Chapter - 4 Time Value of Money Part 1

Chapter 4: The Time Value of Money
PART 1
Pg 125
Copyright 2012 by Pearson Education, Inc.

Engineering Economy, Fifteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Time Value of Money
4.1 Introduction
4.2 Simple Interest
4.3 Compound Interest
4.4 The Concept Equivalence
4.5 Cash Flow-Diagram Table
4.6 Applications of Future and
Present Values

4.1 Why consider return to capital
Return to capital in the form of interest and profit is an
essential ingredient of engineering economy studies.
Interest and profit pay the providers of capital for forgoing

its use during the time the capital is being used.
Faedah dan keuntungan membayar modal yang digunakan.
Interest and profit are payments for the risk the investor
takes in letting another use his or her capital.
Faedah dan keuntungan ialah bayaran untuk pelabur dalam mengambil
risiko apabila menggunakan modal yg dikeluarkan.
Any project or venture must provide a sufficient return to
be financially attractive to the suppliers of money or
property.
Mana-mana projek atau usaha mesti memberikan pulangan yang cukup dari
segi kewangan.

Wang mempunyai nilai masa (money has a time
value).
Ini bermakna nilai wang bergantung kpd masa wang
itu diterima.
Cth : RM100 yg diterima tahun ini mempunyai kuasa
lebih besar berbanding 2thn akan dtg.

Dalam bidang kewangan terdapat 2 jenis
Faedah (Interest) .
i. Faedah mudah
(Simple Interest)
ii. Faedah kompaun

(Compound interest )

4.2 Simple interest is used infrequently
For Simple interest, the total interest, I, earned or paid may be

computed using the formula below.
Jumlah Faedah = Prinsipal, P x Jumlah tahun, n x Kadar
faedah, i%
P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period
The total amount repaid at the end of N interest periods is P +

I.
If $5,000 were loaned for five years at a simple interest
rate of 7% per year, the interest earned would be
Jumlah Faedah = Prinsipal, amount, P x Jumlah tahun, n x Kadar faedah,
i%
So, the total amount repaid at the end of five years would be the
original amount ($5,000) plus the interest ($1,750), or $6,750.

Amirah meminjam wang RM1000 drp sebuah bank.
Andaikan pinjaman tersebut dikenakan faedah mudah
5% setahun. Hitung jumlah hutang Amirah pada akhir
tahun ketiga.
Amirah has borrowed RM1,000 from ABC bank. If loan

interest per year at 5%, how much the total loan would
it be pay in 3 years?

4.3 Compound interest (pg 128)
Interest charge for any period (year) is based on the remaining

principle amount plus any accumulated interest charges up to the
beginning of that period, the interest is said to be compound.
Ex 1: For $1,000 loaned for three periods at an interest of 10%
compounded each period.
(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed at Interest amount for Amount owed at
Period beginning of period period end of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210

3 $1,210 $121 $1,331
Compound interest is commonly used in personal and professional financial
transactions.
FINAL EXAMINATION
SEMESTER I
SESSION 2013/2014

4.4 Economic equivalence (pg 128)
allows us to compare alternatives on a common basis.
Economic equivalence means in a specified interest rate, different
amounts of money raised at different times to the same value in terms
of economy.
Kesetaraan ekonomi bermakna pada kadar faedah tertentu, jumlah
wang yang berbeza yang diperoleh pada masa yg berlainan mempunyai
nilai yg sama dari segi ekonomi.
Example : 10% annual interest rate, currency RM1000

