Interest theory 1-1 Dr. A. Alim Time Value of Money The time value of money is the most important concept in engineering economy All firms make use of investment of funds Investments are expected to earn a return Money possesses a time value
1-2 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Equivalence Different sums of money at different times may be equal in economic value 0 1 $100 now $106 one year from now Interest rate = 6% per year $100 now is said to be equivalent to $106 one year from now, if the $100 is invested at the interest rate of 6% per year. 1-3 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Interest Rate and Rate of Return Interest the manifestation of the time value of money Rental fee that one pays to use someone elses money Difference between an ending amount of money and a beginning amount of money
Interest rate (%) = interest accrued per time unit x 100% original amount 1-4 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Rate of Return Interest earned over a period of time is expressed as a percentage of the original amount, specifically;
interest accrued per time unit Rate of return (%) = x 100% original amount Borrowers perspective interest rate paid Lenders perspective interest rate earned 1-5 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Simple and Compound Interest Simple Interest: Interest = (principal)(number of periods)(interest rate) Future value (F) = principal(P) + P x n x i Compound Interest: Interest earns interest on interest Compounds over time Interest = (principal + all accrued interest) (interest rate) Future value (F) = principal(P) x (1 + i) n
1-6 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Terminology and Symbols
Specific symbols and their respective definitions have been developed for use in engineering economy Symbols tend to be standard in most engineering economy texts world-wide Mastery of the symbols and their respective meanings is most important in understanding of the subsequent material!
1-7 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Terminology and Symbols P = value or amount of money at a time designated as the present or time 0. Also P is referred to as present worth (PW), present value (PV), net present value (NPV), discounted cash flow (DCF), and capitalized cost (CC); dollars
1-8 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Terminology and Symbols F = value or amount of money at some future time. Also F is called future worth (FW) and future value (FV); dollars
1-9 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Terminology and Symbols
A = series of consecutive, equal, end-of-period amounts of money. Also A is called the annual worth (AW) , equivalent uniform annual worth (EUAW); dollars per year, dollars per month
n = number of interest periods; years, months, days
1-10 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Terminology and Symbols i = interest rate or rate of return per time period; percent per year, percent per month t = time, stated in periods; years, months, days, etc 1-11 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Cash Flows: Their Estimation and Diagramming Definition of terms Cash Inflows - amount of funds flowing into the firm Cash Outflows amount of funds flowing out of the firm Net Cash Flow equals cash inflows cash outflows Assumption for analysis end of period Funds flow at the end of a given (interest) period 1-12 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Cash Flow Diagrams A typical cash flow diagram might look like:
0 1 2 n-1 n 1. Draw a time line One time period 0 1 2 n-1 n 2. Show the cash flows Cash flows are shown as directed arrows (+ for up or for down) --- (+) inflow; (-) outflow Always assume end-of-period cash flows! 1-13 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved IMPORTANT
Cash flow diagrams are not limited to P, F, and/or A. For example, this could be a very real diagram: P F 0 1 2 n-1 n 1-14 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved P and F
The symbols P and F represent one-time occurrences: Specifically: $P $F 0 1 2 n-1 n 1-15 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved P and F
It should be clear that a present value P represents a single sum of money at some time prior to a future value F This is an important basic point to remember 1-16 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Annual Amounts
It is important to note that the symbol A always represents a uniform mount (i.e., the same amount each period) that extends through consecutive interest periods. 1-17 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Annual Amounts Cash Flow diagram for annual amounts might look like the following:
$A $A $A $A $A A = equal, end of period cash flow amounts $P 0 1 2 3 .. N-1 N 1-18 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Remember !
A = equal payments, end of each period F = single payment, end of last period P = single payment, beginning of first period 1-19 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Interest Rate i% per period The interest rate i is assumed to be a compound rate, unless specifically stated as simple interest
The rate i is expressed in percent per interest period, for example, 12% per year.
1-20 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Standard Notation for Interest Factors Standard notation has been adopted to represent the various interest factors Consists of two cash flow symbols, the interest rate, and the number of time periods General form: (X/Y,i%,n) X represents what is unknown Y represents what is known i and n represent input parameters; can be known or unknown depending upon the problem 1-21 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Notation - continued Example: (F/P,6%,20) is read as: To find F, given P when the interest rate is 6% and the number of time periods equals 20. In problem formulation, the standard notation is often used.
