2.

0 Time Value of Money

2.1 Compound Interest

Selection and replacement studies must take interest or the cost of money into
account.

Notation
A = amount n periods hence
P = present value of an amount A payable n periods hence
r = rate of interest
For compound interest, when compounding takes place once per period,
A = P(1 + r)n (2.1)
P = A(1 +r)-n (2.2)
Suppose interest is compounded m times per period. From (2.1),
A = P(1 + r/m)mn

As m → ∞ , the expression multiplying P approaches ern, where e = 2.71828.. This is

the method of continuous compounding which is generally used at present; it will be
used
throughout this chapter. [If the periodic method is preferred, ern in the following
formulas need only be replaced by (1 + r)n]. Equations (2.1) and (2.2) thus become

A = Pern (2.3)

P = Ae-rn =A/ern (2.4)

We call ern the compound amount factor; e-rn is the present worth factor for a single
payment or receipt.

EXAMPLE 2.1. What is the amount of $1000 compounded continuously at 6% p.a. for
20 years?

x = r n = (0.06)(20) = 1.2; from Appendix A, e1.2 = 3.3201; from (2.3),

A = 1000(3.3201) = $3320.10

EXAMPLE 2.2. What amount must now be invested at 6.5% to yield $1200 16 years
from now?

x = (0.065)(16) = 1.04; from Appendix A, el.04 = 2.8292; from (2.4),

P = 1200/2.8296 = $424.15
2.2 UNIFORM FLOW

It often happens that, instead of a single amount, there is a uniform flow of costs or
revenues at a constant rate of a per period. The present worth of such a flow is the
amount P which, when invested at time 0 at an interest rate r, will produce a flow of
a per period for n periods. To find P, consider the small time interval from t to t + δ t
during which an amount a δt will flow (i.e. either be received or paid). The present
worth of this element, obtained from (2.4), is a δt e-rt. The present worth of the
entire flow is obtained by integration as

n n
 a  − rn 1 − e − rn
0
∫
P = ae − rt dt = − e − rt  =
 r 0
a 1− e
r
= an
rn
= anf u (2.5)

The term fu. = (1-e-rn ) / rn, which is tabulated as a function of x= rn in Appendix A,

is called the present worth factor for uniform flow; fu may be computed by writing

e rn − 1
fu = (2.6)
rne rn
EXAMPLE 2.3. Find the present value of an annual maintenance charge of $350 for
15 years, assuming a cost of money of 12%.

Here, x = rn = 15(0.12) = 1.8; and for x = 1.8, Appendix A gives fu = 0.46372.

Then, from (2.5),

P = 350(15)(0.46372) = $2434.53

In the above solution the maintenance charge is considered to be paid out

continuously over the year.

EXAMPLE 2.4. An amount of $10,000 is to be invested for 10 years in hope of

realizing an annual income of $2000. At what continuously compounded interest rate
would this investment have to be made?

Here we reverse (2.5) and obtain fu = P/an = 10,000/20000 = 0.5

In Appendix A, x for fu = 0.5 is 1.6; thus

rn = 10 r = 1.6 or r = 16 percent

EXAMPLE 2.5. Find fu for 15 years and an interest rate of 12%, using (2.6).

As in Example 2.3, x =1.8. From Appendix A, e1.8 = 6.0496. From (2.6),

6.0496 − 1
fu = = 0.46372
(1.8)(6.0496)
It also follows. from (2.5) that
 P 1
a= (2.7)
n fu

i.e. the uniform periodic amount is obtained, given the initial investment P and the
term n. The quantity 1/fu is the capital recovery factor, i.e. the total amount paid
over the life of the loan for each dollar of loan. Therefore the total interest is (
1/fu) - 1 for each dollar.

EXAMPLE 2.6. What is the monthly payment for a 25-year, 9% mortgage for
$35,000? How much total interest is paid?

Assume a monthly interest rate of 1/12 * (9%) = 0.75 % for 25(12) = 300
months. x = 0.0075(300) = 2.25.

From Appendix A, fu = 0.39760. From (2.7)

35000
a= = $293.43
300( 0.39760)

The total paid in interest is

 1 
35000 − 1 = 53028.17 = $53028.17
 0.39760 

EXAMPLE 2.7. Should a machine be rented for $500 a month or purchased for
$40,000? Either way, its useful life is 10 years, and money is worth 14%.
We may use (2.5) or (2.7). First, using (2.5) to get the present value of the
rental: x (0.14)(10) = 1.4 and from
Appendix A, fu = 0.53815. Then, with a = $6000/yr,

P = 6000(10)(0.53815) = $32,289

It is more advantageous to rent the machine.

