Engineering Economy: Chapter 4: The Time Value of Money

Engineering Economy
Chapter 4: The Time Value of Money
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.
The objective of Chapter 4 is to
explain time value of money
calculations and to illustrate
economic equivalence.

Time Value of Money
$100 CASH
$100 A YEAR FROM TODAY
NOW, AFTER SAVED
INTO A BANK

Types Of interest
• Simple Interest
• Compound Interest

Simple interest
When the total interest earned or charged is linearly

proportional to the initial amount of the loan
(principal), the interest rate, and the number of
interest periods, the interest and interest rate are said
to be simple.

TOTAL INTEREST = PRINCIPAL (P) X SUM OF YEARS (n) X INTEREST RATE (i%)
End of Year Amount of Loan Simple Interest SUM OWE

5% per annum
0 RM1,000 RM1,000
1 RM50 RM1,050
2 RM50 RM1,100
3 RM50 RM1,150

Computation of simple interest
The total interest, I, earned or paid may be computed
using the formula below.
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
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.
Compound Interest
Whenever the interest charge for any interest

period ( a year, for example) is based on the
remaining principal amount plus any accumulated
interest charges up to be beginning of the period,
the interest is said to be compound

Example: For $1,000 at 10%…
(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed Interest Amount
at beginning of amount for owed at end
Period period period 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.
SUM OF INTEREST = [PRINCIPAL (P)+ ACCUMULATED INTEREST ] X INTEREST RATE (i%)
End of Year Amount of Loan Compound Interest Sum Owe

5% per year
0 RM1,000.00 RM1,000.00
1 RM50.00 RM1,050.00
2 RM52.50 RM1,102.50
3 RM55.13 RM1,157.63

Economic equivalence
• Each alternative can be reduced to an

equivalent basis dependent on
– interest rate,
– amount of money involved, and
– timing of monetary receipts or expenses.
• Using these elements we can “move” cash
flows so that we can compare them at
particular points in time.
Example : Equivalence
Table 1.1 Alternative Plans for Repayment of $5000 in Five Years with Interest at 8%
YEAR PLAN 1 PLAN 2

1 $1,400 $400
2 $1,320 $400
3 $1,240 $400
4 $1,160 $400
5 $1,080 $5,400
$6,200 $7,000

Time Value of Money
Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8%
AMOUNT OWED AT INTEREST OWED TOTAL OWED TOTAL END-OF

YEAR THE BEGINNING OF FOR AT PRINCIPAL YEAR
YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
Plan AT THE END OF EACH YEAR PAY $ 1000 PRINCIPAL +
1 INTEREST DUE
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
Plan PAY INTEREST DUE AT END OF EACH YEAR AND PRINCIPAL AT END OF
2 FIVE YEARS
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
Engineering
copyright @ mia Economy, Fifteenth Edition
Chapter 1 - Equivalence and Time Value of 14 07458
Upper Saddle River, New Jersey
Money All rights reserved.
Time Value of Money
Table 1.1 Four Plans for Repayment of $5000 in Five Years with Interest at 8% (cont.)
AMOUNT OWED AT INTEREST OWED TOTAL OWED TOTAL END-OF
YEAR THE BEGINNING OF FOR AT PRINCIPAL YEAR
YEAR THAT YEAR END OF YEAR PAYMENT PAYMENT
(a) (b) (c) = 8% x (b) (d) = (b) + (c) (e) (f)
Plan PAY IN FIVE EQUAL END-OF-YEAR
3 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
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
Engineering
We need some tools to find economic
equivalence.
• Notation used in formulas for compound interest
calculations.
– i = effective interest rate per interest period
– N = number of compounding (interest) periods
– 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 = end-of-period cash flows in a uniform series
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.

