Week 1: Time Value of Money

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Week 1: Time Value of Money

Week 1: Time Value of Money
Tasks for the week:
z z z z

Participate in the SignIn conference, Read this content, Read chapter 1 Read chapter 3, sections 3.1 and 3.2,

z Read the article Retain, J., "Time Value of Money and the Psychological Value of Money", Blog retrieved 7/27/2011 from http://ourfounder.typepad.com/leblog/2010/02/time-value-ofmoney-and-the-psychological-value-of-money.html z z

Participate in the Week 1 Conference Submit Assignment 1 in the Assignment/Grade book area.

Again, welcome to TMAN 625. The first weeks content summarizes chapter 1 and focuses on the introductory sections of chapter 3. Note that Chapter 2 of the textbook will be covered in week 7. This course is intended to provide students a background in economic and financial analysis needed by managers in technological areas and by employees that create proposals for projects or acquisitions. The purpose of the financial analysis is to evaluate alternative actions, projects or acquisitions. While they can be evaluated using other than financial criteria, this course has a focus on financial evaluation. Periodically, references to other criteria will be made, but mostly these are covered in other courses. Therefore unless indicated otherwise, in this course always consider problems from a financial perspective and one that considers the time value of money (described below).
z z z z z

Financial analysis for projects or acquisitions requires knowledge from the areas of: Micro economics (individual and organization level) Financial accounting (focus on external stakeholders and owners) Cost Accounting (focus on internal management) Finance.(obtaining and using obtained funds effectively)

And a little macro economics (national and international) is even relevant. This encompasses a large area so content from these areas will be selected for relevance to the needs of this course. Do not expect to cover all of these in detail. The use of financial analysis in organizations has many similarities for individuals and their home loans, car loans, retirement plans, etc. Therefore, personal finance issues and examples will often be used, especially in the first three weeks. These can be valuable to you personally and form the basis for later topics in the course. In week 4, the emphasis switches to an organizational perspective and the financial analysis of technological proposals. First this week, some miscellaneous topics will be discussed such as the textbook, instructional videos and spreadsheets. Following this the basic concepts of finance are presented.

1.

The Park Textbook

Many, if not most, of you students do not have an engineering background so a textbook with

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the word Engineering in the title may be intimidating. Our textbook was written for engineering students who one day may be in management positions. And that is much the same situation for most of you. The content area of Engineering Economics is relevant to managing any technical area. These course content presentations will try to present the material in a less engineering way. That is, instead of focusing on equations, this course will focus on a visual presentation using spreadsheets. This course is no more mathematical, in some cases less, than common business school Finance courses. Business finance textbooks differ from Engineering Economy textbooks in that the former have about twice as many topics regarding finance, but minimal content on economics and accounting. This is because students majoring in business students typically have several prerequisite courses before taking a finance course. They usually get two semesters of accounting and two semesters of economics and a statistics course (s). Engineering students usually do not take these prerequisite courses, so from a financial and accounting knowledge standpoint; they start at roughly the same level as most of you. The textbook for this course, as typical in engineering courses, contains more mathematical derivations than found in business finance textbooks. Some students learn and understand better if they know how something is derived, so derivations of equations are often presented. Do not panic if you cannot fully follow these as you will not be asked to derive equations for assignments or exams, and you will not be tested on these derivations. You can skim these when they are encountered in the textbook. In many cases, the textbook author presents alternative ways (perspectives) to look at an analysis: equations, tables and Excel functions. Although the Excel functions are the most common in the business world today and will be emphasized in these course content presentations, you may use the approach that works for you. As the course proceeds, the spreadsheet approach becomes important as other approaches lack capabilities or are much to cumbersome.

2.

Videos

Videos that explain concepts and show solution procedures are available for each Students have found the videos to be particularly helpful. This summer, the previous videos are being separated into smaller segments and links are provided within the content at relevant places. This conversion process is a summer semester project and it is not certain if they will all be finished. If not, links to the previous videos will be listed in the content. The videos are created using the Camtasia software and stored on a site called ScreenCast.com. Accessing the videos by clicking on the links posted in the content. The videos will open in a new window. When opening a video, do the following: 1. Click on the Full Size icon 2. Use the far right scroll bar to position the video in the window as high as you can. You may want to create more room by closing some bars, such as Favorites, by right clicking on a bar and removing a check mark. 3. Start the video by clicking on the arrow in the middle of the window 4. There may be a table of contents on the left. The Table of Contents will disappear and the video will get larger if you position your cursor at the top of the window. The Table of Contents will return if you move the cursor down on the video. If you click on an item in the Table of Contents, the video will jump to that part of the video. 5. You can return to Web Tycho simply by closing the video window in your browser or by switching to the Web Tycho window.