From (2.7), the equivalent annual cost of owning the machine is

40000
a= = $7432.87
10(0.53815)

Again, it is more advantageous to rent. Note that

40000 7432.87
= = 1.239
32289 6000
i.e. the ratios of the present values and of the annual costs for purchase and rental
are equal.
 Appendix A

1 − e−x
Values of the Present Worth Factor for Uniform Flow, f u =
x

x .00 .01 .02 .03 .04 .05 .06 .07 .08 .09

0 1.0000 .99502 .99007 .98515 .98026 .97541 .97059 .96580 .96105 .95632
0
.1 .95163 .94696 .94233 .93773 .93316 .92861 .92410 .91962 .91517 .91074
.2 .90635 .90198 .89764 .89333 .88905 .88480 .88057 .87637 .87220 .86806
.3 .86394 .85985 .85578 .85175 .84773 .84375 .83979 .83585 .83194 .82806
.4 .82420 .82037 .81656 .81277 .80901 .80527 .80156 .79787 .79420 .79056
.5 .78694 .78334 .77977 .77622 .77269 .76918 .76570 .76224 .75880 .75538

.6 .75198 .74861 .74525 .74192 .73861 .73531 .73204 .72879 .72556 .72235
.7 .71916 .71599 .71284 .70971 .70660 .70351 .70044 .69739 .69435 .69134
.8 .68834 .68536 .68240 .67946 .67654 .67363 .67074 .66787 .66502 .66218
.9 .65937 .65657 .65378 .65102 .64827 .64554 .64282 .64012 .63744 .63477
1.0 .63212 .62949 .62687 .62427 .62168 .61911 .61655 .61401 .61149 .60898

1.1 .60648 .60400 .60154 .59909 .59665 .59423 .59182 .58943 .58705 .58469
1.2 .58234 .58000 .57768 .57537 .57308 .57080 .56853 .56627 .56403 .56181
1.3 .55959 .55739 .55520 .55302 .55086 .54871 .54657 .54445 .54233 .54023
1.4 .53815 .53607 .53400 .53195 .52991 .52788 .52587 .52386 .52187 .51988
1.5 .51791 .51595 .51401 .51207 .51014 .50823 .50632 .50443 .50255 .50068

1.6 .49881 .49696 .49512 .49329 .49148 .48967 .48787 .48608 .48430 .48253
1.7 .48077 .47903 .47729 .47556 .47384 .47213 .47043 .46874 .46706 .46539
1.8 .46372 .46207 .46043 .45879 .45716 .45555 .45394 .45234 .45075 .44917
1.9 .44760 .44603 .44448 .44293 .44139 .43986 .43834 .43682 .43532 .43382
2.0 .43233 .43085 .42938 .42791 .42646 .42501 .42357 .42213 .42071 .41929

2.1 .41788 .41647 .41508 .41369 .41231 .41094 .40957 .40821 .40686 .40552
2.2 .40418 .40285 .40153 .40021 .39890 .39760 .39631 .39502 .39373 .39246
2.3 .39119 .38993 .38868 .38743 .38618 .38495 .38372 .38250 .38128 .38007
2.4 .37887 .37767 .37648 .37529 .37411 .37294 .37177 .37061 .36946 .36831
2.5 .36717 .36603 .36490 .36377 .36265 .36154 .36043 .35932 .35823 .35714

2.6 .35605 .35497 .35389 .35282 .35176 .35070 .34964 .34859 .34755 .34651
2.7 .34548 .34445 .34343 .34241 .34140 .34039 .33939 .33839 .33740 .33641
2.8 .33542 .33445 .33347 .33250 .33154 .33058 .32963 32868 .32773 .32679
2.9 .32585 .32492 .32400 .32307 .32215 .32124 .32033 .31943 .31853 .31763
3.0 .31674 .31585 .31497 .31409 .31321 .31234 .31147 .31061 .30975 .30890

3.1 .30805 .30720 .30636 .30552 .30469 .30386 .30303 .30221 .30139 .30057
3.2 .29976 .29895 .29815 .29735 .29655 .29576 .29497 .29419 .29341 .29263
3.3 .29185 .29108 .29032 .28955 .28879 .28803 .28728 .28653 .28578 .28504
3.4 .28430 .28357 .28283 .28210 .28138 .28065 .27993 .27922 .27850 .27779
3.5 .27709 .27638 .27568 .27498 .27429 .27360 .27291 .27223 .27154 .27086

3.6 .27019 .26951 .26884 .26818 .26751 .26685 .26619 .26554 .26489 .26424
3.7 .26359 .26294 .26230 .26166 .26103 .26040 .25976 .25914 .25851 .25789
3.8 .25727 .25665 .25604 .25543 .25482 .25421 .25361 .25301 .25241 .25181
3.9 .25122 .25063 .25004 .24945 .24887 .24829 .24771 .24714 .24656 .24599
4.0 .24542 .24485 .24429 .24373 .24317 .24261 .24206 .24150 .24095 .24041