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IM1027 Sem232 Topic 02-1 Time Value

This document discusses key concepts related to the time value of money, including effective and nominal interest rates, simple and compound interest, cash flow diagrams, and formulas for calculating present value, future value, and annuities. It provides examples of how to use these formulas to find equivalent values when interest rates, time periods, or cash flows change. Spreadsheet functions like NPV, PMT, and RATE are also introduced as tools for solving time value of money problems.

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19 views

IM1027 Sem232 Topic 02-1 Time Value

This document discusses key concepts related to the time value of money, including effective and nominal interest rates, simple and compound interest, cash flow diagrams, and formulas for calculating present value, future value, and annuities. It provides examples of how to use these formulas to find equivalent values when interest rates, time periods, or cash flows change. Spreadsheet functions like NPV, PMT, and RATE are also introduced as tools for solving time value of money problems.

Uploaded by

blaesus.black1704
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We take content rights seriously. If you suspect this is your content, claim it here.
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Topic 02: The time value

of money
Engineering Economics (IM1027)
Instructor: Dr. Nguyen Vu Quang
Contents
• Concepts of interest rate (effective, and nominal), interest (simple
and compound)
• Concept of cash flow diagram
• Formulas, tools to calculate the equivalent value for uniform cash
flow, varying cash flow, and in case of continuous compounding
interest
Interest, Interest Rate
• Money has two dimensions: quantity and time.
• The time value of money is expressed in interest

Interest = (Total accumulated capital) – (Initial investment capital)

• Interest rate: is the interest expressed as a percentage of the initial


capital for a period of time
(Interest in 1 period of time)
(Interest rate) = *100%
(Principal)
Interest, Interest Rate (con’t)
• Simple interest: is linearly proportional to the initial amount of the
loan (principal), not including the accumulated interest charges

Example: $1,000 were loaned for three years at a simple interest rate of 10% per year.
Interest, Interest Rate (con’t)
• Compound interest: is based on the remaining principal amount plus
any accumulated interest charges up to the beginning of that period

I = P (1+ i) N  P

Example: $1,000 were loaned for three years at an interest rate of 10%
compounded each year
Example
Three Plans for Repayment of $17,000 in Four Months
with Interest at 1% per Month

The concept of Equivalence


Interest, Interest Rate (con’t)
• Effective interest rate: When the period of stating the interest rate
matches the compounding period, the stated interest rate is the
effective rate (i)

• 12% per year, compounded annually


• 3% per quarter, compounded quarterly
• 12% per year
• Interest rate of 10%
Interest, Interest Rate (con’t)
• Nominal interest rate: When the period of stating the interest rate is
different from the compounding period, the stated interest rate is the
nominal rate (r)
“12% per year, compounded semiannually”
“10% per year, compounded quarterly”

The relationship between the effective rate i, and the nominal rate r is:

where M is the number of compounding periods per year


Examples
• Find the effective interest rate for the followings:
“12% per year, compounded semiannually”
“10% per year, compounded quarterly”
Interest, Interest Rate (con’t)
The GENERAL relationship between the effective rate i, and the
nominal rate r is:

Where: m1 is the number of compounding periods in the stated period.


m2 is number of compounding periods in the calculating period.

Ex: 10% per year, compounded quarterly. Calculate the interest rate per six-month
Cash flow diagram
• In an investment project, the project's cost is conventionally negative
cash flow (out), the project's income is positive cash flow (in).
• By convention, all cash outflow and inflow in a period occur at the
end of that period.
• Cash inflow and cash outflow generally referred to as Cash-Flows
(CF).
• Net cash flow (NCF) = cash inflow – cash outflow
Cash flow diagram (con’t)
Notation

i = effective interest rate per interest period;


N = number of compounding (interest) periods
P = present worth (PW) or present value (PV)
F = Future worth (FW) or future value (FV)
Cash flow diagram (con’t)
Notation

i = effective interest rate per interest period;


N = number of compounding (interest) periods
P = present worth (PW) or present value (PV)
A = uniform series of value continuing for a specified number of
periods (annuity
Find F given P
Example

Using MS Excel:
= FV(rate,nper,pmt,[pv],0)
= FV(10%,4,0,8000,0) = - 11,713
Find P given F

Using MS Excel:
= PV(rate,nper,pmt,[fv],0)
= PV(10%,4,0,11712.8,0) = -8000
Using tables
• Find (F/P,i%,N), (P/F,i%,N) using table in Appendix C
Find i% given F, P, N

EX: if we want to turn $500 into $1,000 over a period of 10


years, at what interest rate would we have to invest it?
Find N, when given i, F, P

EX: how long would it take for $500 invested today at 15% interest per
year to be worth $1,000?
Find P, F given A

Using MS Excel:
= FV(rate,nper,pmt,0,0)
Example: Find F, given A
Lending the $23,000 of extra annual income to a savings account.
What is the amount that can be withdrawn after the 40th deposit is
made, if the interest rate (i) is 6% per year
Find P, F given A (con’t)

Using MS Excel:
= PV(rate,nper,pmt,0,0)
Example: find P, given A
i=12%
Find A, given F Using MS Excel:
= PMT(rate,nper,0,fv,0)

Find A, given P

Using MS Excel:
= PMT(rate,nper,pv,0,0)
Finding N given A, P, and i
Your company has a $100,000 loan for a new security system it just
bought. The annual payment is $8,880 and the interest rate is 8% per
year for 30 years. Your company decides that it can afford to pay
$10,000 per year. After how many payments (years) will the loan be
paid off?

Using MS Excel:
=NPER(rate,pmt,pv,0,0)
Finding i, given A, F, and N
The car you want to buy will cost $60,000 in eight years. You are
going to put aside $6,000 each year (for eight years) to save for this.
At what interest rate must you invest your money to achieve your goal
of having enough to purchase the car after eight years?

Using MS Excel:
=RATE(nper, pmt, pv, fv)
Approximate i
Discrete Compounding-Interest Factors
and Symbols
Deferred Annuity (uniform series)
Deferred Annuity (uniform series)

i = 8% per year
Calculating the Equivalent P, F, and A
Values
Calculating the Equivalent P, F, and A
Values
Spreadsheet solutions

=NPV(rate,value1,value2,…)

=PMT(rate,nper,pv,[fv])
Contents
• Concepts of interest rate (effective, and nominal), interest (simple
and compound)
• Concept of cash flow diagram
• Formulas, tools to calculate the equivalent value for uniform cash
flow, varying cash flow, and in case of continuous compounding
interest

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