Money-Time Relationships and Equivalence

Chapter 4.
Money-Time
Relationships and
Equivalence
Engineering Economy (Ed.13), Sullivan et. al., 2006, P. H.
Outline
z
z
z
z
z
z
Return of capital
Origins of interest Simple interest and compound
interest
Equivalence
Cash-flow diagrams / tables
Interest formulas
Cash flows
z
z
z
z
arithmetic sequences and geometric sequences
Interest rates that vary with time

Nominal versus effective interest rates
Continuous compounding
9530IEEM281: Engineering Economics, NTHU.

C.-Y. Kuo, Lab. Soft Computing and Fuzzy Optimization.
4.1 Introduction
z
Capital
z
refers to wealth in the form of money or property that

can used to produce more wealth
Money has time value because of the interest

4.2 Why Consider Return to Capital?

z
Capital in the form of money for the people, machines,

materials, energy, and other things needed in the
operation of an organization.
z
z
Equity capital owned by individuals

Debt capital (borrowed capital) obtained form lenders
Reasons
z
Interest and profit pay the providers of capital for forgoing its use
during the time the capital is being used
Interest and profit are payments for the risk the investor takes in
permitting another person, or an organization, to use his or her
capital

4.3 The Origins of Interest

z
z
In Babylon in 2000 B.C.

The idea of interest: International bankers in 575
B.C. for financing international trade
Typical annual rates: 6-25%, or 40% (usury found
in the Bible Exodus 22:21-27)
John Calvin, 1536, Protestant theory of usury was
established

4.4 - 4.5 Simple and Compound

Interest
z
z
Simple Interest
Compound Interest
z
$1,000 loaned for three periods at an interest rate of 10%

compound each period
Period
Amount Owed at
Beginning of Period
Interest Amount
for Period
Amount Owed
an End of
Period
$1,000
$100
$1,100
$1,100
$110
$1,210
$1,210
$121
$1,331

4.6 The Concept of Equivalence

z
Comparison of alternatives should consider the

equivalence
Equivalent basis dependent on
z
z
z
z
(1) the interest rate,

(2) the amount of money involved,
(3) the timing of monetary receipts or expenses, and
(4) the interest (profit) on invested capital and the
initial capital recovered

Example
z
Borrow $17,000 and repay in 4 months with 1% interest

per month on the unpaid balance of principal
z
Plan 1
z Pay interest due at end of each month and principal at end of
forth month.
Plan 2
z Pay off the debt in for equal end-of-month installments (principal
and interest)
Plan 3
z Pay principal and interest in one payment at end of forth month.
The three plans are equivalent


4.7 Notation and Cash-Flow

Diagrams and Tables
z
Notations
z
z
z
z
z
i = effective interest rate per interest period;

N = number of compounding periods;
P = present sum of money;
F = future sum of money;
A = end-of-year period cash flows
Cash flow diagram: an example

z
z
: Cash inflows (positive cash flow), e.g. receipts

: Cash outflows (negative cash flow), e.g. expense

10
F = $17,690.27
4=N
Months
i = 1% per month
P = $17,000

11
Example 4-1
z
Cash-flow diagramming
z
An investment of $10,000 will produce uniform annual revenue

of $5,310 for 5 years. The market value will be 2,000 at the end
of year 5. Annual expenses will be $3,000 at the end of each year
for operating and maintaining the project. Use the cooperations
viewpoint to draw a cash-flow diagram.

