KIX2002

Engineering Economic Analysis

Week 5 Time Value of Money
Part 2

1
Chapter 4: Time Value of Money
 4.2 Simple Interest
 4.3 Compound Interest
 4.4 The Concept of Equivalence
 4.5 Notation and Cash-Flow Diagrams and Tables
 4.6 Relating Present and Future Equivalent Values of Single Cash Flows
 4.7 Relating Uniform Series to Its Present and Future Equivalent Values
 4.8 Summary of Interest Formulas and Relationships for Discrete
Compounding
 4.9 Deferred Annuities (Uniform Series)
 4.10 Equivalence Calculations Involving Multiple Interest Formulas
 4.11 Uniform (Arithmetic) Gradient of Cash Flows
 4.12 Geometric Sequences of Cash Flows
 4.13 Interest Rates that Vary with Time
 4.14 Nominal and Effective Interest Rates
 4.15 Compounding More Often than Once per Year
 4.16 Interest Formulas for Continuous Compounding and Discrete Cash
Flows

2
4.9 Deferred Annuities (Uniform Series)

 We need to be able to handle cash flows that do

not 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 by J periods, then the
first payment (cash flow) begins at the end of
period J+1.

3
 Finding the value at time 0 of a deferred
annuity is a two-step 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.

4
Figure 4-9 General Cash-Flow Representation of a Deferred Annuity (Uniform Series)
EXAMPLE 4-14 Present Equivalent of a
Deferred Annuity

5
continued on next slide
EXAMPLE 4-14 (continued) Present
Equivalent of a Deferred Annuity

6
EXAMPLE 4-15: Deferred Future Value of an
Annuity

continued on next slide

7
EXAMPLE 4-15 (continued) Deferred
Future Value of an Annuity

8
EXAMPLE 4-18 The Present Equivalent
of BP’s Payment Schedule

9
Figure 4-12 Cash-Flow Diagram for
Example 4-18

10
Pause and solve
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?

11
Solution

Present value, at EOY 5, of maintenance expenses in

years 6-10, is

Now move this value to time zero

12
 4.11 Uniform Gradient
Sometimes cash flows change by a constant amount
each period.
We can model these situations as a uniform gradient of
cash flows. The table below shows such a gradient.
End of Cash
Period Flows
1 0
2 G
3 2G
: :
N (N-1)G
Figure 4-13 Cash-Flow Diagram for a Uniform
Gradient Increasing by G Dollars per Period
End of Cash
Period Flows
1 0
2 G
3 2G
: :
N (N-1)G
It is easy to find the present value of a
uniform gradient series.

Similar to the other types of cash flows, there is a

formula (albeit quite complicated) we can use to find
the present value, and a set of factors developed for
interest tables.

15
We can also find A or F equivalent to a
uniform gradient series.

16

End of Year Cash Flows ($)
1 2,000
2 3,000
3 4,000
4 5,000
The annual equivalent
of this series of cash
flows can be found by
considering an annuity
portion of the cash
flows and a gradient
portion.

End of Year Annuity ($) Gradient ($)

1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

𝐴 = $2,000 + $1,000 𝐴Τ𝐺 , 8%, 4 = $3,404

17
EXAMPLE 4-20 Using the Gradient
Conversion Factors to Find P and A

18 continued on next slide

EXAMPLE 4-20 (continued) Using the
Gradient Conversion Factors to Find P and A

19
EXAMPLE 4-21 Present Equivalent of an
Increasing Arithmetic Gradient Series

20
continued on next slide
EXAMPLE 4-21 (continued) Present Equivalent
of an Increasing Arithmetic Gradient Series

21
continued on next slide
EXAMPLE 4-21 (continued) Present
Equivalent of an Increasing Arithmetic Gradient
Series

22
23
EXAMPLE 4-22 (continued) Present Equivalent
of a Decreasing Arithmetic Gradient Series

24
4.12 Geometric Sequences (Geometric
gradient)

Sometimes cash flows change by a constant

rate,𝑓,each period--this is a geometric gradient
series.

This table presents a End of Year Cash Flows ($)

geometric gradient 1 1,000
series.
2 1,200
It begins at the end of 3 1,440
year 1 and has a rate
4 1,728
of growth,𝑓, of 20%.

25
EXAMPLE 4-23 Equivalence Calculations for
an Increasing Geometric Gradient Series

continued on next slide

26
EXAMPLE 4-23 (continued) Equivalence
Calculations for an Increasing Geometric
Gradient Series

27
28
We can find the present value of a geometric
series by using the appropriate formula below
If 𝑓 ≠ 𝑖
𝑨𝟏 𝟏 − (𝑷Τ𝑭 , 𝑰%, 𝑵)(𝑭Τ𝑷 , 𝒇%, 𝑵)
𝒊−𝒇

If 𝑓 = 𝑖
𝑨𝟏 𝑵(𝑷Τ𝑭 , 𝒊%, 𝟏)

Where 𝐴1 is the initial cash flow in the series.

