1

Dr B. Chen
MEC4404/ MAE4404
Professional Practice
Lecture 2:
Time Value of Money
2
Cash Flows
Inflows and outflows of money.
Estimate or observed values. Future = estimate
Accuracy of estimates Quality of economic analysis and
conclusions.
Inflows = Cash Receipts (+)
Revenue, Income
Outflows = Cash Disbursements (-)
Expenses, Cost
Net Cash Flow = Receipts Disbursements
= Cash inflows Cash outflows
3
Examples of Cash Flows
Inflows
Revenues (incremental when
comparing alternatives)
Operating cost reductions (from an
alternative)
Asset salvage value
Receipt of loan principal
Income tax savings
Receipts from stock and bond sales
Construction and facility cost savings
Saving or return of corporate capital
funds
Outflows
First cost of assets
Engineering design costs
Operating Costs (annual and
incremental)
Periodic maintenance and rebuild
costs.
Loan interest and principal payments
Major expected/unexpected
upgrade costs
Income taxes
Expenditure of corporate capital
funds
4
End-of-period convention
All cash flows are assumed to occur at the end of an interest
period.
When several receipts and disbursements occur within a
given interest period, the net cash flow is assumed to occur
at the end of the interest period.
5
Cash Flow Diagram
Helps to visualise complex cash flows.
Graphical representation.
Vertical axis = Cash Flows ($)
Known, estimated
and needed
Horizontal axis = Time
scale (Interest periods)
Most often,
Interest period = Year
Draw to scale
6
Cash Flow Diagram: Example 1
7
Cash Flow Diagram: Example 1
8
Cash Flow Diagram: Example 2
9
Present Value Future Value
Find the present (or past) or future value of a single cash flow.
F = P(1+i)
n
= Future Value
F/P factor = (1+i)
n
Single-payment compound amount factor (SPCAF)
P = F / (1+i)
n
= Present Value
P/F factor = 1 / (1+i)
n
Single-payment present worth factor (SPPWF)
10
Annual Value Present Value
What is the equivalent present value, in year 0, for a uniform
series A of end-of-period cash flows beginning at the end of
year 1, and extending for n periods.
11
Annual Value Present Value
Consider each amount individually as a future value, calculate
their present value, and sum the results.
P = A/(1+i) + A/(1+i)
2
+ A/(1+i)
3
+ + A/(1+i)
n
Show that we therefore have:
P/A Factor =
Uniform-series present worth factor (USPWF)
( )
( )
0
1
1 1

+
+
= i
i i
i
A P
n
n
( )
( )
0
1
1 1

+
+
i
i i
i
n
n
12
Annual Value Present Value
Divide by 1 + i
Subtract line 2 from
line 3
Rearrange
( ) ( ) ( )
( ) ( ) ( )
( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( )
( )
( )
( )
( )
( )
( )
0
1
1 1
1
1 1
1
1
1
1
1
1
1
1
1
1
...
1
1
1
1
1
1
...
1
1
1
1
1
1
1
...
1
1
1
1
1
1
1
1
1
...
1
1
1
1
1
1
1
...
1 1 1
1
2 1 3 2
1 4 3 2
3 2
3 2

+
+
=

+
+
=

+
=

+
=
+

+
+ +
+
+
+

+
+ +
+
+
+
=
+

+
+ +
+
+
+
+
+
=
+

+
+ +
+
+
+
+
+
=
+
+ +
+
+
+
+
+
=
+
+
+
i
i i
i
A P
i
i
A
i
A iP
i
A
i
A P
i
i
i i i
A
i i i
A P
i
P
i i i i
A
i
P
i i i i
A P
i
A
i
A
i
A
i
A
P
n
n
n
n
n
n
n n
n
n
n
13
Capital Recovery Factor (CRF)
Equivalent uniform annual worth A over n years for a given P
in year 0, where interest rate is i.
CRF = A/P Factor =
( )
( ) 1 1
1

