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Chapter Objectives

• Estimate the present and future value of money

• Apply uniform, arithmetic and geometric series

in estimating capital values

• Determine economic equivalence of alternative

capital options

2

Case Study – Warren Buffet’s Berkshire

Hathaway

Worth today (August 22, 2003): $76,200

Annual compound growth: 24.58%

Current market value: $100.36 Billion

If he lives till 100 (current age: 73 years as

of 2003), his company’s total market value

will be ?

an annual rate of 24.58% for the next 27 years.

F $100.36(1 0.2458)27

$37.902 trillions

Time Value of Money

Capital refers to wealth in the form of money

or property that can be used to produce more

wealth.

Engineering economy studies involve the

commitment of capital for extended periods

of time.

A dollar today is worth more than a dollar

one or more years from now (for several

reasons).

Time Value of Money

more money over time (earning power).

Money has a time value because its

purchasing power changes over time

(inflation).

Time value of money is measured in terms of

interest rate which reflects both earning and

purchasing power in the financial market.

Interest is the cost of money—a cost to the

borrower and an earning to the lender

Capital

essential ingredient of engineering economy studies.

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 letting

another use his or her capital.

Any project or venture must provide a sufficient return to be financially

attractive to the suppliers of money or property.

Methods of Calculating Interest

Simple interest: the practice of charging an interest rate only to

an initial sum (principal amount).

Compound interest: the practice of charging an interest rate to

an initial sum and to any previously accumulated interest that

has not been withdrawn.

Simple Interest

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, the interest and interest rate are said to be simple.

The total interest, I, earned or paid may be computed using the formula

below.

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 F = P + I.

Example 1 – Simple Interest

per year, the interest earned would be

So, the total amount repaid at the end of five years would be the

original amount ($5,000) plus the interest ($1,750), or $6,750.

Compound Interest

Compound interest reflects both the remaining principal and any

accumulated interest. For $1,000 at 10%…

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed at Interest amount Amount owed at

Period beginning of period for period end of period

1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

n 0: P

Compound interest is commonly n 1: F1 P(1 i )

used in personal and professional

financial transactions. n 2 : F2 F1 (1 i ) P(1 i ) 2

n N : F P(1 i ) N

Compounding Process

End of Beginning Interest Ending

Year Balance earned Balance

0 $1,000

1 $1,000 $80 $1,080

2 $1,080 $86.40 $1,166.40

3 $1,166.40 $93.31 $1,259.71

$1,080

$1,166.40

0 $1,259.71

1

2

$1,000

3

$1,080

$1,166.40

Compounding Process

interest factor when

the interest rate is 12%

and the number of

interest periods is 10,

we could evaluate the

following equation

using the interest table.

Economic Equivalence

common basis.

an equivalent basis dependent on

interest rate,

amount of money involved, and

timing of monetary receipts or

expenses.

Using these elements we can

“move” cash flows so that we can

compare them at particular points

in time.

Economic Equivalence

Notation used in formulas for compound

interest calculations.

i = effective interest rate per interest period

N = number of compounding (interest)

periods

P = present sum of money; equivalent value

of one or more cash flows at a reference

point in time; the present

F = future sum of money; equivalent value

of one or more cash flows at a reference

point in time; the future

A = end-of-period cash flows in a uniform

series continuing for a certain number of

periods, starting at the end of the first

period and continuing through the last

Cash Flow Diagram

Borrow $20,000 at 9% interest

over 5 years, requiring $200

loan origination fee upfront.

The required annual

repayment is $5,141.85 over 5

years.

o n = 0: $20,000

o n = 0: $200

o n = 1 ~ 5: $5,141.85

Cash Flow Tables

economy problems in a spreadsheet

Example 2 – Repayment Plan

End of Year Receipts Payments

Plan 1 Plan 2

Year 0 $20,000.00 $200.00 $200.00

Year 1 5,141.85 0

Year 2 5,141.85 0

Year 3 5,141.85 0

Year 4 5,141.85 0

Year 5 5,141.85 30,772.48

The amount of loan = $20,000, origination fee = $200,

interest rate = 9% APR (annual percentage rate)

Future-Present Value

flows along the cash flow diagram.

Using the standard notation, we find that a present amount, P, can

grow into a future amount, F, in N time periods at interest rate i

according to the formula below.

Interest Formula

factors.

The term on the right is read “F given P at i% interest per period for N

interest periods.”

Example 3 – Time Value

different points in time.

$2,500 at time zero is equivalent to how much after six years if the interest rate is 8%

per year?

