Time Value of Money

Time value of money

It is better to have money now
rather than later.
you can do much more with the money if you have it now - over time you can
earn more interest on your money.
Example
Simple interest
If you choose Option A and invest the total
amount at a simple annual rate of 4.5%, the
future value of your investment at the end of
the first year is $10,450
i.e. Principle +Pi
Compound interest
Same investment but compounded for n
number of years means the amount at the
end of n years would be termed as future
value


PV-Present Value
FV-future value
N-No. of years
What if we choose option B. That is accepting
Rs. 10000 three years from.

Cash flow diagram
To financially analyze engineering projects, we need
to model the projects in terms of cash flows

Cash flows represent the flow or movement of money
at some specific time over some period of time

Outflows represent cash that is leaving an account
such as a withdrawal (expenses or disbursements or
losses or costs)

Inflows represent cash that is entering an account
such as a deposit ( revenues or receipts or benefits or incomes)
contd
The cash flows over time are represented by arrows at relevant periods: upward
arrows denote positive flows and downward arrows denote negative flows

Arrows represent net cash flows since two or more values
at the same time are summed and shown as a single arrow

Net flows = receipts disbursement
Cash = cash inflows cash outflows
PROBLEM 1
SOLUTION
PROBLEM 2
SOLUTION PART 2
In case of compound interest
FV
Interest rates
Single payment
Equal payment series
Single Payment
Compound amount



Present Worth amount
( )
N
i P F + = 1
( )
N
i F P

+ = 1
Problems
A firm borrows $1000 for eight years.How must it
repay in a lumpsum at the end of 8
th
year at 10%
interest rateType1 : 1000(F/P,10%,8)

A Firm wishes to have $2,143.60 eight years from
now. What amount should be deposited now to
provide for it at interest rate of 10%Type2 :
2143.6(P/F,10%,8)

Uniform series
Compund amount
( )
(

+
=
i
i
A F
N
1 1
A= equal amount to be paid; F is unknown
F=A(F/A,i,n)
Uniform series
Sinking Fund
( )
(

+
=
1 1
N
i
i
F A
F is known; A= is to be found out
A=F(A/F,i,n)
Uniform series
Present worth method
( )
( )
(

+
+
=
N
N
i i
i
A P
1
1 1
A= equal amount to be paid; P is unknown
P=A(P/A,i,n)
Uniform series
Capital recovery method
A=? ; P is known
(

+
+
=
1 ) 1 (
) 1 (
N
N
i
i i
P A
A=P(A/P,i,n)
Uniform gradient series anual
equivalent amount
(

+
+
+ =
i i i
iN i i
G A A
N
N
) 1 (
1 ) 1 (
1
Effective Versus Nominal interest rates
Note:
Interest rate is only meaningful in the context of
time - in general is understood as - per year -
which may be called
-the nominal interest rate
With other periods of time than year - like month,
week, or day - the interest rate may be called
-the effective interest rate
i
n
= (1 + i
e
)
n
- 1
Problems

1. Suppose that you borrow $8000 now, promising to repay the
loan principle plus accumulated interest in four years at
i=10% per year. How much you would repay at the end of
four years?
2. An investor (owner) has an option to purchase a tract of land
that will be worth $10,000 in six years. If the value of land
increases at 8% each year, how much should the investor be
willing to pay now for this property?
3. If a certain machine undergoes a major overhaul now, its
output can be increased by 20% - which translates into
additional cash flow of $20,000 at the end of each year for 5
years. If i=15% per year, how much can we afford to invest to
overhaul this machine?





Problems
4. Suppose that your rich 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,How many years will it
take to completely deplete the account?How long will it take if the
account earns 8% interest per year instead of 6%.
5. An enterprising student is planning to have personal savings totaling
$1000000 when she retires at age 65.She is now 20 years old.If the annual
interest rate will average 7% over the next 45 years on her savings
account, what equal end of year amount must she save to accomplish her
goal.
6. Suppose you make 15 equal annual deposits of $1000 each into a bank
account paying 5% interest per year.The first deposit will be made one
year from today. How much money can be withdrawn from this bank
account immediately after the 15
th
deposit.