3.

Excel
In the pre-computer days (only 50+ years ago), college engineering students often had a slide

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rule clipped to their belt (mostly males at that time), and a book of tables. Practicing engineers and financial analysts typically kept a book(s) containing reference tables on their desk. They could look up square roots, trigonometric functions, logarithms, financial factors and other such data as needed. But times have changed. These books of tables first were replaced by calculators, and today calculators have mostly been replaced by personal computers and spreadsheet software such as found in MS Office, MS Works, OpenOffice (free), Lotus SmartSuite, and others. A simple command will obtain the numbers found in the tables. All of the above mentioned software packages have spreadsheet capabilities that will suffice for this course. Since MS Office functions on both Apple and Microsoft operating systems and is used by over 90% of business organizations, the explanations within the course will focus on MS Excel. But the other brands work much the same and equally well. Engineering textbooks today are gradually migrating from the use of tables to the computer-based spreadsheet approach but the conversion is not yet complete. Seldom do you see tables in the back of Finance textbooks today. A survey was done of UMUC technology management students and it was found that only 4% had no Excel knowledge. Surveys never are perfectly accurate, and students sometimes avoid admitting deficiencies, so maybe this is 10% at the outside. For this 10% of the students, videos prepared for this course to assist in learning Excel are found at the following links. There also are many web sites with training exercises. The first video is a very basic introduction to Excel and is intended for students who have never used a spreadsheet package. Introduction The second video illustrates entering and particularly entering and editing data. Most everyone except regular users of Excel can benefit from this. Students report that this video commonly fills in small gaps of knowledge. Entering and Editing Data The third video explores the some of the remaining capabilities of Excel that are useful in this course. Most everyone can benefit from this. Other Capabilities A final video shows how to interface between spreadsheets and Web Tycho using cut and paste and a useful utility named The Snipping Tool. Copying Excel data into Web Tycho Microsoft Excel comes in three versions: Excel 2003, Excel 2007 and Excel 2010. Almost everywhere in this course, spreadsheet explanations will be made in a way that is the same in each version. These may not be your preferred way, or even the easiest way, but the approaches are used because they generally work in any version and keep things relatively simple. The video used to illustrate solutions have been created using Excel 2007 that appears to be the most common version. The screen formats differ substantially in Excel 2003, so the explanations and videos will be clearer is you are using Excel 2007 or Excel 2010. If you can, upgrade to one of these later versions. Copies of Excel 2007 are generally available at low prices since there is a later 2010 version. A particularly confusing part of the Excel versions (2003, 2007, and 2010) concerns file storage formats. Excel 2003 saves files with an .xls suffix (e.g. DocName.xls) and Excel 2007 and 2010 saves these with an .xlsx suffix (e.g. documentname.xlsx). Open Docs uses another one. The saved documents are in different formats. Do not try to switch from one format to the other simply by changing the name from say DocName.xlsx to DocName.xls, as this makes the documents unreadable. If you are using Excel 2007 and want to save in the 2003 format, do a SaveAs and select the file type (in the box below the document name) as Office 2003. If you want to read Office 2007 documents in Office 2003, you should download a patch from the Microsoft website that enables this. You can submit your documents in either the 2003, 2007, or 2010 format as your instructor can handle all.

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The textbook periodically references an Excel capability named Solver which is an add-on that you may not have. We will not be using Solver in this course so it is not required for conferences, assignments and exams. So it can be ignored. In the last few weeks of the course, we will be using the Goal Seek that achieves the same thing, and also the Scenario Analysis capability. If you are new to Excel, spend some extra time in this first week getting comfortable with it. This will pay off many times over later in the course. Additional training aids can be found on the Internet, or purchase a book like Excel for Dummies. The Help capability in Excel is surprisingly good.

4.

Introduction to Finance

The first three weeks will focus on loans and investments and many situations with personal relevance such as home or car loans and retirement investments. This has relevance to you personally and provides a good framework to introduce the time value of money concepts that typify financial analysis. Week 2 will look at these on an annual basis, and week 3 will expand this to other period lengths such as months and quarters. Weeks 4 and 5 then address the basics of proposal evaluation using the same financial concepts. In these the cash flow is given. The second half of the course starts with a chapter on Accounting and then later weeks present the knowledge needed to determine cash flows in the accounting format. The course ends with a unit on proposals and their evaluation in public and nonprofit organizations. The basic concept of Finance is that money changes value of time due to interest being earned or interest being paid. Monetary amounts in different periods cannot be compared, added or subtracted without considering interest. This is the topic of week 1.