now (at present) is equivalent with the RM1100 in one
year from now.
Cthnya : kadar faedah 10% setahun, wang RM1000 sekarang (pada
masa kini) adalah setara dgn RM1100 pada satu tahun dari sekarang.
F =Engineering
1000 Economy,
+ 1000(0.10)
Fifteenth Edition= 1000 (1.1) = RM1100
Equivalence
Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8%
TOTAL OWED
YEAR AMOUNT OWED AT INTEREST OWED FOR AT PRINCIPAL TOTAL END-OF YEAR
THE BEGINNING OF YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
AT THE END OF EACH YEAR PAY $ 1000 PRINCIPAL + INTEREST
Plan 1 DUE Pay every year
1 $5,000 $400 $5,400 $1,000 $1,400
2 $4,000 $320 $4,340 $1,000 $1,320
3 $3,000 $240 $3,240 $1,000 $1,240
4 $2,000 $160 $2,160 $1,000 $1,160
5 $1,000 $80 $1,080 $1,000 $1,080
$1,200 $5,000 $6,200
PAY INTEREST DUE AT END OF EACH YEAR AND PRINCIPAL AT END OF FIVE
Plan 2 YEARS Pay
1 $5,000 $400 $5,400 $0 $400
2 $5,000 $400 $5,400 $0 $400
3 $5,000 $400 $5,400 $0 $400
4 $5,000 $400 $5,400 $0 $400
5 $5,000 $400 $5,400 $5,000 $5,400
$2,000 $5,000 $7,000
copyright @ mia All rights reserved.
13
Equivalence
Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8% (cont.)
AMOUNT OWED AT
YEAR THE BEGINNING OF INTEREST OWED FOR TOTAL OWED AT PRINCIPAL TOTAL END-OF YEAR
YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
Plan Pay every year
3 PAY IN FIVE EQUAL END-OF-YEAR PAYMENTS
1 $5,000 $400 $5,400 $852 $1,252
2 $4,148 $331 $4,479 $921 $1,252
3 $3,227 $258 $3,485 $994 $1,252
4 $2,233 $178 $2,411 $1,074 $1,252
5 $1,159 $93 $1,252 $1,159 $1,252
$1,260 $5,000 $6,260
Plan
Pay
4 PAY PRINCIPAL AND INTEREST IN ONE PAYMENT AT END OF FIVE YEARS
1 $5,000 $400 $5,400 $0 $0
2 $5,400 $432 $5,832 $0 $0
3 $5,832 $467 $6,299 $0 $0
4 $6,299 $504 $6,803 $0 $0
5 $6,803 $544 $7,347 $5,000 $7,347
$2,347 $5,000 $7,347
14
4.5 Notation and Cash Flow Diagrams
and Tables
Notation used in formulas for compound interest calculations.
i = effective interest rate per interest period
N = n = number of compounding (interest) periods, year
P = present sum of money; equivalent value of one or more
cash flows at a reference point in time; the present
F = future sum of money; equivalent value of one or more
cash flows at a reference point in time; the future
A = Annuallyend-of-period cash flows in a uniform series/
each year..continuing for a certain number of periods, starting
at the end of the first period and continuing through the last

A cash flow diagram is an indispensable tool for clarifying and
visualizing a series of cash flows.
P
TEST 2 SEMESTER I
SESI 2012/2013
Q2 (b) Explain what are these standard notation stand for;
(i) I (ii) N
(iii) P (iv) F
(v) A
(c) Draw a Cash Flow Diagram when P= RM 25,000, N= 5 years, A=

RM6,097, F=RM 35,064.

4.6 Relating a Uniform Series (Annuity) to
its Present & Future Equivalent Values of
Single Cash Flows
Using the standard notation, we find that a Present
amount, P, can grow into a future amount, F, in N
time periods at interest rate i according to the formula
below.
Finding F
when Given P
In a similar way we can find P given F by
Finding P
when Given F

Single Payment Formulas
Calculate
manually

Calculate
manually

Terminology and Symbols
t = time index in periods; years, months, etc.
P = present sum of money at time t = 0; $
F = sum of money at a future time t; $
A = series of equal, end-of-period cash flows;
currency per period, $ per year
n = total number of periods; years, months
i = compound interest rate or rate of return; % per
year

1 - 23 All rights reserved.
Finding F when Given P
E X A M P L E 1. 1
If you had RM 2,000 now and invested it at
10%, how much would it be worth in 8 years?

24
Finding F when Given P
Solution Ex 1.1 Based on Formulas
If you had RM 2,000 now and

invested it at 10%, how much F = P (1+i)n
would it be worth in 8 years? = 2,000 (1+0.1)8
= RM 4,287.18
Cash Flow Diagram F=? Based on Compound Interest

Table
+ i = 10%
F = P (F/P, i, n)
- 0 1 2 3 4 5 6 7 8
= 2,000 (F/P, 10%, 8)
= 2,000 (2.1436)
P= 2,000 = RM 4,287.20
25
Finding P when Given F
E X A M P L E 1. 2
Suppose that RM 1,000 is to be received in 5 years. At an
annual interest rate of 12%, what is the present worth of this
amount?