$3,000 at the end of year seven is equivalent to how much today (time zero) if the

interest rate is 6% per year?

Excel 1 – Future Value

Given: P = $2,000,

i = 10%, N = 8 years

Find: F

F $2,000(1 0.10)8

$2,000(F / P ,10%,8)

$4,287.18

Excel 2 – Future Value

Exercise 1 – Present Value

Betty will need $12,000 in five years to pay for a major overhaul

on her tractor engine. She has found an investment that will

provide a 5% return on her invested funds. How much does Betty

need to invest today so she will have her overhaul funds in five

years?

Excel 3 – Present Value

Given:

F = $1,000, i = 12%, N = 5

years

Find: P

P $1,000(1 0.12)5

$1,000(P / F ,12%,5)

$567.43

Exercise 2 – Multiple Payments

Finding an Equivalent Value for Multiple Payments

Compounding Process: $511.90

Compute the equivalent value V3 100(1 0.10)3 $80(1 0.10)2 $120(1 0.10) $150

of the cash flow series at n = 3, $200(1 0.10)1 $100(1 0.10)2

using i = 10%. Discounting Process: $264.46

$511.90 $264.46

$776.36

V3

Solution

$200 V

$150

$200

$100

$120

$100

= $120

$150

$80

$100 $100

$80

0 1 2 3 4 5 0 1 2 3 4 5

0 1 2 3 4 5

Types of Cash Flows

Equal (uniform)

payment series at

regular intervals

Linear gradient

series

Geometric gradient

series

Irregular (random)

payment series

Future Values of Annuity

How much will you have in 40 years if you save $3,000 each year and

your account earns 8% interest each year?

Present Values of Annuity

$50,000 each year for 20 years, at 9% interest each year?

Sinking Fund

F

A A A

0 1 2 N 1 2 N

How much would you need to set aside each year for 25 years, at 10%

interest, to have accumulated $1,000,000 at the end of the 25 years?

Annual Payout

0 1 2 N

A A A

P

0 1 2 N

Equivalent Present Worth

0 N

If you had $500,000 today in an account earning 10% each year, how

much could you withdraw each year for 25 years?

Exercise 3 – Instalments

borrowed the money for the pump from their bank at an interest

rate of 0.5% per month and will make a total of 24 equal, monthly

payments. How much will Acme’s monthly payments be?

Acme’s monthly payments are

Interest Rate vs Period

We may know P, A, and i and want to find N.

We may know P, A, and N and want to find i.

These problems present special challenges that are best

handled on a spreadsheet.

Example 4 – Loan Period

Finding N

Acme borrowed $100,000 from a local bank, which charges them an interest

rate of 7% per year. If Acme pays the bank $8,000 per year, now many years

will it take to pay off the loan?

So,

This can be solved by using the interest tables and interpolation, but we

generally resort to a computer solution.

Payback Period

Principle

N Cash Flow Cum. Flow

How fast can I recover my initial

investment? 0 −$105,000+$20,000 −$85,000

Method 1 $15,000 −$70,000

Based on the cumulative cash 2 $25,000 −$45,000

3 $35,000 −$10,000

flow (or accounting profit) $45,000 $35,000

4

Screening Guideline 5 $45,000 $80,000

If the payback period is less than 6 $35,000 $115,000

or equal to some specified bench-

mark period, the project would be Payback period should occurs

considered for further analysis. somewhere between

Weakness N = 3 and N = 4.

Does not consider the time value

of money

Example 5 – Rate of Return

Finding i

Jill invested $1,000 each year for five years in a local company and sold her

interest after five years for $8,000. What annual rate of return did Jill earn?

So,

Again, this can be solved using the interest tables and interpolation, but

we generally resort to a computer solution.

Exercise 4 – Interest Rate

Approach

At what interest rate Step 1: Select a base period to compute the equivalent

would you be indifferent value (say, n = 3).

choosing between the two Step 2: Find the equivalent worth of each cash flow

series at n = 3.

cash flows?

$1,000

$500 Option A: F3 $500(1 i)3 $1,000

Option B: F3 $502(1 i)2 $502(1 i) $502 $1,000

A

$500

0 1 2 3 i = 8% A

Option A : F3 $500(1.08)3 $1,000 0 1 2 3

$1,630

$502 $502 $502

Option B : F3 $502(1.08)2 $502(1.08) $502

$502 $502 $502

B $1,630

B

0 1 2 3 0 1 2 3

Excel Spreadsheet

NPER(rate, pmt, pv), which will compute the number of payments of

magnitude pmt required to pay off a present amount (pv) at a fixed

interest rate (rate).

