2-Eng Eco

Chapter - Two
Money time relation

and
Cash flow
2024/25 (2017 EC 1st sem. )
1
Time Value of Money
 In most decisions the change in the value of
money needs to be accounted
 The manifestation of time value of money is
called interest.
 Interest ; Money paid by Borrower for the use of
funds provided by the lender
 Interest represents
- Earning power of money
- Risk of non-repayment
- Loss of used of the loaned money
2
 Therefore time value of money is the relationship
between time and money.
 It is clearly explained in quote;
“An instant dollar is worth more than a distant

dollar… ”
Today 6 months later

 The reason : the time value of money is inflation,
risk and cost of money.
3
Interest could be simple or compound
 Simple; The interest doesn't attract any interest

during the repayment period
 Compound; The interest amount it self also attracts
further interest.
 Consider the following statement by a Bank

“Interest on the deposit will be payable at the rate of
eight percent compound quarterly’’
4
A year for Quarterly compounding of interest:-
Four periods ( 3 months of each)
- If the amount was 100 Birr
1st period = 100 + (100*8%/4)
= 102
2nd Period = 102 + (102*8%/4)
= 104.04
3rd Period = 104.04 + (104.04*8%/4)
=106.12
4th Period = 106.12 + (106.12*8%/4)
= 108.24 5
 From the Example it is clear that Birr 8.24
can be seen as the interest amount attracted
by 100 Birr in one year period under a given
rate ( 8% ) and condition of quarterly
compounding.
6
EXAMPLE 1
HP borrowed money to do rapid prototyping

for a new ruggedized computer that targets
desert oilfield conditions. The loan is $1
million for 3 years at 5% per year interest.
How money will HP repay at the end of 3
years?
i. Simple Interest
ii. Compound Interest
7
Cash-Flow Diagrams / Interest Tables
- Any organization involved in a project received and
spend different amounts of money at different points in
time.
- Cash flow diagram is visual representation of this
inflow and outflow of funds.
- In practice cash flow does not follow any pattern,
however for simplification all cash incomings and
outgoings are assumed to happen either at the
beginning or end of a period
- The period could be day, week, month, quarter, or year.
8
ECONOMIC EQUIVALENCE
 Established when we are indifferent between a

future payment, or a series of future payments, and a
present sum of money .
 Considers the comparison of alternative options, or
proposals, by reducing them to an equivalent basis,
depending on:
 interest rate;
 amounts of money involved;
 timing of the affected monetary receipts and/or expenditures;
 manner in which the interest , or profit on invested capital is paid and the initial
capital is recovered. 9
CASH FLOW DIAGRAMS / TABLE
NOTATION
i = effective interest rate per interest period
N = number of compounding periods (e.g., years)
P = present sum of money; the equivalent value of one or more
cash flows at the present time reference point
F = future sum of money; the equivalent value of one or more cash
flows at a future time reference point
A = end-of-period cash flows (or equivalent end-of-period values )
in a uniform series continuing for a specified number of periods,
starting at the end of the first period and continuing through the
last period
G = uniform gradient amounts -- used if cash flows increase by a
constant amount in each period 10
CASH FLOW DIAGRAM NOTATION
A = $2,524 3 5
1
1 2 3 4 5=N
P =$8,000 2 4 i = 10% per year
1 Time scale with progression of time moving from left to

right; the numbers represent time periods (e.g., years,
months, quarters, etc...) and may be presented within a
time interval or at the end of a time interval.
2 Present expense (cash outflow) of $8,000 for lender.
3 Annual income (cash inflow) of $2,524 for lender.
Dashed-arrow line indicates

4 Interest rate of loan. 5 amount to be determined. 11
Example 2
A father wants to deposit an unknown

lump-sum amount into an investment
opportunity 2 years from now that is large
enough to withdraw $4000 per year for
state university tuition for 5 years starting 3
years from now. If the rate of return is
estimated to be 15.5% per year, construct
the cash flow diagram.
12
Solution
13
RELATING PRESENT AND FUTURE
EQUIVALENT VALUES OF SINGLE
CASH FLOWS
 Finding F when given P:

 Finding future value when given present value
 F = P ( 1+i ) N
 (1+i)N single payment compound amount factor
 functionally expressed as F = ( F / P, i%,N )
 predetermined values of this are presented in a Table
P
N=
0
14
F=?
EQUIVALENT VALUES OF SINGLE
CASH FLOWS
15
EQUIVALENT VALUES OF SINGLE CASH
FLOWS
 Finding P when given F:

