TIME VALUE OF MONEY

Objective: the primary focus of chapter 3 is to explain time value

of money calculations and to illustrate economic equivalence
Time Value of money
 “The value of money varies in terms of Time.”
➢ The Concept of Time Value
➢ Significance of Time Value of Money
➢ Present and Future Value
➢ Concept and Types of Annuity
➢ Present value of Annuity
➢ Future Value of an Annuity, Perpetual Annuity
Concept of Time Value

 The idea that today’s a specific sum of money is

more than the same amount in the Future because
time allows us the opportunity to postpone
consumption and earn returns.
Significance of Time Value
 This chapter introduces the topic of Financial Mathematics also
known as the time value of money:
➢ to avoid Inflationary effects in Assets
➢ To secure the asset’s return both in short and long run
by creating proper working capital Management and
Capital budgeting decisions.
➢ To calculate the cost of capital when a firm is going to
raise capital
 continuation
➢ to determine pricing a bond issuance
➢ To find out whether lease financing is applicable or not.
IWHY RETURN TO CAPITAL
 Capital refers to wealth in the form of money or property that
can be used to produce more wealth. It may be classified into
two broad categories:
▪ 1. Equity Interest:
Capital is owned
the Cost of Money
by individuals who have invested
money of property in a business project or venture in the hope
of receiving profit.
▪ 2. Borrowed/Debt Capital obtained from lenders for
investment, in return, the lender received interest from the
borrowers.
Profit and Interest as return to Capital

 Fundamental Reasons why Profit and interest as

important ingredients in Engineering Economics:
1. Interest and profit pay the providers of capital for

forgoing its use during the time the capital is used.

2. Interest and profit are payments for the risk the
investor takes in permitting another person or
organization to use his capital.
Interest: the Cost of Money
 In this regard, it is recognized that a peso today is more than a peso
one or more years from now because of the interest it can earn.
Therefore it has a time value.
 INTEREST is defined as the amount of money paid for the use of
borrowed capital for a certain period of time.
 Types of Interest (based on use)
Simple Interest
Compound Interest
Simple Interest
 Interest on borrowed capital is said to be simple interest if
the interest to be paid is directly proportional to the
length of time the amount or principal is borrowed.
 The formula for simple interest is

I = Pin
Where: I = total interest earned by the principal
P = amount of principal
i = rate of interest
n = number of interest periods
Formula for simple Interest
Discount is the difference between the future
worth and its present worth.
 F= P+I  Rate of discount:
 F = P + Pni  d = rate of discount
 F = P(1+ ni)  d = F – P1
Where:  d = 1 - __1___
P= Principal  (I + I )
F= Total Future Amount  d = ___i__
n = time period  1+i (rate of discount)
i = interest rate in decimal
Sample Problems
 A borrowed P2,000 from a bank and promise to pay the amount for
one year. He received only the amount of P1,920 after the bank
collected an advance interest of P80.00. What was the rate of
discount and the rate of interest that the bank collected in advance?
 Solution

Rate of discount = (80/ 2000) x 100 = 4%

Rate of interest = (80/1920) x 100 = 4.17%
Sample Problems
 If you borrowed money from a friend with a simple interest of 12% find
the present worth of P50,000 which is due at the end of 7 months. (how
much is the principal amount?)
a. P46,200 c. P46, 730
b. P 44,893 d. P45, 789
 A bank charges 12% simple interest on a P300,000 loan, How much will
be repaid if the loan is paid back in one lump sum after 3 years?
a. P408,000 c. P551,000
b. P415,000 d. P450,000
Compound Interest

 In compound Interest, the interest earned by the principal is not

paid at the end of each interest period, but considered as
added to the principal and therefore will also earn interest for
the succeeding periods. (Interest on top of the interest)
 Using the same nomenclature as that for simple interest, the total
amount due after n for compound interest if given by the formula
▪ F = P (1+i)n
▪ Where (1+i)n = Single Payment Compound Amount Factor
(SPCAF)
Sample Problem
 The amount of P50,000 was deposited in the bank earning an
interest of 7.5% per annum. Determine the total amount at thr end
of 5 years, if the principal and interest were not withdrawn during
the period?
 Solution
P = P50,000 i= 7.5% n= 5 years F=?
F = P(1+i)n
F = P50,000(1 + 0.075)5
F = P71,781.47
 Find the present worth of the payment of P30,000 to be made in
five years with an interest rate of 8% per annum.
 Solution:
F = P30,000 i=8% n=5 years P=?
F = P(1+i)n
P = F/ (1+i)n
P = P30,000/(1+.08)5
P = P20,417.50
Nominal Rate VS. Effective Rate of Interest
 Nominal Rate for compound interest, the rate of interest usually quoted is
Nominal rate of Interest which specifies the rate of interest and the number of
interest period.