RATE(nper, pmt, pv, fv), which returns a fixed interest rate for an annuity

of pmt that lasts for nper periods to either its present value (pv) or future

value (fv).

Deferred Annuity

occur until some time in the future.

Deferred annuities are uniform series that do not begin until

some time in the future.

If the annuity is deferred J periods then the first payment (cash

flow) begins at the end of period J+1.

Value of Deferred Annuity

process.

1. Use (P/A, i%, N-J) find the value of the deferred annuity at

the end of period J (where there are N-J cash flows in the

annuity).

2. Use (P/F, i%, J) to find the value of the deferred annuity at

time zero.

Exercise 5 – Maintenance Expenses

Irene just purchased a new sports car and wants to also set aside cash for

future maintenance expenses. The car has a bumper-to-bumper warranty

for the first five years. Irene estimates that she will need approximately

$2,000 per year in maintenance expenses for years 6-10, at which time she

will sell the vehicle. How much money should Irene deposit into an account

today, at 8% per year, so that she will have sufficient funds in that account

to cover her projected maintenance expenses?

Uniform Gradient

We can model these situations as a uniform gradient of cash flows.

The table below shows such a gradient.

End of Period Cash Flows

1 0

2 G

3 2G

: :

N (N-1)G

present value

Uniform Gradient

Example 6 – G/A

The annual equivalent of this End of Year Cash Flows ($)

series of cash flows can be found

by considering an annuity portion 1 2,000

of the cash flows and a gradient 2 3,000

portion. 3 4,000

4 5,000

1 2,000 0

2 2,000 1,000

3 2,000 2,000

4 2,000 3,000

Geometric Gradient

each period--this is a geometric gradient series.

gradient series. It begins at the end

of year 1 and has a rate of growth,

, of 20%.

1 1,000

2 1,200

3 1,440

4 1,728

Geometric Gradient

Geometric Gradient

We can find the present value of a geometric series by using the

appropriate formula below.

cash flow in the series.

Exercise 5 – Revenue Estimation

Acme Miracle projects good things for their new weight loss pill, LoseIt.

Revenues this year are expected to be $1.1 million, and Acme believes they

will increase 15% per year for the next 5 years. What are the present value

and equivalent annual amount for the anticipated revenues? Acme uses an

interest rate of 20%.

Use the geometric gradient formula to find the present value, then

convert the present amount to an annual amount.

Variable Interest

are necessary.

mortgage).

We often must resort to moving cash flows one period at a time,

reflecting the interest rate for that single period.

Variable Interest

can be computed with the equation below, where ik is the interest rate for

the kth period.

Interest Rates

More often than not, the time between

successive compounding, or the interest 18% Compounded Monthly

period, is less than one year (e.g., daily,

monthly, quarterly).

The annual rate is known as a nominal Interest

Nominal

rate. period

interest rate

A nominal rate of 12%, compounded

monthly, means an interest of 1% Annual

(12%/12) would accrue each month, and percentage

the annual rate would be effectively rate (APR)

somewhat greater than 12%.

The more frequent the compounding the

greater the effective interest.

Effective Interest

compounding periods per year. We can find, i, the effective interest by

using the formula below.

Interest Rates

Nominal and Effective Interest Rates with Different

Compounding Periods

Effective Rates

Nominal Compounding Compounding Compounding Compounding Compounding

Rate Annually Semi-annually Quarterly Monthly Daily

Effective Interest Rates

For an 18% nominal rate, compounded quarterly, the effective interest is.

Exercise 6 – Motorcycle Loan

Ali plans to buy a Honda 500Z with MSRP $20,870 with instant rebate $2,443.

He is required to pay down payment of $3,427 on a loan with 6.25% APR for a

total of 72 months. What would be his monthly payment?

Continuous Compounding

Interest is typically compounded at the end of discrete periods.

In most companies cash is always flowing, and should be immediately

put to use.

We can allow compounding to occur continuously throughout the

period.

The effect of this compared to discrete compounding is small in most

cases.

C

r

i lim 1 1 C

C

CK

er /K 1

Effective Interest Rates

interest factors.

larger), we find that

Exercise 7 – Motorcycle Loan

F =?

If you invest $1,000 in a savings account that pays 6% annual interest

compounded continuously, what would be the balance at the end of 3 years?

0

1 2 3

$1,000

ia e0.06 1

6.18%

F $1, 000( F / P, 6.18%,3)

$1,197.09

Effective Interest Rates

Summary

59

projection of money.

(2) arithmetic, (3) geometric series interest rates

estimation is determined with appropriate

methods/formulae

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