Time Value of Money

Lecture No.4
Chapter 3
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition 2007

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
moneya cost to the
borrower and an earning to
the lender

This a two-edged sword whereby earning

grows, but purchasing power decreases
(due to inflation), as time goes by.

Contemporary Engineering Economics, 4th

edition 2007

The Interest Rate

Contemporary Engineering Economics, 4th

edition 2007

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?

Contemporary Engineering Economics, 4th

edition 2007

Solution
F

10

$100(1+ 0.10)10 = $100(2.59) = $259

$100
$200

$200(1+ 0.10)8 = $200(2.14) = $429

F = $259 + $429 = $688

Contemporary Engineering Economics, 4th

edition 2007

Practice problem

Problem Statement
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn a 10% interest, what would be the
balance at the end of 4 years?
$1,210
0

4
2

$1,000 $1,000

3
$1,500

Contemporary Engineering Economics, 4th

edition 2007

$1,210
0

3
2

$1,000

$1,000

$1,500

$1,100
$1,000
$2,100

$2,310

$1,210

-$1,210

+ $1,500

$1,100

$2,710

Contemporary Engineering Economics, 4th

edition 2007

$2,981

Solution
End of
Period

Beginning
balance

Deposit
made

Withdraw

Ending
balance

n=0

$1,000

$1,000

n=1

$1,000(1 + 0.10)
=$1,100

$1,000

$2,100

n=2

$2,100(1 + 0.10)
=$2,310

$1,210

$1,100

n=3

$1,100(1 + 0.10)
=$1,210

$1,500

$2,710

n=4

$2,710(1 + 0.10)
=$2,981

$2,981

Contemporary Engineering Economics, 4th

edition 2007

Economic Equivalence

Lecture No.5
Chapter 3
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition 2007

Economic Equivalence

Economic equivalence exists between cash

flows that have the same economic effect
and could therefore be traded for one
another.
Even though the amounts and timing of the
cash flows may differ, the appropriate interest
rate makes them equal.

Contemporary Engineering Economics, 4th

edition 2007

Equivalence from Personal Financing

Point of View
F

If you deposit P dollars

today for N periods at
i, you will have F
dollars at the end of
period N.

P F

F = P(1+i)N
0
N

Contemporary Engineering Economics, 4th

edition 2007

Alternate Way of Defining Equivalence

P

F dollars at the end of

period N is equal to a
single sum P dollars
now, if your earning
power is measured in
terms of interest rate i.

N
F
N

P = F (1+ i)
0
Contemporary Engineering Economics, 4th
edition 2007

Practice Problem
At an 8% interest, what is the equivalent worth
of $2,042 now in 5 years?
If you deposit $2,042 today in a savings
account that pays an 8% interest annually.
how much would you have at the end of
5 years?

$2,042

33

=
0

5
Contemporary Engineering Economics, 4th
edition 2007

Solution

F = $2,042(1+ 0.08)
= $3,000

Contemporary Engineering Economics, 4th

edition 2007

Interest Formulas for Single

Cash Flows
Lecture No.6
Chapter 3
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition 2007

Types of Common Cash Flows in Engineering

Economics

Contemporary Engineering Economics, 4th

edition 2007

Equivalence Relationship Between P and

F

Contemporary Engineering Economics, 4th

edition 2007

Single Cash Flow Formula- Compound-Amount

Factor

Single payment
compound amount
factor (growth factor)
Given:
i = 12%
N = 8 ye a rs
P = $5, 000

F = P(1 + i)
F = P( F / P, i, N)
N

0
N

Find: F
F = $5, 000(1 + 0.12)8
= $5, 000( F / P ,12%,8)

= $12, 380
Contemporary Engineering Economics, 4th
edition 2007

Practice Problem

If you had $2,000 now and invested it at

10%, how much would it be worth in 8
years?
F=?
i = 10%
0
8
$2,000
Contemporary Engineering Economics, 4th
edition 2007