+
+
n
n
i
i i
14
Annual Value Future Value
Homework: Use the equations and concepts from the
previous slides to calculate the following.
1) Sinking Fund Factor = A/F Factor
Eqn 2.8 and Eqn 2.9 (page 60 Blank 6
th
Ed)
2) Uniform-series compound amount factor (USCAF) = F/A Factor
15
Arithmetic Gradient Factors
Cash Flow series that
changes by a constant
amount each period.
Arithmetic Gradient, G = Constant arithmetic change in the
magnitude of receipts or disbursements from one time period to
the next. (Eg. $50)
Base amount, A
1
, is paid at the end of period 1. ($1500)
At the end of period 2: A
1
+G
Cash Flow at the end of period n = CF
n
= A
1
+ (n-1)G
16
Arithmetic Gradient Factors
CF
n
= A
1
+ (n-1)G
Convert each CF to its present value:
P = F / (1+i)
n
( ) ( )
( )
( )
( ) ( ) ( ) ( ) ( )
( )
( )
( )
( )
( ) ( )
( )
( )

+ +
+
+
+
=
+

+
+
=
+

+ +
+
+
+
+
+
+ +
+
+
+
+
+
=
+
+
+ +
+
+
+
+
+
+
+
=
n
G
G
n
n
n n
n
i
n
i i
G P
P
i i
i
A P
i
G n
i
G
i
G
i
A
i
A
i
A
i
A
P
i
G n A
i
G A
i
G A
i
A
P
1
1
...
1
2
1
1
1
1 1
1
1
...
1
2
1 1
...
1 1 1
1
1
...
1
2
1 1
3 2
1
3 2
1
3
1
2
1 1
1
3
1
2
1 1
17
P/G Factor
Multiply by (1+i)
Subtract line 1
from line 2
First term on RHS
the same as P/A
( ) ( )
( )
( )
( )
( ) ( )
( )
( )
( )
( ) ( ) ( )
( )
( )
( ) ( )
( )
( )
( )
( )
( ) ( ) ( )
( )
( )
( ) ( ) ( ) ( ) ( )
( )
( ) ( )
( )
( )

+
+
=
+

+
+
=
+

+
+
+
+ +
+
+
+
=

+
+ +
+
+
+
=

+
+

+ +
+
+
+

+
+
+
+
+
+
= +

+ +
+
+
+
= +

+ +
+
+
+
=

n
n
n n
n
G
n n n
G
n n
G
n n
n
G G
n
G
n
G
i i
ni i
G
i i
n
G
i i
i
i
G
P
i
n
G
i i i i
G iP
i
n
i i i
G iP
i
n
i
n
i i
G
i
n
i i i
G P i P
i
n
i i
G i P
i
n
i i
G P
1
1 1
1 1
1 1
1 1
1
1
1
...
1
1
1
1
1
1
1
1
...
1
1
1
1
1
1
1
2
...
1
2
1
1

1
1
...
1
3
1
2
1
1
1
1
1
...
1
2
1
1
1
1
1
...
1
2
1
1
2
1 2 1
1 2 1
1 3 2
1 3 2 1
1 2 1
3 2
18
Arithmetic Gradient Factors
P/G Factor = Arithmetic-Gradient Present Worth factor:
Extension: Find the following factors:
A/G Factor = Arithmetic-Gradient Uniform-series factor.
F/G Factor = Arithmetic-gradient future worth factor.
In each case the cash flow series can be separated into the base amount
series, A and the gradient G, and the present, future or annual worth
calculated from these separately, and then added together.
( )
( )

+
+
=
n
n
G
i i
ni i
G P
1
1 1
2
19
Cash Flow Series
To derive equations:
Describe cash flow using a simple equation, usually as a
combination of:
One-off cash flows: F, CF = F
Uniform series: A, CF = A
Arithmetic gradient: G, CF
n
= (n-1)G
Geometric gradient: g, CF
n
= A
1
(1+g)
n
Convert each component of the cash flow series to a present
value, and then sum present values.
Convert to a future or annual value if need.
20
Cash Flow Series Example
P = F / (1+i)
n
( )
( )