27
Finding P when Given F
Solution E x 1. 2 Based on Formulas
Suppose that RM 1,000 is to be

received in 5 years. At an P = F (1+i) -n
annual interest rate of 12%, = 1,000 (1+0.12) -5
what is the present worth of = RM 567.40

this amount?
RM 1,000 Based on Compound Interest
Table
Cash Flow iDiagram
+ = 12%
P = F (P/F, i, n)
- 0 1 2 3 4 5
= 1000 (P/F, 12%, 5)
= 1,000 (0.5674)
? = RM 567.40
28
Finding i when Given P,F and n
E X A M P L E 1. 3
Suppose you buy a share for RM10 and sell it for RM20, your
profit is RM10. If that happens within a year, your rate of
return is an impressive 100%. If that takes 5 years, what
would be the average annual rate of return on your
investment?

32
Finding i when Given P,F and n
Based on Compound Interest Table

Solution Ex 1. 3
Suppose you buy a share for RM10 F = P(F/P, i, n)
and sell it for RM20, your profit is 20 = 10 (F/P, i, 5)
RM10. If that happens within a year,
your rate of return is an impressive
100%. If that takes 5 years, what
If i = 15%
would be the average annual rate of 20 ? 10 (2.0114)
return on your investment? 20 ? 20.114
RM 20
Cash Flow Diagram
If i = 14%
20 ? 10 (1.9254)
+ i=?% 20 ? 19.254
- 0 1 2 3 4 5 With iteration,
i = 14.87%
RM 10
33
Find interest, i based on equation 4-6 page
137
try calculate i=?

Example to find interest, i based on equation
4-6 page 137

Finding n when Given P,F and i
E X A M P L E 1. 4
You have just purchased 100 shares of General Electric
stock at RM60 per share. You will sell the stock when its
market price has doubled. If you expected the stock price to
increase 20% per year, how long do you expect to wait
before selling the stock?

38
Finding n when Given P,F and i
Based on Formula
Solution Ex 1. 4
You have just purchased 100 shares of F = P (1+i) n
General Electric stock at RM60 per 12,000 = 6,000 (1+0. 20) n
share. You will sell the stock when its 2 = (1+0. 20) n
market price has doubled. If you
log 2 = n log 1.2
expected the stock price to increase
20% per year, how long do you expect n = log 2
to wait before selling the stock? log 1.2
RM 12,000
n = 3.8 4 years
Cash Flow Diagram
+ i = 20 %
- 0 n=?
RM 6,000
39
Based on using equation 4-7 page 140
try calculate to find N?

Example to find years,N based on using equation 4-7
page 140

TUTORIAL
1. You borrow RM200 from a family member and agree to pay it back
in six months. Because you are part of the family, you are only
being charged simple interest at the rate of 1% per month. How
much will you owe after six months? How much of this is interest?
2. You invest RM 25,000 in a stock-based mutual fund. This fund

should earn (on average) 10% per year over a long period of time.
How much should your investment be worth in 25 years?
3. What is present equivalent of RM 18,000 to be received in 15

years when the interest rate is 7% per year?


Chapter - 4 Time Value of Money Part 1

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Chapter 4: The Time Value of Money

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Interest and profit pay the providers of capital for forgoing

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

ii. Faedah kompaun

Copyright 2012 by Pearson Education, Inc.

For Simple interest, the total interest, I, earned or paid may be

P = principal amount lent or borrowed

The total amount repaid at the end of N interest periods is P +

Copyright 2012 by Pearson Education, Inc.

Amirah has borrowed RM1,000 from ABC bank. If loan

Copyright 2012 by Pearson Education, Inc.

Interest charge for any period (year) is based on the remaining

(1) (2)=(1)x10% (3)=(1)+(2)

2 $1,100 $110 $1,210

Copyright 2012 by Pearson Education, Inc.

Example : 10% annual interest rate, currency RM1000

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(c) Draw a Cash Flow Diagram when P= RM 25,000, N= 5 years, A=

Copyright 2012 by Pearson Education, Inc.

In a similar way we can find P given F by

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Solution Ex 1.1 Based on Formulas

If you had RM 2,000 now and

Cash Flow Diagram F=? Based on Compound Interest

Copyright 2012 by Pearson Education, Inc.

Solution E x 1. 2 Based on Formulas

Suppose that RM 1,000 is to be

what is the present worth of = RM 567.40

Copyright 2012 by Pearson Education, Inc.

Based on Compound Interest Table

try calculate i=?

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

try calculate to find N?

Copyright 2012 by Pearson Education, Inc.

Copyright 2012 by Pearson Education, Inc.

2. You invest RM 25,000 in a stock-based mutual fund. This fund

3. What is present equivalent of RM 18,000 to be received in 15

Copyright 2012 by Pearson Education, Inc.

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