Solution
G iv e n :
P = $2,000
i = 10%
N = 8 ye a rs
F in d : F
F = $ 2 , 0 0 0 (1 + 0 . 1 0 ) 8
= $ 2 , 0 0 0 ( F / P ,1 0 % , 8 )
= $ 4 , 2 8 7 .1 8
E X C E L com m and:
= F V (1 0 % ,8 ,0 ,2 0 0 0 ,0 )
= $ 4 ,2 8 7 .2 0
Contemporary Engineering Economics, 4th
edition 2007

Single Cash Flow Formula PresentWorth Factor

Single payment
present worth factor
(discount factor)
Given:
i = 12%

P = F(1 + i) N
P = F(P / F, i, N)
0

N = 5 y e a rs

F = $ 1,0 0 0

Find:

P = $1, 000 (1 + 0 .12 )

= $1, 000 ( P / F ,12% ,5 )

= $567.40
Contemporary Engineering Economics, 4th
edition 2007

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?

Contemporary Engineering Economics, 4th

edition 2007

Solution
$10,000

0
6

P = $10, 000(1 + 0.07) 6

= $10, 000( P / F , 7%, 6)
= $6, 663
Contemporary Engineering Economics, 4th
edition 2007

Solving for i

Contemporary Engineering Economics, 4th

edition 2007

Solution
EXCEL Solution using RATE Function

$20 = $10(1 + i ) 5
2 = (1 + i )
i = 14.87%
5

=RATE(5,0,-10,20)=14.87%

Contemporary Engineering Economics, 4th

edition 2007

Rule of 72 Number of Years Required

to Double Your Investment

Contemporary Engineering Economics, 4th

edition 2007

Solution Analytical Approach

2P

F = 2 P = P(1 + 0.20) N
2 = 1.2
log 2 = N log1.2
log 2
N=
log1.2
= 3.80 years
N

0
N=?
P

Contemporary Engineering Economics, 4th

edition 2007

Solution - Rule of 72

Approximating
how long it will
take for a sum of
money to double

72
N
interest rate (%)
72
=
20
= 3.6 years

Contemporary Engineering Economics, 4th

edition 2007

Number of Years Required to Double an Initial

Investment at Various Interest Rates

Contemporary Engineering Economics, 4th

edition 2007

Uneven Payment Series

$25,000

$5,000

$3,000
0
1

How much do you need

to deposit today (P) to
withdraw $25,000 at n
=1, $3,000 at n = 2,
and $5,000 at n =4, if
your account earns
10% annual interest?

Contemporary Engineering Economics, 4th

edition 2007

$25,000

Uneven
Payment Series

$5,000

$3,000
0
1

P
$25,000

$5,000

$3,000
0
1

0
1

P2

= $22, 727

P4

P1
P1 = $25, 000( P / F ,10%,1)

P2 = $3, 000( P / F ,10%, 2)

= $2, 479

P = P1 + P2 + P4 = $28, 622
Contemporary Engineering Economics, 4th
edition 2007

P4 = $5, 000( P / F ,10%, 4)

= $3, 415

Interest Formulas Equal

Payment Series
Lecture No.7
Chapter 3
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition 2007

Equal Payment Series

F

0
A

P
0

N
0

Contemporary Engineering Economics, 4th

edition 2007

Equal Payment Series Compound Amount

Factor
F

A
0

2
N

A
Contemporary Engineering Economics, 4th
edition 2007

Process of Finding the Equivalent Future

Worth, F

A(1+i)N-2
A

A
A(1+i)N-1

(1
+
i
)
1
N 1
N 2
F = A(1+ i) + A(1+ i) +"+ A = A

Contemporary Engineering Economics, 4th

edition 2007

Another Way to Look at the Compound

Amount Factor

Contemporary Engineering Economics, 4th

edition 2007

Equal Payment Series Compound Amount

Factor (Future Value of an Annuity)
F
0

3
N

(1 + i ) N 1
F=A
i
= A( F / A, i , N )

Example:
Given: A = $5,000, N = 5 years, and i = 6%
Find: F
Solution: F = $5,000(F/A,6%,5) = $28,185.46
Contemporary Engineering Economics, 4th
edition 2007

Validation
$5,000(1+ 0.06) = $6,312.38

F =?

