simple interest: the practice of charging an interest

rate only to an initial sum (principal amount).

 Compound interest: the practice of charging an

interest rate to an initial sum and to any previously
accumulated interest that has not been withdrawn.

 Engineering economic analysis uses the compound

interest scheme exclusively, as it is most frequently
practiced in real world.
F P  (iP ) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N
n 0 : P
n 1 : F1  P (1  i )
n 2 : F2  F1 (1  i )  P (1  i ) 2

n  N : F  P (1  i ) N
 Practice Problem

Problem Statement

If you deposit $100 now (n = 0) and $200 two years from

now (n = 2) in a savings account that pays 10% interest,
how much would you have at the end of year 10?
 Solution F

0 1 2 3 4 5 6 7 8 9 10

$100(1  0.10)10 $100(2.59) $259

$200(1  0.10)8 $200(2.14) $429
$100
F $259  $429 $688
$200
 Economic Equivalence

 What do we mean by “economic equivalence?”

 Why do we need to establish an economic equivalence?

 How do we establish an economic equivalence?

 Economic Equivalence
How do we know, whether we should prefer to have $20,000
today and
$50,000 ten years from now, or $8,000 each year for the next
ten years?

Figure 2-3 Which option would you prefer?

 Equivalence Calculation: A Simple example

Figure 2-4 Using compound interest to establish economic equivalence

Equivalence relation between P and F.
EXAMPLE 2.3 Equivalence Calculation

(Consider cash flow in Fig 2.6. Compute the

equivalence at n=3)
FIND: V3 (equivalent worth at n = 3) and i = 10%.
Step 1: $100(1+0.1)3+ $80(1+0.1)2+$120(1+0.1)1+
$150 = $511.90
Step 2: $200(1+0.1)-1+ $100(1+0.1)-2 = $264.46
Step 3: V3= $511.90 + $264.46 = $776.36

Figure 2-6 Equivalent worth calculation at n = 3

 Interest Formulas for Single Cash Flows
Compound Amount Factor

Figure 2-7 Compounding process: Find F, given P, i, and N

Interest Rate Factors (10 %)
Example 2.4 If you had $1,000 now and invested it at 7%
interest compounded annually, how much would it
be worth in 8 years?

Given: P = $1,000, i = 7 %, and N = 8 years; Find: F

F = $1,000 (1+0.07)8 = $1,718.19 or using this
F = P (F/P, i, N) factor notation together with table value
F = $1,000 (1.7182) = $1,718.19

Figure 2-8 Cash flow diagram

Present -Worth Factor
 Example 2.5 Given: F = $1000, i = 6%, and N = 8
years

Find: P P = $1,000 (1+0.06)-8 = $1,000 (0.6274) =

$627.40

Figure 2-10 Cash flow diagram

 Example 2.6 Given: P = $10, F = $20 and N = 5 years,
Find: i

F = $20 = $10 (1+ i )5 $2 = (1+ i )5 = (F / P, i, 5)

1+ i = = 1.14869 i = 1.14869 – 1 = 0.14869 or

0.1487 = 14.87%
 Example 2.7

Given: P = $3,000, F = $6,000 and i = 12%,

Find: N

F = P (1+ i )N = P (F/P, i, N) …… 6,000 = $3,000 (1+

0.12)N

2 = (1.12) N ………… Log 2 = N log 1.12 solve for

N gives
N = log 2 / log 1.12 = 0.301 / 0.049 = 6.116 ≈ 6.12 years

Figure 2-12 Cash flow diagram

 Practice Problem

$1,000

$500

A
Given: i = 10%,
0 1 2 3
Find: C that makes the
two cash flow streams
to be indifferent C C

0 1 2 3
 Approach

Step 1: $1,000
Select the base period to use,
say n = 2 $500

Step 2:
A0 1 2 3
Find the equivalent lump sum
value at n = 2 for both A and B.

C C

Step 3:
B
Equate both equivalent values
and solve for unknown C. 0 1 2 3
 Solution
For A:
$1,000
V2 $500(1  0.10) 2  $1, 000(1  0.10)  1
$1, 514.09 $500
A

For B:
V2 C (1  0.10)  C 0 1 2 3
2.1C

C C
To Find C:
2.1C $1, 514.09 B
C $721
0 1 2 3
 Practice Problem
$1,000

$500

A
0 1 2 3
At what interest rate would
you be indifferent between
the two cash flows? $502 $502 $502

B
0 1 2 3
 Approach

Step 1:
$1,000
Select the base period to
compute
$500
the equivalent value (say, n =
3)
A
0 1 2 3

Step 2:
Find the net worth of each at n
= 3. $502 $502
$502

B
0 1 2 3
 Establish Equivalence at n = 3

Option A : F3 $500(1  i ) 3  $1, 000

Option B : F3 $502(1  i ) 2  $502(1  i )  $502

Find the solution by trial and error, say i = 8%

Option A : F3 $500(1.08) 3  $1, 000

$1, 630
Option B : F3 $502(1.08) 2  $502(1.08)  $502
$1, 630
 Practice Problem

• You want to set aside a lump sum amount today in a

savings account that earns 7% annual interest to meet a
future expense in the amount of $10,000 to be incurred
in 6 years.

