CHAPTER IV
The Time Value of Money
Bisrat H. ( B-pharm, MSc)
Pharmaceutical Supply Chain Management
Haramaya University, Harar
1
What is Time Value?
Would you prefer to have $100 now or in the future?
In other words, “a dollar received today is worth more
than a dollar to be received tomorrow”
That is because today’s dollar can be invested so that we
have more than one dollar tomorrow.
4
5
Time Preference
Would you prefer to have $100 now or in the future?
Why positive rate of time preference?
• ‘live now, pay later’ attitude (I.e Short term view of life, living
for today rather than thinking about the future)
• future is uncertain(a bird in the hand is worth having two in the
bush)
•Positive economic growth (since WWII) individuals might
expect to be more wealthy in the future - after graduate school!!!
•Expectation of positive return when making riskless
investments
6
The Terminology of Time Value
Present Value(PV) - An amount of money today, or the
current value of a future cash flow
Future Value(FV) - An amount of money at some future
time period
Period(t or n) - A length of time (often a year, but can be a
month, week, day, hour, etc.)
Interest Rate (I or r) - The compensation paid to a lender
(or saver) for the use of funds expressed as a percentage
for a period (normally expressed as an annual rate)
7
Timelines
A timeline is a graphical device used to clarify the timing of the
cash flows for an investment
Each tick represents one time period
PV FV
0 1 2 3 4 5
Today
8
Compound Interest
Note from the example that the future value is increasing
at an increasing rate
In other words, the amount of interest earned each year is
increasing
•Year 1: $10
•Year 2: $11
•Year 3: $12.10
The reason for the increase is that each year you are
earning interest on the interest that was earned in previous
years in addition to the interest on the original principle
amount
9
Compound Interest Graphically
4500
3833.76
4000
5%
3500
10%
3000
15%
Future Value
2500 20%
2000 1636.65
1500
1000
672.75
500 265.33
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Years
10
The Magic of Compounding
On Nov. 25, 1626 Peter Minuit, a Dutchman, reportedly purchased
Manhattan from the Indians for $24 worth of beads and other
trinkets. Was this a good deal for the Indians?
This happened about 382 years ago, so if they could earn 5% per
year they would now (in 2008) have:
$2,982,108,814 = 24(1.05)382
v If they could have earned 10% per year, they would now have:
$155,674,318,134,231,800 = 24(1.10)382
That’s about 155,674 Trillion dollars!
11
The Magic of Compounding (cont.)
The total assessed value for land in Manhattan was $169 billion in 2004
At 10%, this is $ 155,674 trillion! The US GDP (purchasing power
parity):$13.86 trillion (2007 est.) per year. So this amount represents
about 11,232 years worth of the total economic output of the USA!
At 5% it seems the Indians got a bad deal, but if they earned 10% per
year, it was the Dutch that got the raw deal.
Not only that, but it turns out that the Indians really had no claim on
Manhattan (then called Manahatta). They lived on Long Island!
As a final insult, the British arrived in the 1660’s & unceremoniously
tossed out the Dutch settlers
12
Discounting in Pharmacoeconomics
Most interventions involve costs and consequences that
are spread out over time.
Cost and benefit flows have a time value.
Fair comparisons of interventions requires that these
flows be adjusted and translated to a common metric.
13
Discounting in Pharmacoeconomics
What is Discounting?
•The process of converting future costs to their present
value (PV) assuming that individuals and society has positive
time preference.
•E.g. From today’s perspective , $ 10,000 payable
after ten years is not seen as high as $ 10,000
payable now- The PV of $ 10,000 payable in 10 yrs
is less than $10,000.
14
Discounting in Pharmacoeconomics
General consensus that future costs should be discounted
However, economists do not agree that health outcomes
should be discounted
And those who agree on discounting, disagree about the rate
But if discount at lower rate than costs, projects become
more desirable if we delay their implementation (Keeler &
Cretin 1983)
So soft recommendation is to discount at same rate as costs
and carry out sensitivity analysis
15
In many economic analyses of drugs, discounting is not really an
issue as costs are incurred and benefits gained contemporaneously
over a short period of time
However, discounting can be important when there are
large up-front costs and
potential benefits are not realized for many years,
e.g. interferon- α for hepatitis C, where discounting has little effect on costs
but a substantial effect on estimated benefits.
16
Concept of discounting is related to the concept of
compounding interest
Compound Interest Rate- used to calculate FV of the
money(how much a sum of money invested today will worth
in the future)
Discount Rate- used to calculate PV of the money (present
value of the sum of money to be received (paid) in the
future.)
17
Justification for the “present value” approach
•Inflation
•Technological innovation
•Empirical evidence of positive time preference
18
Why adjustment for time effects?