 Finding present value when given future value
 P = F (1 / (1 + i )N )
 (1+i)-N single payment present worth factor
 functionally expressed as P = F ( P / F, i%, N )
 predetermined values of this are presented in a Table
F
0 N=
P=? 16
Example 3
Hewlett-Packard has completed a study indicating
that $50,000 in reduced maintenance this year (i.e.,
year zero) on one processing line resulted from
improved wireless monitoring technology.
a. If Hewlett-Packard considers these types of
savings worth 20% per year, find the equivalent
value of this result after 5 years.
b. If the $50,000 maintenance savings occurs now,
find its equivalent value 3 years earlier with interest
at 20% per year. 17
RELATING A UNIFORM SERIES (ORDINARY
ANNUITY) TO PRESENT AND FUTURE EQUIVALENT
VALUES
• Finding P given A:
• Finding present equivalent value given a series of
uniform equal receipts
(1+i)N-1
P=A
i(1+i)N
– uniform series present worth factor in [ ]
– functionally expressed as P = A ( P / A, i%, N )
– predetermined values are in a Table.
A= 1 2 3 4 5 6 7 8
18
P=?
VALUES
• Finding A given P:
• Finding amount A of a uniform series when given the
equivalent present value
i ( 1+i )N
A=P
( 1 + i ) N -1
– capital recovery factor in [ ]
– functionally expressed as A = P ( A / P,i%,N )
– predetermined values are in a Table
P=
1 2 3 4 5 6 7 8 19
A =?
Example 4
How much money should you be willing to pay

now for a guaranteed $600 per year for 9 years
starting next year, at a rate of return of 16% per
year?
20
RELATING A UNIFORM SERIES TO
PRESENT AND FUTURE
EQUIVALENT VALUES
 Finding F given A:
 Finding future equivalent income (inflow) value given a
series of uniform equal Payments
(1+i)N-1
F=A
i
 uniform series compound amount factor in [ ]
 functionally expressed as F = A ( F / A, i%, N )
F=?
1 2 3 4 5 6 7 8 21
A=
VALUES
• Finding A given F:
• Finding amount A of a uniform series when given the
equivalent future value
i
A=F
( 1 + i ) N -1
– sinking fund factor in [ ]
– functionally expressed as A = F ( A / F,i%,N )
– predetermined values are in a Table
F=
1 2 3 4 5 6 7 8 22
A =?
Example 5
1. Formasa Plastics has major fabrication plants in
Texas and Hong Kong. The president wants to know
the equivalent future worth of $1 million capital
investments each year for 8 years, starting 1 year
from now. Formasa capital earns at a rate of 14% per
year. Compute the future worth.
2. How much money must an electrical contractor
deposit every year in her savings account starting 1
year from now at 5.5% per year in order to
accumulate $6000 seven years from now?
23
RELATING A UNIFORM GRADIENT OF CASH
FLOWS TO FUTURE EQUIVALENTS
 Find F when given G:

 Find the future equivalent value when given the uniform
gradient amount
(1+i)N-1 -1 (1+i)N-2 -1 (1+i) 1 -1
 F=G i + i + ... + i
 Functionally represented as (G/ i) (F/A,i%,N) - (NG/ i)

 Usually more practical to deal with annual and present
equivalents, rather than future equivalent values
24
Cash Flow Diagram for a Uniform Gradient
Increasing by G Dollars per period
(N-1)G
i = effective interest rate
per period
(N-2)G
(N-3)G
3G
2G
G
1 2 3 4 N-2 N-1 N
End of Period 25
FLOWS TO ANNUAL AND PRESENT
EQUIVALENTS
• Find P when given G:
• Find the present equivalent value when given the
uniform gradient amount
1 (1 + i ) N-1 N
• P=G -
i i (1 + i ) N (1 + i ) N
• Functionally represented as P = G ( P / G, i%,N )
• The value shown in{ } is the gradient to present
equivalent conversion factor and is presented in a
Table
26
Example 6
The Highway Department expects the cost

of maintenance for a piece of heavy
construction equipment to be $5000 in
year 1, to be $5500 in year 2, and to
increase annually by $500 through year
10. At an interest rate of 10% per year,
determine the present worth of 10 years of
maintenance costs.
27
FLOWS TO ANNUAL AND PRESENT
EQUIVALENTS
• Find A when given G:
• Find the annual equivalent value when given the
uniform gradient amount
1 N
• A=G -
i (1 + i ) N - 1
• Functionally represented as A = G ( A / G, i%,N )
• The value shown in [ ] is the gradient to uniform series
conversion factor and is presented in a Table.
28
QUESTIONS?
29

2-Eng Eco

Uploaded by

Copyright:

Available Formats

2-Eng Eco

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

2-Eng Eco

Uploaded by

Copyright:

Available Formats

Chapter - Two

Money time relation

“An instant dollar is worth more than a distant

Today 6 months later

 Simple; The interest doesn't attract any interest

 Consider the following statement by a Bank

HP borrowed money to do rapid prototyping

 Established when we are indifferent between a

1 Time scale with progression of time moving from left to

3 Annual income (cash inflow) of $2,524 for lender.

Dashed-arrow line indicates

A father wants to deposit an unknown

 Finding F when given P:

 Finding P when given F:

How much money should you be willing to pay

 functionally expressed as F = A ( F / A, i%, N )

 Find F when given G:

 Functionally represented as (G/ i) (F/A,i%,N) - (NG/ i)

The Highway Department expects the cost

You might also like