 Effective Rate of Interest is the actual rate of interest on the principal for one
year.
The relationship between effective rate of interest, i, and the nominal
interest rate, r, is i = ( 1 + r/M)M – 1
where M = is the number of compounding periods per year
Sample Problem
 Calculate the effective rate corresponding to each of the following rates:
a.10% compounded semiannually c. 10% compounded bi-monthly
b.10% compounded quarterly d. 10% compounded monthly
Solutions:
a. ER1 = 1 + 0.1 2 2 -1 = 0.1025 = 10.25%
b. ER2 = 1 + 0.1 4 4 -1 = 0.1038 = 10.38%
c. ER3 = 1 + 0.1 6 6 -1 = 0.1043 = 10.43%
d. ER4 = 1 + 0.1 12 12-1 = 0.1047 = 10.47%
Sample Problem
 How many years is required 2.5 = (1.06)2n
for P2,000 to increase by Log 2.5 = 2n log 1.06
P3000 if the interest rate is 2n = log 2.5
12% compounded semi log 1.06
annually. 2n = 15.73 semi annuals
 Solution: n = 7.86 years
P = P2,000 F= P5,000 i= 12%/2
= 6% per semi annual n= 2n= ?
F= P (1+i)n
P5,000 = P2,000 (1+.06)2n
CASH FLOW
CASH FLOW
 describe the manner of cash receipt (i.e. income) and cash
disbursement (i.e. expenses) of an economic activity.

 5 Types of Cash Flow

a. Single Cash Flow
b. Uniform Series of Cash Flow
c. Linear or Arithmetic Gradient Series of Cash Flow
d. Geometric Gradient Series of Cash Flow
e. Irregular Series of Cash Flow
 Single Cash Flow
 simplest case of cash flow
 involves the equivalence of a
single present amount and its
future worth or vice versa.
Uniform Series of Cash Flow
 includes transactions
arranged as a series of equal
cash flows at regular interval
of time
 a.k.a equal payment series
 Ex: Installment loan contract –
which arranges repayment of
a loan in equal periodic
installment (amortization)
Types of annuity
 Ordinary Annuity is one where the equal payments are made at the
end of each payment period starting from the first period.
 Deferred Annuity is one where the first payment of the first amount
is deferred a certain number of periods after the first.
 Annuity Due is one where the payments are made at the start of its
period, beginning from the first period.
 Perpetuity is an annuity where the payment period extend forever
or which the periodic payments continue indefinitely.
 Summary of Formula (Discrete Compounding Interest Factors &
Symbols)
To Find Given Factor by which to Factor Name Factor Functional
Multiply Symbol
For Single Cash Flows
F P (1+i)n Single Payment Compound (F/P, i%, n)
Amount
P F (1+i)-n Single Payment Present (P/F, i%, n)
Worth
For Uniform Series
F A (1+i)n - 1 Uniform Series Compound (F/A, i%, n)
i Amount
P A (1+i)n - 1 Uniform Series Present Worth (P/A, i%, n)
i(1+i)n
A F i Sinking Fund (A/F, i%, n)
------------------
(1+i)n - 1

A P i(1+i)n Capita Recovery (A/P, i%, n)

(1+i)n - 1
Sample Problems
 Suppose you make 15 equal deposits of P1,000 each into a bank
account paying 5% interest per year. The first deposit will be made
one year from today. How much money can be withdrawn from this
bank account immediately after the 15th deposit?
 How much can be withdrawn at the end of 15th year, if the first
deposit will be made today?
 A man invest P100,000 now for the college education of his 2-year
old son. If he earns 12% compounded quarterly, how much will the
son get each year starting from his 18th to 22nd birthday?
Perpetuity
 If money is worth 10% compounded quarterly compare the present value
of the following:
a. the annuity of P1,000 payable quarterly for 50 years
b. the annuity of P1,000 payable quarterly for 100 years
c. a perpetuity of P1,000 payable quarterly.