Cost and benefits in economic evaluation often times
spread over multiple years
Some times it will not be possible to obtain unit prices
from the year of the study and may be necessary to
extrapolate from previous years
Adjusting time effects involves accounting for:
Discounting
Inflation
Annuitizing capital Expenditures
19
Mechanics
The present value of cost FV in t years at interest (
“discount”) rate r is:
PV FV
(1 r ) t
20
Example
Suppose you invest $100 today. How much is it worth next
year?
FV = 100*(1+r)1
If we use an interest rate of 7%, we get:
FV = 100*(1.07)^1 = $107
FV in two years would be would be 100*(1.07)^2 = $ 114.50
Note that without interest (i=0), the FV would be $100
21
Exercise
Suppose you place $100 in the bank immediately, another $100 one year from
now, $500 two years from now, and $500 three years from now. How much will
you have in the bank in 5 years?
FV = 100*(1+i)5 + 100*(1+i)4 + 500*(1+i)3 + 500*(1+i)2
If we use an interest rate of 5%, we get:
FV = 128 + 122 + 579 + 551 = $1,379
Note that without interest (i=0), the FV would be $1,200.
22
How much would you pay today for a promise of
receiving $100 in five years with discount rate of
7%, ?
23
Example
How much would you pay today for a promise of receiving $100 in five
years with discount rate of 7%, ?
PV = 100 / (1+i)5
we get:
PV = 100 / (1.07)^5 = $71
Note that without discounting (i=0), the PV would be $100.
24
Example
Suppose that a program will cost $1,000,000
immediately, $1,000,000 one year from now,
$500,000 two years from now, and $500,000 three
years from now. The present value of the costs of
the program is
25
Example
PV = 1,000,000 / (1+i)0 + 1,000,000 / (1+i)1
+ 500,000 / (1+i)2 + 500,000 / (1+i)3
If we use a discount rate of 5%, we get:
PV = 1,000,000 + 952,381 + 453,515 + 431,919 = $2,837,814
Note that without discounting (i=0), the PV would be $3,000,000.
26
Hypothetical Scenario:
A decision maker has funds of approximately £146,000 to commit
now to a preventative programme. He is also looking for a cost
effectiveness ratio of less than £3000 per life year gained as this
would compare favourably with other preventative programmes
that have been successfully introduced with Department of
Health approval.
Suppose a 5 year programme has been proposed with the
following anticipated streams of costs and health consequences
relative to the status quo.
27
Question on Discounting
Year Cost Consequences 1. Does the proposed programme fit within the
proposed current budget recommended under
the discount rate of 6%?
2. What if, if you use discount rate of 3.5%
1 £20,000 2 LY
3. What is the cost effectiveness ratio of the
proposed programme if the same discount
rate is also applied to health benefits
2 £30,000 4 LY
3 £50,000 10 LY Assume all costs and benefits occur in the
beginning of the year
4 £35,000 15 LY
5 £30,000 20 LY
28
Adjusting for Inflation and Annuitizing
Capital Expenditures
30
What Is Inflation?
Inflation is a persistent and appreciable increase in the
general price level that occurs over time.
This increase in general price level decreases the purchasing
power of each unit of currency (e.g., $1).
Because of inflation, $1 is worth less (in terms of what it can
purchase) this year than last year.
31
Why Do We Need adjusting for Inflation in Cost
Analysis?
Cost data are often collected from years other than base
year of the evaluation.
•Inflation renders direct comparison of unadjusted cost data
inaccurate.
To ensure that all costs are comparable and that costs
can be weighed against benefits that occur in the same
time period, we need to standardize costs into common
base year.
32
To make costs from different years comparable, we have
to standardize all costs to the same base year.
Because we want our cost analysis results to be as up-to-
date as possible, the most recent year for which data are
available is usually chosen as the base year.
33
Approach
Consumer Price Index( CPI)- reflects the change in the
cost to the average consumer of acquiring a fixed basket of
goods and services.
Relevant Sub index (Medical care component of CPI)
Costs can be adjusted to the same base year using the
Consumer Price Index (CPI).
34
How Do We Adjust for Inflation?
Unadjusted prices are referred to as "nominal prices,"
"nominal dollars," "current dollars," or "current prices".
After these unadjusted prices are adjusted for inflation,
they are referred to as "constant dollars," "constant
prices," "real dollars," or "real prices."
35
Prices can be adjusted for inflation by using the following
equation:
YB=YP(CPIB/CPIP)
Where;
YB=base year value
YP=past year value
CPIB=CPI value of base year
CPIP=CPI value of past year
36
An Example: Adjusting Prices for Inflation
In conducting a cost analysis, you decide that program costs will
be reported in 1999 dollars. Supply costs were collected for
1997 and therefore must be converted to the base year, 1999.