29
EXAMPLE 4-24 Equivalence Calculations for a
Decreasing Geometric Gradient Series

30
Pause and solve
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%.
If 𝑓 ≠ 𝑖
𝑨𝟏 𝟏 − (𝑷Τ𝑭 , 𝑰%, 𝑵)(𝑭Τ𝑷 , 𝒇%, 𝑵)
𝑷𝟎 =
31 𝒊−𝒇
Solution
Use the geometric gradient formula to find the present
value, then convert the present amount to an annual
amount.

32
4.13 Interest rates vary with time*

 When interest rates vary with time different

procedures are necessary.
 Interest rates often change with time (e.g., a
variable rate mortgage).
 We often must resort to moving cash flows one
period at a time, reflecting the interest rate for
that single period.

33
EXAMPLE 4-27 Compounding with
Changing Interest Rates

continued on next slide

34
EXAMPLE 4-27 (continued) Compounding with Changing
Interest Rates

continued on next slide

35
EXAMPLE 4-27 (continued)
Compounding with Changing Interest Rates

36
The present equivalent of a cash flow occurring at the
end of period N can be computed with the equation
below, where ik is the interest rate for the kth period.
𝑭𝑵
𝑷= 𝑵
ς𝒌=𝟏(𝟏 + 𝒊𝒌 )

If 𝐹4 = $2,500 and 𝑖1 = 8%, 𝑖2 = 10%, 𝑎𝑛𝑑 𝑖3 = 11%,

then

37
4.14 Nominal and Effective Interest Rates
 More often than not, the time between successive
compounding, or the interest period, is less than
one year (e.g., daily, monthly, quarterly).
 The annual rate is known as a nominal rate.
 A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.
 The more frequent the compounding the greater
the effective interest.
38
The effect of more frequent compounding
can be easily determined

Let r be the nominal, annual interest rate and M

the number of compounding periods per year.
We can find, i, the effective interest by using
the formula below.
𝑴
𝒊 = 𝟏 + 𝒓Τ𝑴 −𝟏

39
Finding effective interest rates.

For an 18% nominal rate, compounded quarterly,

the effective interest is:
𝒊 = 𝟏 + 𝒓Τ𝑴 𝑴 − 𝟏

For a 7% nominal rate, compounded monthly,

the effective interest is:
𝒊 = 𝟏 + 𝒓Τ𝑴 𝑴 − 𝟏

40
Figure 4-18 $1,000 Compounded at a
Semiannual Frequency (r = 12%, M = 2)
Figure 4-19 $1,000 Compounded at a Monthly
Frequency (r = 12%, M = 12)

42
TABLE 4-4 Effective Interest Rates for Various
Nominal Rates and Compounding Frequencies

43
EXAMPLE 4-28 Effective Annual Interest
Rate

44
We can use the effective interest formula to
derive the interest factors.

𝒓 𝑴
𝒊= 𝟏+ −𝟏
𝑴

As the number of compounding periods gets

larger (M gets larger), we find that

𝒊 = 𝒆𝒓 − 𝟏
45
4.15 Compounding More Often than Once per Year
 Single Amounts
 Nominal interest rate
 Known number of compounding periods per year
 Known number of years
𝐹 = 𝑃(𝐹 Τ𝑃 , 𝑖%, 𝑁)
𝑟 𝑀
𝑖 = 1+ −1
𝑀
 i.e. example 4-29

 Uniform Series and Gradient Series

 More than one compounded interest per year
 i.e. example 4-30,4-31,4-32
46
EXAMPLE 4-29 Future Equivalent when
Interest Is Compounded Quarterly

47
EXAMPLE 4-30 Computing a Monthly
Auto Payment

48
EXAMPLE 4-31 Uniform Gradient Series
and Semiannual Compounding

49 continued on next slide

EXAMPLE 4-31 (continued) Uniform Gradient
Series and Semiannual Compounding

50
EXAMPLE 4-32

continued on next slide

51
EXAMPLE 4-32 (continued) Finding the
Interest Rate on a Loan

52
4.16 Interest Formulas for Continuous
Compounding and Discrete Cash Flows

 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

53
Continuous compounding interest factors.
𝒊 = 𝒆𝒓 − 𝟏

𝟏
𝑷Τ𝑭 , 𝒓%, 𝑵 = 𝒓𝑵 = 𝒆−𝒓𝑵
𝒆

𝒆𝒓𝑵 − 𝟏
𝑭Τ𝑨 , 𝒓%, 𝑵 = 𝒓
𝒆 −𝟏

𝟏 − 𝒆−𝒓𝑵 𝒆𝒓𝑵 − 𝟏
𝑷Τ𝑨 , 𝒓%, 𝑵 = 𝒓 = 𝒓𝑵 𝒓
𝒆 −𝟏 𝒆 (𝒆 − 𝟏)

 The other factors can be found from these

54
55
EXAMPLE 4-33 Continuous
Compounding and Single Amounts

56
EXAMPLE 4-34 Continuous
Compounding and Annual Payments

57
EXAMPLE 4-35 Continuous
Compounding and Semiannual Payments

58