12
Example 4-2 Developing a net cash

flow table
z
Two feasible alternative for upgrading the heating, ventilation, and air
conditioning (HAVC) system
z Alternative A - Rebuild the existing HVAC system
z
z
z
$18,000
32,000
2,400
Alternative B - Install a new HAVAC system that utilizes existing

ductwork
z
z
z
z
Equipment, labor, and materials to rebuild

Annual cost of electricity
Annual maintenance expenses
Equipment, labor, and materials to install

Annual cost of electricity
Annual maintenance
Replacement of a major component 4 years hence
$60,000
9,000
16,000
9,400
At the end of 8 years, the estimated market value for Alternative A is

$2,000, and for Alternative B is $8,000

13

14
4.8 Interest Formulas Relating Present

and Future Equivalent Values of Single
Cash Flows
z
General Cash-Flow Diagram Relating Present Equivalent

and Future Equivalent of Single Payments
F = Future Equivalent (Find)
i = Interest Rate per Period

0
1
3
Period
N-2
N-1
P = Present Equivalent (Given)

15
4.8.1 Finding F when Given P

z
F = P (1 + i )
z
The (1 + i ) is called single payment compound amount

factor with interest rate i%. The functional symbol (F/P, i%,
N) can be used for (1 + i )N .
Hence,
N
F = P(F/P, i%, N).

16
4.8.2 Finding P when Given F

z
P = F (1 + i )
N
The (1 + i ) is called single payment present worth factor and
the functional symbol is (P/F, i%, N).
Hence,
P = F(P/F, i%, N).

17

18

19
4.9 Interest Formulas Relating a Uniform

Series (Annuity) to Its Present and Future
Equivalent Values
A = Uniform Amount (Given)
A
A
A
A
A
0
1
3
N-2
N-1
Period
i = Interest Rate per Period
P = Present Equivalent (Find)

F = Future Equivalent (Find)
20
4.9.1 Finding F when Given A

z
(1 + i )N 1
F = A
The quantity [(1 + i ) 1 i ] is called the uniform series

compound amount factor and the functional symbol is
(F/A, i%, N), hence,
N
F = A(F/A, i%, N)

Example 4-5
z
21
Suppose you make 15 equal annual deposits of $1,000

each into a bank account paying 5% interest per year.
How much money can be withdrawn from this bank
account immediately after the 15th deposit?
Example 4-6
z
If you are 20 years of age and save $1.00 each day,

you can become a millionaire. Assumption: live to 80
years old, and the annual interest rate is 10%.

22
4.9.2 Finding P when Given A

(1 + i )N 1
P = A
N
(
)
i
i
1
+
The quantity in brackets is called the uniform series

present worth factor and the functional symbol is
(P/A, i%, N), hence,
P = A(P/A, i%, N)

Example 4-7
z
23
i = 15% per year. Maintain a machine can add $20,000

revenue at the end of each year of 5 years. How much is the
investment?
z P = A(P/A, i%, N) = 20,000(P/A, 15%, 5) = 20,000(3.3522)
= 67,044
Example 4-8
z
Suppose that your uncle has $1,000,000 that he wishes to

distribute to his heirs at the rate of $100,000 per year. If the
$1,000,000 is deposited in a bank account that earns 6% interest
per year,
z How many years will it take to completely deplete the
account?
z How long will it take if the account earns 8% interest per
year instead of 6%?
1,000,000 = 100,000(P/A, i%, N) = 10,000(P/A, 6%, N)

(P/A, 6%, N) = 10,
(P/A, 6%, 15) = 9.7122 , (P/A, 6%, 16) = 10.1059

24
4.9.3 Finding A when Given F
i
A = F
N
(
)
i
1
+
The quantity in brackets is called the sinking fund

factor and the functional symbol is (A/F, i%, N), hence,
A = F(A/F, i%, N).

25
Example 4-9
z
One who is 20 years old now hopes to have 1,000,000 savings

when she at age 65. what equal end-of-year amount must she
save over the next 45 years with annual 7% interest rate?