4.1. Time Value of Money (TVOM)

Technology managers regularly propose changes in technology. Implementing these proposals requires an investment of resources that is stated in monetary terms. These proposals are scrutinized by executives and their financial staff, and also compared to other competing proposals. Further, if approved, they get further scrutiny concerning benefits and costs as the project is implemented. Therefore, it is critical for both organizational success and a technology managers career that financial analyzes be prepared carefully, accurately, and in an acceptable and standardized format. This is the focus of this course. Given a choice of $1 million today, or $1 million in a year, most people would choose $1 million today. One reason is the proverbial a bird in the hand is better than a two in the bush. But financially, if the million dollars was invested and earned 3% interest, in one year you would have both the million dollars plus $30,000 in interest (3% x $1,000,000), or $1,000,000 + $30,000 = $1,030,000. What if the decision is between $1 million today or $1.1 million in a year? A means of evaluating these two alternatives is to look at the earned interest that this represents. In this case, it is $1,000,000 + x% x $1,000,000 = $1,100,000. Solving this equation for x gives $100,000 / $1,000,000 = 10%. Therefore, the basic equation to determine the future value FV from the present value PV and an interest rate r is to add the earned interest (PV times r) to the present value PV or: FV = PV + PV x r Factoring out PV on the right side of the equation gives: FV = PV x (1+r)

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If you have $100 today at 5% interest, the Future Value in one year will be 100 x (1+5%) = $105 in one year. This equation can be arranged algebraically to solve for todays value described as the Present Value PV. To determine the present value (PV) from a FV and rate, divide both sides of the equation by (1+r): PV = FV / (1+r) The present value today of $100 a year from now at 5% interest is =100 / (1+5%) = $95.24. Further algebraic manipulation of FV = PV * (1+r) can be used to determine a rate r by dividing both sides by 1+r and then subtracting 1 from both sides: FV/PV = 1+r r = FV/PV -1 If you can receive $100 in one year if you loan $90 today, the rate of interest is (100 / 90) -1 = 11.11%. These single year calculations in Excel are shown in a video segment at: Single Year Calculations

4.2. Multiple Years

It is slightly more complicated for multiple years. Note to find the future value in two years, the result of the first year has to be used to find the value at the end of the second year. FV(year 1) = FV(year 0) * (1+r) FV(year 2) = FV(year 1) * (1+r) Combining these by substituting the first equation into the second, FV(year 2) = [FV(year 0) * (1+r)] * (1+r) FV(year 2) = FV(year 0) * (1+r) * (1+r) = PV (year 0) x (1+r)^2 To determine future values for periods further in the future, just keep multiplying by 1+r for the number of periods; so the general case for n periods is: FV = PV x (1+r)n If you have $500 and invest it at 4% for 6 years, the future value FV is: FV = $500 x (1+4%)6 = $632.66

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Alternatively, going from the future to the present can be performed by rearranging the terms as: PV = FV / (1+r)n If you expect to have $10,000 in five years, and a rate of 4% is used, this would be valued at $8219.27 today. PV = $10,000 / (1+4%)5 = $8,219.27 As above in the single year case, the variables can be rearranged to solve for the rate r: FV / PV = (1+r)n (FV/PV)1/n = 1+r r = (FV/PV)1/n - 1 The rate for investing $1000 today that has a future value in 5 years of $1,500 dollars is, r = (1500/1000)1/5 1 = 1.08447 1= .08447 = 8.447% = 8.45% The multiple year calculations in Excel are presented in a video at: Multiple Year Calculations In summary, the above time value of money calculations are:
z z z

To move forward in time, multiply by 1 + interest rate. To move backward in time, divide by 1 + interest rate. To determine a rate, divide the future value by the present value, raise it to the 1/n power, and subtract 1.

In week 2, spreadsheet functions will be presented for doing these financial calculations. This week, stay with the equations.

