The Time Value of Money

 The term capital refers to wealth in the form of money or property that can be used to

produce more wealth.

The majority of engineering economy studies involve commitment of capital for extended

periods of time, so the effect of time must be considered.

It is recognized that a dollar today is worth more than a dollar one or more years from now

because of the interest (or profit) it can earn.

Therefore, money has a time value.

It has been said that often the riskiest thing a person can do with money is nothing!

Money has value, and if money remains uninvested (like in a large bottle), value is lost.
 The time value of money seems like a sophisticated concept, yet it is one that you deal
with every day.
Should you buy something today or save your money and buy it later?
Here is a simple example of how your buying behavior can have varying results:
Pretend you have $100 and you want to buy a $100 refrigerator for your residence room.
If you buy it now, you end up broke.
But if you invest your money at 6% annual interest, then in a year you can still buy the
refrigerator, and you will have $6 left over.
However, if the price of the refrigerator increases at an annual rate of 8% due to inflation,
then you will not have enough money (you will be $2 short) to buy the refrigerator a year
from now.
In that case, you probably are better off buying the refrigerator now (Park, 2004)
 
 INTEREST FORMULAS
While making investment decisions, computations will be done in many ways.
To simplify all these computations, it is extremely important to know how to use interest formulas
more effectively.
Before discussing the effective application of the interest formulas for investment-decision making,
the various interest formulas are presented first.
Interest rate can be classified into simple interest rate and compound interest rate.
In simple interest, the interest is calculated, based on the initial deposit for every interest period. In
this case, calculation of interest on interest is not applicable.
When the total interest earned or charged is linearly proportional to the initial amount of the loan
(principal), the interest rate, and the number of interest periods for which the principal
iscommitted, the interest and interest rate are said to be simple.
Simple interest is not used frequently in modern commercial practice.
When simple interest is applicable, the total interest, I , earned or paid may be computed using
the formula
I = (P)(N)(i)
where P = principal amount lent or borrowed;
N = number of interest periods (e.g., years);
i = interest rate per interest period.
The total amount repaid at the end of N interest periods is P + I. Thus, if $1,000
were loaned for three years at a simple interest rate of 10% per year, the interest
earned would be
I = $1,000 × 3 × 0.10 = $300.
The total amount owed at the end of three years would be $1,000 + $300 = $1,300.
Notice that the cumulative amount of interest owed is a linear function of time
until the principal (and interest) is repaid (usually not until the end of period N).
In compound interest, the interest for the current period is computed based on

the amount (principal plus interest up to the end of the previous period) at the

beginning of the current period.

Whenever the interest charge for any interest period (a year, for example) is

based on the remaining principal amount plus any accumulated interest charges

up to the beginning of that period, the interest is said to be compound.

The effect of compounding of interest can be seen in the following table for

$1,000 loaned for three periods at an interest rate of 10% compounded each

period:
A total of $1,331 would be due for repayment at the end of the third period.

If the length of a period is one year, the $1,331 at the end of three periods (years) can be

compared with the $1,300 given earlier for the same problem with simple interest.

The difference is due to the effect of compounding, which is essentially the calculation of

interest on previously earned interest.

This difference would be much greater for larger amounts of money, higher interest rates, or

greater numbers of interest periods.

Thus, simple interest does consider the time value of money but does not involve compounding

of interest.

Compound interest is much more common in practice than simple interest .

 Future Worth (Compounding)
Compounding method used to determine the future value of present investment
is known as Compounding
Suppose you deposit $1,000 into a savings account at the Surety Savings Bank
and you are promised 10% interest per period.
At the end of one period you would have $1,100.
This $1,100 consists of the return of your principal amount of the investment
(the $1,000) and the interest or return on your investment (the $100).
Let’s label these values: $1,000 is the value today, the present value, PV.
$1,100 is the value at the end of one period, the future value, FV. 10% is the
rate interest is earned in one period, the interest rate, i.
To get to the future value from the present value:
i = interest rate compounded annually,
n = period of deposit.
Discounting
Sometimes we may wish to find the present value at a
given rate of interest (discount rate) of an amount due
at some future date.
The method used to determine the present value of
future cash flows is known as Discounting.
For example if an amount PV is lent today at ‘i’ rate
of interest, it value after ‘n’ years will be FV.
Now if FV is given, we can estimate the present value
PV, given the n and i.
PV= FV x 1/(1+i)n
 