• How much do you need to deposit today?

Solution
$10,000

F = $10,000; N = 6 years; i = 7 %; Find P

P $10, 000(1  0.07)  6

$10, 000( P / F , 7%, 6)
P $6, 663
Figure 2.13 Decomposition of uneven cash flow series
 Equal - Payment Series

Figure 2-14 Equal payment series: Find equivalent P or F

 Equal Payment Series Compound Amount Factor:
Find F, Given A, i, and N

Figure 2-15 Cash flow diagram of the relationship between A and F

 Equal Payment Series Compound Amount Factor
(Future Value of an annuity)

(1  i ) N  1
0 1 2 3 F A
i
N
 A( F / A, i , N )
A
Example 2.9: 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% Find: F

 Solution: F = $5,000(F/A, 6%, 5) = $28,185.46 or

use interest factor table and get the value, F = $5,000

(5.6371) = $28,185.46
$5, 000(1  0.06) 4 $6, 312.38
$5, 000(1  0.06)3 $5, 955.08
$5, 000(1  0.06) 2 $5, 618.00 Validation
$5, 000(1  0.06)1 $5, 300.00
$5, 000(1  0.06) 0 $5, 000.00
$28.185.46
 Example 2.10 Handling Time Shifts in a Uniform Series
First deposit of the five deposit series was made at the end of period one and the remaining four deposits were made at the end of
each following period. Suppose that all deposits were made at the beginning of each period instead. Compute the balance at the end of
period five.

F=?
F5 $5, 000( F / A , 6%, 5)(1.06)
$29, 876.59

First deposit occurs at n i = 6%

= 0

0 1 2 3 4 5

$5,000 $5,000 $5,000 $5,000 $5,000

 Finding an Annuity Value

F
i
A F
0 1 2 3 (1  i ) N  1
N F ( A / F ,i, N )

A =?

Example:
 Given: F = $5,000, N = 5 years, and i = 7%
Find: A
(0.1739)
 Solution: A = $5,000 (A/F, 7%, 5) = $869.50
 Sinking fund

 A fund created by making periodic deposits (usually

equal) at compound interest in order to accumulate a
given sum at a given future time for some specific
purpose.

48
Sinking Fund Factor is an interest-bearing account into which a
fixed sum is deposited each interest period; The term within the
colored area is called sinking-fund factor.

i
0 1 2 3 A F
N (1  i ) N  1
F ( A / F ,i, N )
A

Example 2.11 – College Savings Plan:

 Given: F = $100,000, N = 8 years, and i = 7 % Find: A

 Solution: A = $100,000 (A/F, 7%, 8) = $9,746.78

49
 Given:
$100,000
F = $100,000
i = 7%
Current age: 10 years old N = 8 years

0
1 2 3 4 5 6 7 8

A= ?

i = 7%
Find: A from table (0.0975)
Solution: A = $100,000 (A/F, 7%, 8) = $9,746.78
 Capital Recovery Factor (Annuity Factor)

Annuity:
 An amount of money payable to a recipient at
regular intervals for a prescribed period of time out
of a fund reserved for that purpose.
 A series of equal payments occurring at equal
periods of time.

Annuity factor:

 The function of interest rate and time that determines

the amount of periodic annuity that may be paid out
of a given fund.

51
 Capital Recovery Factor

is the colored area which is designated (A/P, i, N). In

finance, this A/P factor is referred to as the annuity
P factor which indicates a series of payments of a fixed
amount for a specified number of periods.
1 2 3
0 N i (1  i ) N
A P
(1  i ) N  1
A=?  P( A / P, i , N )

Example 2.12
You borrowed $21,061.82 to finance the educational expenses for
your senior year of college. The loan will be paid off over five
years. The loan carries an interest rate of 6% per year and is to be
repaid in equal annual installments over the next five years.
Assume that the money was borrowed at the beginning of your
senior year and that the first installment will be due a year later.
 Example 2.12 Paying Off
P =$21,061.82 Educational Loan

i = 6%

0 1 2 3 4 5

A A A A
A

Example 2.12 Paying Off Education Loan

i (1  i ) N
A P
(1  i ) N  1
 Given: P = $21,061.82, N = 5 years, and i = 6% Find: A
 P( A / P, i , N )

(0.2374) from table

 Solution: A = $21,061.82(A/P,6%,5) = $5,000
Example 2.13 Deferred (delayed) 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) =

$22,325.53

0 1 2 3 4 5 6

A’ A’ A’ A’ A’
 Two - Step Procedure

P ' $21, 061.82( F / P , 6%,1)

$22, 325.53
A $22, 325.53( A / P , 6%, 5)
$5, 300
 Linear Gradient Series
Engineers frequently meet situations involving periodic
payments that increase or decrease by a constant amount (G)
from period to period.