4.3. Tables
Note that the (1+10%)^n equation used above can be evaluated for many different numbers of years as shown in the following table. Values entered =1.10^0 =1.10^1 =1.10^2 =1.10^3 =1.10^4 =1.10^5 =1.10^6 Present Value Factor 1.0000 1.1000 1.2100 1.3310 1.4641 1.6105 1.7716

Years 0 1 2 3 4 5 6

Equation =(1+10%)^0 =(1+10%)^1 =(1+10%)^2 =(1+10%)^3 =(1+10%)^4 =(1+10%)^5 =(1+10%)^6

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7 8 9 10

=1.10^7 =1.10^8 =1.10^9 =1.10^10

=(1+10%)^7 =(1+10%)^8 =(1+10%)^9 =(1+10%)^10

1.9487 2.1436 2.3579 2.5937

Present value factors for a variety of interest rates (like 10% above) can be found in Appendix B of the textbook (see page 909) and the above present value factors above correspond with the third column in the table. Each page is for a different percentage. You multiply the appropriate factor times the value in a year, and you get the present value. The second column shows the result of the (1+r)^n calculation which is a future value factor (Compound Amount Factor) that can be multiplied times a value in one period to get the equivalent value in a future period. Prior to financial calculators and now personal computers on most every desk, these tables were invaluable. Since the factors are all rounded off to 4 decimal places, the accuracy is less than for spreadsheet software that uses 16 digits. The notation for the tabled values is explained in the textbook.

5.

Equivalency

Consider the following two alternative projects shown below where the numbers in parenthesis mean they are negative (as does the red color). In both, an investment is proposed to be made up front (cash outflow) in 2011 and incoming cash resulting from the investments is received in the four years 2012 through 2015. The project A alternative is an investment of $4 million in 2011 that results in cash flows of $7, $4, $5, and $4 million per year in years 2012 through 2015 respectively. Project B is an alternative investment of $8 million in 2011 that is forecasted to result in $2, $5, $7, $10 million dollars per year of cash flow in years 2012 through 2015 respectively. Project A B Net Cash Flow (in millions of dollars) 2011 2012 2013 2014 ($4) $7 $4 $5 ($8) $2 $5 $7 2015 $4 $10

Which Project is preferable? If you simply add the numbers for the five years of each project (note that the amounts in year 2011 are negative), they both total to $16 million over the five years. Some people might prefer project A as it is half the price of B ($4 million versus $8 million), and others might like the higher profits in years 2012-2015 of alternative B. The time value of money approach used throughout this course requires that the five numbers for each proposal need to be converted into a single number to compare the alternatives. This is achieved by recognizing the money has a different value in the future than it does today. Therefore a sum does not accurately describe each project because it ignores the time value of money. One should never add monetary values from two different time periods because this ignores the time value of money. In a financial analysis, the computed single number can be expressed is several alternative forms. Above we looked at present value and future value. Later we will look at annual value. These are referred to as equivalent values as each can be determined from the other. Lets now determine single equivalent values for the two projects described above. Year 2011 is considered the present year and often will be designated as year 0. Since 2011 is already in the present, it does not need to be discounted, and should not be discounted. The values for Year 2012 in the above table can be discounted to 2011 (the present value) by dividing by 1+ the interest rate. Thus for project A, the present value of $7 million in 2012 is $7/(1 + 10%) = $7/1.1 = $6.363636 million or $6,363,636 in 2011.

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For project B, the present value of $2 million in 2012 is $2/(1 + 10%) = $2/1.1 = $1.818182 million or $1,818,182 in 2011. This calculation for the remaining three years (2013-2015) is similar except that they have to be discounted additional years. One could discount year 2013 to year 2012, then discount the 2012 result to year 2011. Or one can simply divides the year 2013 value by 1 + interest rate raised to the power 2. That is, to discount the value in 2013 to year 2011, divide $4 by (1+.10)^2 = $4/(1.1^2) = $6/1.2100 = $3.305785 million = $3,305,785. Similar calculations are shown below for all the values in the other years. Since this converts all cash flows to the same year, they can be summed. The result shown below shows that project A is preferred since the present value is higher. The higher values for the later years of project B are of less value when discounted to the present.

