BFC44602

Engineering Economy
Dr. Farzaneh Moayedi
 CHAPTER 4
Time Value of Money

(Part 2)

2
Economic Equivalence
Thus:
68 mph is equivalent to
You travel at 68 miles per hour 110 kph
Equivalent to 110 kilometers per hour
Using two measuring scales
Miles and Kilometers

Is “68” equal to “110”?

No, not in terms of absolute
numbers

• But they are

“equivalent” in terms of
the two measuring
scales
• Miles
• Kilometers
Economic Equivalence

Two sums of money at two different points in time

can be made economically equivalent if:
➢ We consider an interest rate and,
➢ Number of Time periods between the two sums

Equality in terms of Economic Value

Economic Equivalence

$20,000 now is not equal in magnitude to $21,800 one

year from now
But, $20,000 now is economically equivalent to $21,800
one year from now if the interest rate in 9% per year.
 If receiving $100 today is
not the same thing as
receiving $100 at any
future point, how do we
measure and compare
various cash flows? How
do we know, for example,
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?
Economic Equivalence

• Relative attractiveness of different alternatives can be

judged by using the technique of equivalence

• We use comparable equivalent values of alternatives to

judge the relative attractiveness of the given alternatives

• Equivalence is dependent on interest rate

• Compound Interest formulas can be used to facilitate

equivalence computations

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Technique of Equivalence

• Determine a single equivalent value at a point in

time for plan 1.
• Determine a single equivalent value at a point in
time for plan 2.

Both at the same interest rate and at the same time

point.

•Judge the relative attractiveness of the two

alternatives from the comparable equivalent
values.
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Economic Equivalence

• Allows us to compare alternatives on a common basis.

• Equivalent basis is dependent on:
• Interest Rate
• The amount of money involve
• The time of the monetary receipts and expense
• Economic equivalence means in a specified interest
rate, different amounts of money raised at different times
to the same value in terms of economy.
Example :

10% annual interest rate, currency RM1000 now (at present) is

equivalent with the RM1100 in one year from now.

F = 1000 + 1000(0.10) = 1000 (1.1) = RM1100

 Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8%

TOTAL OWED
YEAR AMOUNT OWED AT INTEREST OWED FOR AT PRINCIPAL TOTAL END-OF YEAR
THE BEGINNING OF YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)

Plan 1 AT THE END OF EACH YEAR PAY $ 1000 PRINCIPAL + INTEREST DUE Pay every year
1 $5,000 $400 $5,400 $1,000 $1,400
2 $4,000 $320 $4,340 $1,000 $1,320
3 $3,000 $240 $3,240 $1,000 $1,240
4 $2,000 $160 $2,160 $1,000 $1,160
5 $1,000 $80 $1,080 $1,000 $1,080
$1,200 $5,000 $6,200

Plan 2 PAY INTEREST DUE AT END OF EACH YEAR AND PRINCIPAL AT END OF FIVE YEARS Pay
1 $5,000 $400 $5,400 $0 $400
2 $5,000 $400 $5,400 $0 $400
3 $5,000 $400 $5,400 $0 $400
4 $5,000 $400 $5,400 $0 $400
5 $5,000 $400 $5,400 $5,000 $5,400
$2,000 $5,000 $7,000

copyright @ mia 11
 Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8% (cont.)

AMOUNT OWED AT
YEAR THE BEGINNING OF INTEREST OWED FOR TOTAL OWED AT PRINCIPAL TOTAL END-OF YEAR
YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)

Plan 3 PAY IN FIVE EQUAL END-OF-YEAR PAYMENTS Pay every year

1 $5,000 $400 $5,400 $852 $1,252
2 $4,148 $331 $4,479 $921 $1,252
3 $3,227 $258 $3,485 $994 $1,252
4 $2,233 $178 $2,411 $1,074 $1,252
5 $1,159 $93 $1,252 $1,159 $1,252
$1,260 $5,000 $6,260