26
4.9.4 Finding A when Given P

z
i (1 + i )N
A = P
N
(
)
i
+
1
1
The quantity in brackets is called the capital recovery

factor and the functional symbol is (A/P, i%, N), hence,
A = P(A/P, i%, N)
z
Ex. Plan 2 in Table 4-1

z
A = $17,000(A/P, 1%, 4) = $17,000(0.2563) = $4,357.10

27
4.10 Interest Formulas for Discrete

Compound and Discrete Cash Flows

28
4.11 Deferred Annuities (Uniform

Series
Time Present
0
J-1
Period
J+1
J+2
N-1
i%
z
All annuities discussed to this point involve the first cash

flow being made at the end of the first period, and they are
called ordinary annuities. If the cash flow does begin until
some later date, the annuity is known as a deferred annuity.
P0 = A(P/A, i%, N - J)(P/F, i%, J)

Example 4-10
z
29
12% per year interest. One day a new baby born. His father
wishes to determine what lump amount could provide
$2,000 on his 18th, 19th, 20th, and 21st birthdays.
Example 4-11
z
Determine the equivalent worth of the four $2,000 as of the sons

24th birthday.

30
4.12 Equivalence Calculations Involving

Multiple Interest Formulas

31
Example 4-12
z
Cash flows over 8 years. The amounts are $100 for the
first year, $200 for the second year, $500 for the third
year, and $400 for each year from the 4th through the 8th.

32
Example 4-13
z
Transform the cash flows on the left-hand side to their

equivalent cash flows on the right-hand side.
2H
Q
H
End of Year (EOY)
End of Year (EOY)

Q

33
4.13 Interest Formulas for A Uniform

(Arithmetic) Gradient of Cash Flows
z
Receipts or expenses are projected to increase or decrease by a

uniform amount each period, thus constituting an arithmetic
sequence of cash flows. This situation can be modeled as a
uniform gradient of cash flows
z Notice: the first cash flow occurs at the end of period 2
(N-1)G
(N-2)G
(N-3)G
3G
2G
G
0

N-2
N-1
N
34
4.13.1 Finding F when Given G

z
F = G(F/A, i%, N - 1) + G(F/A, i%, N - 2) +

+ G(F/A, i%, 2) + G(F/A, i%, 1)
F=
G
NG
( F/A, i%, N )
i
i
4.13.2 Finding A when Given G

z
The quantity in brackets is called the gradient to

uniform series conversion factor and the functional
symbol is (A/G, i%, N), hence
A = G(A/G, i%, N)

35
4.13.3 Finding P when Given G

1 (1 + i )N 1
N
P = G
N
(1 + i )N
i i (1 + i )
The quantity in braces is called the gradient to

present equivalent conversion factor and the
functional symbol is
z
z
z
(1/i)[(P/A, i%, N) - N(P/F, i%, N)]
also can be expressed as (P/G, i%, N), hence,

P = G(P/G, i%, N)

36
Example 4-15
z
End-of-year cash flows are expected to be $1,000 for the

2nd year, $2,000 for the 3rd year, and $3,000 for the 4th
year. If the interest is 15% per year, find that
z
z
(a) present equivalent value at the beginning of the first year,

(b) uniform annual equivalent value at the end of the four years.

37
Example 4-16
z
Calculate the present equivalent at i = 15% per year, using

arithmetic gradient interest factors
End of Year
Cash Flows ($)
1
2
3
4
-8,000
-7,000
-6,000
-5,000

38
4.14 Interest Formulas Relating A

Geometric Sequence of Cash Flows to Its
Present and Annual Equivalents
z
The cash flow patterns change at an average rate f . And the

resultant end-of-period cash flow pattern is referred to a
geometric gradient series.
A1 [1 ( P / F , i %, N )( F / P, f %, N )]
P=
i f
A N ( P / F , i %,1)
1
f i
f = i.

39
Example 4-20
z
Consider the end-of-year geometric sequence of cash flow

and determine the P, A, and F equivalent values. The rate
of increase is 20% per year after the first year, and the
$1,000(1.2)
interest rate is 25% per year.
$1,000(1.2)2
$1,000(1.2)1
$1,000
End of Year

40
Example 4-19
z
As the same in Example 4-18, suppose that the geometric

gradient decreases by 20% per year after the first year.
Determine P, A, and F under this condition.

41
4.15 Interest Rates That Vary with

Time
z
Example 4-21
z
A person has made an arrangement to borrow $1,000 now and

another $1,000 two years hence. If the projected interest rates in
years one, two, three, and four are 10%, 12%, 12%, and 14%,
respectively, how much will be repaid as a lump-sum amount at
the end of four years.