Figure 2-25 Cash flow diagram of a strict gradient

series
Gradient Series as a Composite Series of a Uniform Series of N
Payments of A1
and the Gradient Series of Increments of Constant Amount G.
Present-Worth Factor: Linear Gradient
Find P, Given G, N, and i

Figure 2-27 Cash flow diagram of a strict gradient series

Example 2.17 Creating a Graduated (divided into regular
stages) Loan Repayment with a Linear
Gradient Series; Given P, A1, N and i Find: G
You borrowed $10,000 from a local bank, with the agreement that
you will pay back the loan according to a graduated payment plan. If
your first payment is set at $1,500, what would the remaining
payment look like at a borrowing rate of 10% over five years?

Figure 2-28 Cash flow diagram representing a graduated

payment plan
Example 2.17

SOLUTION:
Since the loan payment series consist of two parts: (1) a $1,500
equal payment series and (2) A strict gradient series
(unknown, yet to be determined) – we can calculate the
present value of each series and equate them with $10,000.
$10,000 = $1,500 (P/A, 10%, 5) + G (P/G, 10%, 5) get the
table values from appendix B …… (3.7908)
(6.8618)

$10,000 = $5,686.20 + 6.8618 G $10,000 -

Present value calculation for a gradient series:
$2,000
$1,500 $1,750
$1,250
$1,000

0
1 2 3 4 5

Q: 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 series as shown
P =? in the figure?

How many Methods to find P?

Method 1: Using the (P/F, i, N) Factor
$2,000
$1,750
$1,500
$1,250
$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
P =? $2,000(P/F, 12%, 5) = $1,134.85

$5, 204.03
 Method 2: Using the Gradient Factor

P1 $1,000( P / A,12%,5)
$3,604.80

P2 $250( P / G,12%,5)
$1,599.20

P $3,604.08  $1,599.20
$5,204
 Geometric Gradient Series
Many engineering economic problems, particularly those relating to construction costs,
involve cash flows that increase over time, not by a constant amount, but rather by a
constant percentage (geometric), called compound growth.
 Example 2.19 Required Cost-of-living
Adjustment Calculation

Suppose that your retirement benefits during your

first year of retirement are $50,000. Assume that this
amount is just enough to meet your cost of living
during the first year. However, your cost of living is
expected to increase at an annual rate of 5%, due to
inflation. Suppose you do not expect to receive any
cost of living adjustment in your retirement pension.
Then, some of your future cost of living has to come
from your savings other than retirement pension. If
your savings account earns 7% interest a year, how
much should you set aside in order to meet this future

increase in the cost of living over 25 years?

 Example 2.18 Required Cost- of - living Adjustment
Calculation Find P, Given
A1, g, i, N

Figure 2-31 Cash flow diagram

 Given: g = 5%, i = 7%, N = 25 years, A1 = $50,000

 Find the equivalent amount of total benefit paid over 25 years.

P = $50,000 (P/A, 7%, 25) = $582,679

 Find the equivalent amount of total cost of living with inflation.

P = $50,000 (P/A, 5%, 7%, 25)

 1  (1  0.05) 25 (1  0.07)  25 
P $50, 000  
 0.07  0.05 
$940, 696

The Required additional savings to meet the future increase in

cost of living will be ∆P = $940,167 - $582,679 =
$357,488
 COMPOSITE CASH FLOWS
Compute the equivalent present worth for mixed payment series at 15%.

METHOD 1
METHOD 2: GROUP THE CASH FLOW
COMPONENTS
PRACTICE PROBLEMS

CHAPTER 2
 PRACTICE PROBLEM

• A series of receiving equal quarterly payments of

$5,000 for 10 years is equivalent to what present
amount at an interest rate of 9% compounded ….

a) Quarterly
b) Monthly
 SOLUTION

A = $5,000

1 2 40 Quarters
 (a) QUARTERLY

A = $5,000  Payment period : Quarterly

 Interest Period: Quarterly

1 2 40 Quarters  (1  i ) N  1
( P / A, i, N )  P  A N 
 i (1  i ) 

9%
i  2.25% per quarter
4
N 40 quarters
P $5, 000( P / A , 2.25%, 40)
$130, 968
 (b) MONTHLY