Plan 4 PAY PRINCIPAL AND INTEREST IN ONE PAYMENT AT END OF FIVE YEARS Pay
1 $5,000 $400 $5,400 $0 $0
2 $5,400 $432 $5,832 $0 $0
3 $5,832 $467 $6,299 $0 $0
4 $6,299 $504 $6,803 $0 $0
5 $6,803 $544 $7,347 $5,000 $7,347
$2,347 $5,000 $7,347

copyright @ mia 12
Cash flow

Cash flow is a statement which picturise the position of

the changes in cash between one period to another
period. means cash flow statement describes the
causes of change in cash in one period to another
period.
Cash flow

• Engineering projects generally have economic consequences that

occur over an extended period of time

• For example, if an expensive piece of machinery is installed in

a plant were brought on credit, the simple process of paying for
it may take several years

• The resulting favorable consequences may last as long as the

equipment performs its useful function

• Each project is described as cash receipts or disbursements

(expenses) at different points in time

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Categories of Cash Flows

• The expenses and receipts due to engineering projects usually

fall into one of the following categories:
• First cost: expense to build or to buy and install
• Operations and maintenance (O&M): annual expense,
such as electricity, labor, and minor repairs
• Salvage value: receipt at project termination for sale or
transfer of the equipment (can be a salvage cost)
• Revenues: annual receipts due to sale of products or
services
• Overhaul: major capital expenditure that occurs during the
asset’s life
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Purpose of Cash flow

The purpose of the cash flow statement or statement of

cash flows is to provide information about a company's
gross receipts and gross payments for a specified period of
time.
The gross receipts and gross payments will be reported in
the cash flow statement according to one of the following
classifications:
• Operating activities
• Investing activities
• Financing activities

The net change from these three classifications should

equal the change in a company's cash and cash
equivalents during the reporting period.
If you buy a printer in 1999 for $300, maintain it for three years at a
cost of $20 per year, and then sell it for $50, what are your cash flows
for each year?

Its important to remember that all receipts and disbursements and

thus cash flows are assumed to be end-of period amounts.
Therefore, 1999 is the present (now) and 2002 is the end of year 3
Cash Flow Diagram

The costs and benefits of engineering projects over time are

summarized on a cash flow diagram (CFD). Specifically, CFD
illustrates the size, sign, and timing of individual cash flows,
and forms the basis for engineering economic analysis

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Drawing a Cash Flow
Diagram

• In a cash flow diagram (CFD) the end of period t is the same as

the beginning of period (t+1)

• Beginning of period cash flows are: rent, lease, and insurance

payments

• End-of-period cash flows are: O&M, salvages, revenues,

overhauls

• The choice of time 0 is arbitrary. It can be when a project is

analyzed, when funding is approved, or when construction begins

• One person’s cash outflow (represented as a negative value) is

another person’s inflow (represented as a positive value)

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Cash Flow Diagram

A cash flow diagram is simply a graphical representation of

cash flows (in vertical direction) on a time scale (in horizontal
direction). Time zero is considered to be present, and time 1 is
the end of time period 1.

This cash flow diagram is set up for five years.

Cash Flow Diagram

The direction of the cash flows (income or outgo) is indicated

by the direction of the arrows.

From the investor’s point of view, the borrowed funds are cash
flows entering the system, while the debt repayments are cash
flows leaving the system.
Example :

• A man borrowed $1,000 from a bank at 8% interest.

Two end-of-year payments: at the end of the first
year, he will repay half of the $1000 principal plus
the interest that is due. At the end of the second
year, he will repay the remaining half plus the
interest for the second year.
• Cash flow for this problem is:
End of year Cash flow
0 +$1000
1 -$580 (-$500 - $80)
2 -$540 (-$500 - $40)

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$1,000

1 2

$540
$580

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Cash Flow Diagram

If you borrow $2,000 now and must repay the loan plus interest (at
rate of 6% per year) after five years. Draw the cash flow diagram.
What is the total amount you must pay?
Cash Flow Diagram

If you start now and make five deposits of $1,000 per year (A) in
a 7% per year account, how much money will be accumulated
immediately after you have made the last deposit. Draw the cash
flow diagram. What is the total amount you will accumulate?