Example : F = P (F/P,6%,20)
1-22 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Notation - continued There are 3 sources to determine the values of these factors: Tables at the back of many books provide tabulations of common values for i% and n. Using EXCEL functions. Calculating the factors from formulas. 1-23 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 1-24 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Introduction To Solution By Computer Application of Microsofts Excel
spreadsheet program Good review in Appendix A, Blanks Book. Excel financial functions Present Value P: =PV(i%,n,A,F) e.g. =PV(i%,n,A) or PV(i%,n,,F) Future Value F: =FV(i%,n,A,P) Equal, periodic value A: =PMT(i%,n,P,F) No. of periods: =NPER((i%,A,P,F) Compound interest rate: =RATE(n,A,P,F) Compound interest rate: =IRR(first_cell:last_cell) Present value of a series: =NPV(i%,second_cell:last_cell) + first_cell
1-25 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 1-26 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Calculating factors From formulas: Example: 1-27 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved P F 5 years i = 8% Cash flow diagram from the point of view of the graduate. Example: P = 10000 dollars i = 8% n = 5 years 1) Using tables: From Blank's book table 12, for 8% interest rate and 5 years, we find: F/P = 1.4693 then F= $10000 x 1.4693 = $14,693 2) Using formula: F/P = (1+i)^5 = 1.46932808 then F = $14,693.28 3) Using EXCEL function FV EXCEL assigns a negative value to cash outflow and a positive value to cash inflow P in this case is a positive cash flow, hence F calculated will be negative. F = ($14,693.28) 1-28 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Example: 1-29 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 6th Edition, 2005 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Summary: Compounding Factors 1. Single-Payment compound amount factor (F from P) 2. Single-Payment present worth factor (P from F)
3. Uniform-series present worth factor (P from A) 4. Capital recovery factor (A from P)
5. Uniform-series compound amount factor (F from A) 6. Sinking fund factor (A from F) Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-30 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Single-Payment Factors(F/P and P/F) Objective: Derive factors to determine the present or future worth of a cash flow Cash Flow Diagram basic format 0 1 2 3 n-1 n P 0
F n i% / period P 0 = F n 1/(1+i) n (P/F,i%,n) factor: Excel: =PV(i%,n,,F) F n = P 0 (1+i) n (F/P,i%,n) factor: Excel: =FV(i%,n,,P) Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-31 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Uniform-Series: Present Worth Factor (P/A) and Capital Recovery Factor(A/P) Cash flow profile for P/A factor . . . . 0 1 2 3 n-2 n-1 n $A per interest period i% per interest period Required: To find P given A Cash flows are equal, uninterrupted and flow at the end of each interest period Find P Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-32 2012 by McGraw-Hill, New York, N.Y All Rights Reserved (P/A) and (A/P) Factor Formulas
(1 ) 1 0 (1 ) n n i P A for i i i ( + = = ( +
(1 ) (1 ) 1 n n i i A P i ( + = ( +
(P/A,i%,n) factor Excel: =PV(i%,n,A) (A/P,i%,n) factor Excel: =PMT(i%,n,P) Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-33 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Sinking Fund Factor and Uniform Series Compound Amount Factor (A/F and F/A) Cash flow diagram for (A/F) factor
Start with what has already been developed
1 (1 ) (1 ) (1 ) 1 n n n i i A F i i ( ( + = ( ( + +
. . . . 0 1 2 3 n-2 n-1 n A=? per interest period i% per interest period F = given Find A, given F (1 ) 1 n i A F i ( = ( +
Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-34 2012 by McGraw-Hill, New York, N.Y All Rights Reserved (F/A) factor from (A/F) Given:
Solve for F in terms of A to yield (1 ) 1 n i A F i ( = ( +
(1 ) 1 n i F A i ( + = (
(A/F,i%,n) factor Excel: =PMT(i%,n,,F) (F/A,i%,n) factor Excel: =FV(i%,n,A) Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 1-35 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Minimum Attractive Rate of Return Investors expect to earn a return on their investment (commitment of funds) over time A profitable investment should earn (return) funds in excess of the investment amounts Economic projects should earn a reasonable return, which is termed: MARR Minimum attractive rate of return Also termed the hurdle rate for an investment 1-36 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved The MARR The MARR is established by the financial managers of the firm The MARR is expressed as a percent value Most, if not all, projects should earn at a rate equal to or greater than the established MARR MARR is set based upon: The cost of all types of capital Allowance for risk 1-37 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Types of Financing Equity Financing the firm uses funds either from retained earnings, new stock issues, or owners infusion of money Debt Financing the firm borrows funds from outside sources The cost of debt financing = the interest rate charged on the debt (loan) amounts Weighted average cost of capital (WACC) = X i (int. rate) i
The MARR is approximated from the weighted average cost of all sources of capital to the firm A firms ROR > MARR > WACC 1-38 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved Graphical Presentation: MARR 0% ROR - % MARR - % Safe Investment e.g. bank WACC - % Acceptable range for new projects 1-39 Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved 1-40 Source: Plant design and economics for chemical engineers, 5 th edition By M.S. Peters et. al., McGraw Hill 2005. Slide Sets to accompany Blank & Tarquin, Engineering Economy, 7th Edition, 2012 2012 by McGraw-Hill, New York, N.Y All Rights Reserved