Kathmandu University

Engineering Economy MGTS 301

Chapter-4
Time value of money
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Today’s class

The objective of Chapter 4 is to explain time value of

money calculations and to illustrate economic
equivalence.

2
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The Time Value of Money

The Time value of money is the concept that money

available at the present time is worth more than the
identical sum in the future due to its potential
earning capacity.
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Why does the value of money decline?

The value of money decline due to the combined impact of the
following:

1. Inflation of the economy

2. Risk involved in the delayed receipt of cash /financial transaction
3. Opportunity cost of capital delayed
4. Consumption
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Techniques of to find Time Value of Money

1.Compounding (Future Value)

2.Discounting (Present Value)
Valuation Concepts

1.Simple Interest
2.Compound Interest
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Compound interest reflects both the remaining principal

and any accumulated interest. For $1,000 at 10%…
(1)
Amount owed at (2)=(1)x10% (3)=(1)+(2)
beginning of Interest amount Amount owed at
Period period for period end of period
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331
4 $1331 $133.1 $1464.1
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Economic equivalence allows us to compare

alternatives on a common basis.
• 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.
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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
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A cash flow diagram/Time Line is an

indispensable tool for clarifying and
visualizing a series of cash flows.
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A cash flow diagramming/Time Line

The ABC Corporation insists that its engineers develop a cash flow
diagram of the proposal. An investment of $20,000 can be made
that will produce uniform annual revenue of $6,320 for five years
and then have a market (recovery) value of $3200 at the end of
year (EOY) five. Annual expenses will be $3050 at the end of each
year for operating and maintaining the project. Draw a cash flow
diagram for the five year life of the project. Use the corporation’s
viewpoint.
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Basic Patterns of Cash Flows

1. Single Amount
2. Annuity
- Ordinary Annuity (at the end of year)
- Annuity Due (at the beginning of year)
3. Mixed Stream (Unequal Periodic of Cash
Flow)
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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

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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.

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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?
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1. Pause and solve

An Investor (owner) has an option to purchase a tract of
land that will be worth $10,000 in six years. If the value of
the land increases at 8% each year, how much should
the investor be willing to pay now for this property?
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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?
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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?
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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?
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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?
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2. Pause and solve

Acme Steamer purchased a new pump for $75,000. They

borrowed the money for the pump from their bank at an interest
rate of 0.5% per month and will make a total of 24 equal, monthly
payments. How much will Acme’s monthly payments be?
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3. Pause and solve

If you are 20 years of age and save $1each day for the rest of your life,
you can become a millionaire. Let’s assume that you live to age 80 and
that the annual interest rate is 10%. Under these specific conditions,
compute the future compound amount.
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4. Pause and solve

If a certain machine undergoes a major overhaul now, its output
can be increased by 20% - which translate into additional cash
flow of $20,000 at the end of each year for five years. If I = 15%
per year, how much can we afford to invest to overhaul this
machine? Make a C/F diagram.
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5. Pause and solve

You borrow $15,000 from your credit union to purchase a used car.
The interest rate on your loan is 0.25% per month and you will make
a total of 36 monthly payments. What is your monthly payment?
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Deferred Annuities
A Deferred Annuity is a type of annuity contract that delays
income, installment or lump-sum payments until the investor
elects to receive them.
A Deferred annuity is an insurance contract designed for
long-term savings. Unlike an immediate annuity, which starts
annual or monthly payments almost immediately, investors
can delay payments from a deferred annuity indefinitely.
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6. Pause and solve

Assume that a $20,00,000 plant expansion is to be financed as
follows: The firm makes a 15% down payment and borrows the
remainder at 9% interest rate. The loan is to be repaid in 8 equal
annual installments beginning 4 years from now. What is the size
of the required annual loan payments. $397,750
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7. Pause and solve

Assume that a 10 years saving annuity of $2000 per year is
beginning at year zero. The retirement annuity is to be begin 15
years from now. The first payment is to be received in year 15 and
has to provide a 20 year annuity. If this plan is arranged through a
saving bank that pays interest @7% per year on the deposited
funds, what is the size of the yearly retirement annuity that will
result?
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8. Pause and solve

1. Your company wants to have $100,000 saved up in 5 years. How
much must you invest today, earning 7% annually, in order to have the
necessarily amount saved?