A = $5,000
 Payment period : Quarterly
 Interest Period: Monthly

0
 (1  i ) N  1
( P / A, i , N )  P  A 
1 2 40 Quarters  i (1  i )
N


9%
i 0.75% per month
12
iQ (1  0.0075) 3  1 1.022669  1 0.022669 2.267% per quarter
N 40 quarters
P $5,000( P / A,2.267%, 40) $130,586
1) [Problem 2.7]
Suppose you have the alternative of
receiving either $15,000 at the end of seven
years or P dollars today. Currently, you have
no need for the money, so you could deposit
the P dollars into a bank account that pays
6% interest compounded annually. What
value of P would make you indifferent in
your choice between P dollars today and the
promise of $15,000 at the end of seven
years?
P F ( P / F , i, N ) 15, 000( P / F , 0.06, 7) 15, 000 0.6651 $9976.5
 2) [Problem 2.8]
Suppose that, to purchase a car, you are
obtaining a personal loan from your uncle in
the amount of $75,000 (now) to be repaid in
three years. If your uncle could earn 9%
interest (compounded annually) on his
money invested in various sources, what
minimum lump-sum payment three years
from now would make your uncle happy
Feconomically?
P ( F / P, i, N ) 75, 000( F / P, 0.09,3) 75, 000 1.2950 $97125
 3) [Problem 2.17]
How many years will it take to triple your
investment of $8,000 if it has an interest rate of
7% compounded annually?

3P = P [1 + 0.07]N

N = log 3 / log 1.07 = 16.24 years

4) [Problem 2.23]
A project is expected to generate a cash flow of
$8,000 in year 1, $2,000 in year 2, and $5,000 in
year 3. At the interest rate of 8%, what is the
maximum amount that you could invest in the
project at year zero?

P  F1  P / F , i %, N1   F2  P / F , i%, N 2   F3 P / F , i %, N3 
 8000( P / F ,8%, 1  2000  P / F , 8%, 2   5000  P / F ,8%, 3 
8000 0.9259  2000 0.8573  5000 0.7938  $13090.80 Ans.
5) [Problem 2.25]
If $4,000 is invested now, $7,000 two years
from now, and $5,000 four years from now at
an interest rate of 9% compounded annually,
what will be the total amount in 8 years?

F  P1  F / P, 9%, 8   P2  F / P, 9%, 6   P3  F / P, 9%, 4 

 4000  F / P, 9%, 8   7000  F / P, 9%, 6   5000  F / P, 9%, 4 
4000 1.9926  7000 1.6771  5000 1.4116  $26768.10 Ans.
6) [Problem 2.27]
How much invested now at an interest rate of
10% compounded annually would be just
sufficient to provide three payments as
follows: the first payment in the amount of
$5,000 occurring two years from now, the
second payment in the amount of $7,000 four
years thereafter, and the third payment in the
amount of $9,000 six years thereafter.

= 5000*0.8264 + 7000*0.5645 +
9000*0.3186
=10951
•
8) [Problem 2.58]
Suppose that an oil well is expected to
produce 1,200,000 barrels of oil during its first
year in production. However, its subsequent
production (yield) is expected to decrease by
9% over the previous year's production.
(a) Suppose that the price of oil is expected to
be $120 per barrel for the next five years.
What would be the present worth of the
anticipated revenue stream at an interest rate
of 10% compounded annually over the next
five years?
 (b) Suppose that the price of oil is expected
to start at $120 per barrel during the first
year, but to increase at the rate of 5% over
the previous year's price. What would be the
present worth of the anticipated revenue
stream at an interest rate of 10%
compounded annually over the next five
years?
(1+g) =(1+g1)(1+g2) => g = g1 + g2 + g1*g2

g = -0.09 + 0.05 - 0.0045 = -0.0445

P = 144 x 106 [ 1 – (1-0.0445)5(1.1)-5]/[0.1+0.0445] = $503,723,932

9) [Problem 2.60]
What is the amount of 10 equal annual
deposits that can provide five annual with­
drawals when a first withdrawal of $2,000 is
made at the end of year 11 and sub­sequent
withdrawals increase at the rate of 5% per
year over the previous year's withdrawal if

a) The interest rate is 7% compounded

annually?

b) The interest rate is 5% compounded

annually?
 A1  1  1  i  1 1  g  1 
N N

(a ) F A ( F / A , i %, N ) P   
i g
2000  1  1  0.07  1  0.05  
5 5

A( F / A , 7%,10)   
0.07  0.05
2000 1  1  0.07  1  0.05  
5 5

A   $652.6 Ans.
(0.07  0.05) 13.8164
AN
(b) F A ( F / A , i %, N ) P  1
1  i 
2000 5 2000 5
A  $757.18 Ans.
1  0.05 ( F / A,5%,10) 1  0.05(12.5779)