+
+
=
n
n
G
i i
ni i
G P
1
1 1
2
( )
( )
0
1
1 1

+
+
= i
i i
i
A P
n
n
21
Cash Flow Series Example
Draw the cash
flow diagram.
Separate the cash
flow series into its
components
22
Cash Flow Series Example
Calculate the present value of each component
23
Cash Flow Series Example
Calculate the annual value of each component
24
Geometric Gradient Series
Extension: Calculate the equivalent present value of a cash flow
series that changes from period to period by a constant
percentage.
g = constant rate of change,
in decimal form, by which
amounts increase or
decrease from one period to
the next. Eg. g = 0.05
Cash Flow Series = A
1
(1+g)
n
P(A
1
, g, i) = ?
25
Combining Cash Flows Series
What if the cash flow series is more complicated?
26
Combining Cash Flows
Use the following steps to avoid errors
Draw a cash flow diagram.
Identify the component cash flows: Single payments, annual series,
arithmetic gradient series or geometric gradient series.
Locate the appropriate reference point at which to calculate the
present value of each component cash flow on the cash flow
diagram.
Renumber the cash flow diagram to determine n for each calculation.
Solve the equations for each present value.
Calculate the value of each present value at the reference time you
need, and add them together.
27
Shifting Single Cash Flows
P = F / (1+i)
n
P is at the end of period 0, F is at the end of period n.
Use to shift any future single cash flow, back to a previous value
by n years, at a compound interest rate, i.
Use the inverse to shift any single cash flow forward.
Single cash flows can therefore be easily evaluated at any
reference year.
28
Shifted Annual Value
Uniform Annual Cash Flows:
Start at the end of period 1, and continue consecutively, and
uniformly until the end of period n.
( )
( )
0
1
1 1

+
+
= i
i i
i
A P
n
n
29
Shifted Arithmetic Gradient
Arithmetic Gradients are made up of:
A uniform cash flow, starting at the end of period 1, and
continuing until the end of period n.
A gradient, starting at the end of period 2, and continuing until
the end of period n.
( )
( )
0
1
1 1

+
+
=
+ =
i
i i
i
A P
P P P
n
n
A
G A T
( )
( )

+
+
=
n
n
G
i i
ni i
G P
1
1 1
2
30
Shifted Geometric Gradient
Extension:
How do we represent geometric gradients?
When does each component start and end?
What are the equations for converting each component to
present value?
31
Combining Cash Flows Example
( )
( )
0
1
1 1

+
+
=
+ =
i
i i
i
A P
P P P
n
n
A
G A T
( )
( )

+
+
=
n
n
G
i i
ni i
G P
1
1 1
2
( )
n
i
F
P
+
=
1
( )
( )
0
1
1 1

+
+
= i
i i
i
A P
n
n
32
Combining Cash Flows Example
33
Combining Cash Flows Example
34
Combining Cash Flows Example
35
Summary
What did we learn today?
36
Summary
Interest Rates (Simple, Compound)
Rates of Return, Minimum Attractive Rate of Return (MARR)
Interest ($) = Final ($) Original ($)
Interest Rate (%) = Interest accrued per time unit x 100%
Original Amount
Rate of Return (%) = Interest accrued per time unit x 100%
Original Amount
Simple Interest: Final Amount = Principal (1 + ni)
Compound Interest: Final Amount = Principal (1 + i)
n
Equivalence
Time Value of Money
Present Value
Future Value
Annual Value
Cash Flows, Series
( )
( )
0
1
1 1

+
+
=
+ =
i
i i
i
A P
P P P
n
n
A
G A T
( )
( )

+
+
=
n
n
G
i i
ni i
G P
1
1 1
2
( )
n
i
F
P
+
=
1
( )
( )
0
1
1 1

+
+
= i
i i
i
A P
n
n