Practice Problems
1. Assume you put 20,000 dollars (principal) in a bank for the interest rate of
4%. How much money will bank give you after 10 years?
2. A business is to receive $100 in one year’s time and the interest rate/discount
rate is 10%. What is the PV of that money?
3. A business is to receive $100 in two years’ time and the interest rate/discount
rate is 10%.  What is the PV of that money?
4. A principal of $2000 is placed in a savings account at 3% per annum
compounded annually. How much is in the account after one year, two years and
three years? 
The Concept of Equivalence
Alternatives should be compared when they produce similar results, serve the
same purpose, or accomplish the same function.
This is not always possible in some types of economy studies (as we shall see
later), but now our attention is directed at answering the question:
How can alternatives for providing the same service or accomplishing the same
function be compared when interest is involved over extended periods of time?
Thus, we should consider the comparison of alternativeoptions, or proposals, by
reducing them to an equivalent basis that is dependent on
(1) the interest rate, (2) the amounts of money involved, and (3) the timing of
the
monetary receipts or expenses.
Figure 4-1 Illustration of Simple versus Compound Interest
suppose you have a $17,000 balance on your credit card. “This has got to stop!”
you say to yourself.
So you decide to repay the $17,000 debt in four months.
An unpaid credit card balance at the beginning of a month will be charged
interest at the rate of 1% by your credit card company.
For this situation, we have selected three plans to repay the $17,000 principal
plus interest owed.
These three plans are illustrated in Table 4-1, and we will demonstrate that they
are equivalent (i.e., the same) when the interest rate is 1% per month on the
unpaid balance of principal.
Plan 1 indicates that none of the principal is repaid until the end of the fourth
month. The monthly payment of interest is $170, and all of the principal is also
repaid at the end of month four. Because interest does not accumulate in Plan 1,
compounding of interest is not present in this situation. In Table 4-1, there are
68,000 dollar-months of borrowing ($17,000×4 months) and $680 total interest.
Therefore, the monthly interest rate is ($680 ÷ 68,000 dollar-months) × 100% =
1%
Plan 2 stipulates that we repay $4,357.10 per month.
For our purposes here, you should observe that interest is being compounded
and that the $17,000 principal is completely repaid over the four months.
From Table 4-1, you can see that the monthly interest rate is ($427.10 ÷ 2,709.5
dollar-months of borrowing) ×100% = 1%.
There are fewer dollar-months of borrowing in Plan 2 (as compared with Plan 1)
because principal is being repaid every month and the total amount of interest
paid ($427.10) is less.
Finally, Plan 3 shows that no interest and no principal are repaid in the first three months.
Then at the end of month four, a single lump-sum amount of $17,690.27 is repaid.
This includes the original principal and the accumulated (compounded) interest of $690.27.
The dollar-months of borrowing are very large for Plan 3 (69,026.8) because none of the
principal and accumulated interest is repaid until the end of the fourth month.
Again, the ratio of total interest paid to dollar-months is 0.01.
This brings us back to the concept of economic equivalence.
If the interest rate remains at 1% per month, you should be indifferent as to which plan you use
to repay the $17,000 to your credit card company.
This assumes that you are charged 1% of the outstanding principal balance (which includes any
unpaid interest) each month for the next four months.
If interest rates in the economy go up and increase your credit card rate to say, 11 4% per
month, the plans are no longer equivalent.
What varies among the three plans is the rate at which principal is repaid and how interest is
repaid
 Notation and Cash-Flow Diagrams and Tables
The following notation is utilized in formulas for compound interest calculations:
i = effective interest rate per interest period; N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more cash flows
at a reference point in time called the present; F = future sum of money; the equivalent value of
one or more cash flows at a reference point in time called the future;
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.
The use of cash-flow (time) diagrams or tables is strongly recommended for situations in which
the analyst needs to clarify or visualize what is involved when flows of money occur at various
times.
The difference between total cash inflows (receipts) and cash outflows (expenditures)
for a specified period of time (e.g., one year) is the net cash flow for the period.
Indeed, the usefulness of a cash-flow diagram for economic analysis problems is
analogous to that of the free-body diagram for mechanics problems.
Figure 4-2 shows a cash-flow diagram for Plan 3 of Table 4-1, and Figure 4-3
depicts the net cash flows of Plan 2.
These two figures also illustrate the definition of the preceding symbols and their
placement on a cash-flow diagram.
Notice that all cash flows have been placed at the end of the month to correspond with
the convention used in Table 4-1. In addition, a viewpoint has been specified.
Figure 4-2 Cash-Flow Diagram for Plan 3 of
Table 4-1 (Credit Card Company’s Viewpoint)
Figure 4-3 Cash-Flow Diagram for Plan 2 of Table
4-1 (Lender’s Viewpoint)
 Cash-Flow Diagramming

Before evaluating the economic merits of a proposed investment, the

XYZ Corporation insists that its engineers develop a cash-flow
diagram of the proposal.
An investment of $10,000 can be made that will produce uniform
annual revenue of $5,310 for five years and then have a market
(recovery) value of $2,000 at the end of year (EOY) five.
Annual expenses will be $3,000 at the end of each year for operating
and maintaining the project.
Draw a cash-flow diagram for the five-year life of the project. Use
the corporation’s viewpoint.
Finding the Interest Rate Given P, F, and N

There are situations in which we know two sums of money (P and F)

and how much time separates them (N), but we don’t know the
interest rate (i) that makes them equivalent.
For example, if we want to turn $500 into $1,000 over a period of 10
years, at what interest rate would we have to invest it? We can easily
solve Equation (4-2) to obtain an expression for i.
 Finding N when Given P, F, and I

Sometimes we are interested in finding the amount of time needed for a present
sum to grow into a future sum at a specified interest rate. For example, how long
would it take for $500 invested today at 15% interest per year to be worth $1,000?We
can use the equivalence relationship given in Equation (4-2) to obtain an expression

for N.