Given:
CPI1997=All-items component of the CPI for 1997=160.5
CPI1999=All-items component of the CPI for 1999=166.6
37
To adjust the 1997 supply cost of $15.00 to the 1999
price, use the following equations
Price1999=Price1997x(CPI1999/CPI1997)
Price1999=$15.00x(166.6/160.5)
Price1999=$15.00x1.038
Price1999=$15.57
38
Adjusting Earnings to Base Year Monetary Units
We must also adjust previous year earnings to the base year
to be able to make consistent comparisons.
The appropriate index to use for this adjustment is the
estimated annual increase in average hourly earnings.
The equation that you should use for adjusting earnings is
essentially the same as the one for adjusting for inflation:
39
IB=IP(WB/WP)
Where
IB=income in base year
IP=income in the past year
WB=average hourly wage in base year
WP=average hourly wage in the past year
40
Example: Earnings Adjustment
The cost analysis has revealed the productivity losses caused
by an influenza outbreak in 1990, which totaled $125
million.
We want to report the results in 1993 base year dollars.
The average hourly earnings for 1990 and 1993 were $10.01
and $10.83, respectively.
The adjusted productivity loss for 1993 will be:
Productivity Loss1993=$125 (10.83/10.01)=$135.24 Million.
41
Annuitizing Capital Expenditures/Costs
What are Capital Costs?
Capital costs represent expenditures on resources like
equipment, buildings, and land.
They are usually purchased once at the beginning of the program
and have useful lives greater than 1 year.
Resources with a useful life of less than 1 year that are purchased
repeatedly over the lifespan of the program or intervention are
called recurrent or operating costs.
Drugs, office supplies, and gasoline are examples of operating costs.
42
Economic cost of using capital consists of two
components:
☞Opportunity cost of making the investment and
☞Rate at which the capital is used up (depreciation)
Can be approximated by rental price; if rental market
functions well
43
Why adjusting for Inflation?
•Cost data are often collected from years other than base year of
the evaluation
•To ensure that all costs are comparable and that costs can be
weighed against benefits that occur in the same time period, we
need to standardize costs into common base year
44
Why Should Capital Costs Be Annuitized?
Annuitizing allows us to match the services capital resources provided
with their costs.
Assigning the entire purchase cost to only the purchase year would
overestimate that year's costs and underestimate future periods' costs.
Annuitizing spreads the capital costs over the useful life of resources
and provides more accurate estimates of true resource use.
Although the costs of capital expenditure occur at one time, the
benefits occur over their life time
45
If the capital outlay K, the annual sum E which over
a period of n years (the life of the capital item) at an
interest rate of r , then:
K =E(annuity factor, n period, interest r)
46
For situations where the capital item has a resale value
at the end of the programme the equivalent annual cost
is calculated as follows:
Estimate the scrap value
Subtract Scrap value (resale value at the end of the project)
from the original purchase cost
Divide the result by the annuity factor
47
How Do We Annuitize Capital Costs?
Capital costs can be annuitized in three steps.
Step 1: Calculate the Present Value (PV) of the Capital Item's
Scrap Value.
We base the calculation on the year that the good is scrapped
and on the discount rate.
PV=SV x 1 / (1 + r)n
SV=Scrap value (after t years of service) of the unit
r=Discount rate
n=Length of the item's useful life
48
Step 2: Calculate the Item's Annuity Factor (A).
A=( 1 / r ) - ( 1 / ( r ( 1 + r )n) )
Where
r=Discount rate
n=Length of the item's useful life
49
Step 3: Calculate the Item's Equivalent Annual Cost (EAC).
EAC=( PC - PV )/A
Where:
PC=Purchase/Replacement cost of the capital item
PV=Present value of scrap value (from Step 1)
A=Annuity factor (from Step 2)
n=Length of the item's useful life
50
An Example: Annuitizing Capital Costs
A building is purchased for $200,000 in Year 1 of a
program. Let us assume that the:
useful life of the building is 10 years,
building can be sold after 10 years for $50,000 (scrap
value), and
social discount rate is 3% per year.
51
Step 1: Calculate the Present Value of the Scrap Value
(PV)
PV=( $50,000 x 0.7441 )=$37,205
Step 2: Calculate the Annuity Factor (A)
A=1 /0.03 - 1/(0.03(1 + 0.03)10)=8.5302
52
Step 3: Calculate the Equivalent Annual Cost (EAC)
EAC=( 200,000 - 37,205 ) / 8.5302=$19,085
This equivalent annual cost of $19,085 can now be
used as an estimate for the average annual cost of the
building.
53
Bisrat H
54