❑ How much is the capitalized costs for a Research Building if money is

worth 8% per annum compounded quarterly with the following cost
requirements. Investment costs of P34 Million for the building, equipment
and other facilities; Quarterly operating and maintenance costs of
P100,000 and Repair and replacement costs of P500,000 every 5
years.?
Linear or Arithmetic Gradient Series of Cash Flow

 Each cash flow in a given series increases or decreases by a fixed

amount per period.
Arithmetic Gradient

 G = fixed amount of decrease or

increase per period

Present Worth where 1  (1 + i) n − 1 n 

(P/G, i%, n) =  −
i  i (1 + i ) n (1 + i ) n 
P = PA + PG (increasing) PG = G(P/G, i%, n)
P = PA - PG (decreasing)
 For finding the future equivalent, F For finding the uniform equivalent, A
F = FA + FG (for increasing gradient) A = A + AG (for increasing gradient)
A = A - AG(for decreasing gradient)
F = FA - FG (for decreasing gradient)

Where: FG = G(F/G, i%, n) Where: AG = G(A/G, i%, n)

1  (1 + i) n − 1  1 n
(F/G, i%, n) =  − n
(A/G, i%, n) = −
i i  i (1 + i ) n − 1
 Geometric Gradient Series of Cash Flow
 series of cash flows that
increases or decrease by
fixed rate usually express
as percentage
 if i% ≠ f
1+ i A1
icr = − 1 P = 1 + f ( P / A, icr %, n )
1+ f

i% if i% = f;
A1 nA1
icr = 0 P= ( P / A,0%, n ) =
1+ f 1+ f
Irregular Series of Cash Flow
 Does not exhibit a
regular overall
pattern
Sample Problem 5.21
 Suppose that one has cash flows as follows:
End-of-Year 1 2 3 4
Cash Outflows 5,000 6,000 7,000 8,000
(in pesos)

 Assume that one wishes to calculate their present equivalent at 15%

rate of interest compounded annually, what is its present worth?
Using Single Cashflow Concept :
P0 = Php5000(P / F,15%,1) + 6000(P / F,15%,2) + 7000(P / F,15%,3) + 8000(P / F,15%,4)
= 5000(1.15)1 + 6000(1.15)2 + 7000(1.15)3 + 8000(1.15)4
= Php18061.32768...

Using the Gradient Concept

P0 = Php5000(P / A,15%,4) + Php1000(P / G,15%,4)
 (1.15)4 - 1  1000  (1.15)4 - 1 4 
= 5000  4
+  4
- 4
 (0.15)(1.15)  0.15  (0.15)(1.15) (1.15) 
= Php18061.32768
Sample Problem 5.22
 Calculate the future equivalent at the end of 1999, at 8% per year,
of the following series of cash flows.

End-of-Year 1996 1997 1998 1999

Cash flows (in 10,000 8,000 6,000 4,000
pesos)
Sample Problem 5.23
 Suppose an engineer receives an initial annual salary of Php24,000
increasing at the rate of Php1,200 a year. If money is worth 12%
annually, determine its equivalent annual salary for a period of 10
years.
Sample Problem 5.23
 The heat loss through the exterior wall of a certain poultry
processing plant is estimated to cost the owner Php3,000 next year.
A salesman from Super Fiber Insulation, Inc. has told you, the plant
engineer, that he can reduce the heat loss by 80% with the
installation of Php15,000 worth of Super Fiber Insulator now. If the
cost of heat loss rises by Php200 per year after the next year and
the owner plans to keep the present building for 15 more years,
what would you recommend? The interest rate is 12% effective.
Sample Problem 5.24
 Annual maintenance costs for a machine are Php1,500 next year
and are estimated to increase by 10% each year starting one year
from now. What is the present worth of the maintenance costs for six
years if (a.) = 8%, (b.) = 10%, and (c.) = 12%?
Sample Problem 5.25
 Eleanor makes year-end deposits of Php500 the first year, Php550
the second year, Php605 the third year, and so on, increasing the
next year’s deposit by 10% of the deposit in the preceding year
until the end of the tenth year. Ronald makes equal year-end
deposits of Php700 each year for 10 years. If interest on both
funds is 12% compounded annually, who will be able to save more
at the end of the 10 years?
Sample Problem 5.26
 A young man has decided to go into business at age 40. He wishes
to accumulate Php200,000 at that age. On his twenty-fifth
birthday, he deposits a certain amount and will increase the deposit
by 10% each year until the fortieth year. If the funds can be
invested at 9.6% compounded annually, how much should his initial
investment be?
Sample Problem 5.27
 A firm is considering the installation of an automatic data processing
unit to handle some of its accounting operations. Machines for that
purpose may be purchased for P200,000 or maybe leased for
P80,000 for the first years and P10,000 less every year now and
then until the end of the 4th year. If money is worth 15% is it
advisable to rent or buy the machine?