Cash flow tables are essential to
modeling engineering economy
problems in a spreadsheet

We can apply compound interest
formulas to “move” cash flows along the
cash flow diagram.
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.
In a similar way we can find P given F by

It is common to use standard notation for
interest factors.
This is also known as the single payment

compound amount factor. The term on the
right is read “F given P at i% interest per
period for N interest periods.”
is called the single payment present worth

factor.
We can use these to find economically
equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six
years if the interest rate is 8% per year?
$3,000 at the end of year seven is equivalent to how

much today (time zero) if the interest rate is 6% per
year?

Single Payment Formulas
 E X A M P L E 1. 1  Based on Formulas
If you had RM 2,000 now and invested F = P (1+i)n

it at 10%, how much would it be worth = 2,000 (1+0.1)8
in 8 years?
= RM 4,287.18
 Based on Compound Interest Table

 Cash Flow Diagram
F=? F = P (F/P, i, n)
= 2,000 (F/P, 10%, 8)
+ i = 10% = 2,000 (2.1436)
= RM 4,287.20
- 0 1 2 3 4 5 6 7 8
P= 2,000
Engineering
Pause and solve
Betty will need $12,000 in five years to pay for a major
overhaul on her tractor engine. She has found an
investment that will provide a 5% return on her
invested funds. How much does Betty need to invest
today so she will have her overhaul funds in five
years?

There are interest factors for a series of
end-of-period cash flows.
How much will you have in 40 years if you

save $3,000 each year and your account
earns 8% interest each year?

Finding the present amount from a series
of end-of-period cash flows.
How much would is needed today to provide

an annual amount of $50,000 each year for
20 years, at 9% interest each year?

Finding A when given F.
How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?

Finding A when given P.
If you had $500,000 today in an account

earning 10% each year, how much could you
withdraw each year for 25 years?

Pause and solve
Paul Steamer purchased a new pump for $75,000.
They borrowed the money for the pump from their
bank at an interest rate of 6% per year and will make a
total of 24 month. How much will Paul’s monthly
payments be?

It can be challenging to solve for N or i.
• We may know P, A, and i and want to find

N.
• We may know P, A, and N and want to find
i.
• These problems present special challenges
that are best handled on a spreadsheet.

Finding N
Alvin borrowed $100,000 from a local bank, which
charges them an interest rate of 7% per year. If Alvin
pays the bank $8,000 per year, now many years will it
take to pay off the loan?
So,
This can be solved by using the interest tables and

interpolation, but we generally resort to a computer
solution.
Finding i
Jill invested $1,000 each year for five years in a local
company and sold her interest after five years for
$8,000. What annual rate of return did Jill earn?
So,
Again, this can be solved using the interest tables

and interpolation, but we generally resort to a
computer solution.
Uniform Series Formulas
CAPITAL RECOVERY FACTOR SERIES COMPOUND AMOUNT FACTOR
Find A Given P Find F Given A
 i1  i   1  i 1
n n
AP  F A  
 1  i 1
n
 i 
A  P (A/P,i, n) F  A (F/A,i,n)
SERIES PRESENT WORTH FACTOR SINKING FUND FACTOR

Find P Given A Find A Given F
 i 
 1 i n  1 A F  
P A   1  i 1
n
n 
 i 1  i  
P  A (P/A, i, n) A  F (A/F,i,n)

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 Period Cash Flows
1 0
2 G
3 2G
: :
N (N-1)G
5G
4G
3G
2G
G
0 1 2 3 4 5
P
A
Notes
P : a present sum of money
F : a future sum of money
A : an end-of-period cash receipt or disbursement in a uniform series
G : uniform period-by-period increase or decrease in cash receipts
(arithmetic gradient)
g : uniform rate of cash flow increase or decrease from period to
period (geometric gradient)
i : interest rate per interest period (decimal)
n : number of interest periods

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.