2. Your client wants to retire in 30 years with $ 2 million. If you can earn
8% annually, how much should your client invest every quarter?
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9. Pause and solve

Mr. Zone borrows $1,00,000 @8% compounded
annually. Equal annual payments are to be made for 6
years. However at the time of the 4th payment, the
individual elects to pay off the loan. How much should
be paid?
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10. Pause and solve

Suppose that a father, on the day of his son is born, wishes to

determine what lump amount would have to be paid into an
account bearing interest of 12% per year to provide withdrawals
of $2000 on each of the son’s 18th, 19th, 20th, and 21st birthdays.
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11. Pause and solve

When you take your first job, you decide to start saving right away for
your retirement. You put $5000 per year in the company’s 401 (k) plan
which average interest 8% per year. Five year later, you moved to
another job and start a new 401 (k) plan. You never get around to
merging the funds in the two plans. If the first plan continued to earn
interest @8% per year for 35 years after you stopped making
contribution. How much is the account worth?
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10. Pause and solve

A 40-year-old person wants to accumulate $500,000 by age 65. How much
will she need to save each month, starting one month from now, if the
interest rate is 0.5% per month?
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11. Pause and solve

The price of oil in 2005 was $67 per barrel. “This price is still lower than the
price of oil in 1981” says a government publication. If inflation has averaged
3.2% per year from 1981 to 2005, what was the price per barrel of oil in
1981?
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Finding N when Given P, F & i

The average price of gasoline was given as $2.31 in 2005. We computed the
average annual rate of increase in the price of gasoline to be 6.62%. If we
assume that the price of gasoline will continue to inflate at this rate, how
long will it be before we are paying $5.00 per gallon.
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12. Pause and solve

10 years from now Mr. X will start receiving a
pension of $ 3000 a year for 16 years. How much
the pension worth now if interest rate is 10%.
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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
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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.
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We can also find A or F equivalent to a uniform gradient

series.
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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
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Pause and solve

A person is planning for his retirement. He has 10 more years of
service. He would like to deposit 20% of his salary, which is $
4,000, at the end of the first year, and thereafter he wishes to
deposit the amount with an annual increase of $ 500 for the next
9 years with an interest rate of 15%. Find the total amount at the
end of the 10th year of the above series.
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Pause and solve

A person is planning for his retirement. He has 10 more years of
service. He would like to deposit $ 8,500, at the end of the first
year, and thereafter he wishes to deposit the amount with an
annual decrease of $ 500 for the next 9 years with an interest rate
of 15%. Find the total amount at the end of the 10th year of the
above series.
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Pause and solve

John and Jack have just opened two saving accounts. The
accounts earn 10% annual interest. John wants to deposit $1,000
in his account at the end of the first year and increase this amount
by $300 for each of the following 5 years. Jack wants to deposit
an equal amount each year for next 6 years. What should be the
size of the Jack’s annual deposit so that the two accounts would
have equal balance at the end of 6 years?
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Pause and solve

An engineer has inspected the average cost on a cement
production for 8 years. Cost averages were steady at $10,000 per
completed unit for the first 4 years, but have increased
consistently by $5,000 per unit for each of the last 4 years. He
plans to analyze the gradient increase using the P/G factor. Where
is the present worth located for the gradient? What is the gradient
relation used to calculate total present worth in year zero?
Assume i=10% compounded annually.
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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
begins at the end of year 1 1 1,000
and has a rate of growth, , 2 1,200
of 20%. 3 1,440
4 1,728
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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.

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Present Equivalent of an Increasing Arithmetic Gradient Series

As further example of the use of arithmetic gradient formulas, suppose that
we have cash flows as follows:

End of Year Cash Flows ($)

1 5,000
2 6,000
3 7,000
4 8,000
Also, assume that we wish to calculate their present equivalent at i = 15%
per year, using gradient conversion factors.
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Present Equivalent of a Decreasing Arithmetic Gradient Series

As further example of the use of arithmetic gradient formulas, suppose that
we have cash flows as follows:

End of Year Cash Flows ($)

1 8,000
2 7,000
3 6,000
4 5,000
Also, assume that we wish to calculate their present equivalent at i = 15%
per year, using gradient conversion factors.
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To find future value CVF

To find present value PVF

To find future value if given

annuity CVAF

To find present value if

given annuity PVAF

To find annuity if given present

value (Capital Recovery)
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5. Pause and solve

In the future, you decide to open a retirement plan for
your child on his first birthday. You will invest $ 5000
expecting an 8% return, compounded quarterly. How much
will your child’s account have in 50 years.