$5,000(1+ 0.06)3 = $5,955.08

$5,000(1+ 0.06) = $5,618.00
2

i = 6%
0

$5,000(1+ 0.06)1 = $5,300.00

$5,000(1+ 0.06) = $5,000.00
$28.185.46
0

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

Contemporary Engineering Economics, 4th

edition 2007

Finding an Annuity Value

F
0

3
N

A=?

i
A= F
N
(1 + i) 1
= F ( A / F , i, N )

Example:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
Solution: A = $5,000(A/F,7%,5) = $869.50
Contemporary Engineering Economics, 4th
edition 2007

Handling Time Shifts in a Uniform Series

F=?
First deposit occurs at n = 0

i = 6%
0

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

Contemporary Engineering Economics, 4th
edition 2007

 Annuity

Due

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

Solution

Beginning period

=FV(6%,5,5000,0,1)

Contemporary Engineering Economics, 4th

edition 2007

Sinking Fund Factor

F
0

i
L
O
A = FM
P
(
1
)
1
+
i

N
Q
N

3
N

= F( A / F, i, N)

Example: 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
Contemporary Engineering Economics, 4th
edition 2007

Excel Solution

Given:

F = $100,000
i = 7%
N = 8 years

$100,000

Current age: 10 years old

Find:
0
1

=PMT(i,N,pv,fv,type)
=PMT(7%,8,0,100000,0)
=$9,746.78

A=?

Contemporary Engineering Economics, 4th

edition 2007

i = 8%

Example 3.15 Combination of a Uniform Series

and a Single Present and Future Amount

Contemporary Engineering Economics, 4th

edition 2007

Solution: A Two-Step Approach

Step 1: Find the required

savings at n = 5.

Step 2: Find the required

annual contribution (A)
over 5 years.

FC =$500(F/ P,7%,5) =$701.30

FRequired Savings =$5,000$701.30 =$4,298.70

A= $4,298.70(A/ F,7%,5)
= $747.55

Contemporary Engineering Economics, 4th

edition 2007

Comparison of Three Different

Investment Plans Example 3.16

Contemporary Engineering Economics, 4th

edition 2007

Solution:

Investor A:

Balance at the end of 10 years





F65 = $2,000(F / A,9.38%,10)(1.0938)(F / P,9.38%,31)

 

$33,845

= $545,216

Investor B:

F65 = $2,000( F / P,9.38%,31) (1.0938)

 

$322,159

= $352,377

Investor C:

F65 = $2, 000( F / P,9.38%, 41) (1.0938)

 

$820,620

= $897,594
Contemporary Engineering Economics, 4th
edition 2007

How Long Would It Take to Save $1

Million?

Contemporary Engineering Economics, 4th

edition 2007

Loan Cash Flows

Contemporary Engineering Economics, 4th

edition 2007

Capital Recovery Factor

P

i(1 + i)
A= P
N
(1 + i) 1
= P( A / P, i, N )
N

A=?

Example: Paying Off an Educational Loan

Given: P = $21,061.82, N = 5 years, and i = 6%
Find: A
Solution: A = $21,061.82(A/P,6%,5) = $5,000
Contemporary Engineering Economics, 4th
edition 2007

Example 3.17 Loan Repayment

Contemporary Engineering Economics, 4th

edition 2007

Solution:

Using Interest Factor:

A = $250,000( A/ P,8%,6)
= $250,000(0.2163)
= $54,075

Using Excel:
= PMT(i, N, P)
= PMT(8%,6, 250000)
= $54,075
Contemporary Engineering Economics, 4th
edition 2007

Example 3.18 Deferred Loan

Repayment

Contemporary Engineering Economics, 4th

edition 2007

A Two-Step Procedure

P ' = $250, 000( F / P,8%,1)

= $270, 000
A ' = $270, 000( A / P,8%, 6)
= $58, 401
Contemporary Engineering Economics, 4th
edition 2007

Present Worth factor Find P, Given A,

i, and N

(1+i) 1
P= A
N
i(1+i)
= A(P/ A,i, N)
N

P=?

