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Time Value of Money

Lecture No.2
Professor C. S. Park
Fundamentals of Engineering Economics
Chapter 2
Time Value of Money
Interest: The Cost of
Money
Economic Equivalence
Interest Formulas
Single Cash Flows
Equal-Payment Series
Series
Composite Cash Flows.
Decision DilemmaTake a Lump Sum or Annual
Installments

A suburban Chicago couple

won the Power-ball.
between a single lump sum
\$104 million, or \$198 million
paid out over 25 years (or
\$7.92 million per year).
The winning couple opted
for the lump sum.
Did they make the right
choice? What basis do we
make such an economic
comparison?
Option A Option B
(Lump Sum) (Installment
Plan)
0 \$104 M
1 \$7.92 M
2 \$7.92 M
3 \$7.92 M

25 \$7.92 M
What Do We Need to Know?

To make such comparisons (the lottery

decision problem), we must be able to
compare the value of money at different point
in time.
To do this, we need to develop a method for
reducing a sequence of benefits and costs to
a single point in time. Then, we will make our
comparisons on that basis.
Time Value of Money
Money has a time value
because it can earn more
money over time (earning
power).
Money has a time value
power changes over time
(inflation).
Time value of money is
measured in terms of
interest rate.
Interest is the cost of
moneya cost to the
borrower and an earning to
the lender
Delaying Consumption
Account Value Cost of Refrigerator

Case 1: N = 0 \$100 N = 0 \$100

Inflation
exceeds N = 1 \$106 N = 1 \$108
earning power
(earning rate =6%) (inflation rate = 8%)
Case 2: N = 0 \$100 N = 0 \$100
Earning power
exceeds N = 1 \$106 N = 1 \$104
inflation
(earning rate =6%) (inflation rate = 4%)
Key terms

Principal (P)
Interest rate (i)
Interest period (n)
Number of interest periods (N)
A plan for receipt (An)
Future amount of money (F)
Which 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)
Cash Flow Diagram
End-of-Period Convention

0
1

Beginning of End of interest

Interest period period

0 1
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
P = Principal amount
i = Interest rate End of Beginnin Interest Ending
Year g earned Balance
N = Number of Balance
interest periods 0 \$1,000
Example:
1 \$1,000 \$80 \$1,080
P = \$1,000
i = 8% 2 \$1,080 \$80 \$1,160
N = 3 years
3 \$1,160 \$80 \$1,240
Simple Interest Formula
F P (iP) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N

F \$1, 000 (0.08)(\$1, 000)(3)

\$1, 240
Compound Interest

Compound interest: the practice of

charging an interest rate to an initial sum
and to any previously accumulated interest
that has not been withdrawn.
Compound Interest
P = Principal amount
i = Interest rate End Beginning Interest Ending
of Balance earned Balance
N = Number of Year
interest periods 0 \$1,000
Example:
1 \$1,000 \$80 \$1,080
P = \$1,000
i = 8% 2 \$1,080 \$86.40 \$1,166.40
N = 3 years
3 \$1,166.40 \$93.31 \$1,259.71
Compounding Process

\$1,080

\$1,166.40
0 \$1,259.71
1
\$1,000
2
3
\$1,080
\$1,166.40
\$1,259.71

0 1 2

F \$1, 000(1 0.08)3

\$1,000
\$1, 259.71
Compound Interest Formula

n 0: P
n 1: F1 P(1 i )
n 2 : F2 F1 (1 i ) P(1 i ) 2

n N : F P(1 i ) N
Some Fundamental Laws

F m a
V i R
E m c 2

The Fundamental Law of Engineering Economy

F P(1 i) N
Compound Interest

The greatest mathematical discovery of

all time,
Albert Einstein
Practice Problem: Warren Buffetts
Berkshire Hathaway
Went public in 1965: \$18
per share
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 companys total market
value will be ?
Market Value

Assume that the companys stock will continue to

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

F \$100.36(1 0.2458) 27

\$37.902 trillions
EXCEL Template
In 1626 the Indians sold Manhattan Island to Peter Minuit
Of the Dutch West Company for \$24.

If they saved just \$1 from the proceeds in a bank account

that paid 8% interest, how much would their descendents
have now?

As of Year 2003, the total US population would be close to

275 millions. If the total sum would be distributed equally
among the population, how much would each person receive?
Excel Solution
P \$1
i 8%
N 377 years

FV(8%,377,0,1)
= \$3,988,006,142,690
\$3,988,006,142,690
A
275,000,000
\$14,502
Excel Worksheet

A B C

1 P 1

2 i 8%

3 N 377

4 FV

5 FV(8%,377,0,1)
= \$3,988,006,142,690
Practice Problem

Problem Statement
If you deposit \$100 now (n = 0) and \$200 two
years from now (n = 2) in a savings account
that pays 10% interest, how much would you
have at the end of year 10?
Solution

0 1 2 3 4 5 6 7 8 9 10

\$100(1 0.10)10 \$100(2.59) \$259

\$200(1 0.10)8 \$200(2.14) \$429
\$100
\$200 F \$259 \$429 \$688
Practice problem
Problem Statement
Consider the following sequence of deposits
and withdrawals over a period of 4 years. If
you earn 10% interest, what would be the
balance at the end of 4 years?

0 1
\$1,210

4
?
2 3

\$1,000 \$1,000 \$1,500

\$1,210 ?
0 1 3
2 4

\$1,000 \$1,000
\$1,500
\$1,100
\$1,000
\$1,210 \$2,981
\$2,100 \$2,310
-\$1,210 + \$1,500

\$1,100 \$2,710
Solution
End of Beginning Deposit Withdraw Ending
n=0 0 \$1,000 0 \$1,000

=\$1,100

=\$2,310

=\$1,210

=\$2,981