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

The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an
2 3,000
annuity portion of the cash
flows and a gradient 3 4,000
portion. 4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

 E X A M P L E 1. 8
A textile mill has just purchased a lift truck that has a useful life of 5 years. The
engineer estimates that the maintenance costs for the truck during the first year will
be RM1,000. Maintenance cost are expected to increase as the truck ages at a rate of
RM250 per year over the remaining life. Assume the maintenance account earns 12%
annual interest. All future maintenance expenses will be paid out of this account. How
much does the firm have to deposit in the account now?
 Cash Flow Diagram

Sometimes cash flows change by
a constant rate, ,each period--this
is a geometric gradient series.
This table presents a End of Year Cash Flows ($)

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

We can find the present value of a
geometric series by using the appropriate
formula below.
Where is the initial cash flow in the series.

 E X A M P L E 1. 10
A self-employed individual, Jimi Asmara, is opening a retirement account

at a bank. His goal is to accumulate RM1,000,000 in the account by the
time he retires from work in 20 years time. A local bank is willing to open
a retirement account that pays 8% interest, compounded annually,
throughout the 20 years. Jimi expects his annual income will increase at
a 6% annual rate during his working career. He wishes to start with
deposit at the end of year 1 (A1) and increase deposit at a rate of 6%
rate each year thereafter. What should be the size of his first deposit
(A1)? The first deposit will occur at the end of year 1, and subsequent
deposit will be made at the end of each year. The last deposit will be
made at the end of year 20.

 Types of Compound Interest
 Nominal Interest Rate
 Effective Interest Rate
 Nominal and Effective Interest Rate is stated for a time period

of less than 1 year.
.
 A nominal rate of 12%, compounded monthly, means an interest
of 1% (12%/12) for each month, and the annual rate would be
effectively somewhat greater than 12%.

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.

Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the
effective interest is.
For a 7% nominal rate, compounded monthly, the

effective interest is.

EXAMPLE 1:
4.10 A lump sum loan of $5000 is needed by Chandra to

pay for college expenses. She has obtained small consumer
loans with 12% interest per year in the past to help pay for
college. But her father has advised Chandra to apply for a
PLUS student loan charging only 8.5% interest per year. If
the loan will be repaid in full in 5 years, what is the
difference in total interest accumulated by these two types of
student loans?

EXAMPLE 2:
Mr. Smith has saved $1200 each year for 20 years. A year
after the saving period ended, Mr. Smith withdraw $7500
each year for a period of 5 years. In the sixth and seventh
years, he only withdraw $4500 per year. In the eighth year, he
decided to withdraw the remaining money in his account. If
the interest rate was 8% per year throughout the whole
period, what was the amount the withdraw at the end of the
eighth year?


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Engineering Economy

Chapter 4: The Time Value of Money

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

Copyright ©2012 by Pearson Education, Inc.

When the total interest earned or charged is linearly

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End of Year Amount of Loan Simple Interest SUM OWE

Copyright ©2012 by Pearson Education, Inc.

P = principal amount lent or borrowed

So, the total amount repaid at the end

Whenever the interest charge for any interest

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

2 $1,100 $110 $1,210

Compound interest is commonly used in personal and

End of Year Amount of Loan Compound Interest Sum Owe

Copyright ©2012 by Pearson Education, Inc.

• Each alternative can be reduced to an

YEAR PLAN 1 PLAN 2

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AMOUNT OWED AT INTEREST OWED TOTAL OWED TOTAL END-OF

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Copyright ©2012 by Pearson Education, Inc.

In a similar way we can find P given F by

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This is also known as the single payment

is called the single payment present worth

$3,000 at the end of year seven is equivalent to how

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If you had RM 2,000 now and invested F = P (1+i)n

 Based on Compound Interest Table

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How much will you have in 40 years if you

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How much would is needed today to provide

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How much would you need to set aside each

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If you had $500,000 today in an account

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Copyright ©2012 by Pearson Education, Inc.

• We may know P, A, and i and want to find

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This can be solved by using the interest tables and

Again, this can be solved using the interest tables

SERIES PRESENT WORTH FACTOR SINKING FUND FACTOR

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 Cash Flow Diagram

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

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Where is the initial cash flow in the series.

A self-employed individual, Jimi Asmara, is opening a retirement account

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 Nominal and Effective Interest Rate is stated for a time period

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