Project A Discounted to 2011 Present Value (millions) B Discounted to 2011 Present Value (millions)

Net Cash Flow in millions of dollars 2011 2012 2013 2014 ($4) $7 $4 $5 ($4) =7/(1.1^1) =4/(1.1^2) =5/(1.1^3) ($4) $6.36 $3.31 $3.76 $12.16 =Sum of the five discounted values ($8) ($8) ($8) $10.04 $2 $5 $7 =2/(1.1)^1 =5/(1.1)^2 =7/(1.1)^3 $1.82 $4.13 $5.26 =Sum of the five discounted values

2015 $4 =4/(1.1^4) $2.73

$10 =10/(1.1)^4 $6.83

The resulting present values are defined as equivalent to the 2011-2015 cash flows. Numerically they are different, but the present value can be calculated from the values. The equivalent Future value of Project A in 2015 is calculated as $12.16 * (1+10%)^4 = $17.80 and the equivalent future value of Project B in 2015 is $14.70. So for Project A, a future value of $17.80 is equivalent to a present value of $12.16 that is equivalent to a series of cash flows in year 2011 through 2015 of ($4), $7, $4, $5, and $4 respectively. A video on equivalency calculations can be viewed at: Equivalency Calculations

6.

Compound versus Simple Interest

Compound interest is where the interest is computed using the balance from the end of the previous period. For the first year is just the interest on the initial deposit. But in the second years and following, interest is also earned on the previous interest. The interest constantly grows because the balance at the end of the previous period continuously grows. An older approach that is seldom used anymore is labeled Simple Interest. With this, the interest amount for each period is calculated using the original year 0 amount. The following table illustrates the difference between compound and simple interest. Note that for simple interest, the interest stays constant at $50. For compound interest, the computed interest continues to increase (compounds). We will not be using simple interest in this course and it is only presented to contrast compound interest. Simple Compound

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Year 0 1 2 3 4 5

Interest of 5% $50.00 $50.00 $50.00 $50.00 $50.00

Balance $1,000.00 $1,050.00 $1,100.00 $1,150.00 $1,200.00 $1,250.00

Interest of 5% $50.00 $52.50 $55.13 $57.88 $60.78

Balance $1,000.00 $1,050.00 $1,102.50 $1,157.63 $1,215.51 $1,276.28

A video converning simple interest calculations in Excel can be viewed at: Simple Interest Calculations

7.

Multiple Criteria

In most all problems in this course, it will be assumed that the TVOM approach is the only criteria in making a decision. But other criteria may also be used in the real world. If an alternative enabled the installation of new technology which has applications to other products or processes, or had other strategic importance to the organizations future, perhaps it should be chosen even though it has a smaller present value. That is, there may be other criteria or potential benefits that cannot be quantified.

8.

Conferences

Problems related to each chapter will be put into the course discussion area where you can interact with fellow students concerning solutions and interpretations. Solutions will be posted in the middle of the following week. The first question in every weeks conference offers students a place to ask for questions or seek clarifications concerning the topics of the week. The second question is for asking technical questions concerning Excel. Sometimes other students can help you out, but your professor will be there as well. Conferences are open group activities to work and learn with your colleagues. Take advantage of these! Grading is based more on participation than posting a perfect answer.

9.

Concluding Comments

The crucial concept that will be used throughout this course is that all financial numbers need to be converted to a common time frame to be accurately compared. The term equivalency is used to describe the values at different times that can be computed from one another. The $4 in year 2015 for project A is equivalent to $2.73 in year 2011. The present value of Project A of $12.16 is equivalent to the series of cash flows in years 2011 through 2015. Virtually every problem situation, to be solved correctly in this course, requires looking at it from this Time Value of Money (TVOM) perspective. This also infers that monetary amounts from different time periods should not be added. That is $4 in year 2015 cannot be added to $5 in year 2011 to get -$1. This would be like adding apples and oranges. They can only be added if they are first discounted to the same time period. A sum over the five years is meaningless. The sum of the values all discounted to 2011 of $12.16 is equivalent to the original values. This also infers that averages over several years should not be made. Feeling comfortable with the terminology and acronyms is a major hurdle every week of this course. The Time Value of Money (TVOM) is the label given to all financial analysis involving interest over time. Discounted Cash Flow (DCF) is where one moves backward in time and so discounts the monetary value. Technically when one goes forward in time, it is compounding, and even though it logically should be labeled as Compounded Cash Flow (CCF), in practice, it is not. Discounted Cash Flow is used for either direction. If terms and concepts are not clear, use the conferences to clarify these. This graduate course is challenging and time consuming, but there is no other way to gain the

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knowledge needed to be an effective technology manager. For most of you, it will take you out of your comfort zone, which is what graduate education should do. Take advantage of the various resources and learning modes offered in the course, realize that understanding the course material takes time and practice, and do not assume you can easily catch up later. Every week the content builds on the previous week, and weeks. This means that if you miss an earlier building block, the current material becomes much more difficult.

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