42
4.15 Interest Rates That Vary with

Time
z
Obtaining the present equivalent of a series of

future cash flows subjected to vary interest rates
P=
FN
.
N
k =1 (1 + ik )
For instance, if F4 = $1,000 and i1 = 10%, i2 = 12%, i3

= 13%, i4 = 10%, then
z
P = $1,000[(P/F, 10%, 1)(P/F, 12%, 1) (P/F, 13%, 1)(P/F,

10%, 1)]

43
4.16 Nominal and Effective Interest

Rate
z
z
The interest period is less than one year

E.g. 6% interest rate per half-year v.s. 12% per year
z
12% is the nominal, but effective rate is larger than 12%

z 1st half-year
$1,000 + $1,000 (0.12/2) = $1,000 + $60 = $1,060
z 2nd half-year
$1,060 + $1,060 (0.12/2) = $1,060 + $63.6 = $1,123.6
z The effective annual interest rate for the entire year is
$123.6
100% = 12.36%.
$1,000
44

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Chapter 4.

Engineering Economy (Ed.13), Sullivan et. al., 2006, P. H.

arithmetic sequences and geometric sequences

Interest rates that vary with time

9530IEEM281: Engineering Economics, NTHU.

refers to wealth in the form of money or property that

Money has time value because of the interest

9530IEEM281: Engineering Economics, NTHU.

4.2 Why Consider Return to Capital?

Capital in the form of money for the people, machines,

Equity capital owned by individuals

9530IEEM281: Engineering Economics, NTHU.

4.3 The Origins of Interest

In Babylon in 2000 B.C.

9530IEEM281: Engineering Economics, NTHU.

4.4 - 4.5 Simple and Compound

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

9530IEEM281: Engineering Economics, NTHU.

4.6 The Concept of Equivalence

Comparison of alternatives should consider the

(1) the interest rate,

9530IEEM281: Engineering Economics, NTHU.

Borrow $17,000 and repay in 4 months with 1% interest

9530IEEM281: Engineering Economics, NTHU.

9530IEEM281: Engineering Economics, NTHU.

4.7 Notation and Cash-Flow

i = effective interest rate per interest period;

Cash flow diagram: an example

: Cash inflows (positive cash flow), e.g. receipts

9530IEEM281: Engineering Economics, NTHU.

9530IEEM281: Engineering Economics, NTHU.

An investment of $10,000 will produce uniform annual revenue

9530IEEM281: Engineering Economics, NTHU.

Example 4-2 Developing a net cash

Alternative B - Install a new HAVAC system that utilizes existing

Equipment, labor, and materials to rebuild

Equipment, labor, and materials to install

At the end of 8 years, the estimated market value for Alternative A is

9530IEEM281: Engineering Economics, NTHU.

9530IEEM281: Engineering Economics, NTHU.

4.8 Interest Formulas Relating Present

General Cash-Flow Diagram Relating Present Equivalent

i = Interest Rate per Period

P = Present Equivalent (Given)

4.8.1 Finding F when Given P

The (1 + i ) is called single payment compound amount

F = P(F/P, i%, N).

9530IEEM281: Engineering Economics, NTHU.

4.8.2 Finding P when Given F

P = F(P/F, i%, N).

9530IEEM281: Engineering Economics, NTHU.

9530IEEM281: Engineering Economics, NTHU.

9530IEEM281: Engineering Economics, NTHU.

4.9 Interest Formulas Relating a Uniform

P = Present Equivalent (Find)

9530IEEM281: Engineering Economics, NTHU.

F = Future Equivalent (Find)

4.9.1 Finding F when Given A

The quantity [(1 + i ) 1 i ] is called the uniform series

9530IEEM281: Engineering Economics, NTHU.

Suppose you make 15 equal annual deposits of $1,000

If you are 20 years of age and save $1.00 each day,

9530IEEM281: Engineering Economics, NTHU.

4.9.2 Finding P when Given A