Contemporary Engineering Economics, 4th

edition 2007

Example 3.19 Louise Outings Lottery

Problem

Given:

A = $280,000
i = 8%
N = 19

Find: P

Using interest factor:

P =$280,000(P/A,8%,19)
= $2,689,008

Using Excel:

=PV(8%,19,-280000)
= $2,689,008
Contemporary Engineering Economics, 4th
edition 2007

Interest Formulas
(Gradient Series)
Lecture No.8
Chapter 3
Contemporary Engineering Economics
Copyright 2006

Linear Gradient Series

L
i(1+ i) iN 1O
P = GM
P
N i (1+i) Q
N

= G(P / G, i, N)

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.

Example Present value calculation for a

$2,000
gradient series
$1,000

$1,250 $1,500

$1,750

0
1

P =?

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 in the figure?

Method 1: Using the (P/F, i, N) Factor

$2,000
$1,000

$1,250 $1,500

$1,750

0
1

P =?

$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
$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)
.
= $3,60480

P2 = $250(P / G,12%,5)
P = $3,604.08 + $1,59920
.
= $5,204

= $1,599.20

Gradient-to-Equal-Payment Series
Conversion Factor, (A/G, i, N)

Example 3.21 Find the Equivalent

Uniform Deposit Plan

Solution:

Given: A1 =$1,000,G=$300,i =10%,and, N =6

Find: A
A=$1,000+$300(A/ G,10%,6)
=$1,000+$300(2.22236)
=$1,667.08

Example 3.22 Declining Linear Gradient

Series

Solution:
F = F1 F2
Equivalent Present Worth at n = 0




= A1(F / A,10%,5) $200(P/ G,10%,5) (F / P,10%,5)
=$1,200(6.105) $200(6.862)(1.611)
=$5,115

Types of Geometric Gradient

Series

g > 0

Present Worth Factor

R|A L1(1+g) (1+i) O, if i g

P
P = S MN
i g
Q
|TNA /(1+i),
if i = g
N

Example 3.23 Annual Power Cost if

Repair is Not Performed

Solution Adopt the new compressed-air

system
1 (1 + 0.07)5 (1 + 0.12)5
POld = $54, 440

0.12 0.07

= $222, 283
PNew = $54, 440(1 0.23)( P / A,12%,5)
= $41,918.80(3.6048)
= $151,109

Example 3.24 Jimmy Carpenters

Retirement Plan Save $1 Million

What Should be the Size of his first

Deposit (A1)?
1 (1 + 0.06) (1 + 0.08)
= A1
0.08 0.06

= A1 (72.6911)
20

F20

= $1, 000, 000

$1, 000, 000
A1 =
72.6911
= $13, 757

20

Unconventional Equivalence
Calculations
Lecture No. 9
Chapter 3
Contemporary Engineering Economics
Copyright 2006

Equivalent Present Worth Calculation Brute

Force Approach using Only P/F Factors

Equivalent Present Worth Calculation

Grouping Approach
$200
$150 $150 $150 $150
$100 $100 $100
$50
0
1

PG r o u p

= $ 5 0 ( P / F ,1 5 % ,1)
= $ 4 3 .4 8

PG r o u p

= $ 1 0 0 ( P / A ,1 5 % , 3 )( P / F ,1 5 % ,1)
= $ 1 9 8 .5 4

PG r o u p

= $ 1 5 0 ( P / A ,1 5 % , 4 )( P / F ,1 5 % , 4 )
= $ 2 4 4 .8 5

PG r o u p

= $ 2 0 0 ( P / F ,1 5 % , 9 )
= $ 5 6 .8 5

P = $ 4 3 .4 8 + $ 1 9 8 .5 4 + $ 2 4 4 .8 5 + $ 5 6 .8 5
= $ 5 4 3 .7 2

Unconventional Equivalence Calculations A

Personal Savings Problem
Situation 1: If you make
4 annual deposits of
$100 in your savings
account which earns a
10% annual interest,
what equal annual
amount (A) can be
withdrawn over 4
subsequent years?

