Lecture # 2

Time Value of Money

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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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P and F

The symbols P and F represent one-time occurrences:
Specifically:
$P
$F
0 1 2 n-1 n
1-15
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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
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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
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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
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Remember !

A = equal payments, end of each period
F = single payment, end of last period
P = single payment, beginning of first period
1-19
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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
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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
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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
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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
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1-24
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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
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1-26
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Calculating factors
From formulas:
Example:
1-27
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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
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Example:
1-29
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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)
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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)
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1-31
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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
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(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)
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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
(
=
(
+

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(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)
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1-35
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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
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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
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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
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Graphical Presentation: MARR
0%
ROR - %
MARR - %
Safe Investment e.g.
bank
WACC - %
Acceptable range for new projects
1-39
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1-40
Source: Plant design and economics for chemical engineers, 5
th
edition
By M.S. Peters et. al., McGraw Hill 2005.
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