Unconventional Equivalence Calculations

An Economic Equivalence Problem

Situation 2:
What value of A
would make the two
cash flow
transactions
equivalent if i =
10%?

Method 1: Establish the Economic

Equivalence at n = 0

Method 2: Establish the Economic

Equivalence at n = 4

Multiple Interest Rates

F=?

Find the balance at the end of year 5.

6%

6%

5%

4%

4%

0
1

$400

$300
$500

Solution
n = 1:
$300( F / P , 5% ,1) = $315
n = 2:
$315( F / P , 6% ,1) + $500 = $833.90
n = 3:
$833.90( F / P , 6% ,1) = $883.93
n = 4:
$883.93( F / P , 4% ,1) + $400 = $1, 319.29
n = 5:
$1, 319.29( F / P , 4% ,1) = $1, 372.06

Cash Flows with Missing Payments

P=?

9 10

11 12 13

14 15

0
$100

i = 10%

Missing payment

Solution
P=?

$100

9 10

Add $100 to
offset the change

11 12 13

14 15

0
$100

i = 10%

Pretend that we have the 10th

Payment in the amount of $100

Approach
P=?

$100

9 10

11 12 13

0
$100

i = 10%
Equivalent Cash Inflow = Equivalent Cash Outflow

14 15

Equivalence Relationship

P+$100(P/ F,10%,10) = $100(P/ A,10%,15)

P+$38.55 = $760.61
P = $722.05

Unconventional Regularity in Cash Flow

Pattern
$10,000

i = 10%
1

10 11 12 13 14

0
C

Payments are made every other year

Approach 1: Modify the Original Cash

Flows
$10,000

i = 10%
1

10 11 12 13 14

A = $10, 000( A / P ,10%,14)

= $1, 357.46

Relationship Between A and C

$10,000

i = 10%
1

10 11 12 13 14

0
C

$10,000

i = 10%
1

10 11 12 13 14

Solution

i = 10%

A =$1,357.46

A = $10,000( A/ P,10%,14)
= $1,357.46

C = A(F / P,10%,1) + A
=1.1A+ A
= 2.1A
= 2.1($1,357.46)
= $2,850.67

Approach 2: Modify the Interest Rate

Idea: Since cash flows occur every other

year, let's find out the equivalent compound
interest rate that covers the two-year period.
How: If interest is compounded 10%
annually, the equivalent interest rate for twoyear period is 21%.
(1+0.10)(1+0.10) = 1.21

Solution
$10,000
i = 21%
1
1

2
3

3
5

4
7

5
9

10 11 12 13 14

0
C

C = $10,000( A / P,21%,7)
= $2,850.67

Example 3.25 At What Value of C would

Make the Two Cash Flows Equivalent?

V1 = $100(F / A,12%,2) +$300(P/ A,12%,3) = $932.55

V2 = C(F / A,12%,2) +C(P/ A,12%,2)(P/ F,12%,1) = 3.6290C
3.6290C = $932.55
C = $256.97

Example 3.26 Establishing a College

Fund

Solution: Establish the Economic

Equivalence at n = 18

Example 3.27 Calculating an Unknown

Interest Rate with Multiple Factors

Establish an economic Equivalence at n =7

Linear Interpolation to Find an Unknown

Interest Rate

Linear Interpolation
( F / A, i, 7 )
=1
( P / A , i ,1 3)

6%

( F / A, i, 7 )
( P / A , i ,1 3)
0 .9 4 8 2

?
7%

1 .0 0 0 0
1 .0 3 5 5

1 0 .9 4 8 2

i = 6 % + (7 % 6 % )
1 .0 3 5 5 0 .9 4 8 2
= 6 .5 9 3 4 %

Using the Goal Seek Function to Find the

Unknown Interest rate