TVM Solution 03

SEEM2440
Engineering Economic
Lecture 03 The Time Value of Money
Present Value, Future Value and Annuity

Suppose you lend $100,000 to your friend, and he promises to
repay the loan and interest after 9 years at 10% interest rate,
how much you can receive after 9 years?
$F
What is this amount?
Time 0 is the base year
0
1
$100,000
You lend $100,000 to your friend.

Copyright (c) 2015. Gabriel Fung. All rights reserved.
This is a cash flow diagram
Present Value, Future Value and Annuity (contd)

repay the loan and interest to you at 10% interest rate in 9

years so that each year he will pay you $A dollars. How much
you would expect to receive in every year?
$A
$A $A
0
1
$100,000
You lend $100,000 to your friend.

Present Value, Future Value and Annuity (contd)

Future Value
Annuity
$F
$A
$A $A
0
1
$P
Present Value
0
9
$P
Interest Rate
Solving the previous problems require an understanding and
precious definition of interest rate

Simple interest rate
Compound interest rate
Nominal interest rate
Effective interest rate
Simple Interest
The total interest earned is linearly proportional to the
principal (i.e., loan).

The interest do not accumulate
I = (P)(N)(i)
P = Principle
N = number of periods (e.g., year)
i = interest rate per interest period
Question:
How much interest we need to pay if we borrow $1000 for 3
years with an annual simple interest rate of 10%?

Compound Interest
The interest earned for any period is based on the remaining
principal amount plus any accumulated interest charges up to

the beginning of that period.
N
I = (Pi) (1+ i )
n1
=P[(1+ i)N 1]
n=1
Question:
What is the interest we need to pay if we have borrowed $1000
for 3 years with an annual interest rate of 10%?

Year 1
Year 2
Year 3
Borrowed
$1,000
$1,100
$1,210
Interest
$100
$110
$121
Compound Interest (contd)

Question:
Suppose interest is accumulated every six months (twice a year),
what is the interest we need to pay if we have borrowed $1000
for 3 years with a 5% interest rate for every six months?
Year 0.5
Year 1
Year 1.5
Year 2
Year 2.5
Year 3
Borrowed
$1,000
$1,050
$1152.5
$1207.6
Interest
$50
$52.5
$55.1
$60.4
Note that the interest we have to pay is more than 10% a year!
Nominal and Effective Interest Rate

Nominal Interest Rate
For the shake of convenient, even if the interest period is not
equal to 1 year, we usually still quote the interest rates on an
annual basis but followed by the compounding period.
Example:
If the interest period is 6 months and the interest rate during this
period is 6%, then we will say: The interest rate is 12%

compounded semiannually.
12% is called Nominal Interest Rate and is usually denoted by r.
Nominal and Effective Interest Rate (contd)

Effective Interest Rate
Effective interest rate is the truth interest rate for 1 year. It
MUST BE expressed in a yearly basic.
Example:
If the interest rate is 12% compounded semiannually, then the
real interest is 12.36%.

The 12.36% is known as Effective Interest Rate, and is usually
denoted by i.
The relationship between i and r is (assume M compounding
period in a year):
M
r
i = 1+ 1
M

The differences of some interest rates:
7% nominal rate = 7.23% effective rate
18% nominal rate = 19.25 effective rate

A credit card company claim that they charge their customers
only 1.375%/month for any unpaid balance. What is the

actual rate (effective rate) they charge?
Answer:
17.81% per year!

In the rest of the slides, unless otherwise specified, all interest
rates are Effective Interest Rates.
The Concept of Equivalence

A bank wants to design the following three payment options
for their customers if they borrow $1M from her at 15%

interest rate.
Plan 1: Pay principal and interest in one payment at Year 10.
Plan 2: Pay the debt in equal payments for 15 years.
Plan 3: Pay interest at the end of each year for 4 years and
principal at Year 4.
What should be the payment for each plan?
Formulas
Consider Plan 1 in the previous slide:
$P
1
10
$F
We need to do identify $F given $P ($1M), N (10 years) and i
(15%). Hence:
$F = $P f (F | P, i%, N) where f (F | P, i%, N) is a function
that can help us to identify the necessary component for

computing $F when $P, i% and N are given.
$F = $P f (F | P, i%, N) = $P (1 + i%)N
Formulas (contd)
Consider Plan 3 in the previous slide:
$P
End of each year
15
$A
$A
$A
We need to do identify $A given $P ($1M), N (15 years) and i
(15%). Hence:
$A = $P f (A | P, i%, N) where f (A | P, i%, N) is a function
that can help us to identify the necessary component for

computing $A when $P, i% and N are given.
Formulas (contd)
Up to now, we have Present Value (P), Future Value (F) and
Annuity (A), hence we will have six equation:

1. Identify the component for computing P, given F, i%, and N
2. Identify the component for computing F, given P, i%, and N
3. Identify the component for computing A, given P, i%, and N
4. Identify the component for computing P, given A, i%, and N

Formulas (contd)
(F | P,i%,N) = (1+ i)N
(P | F,i%,N) =
1
(1+ i)N
(1+ i)N 1
i
i
(A | F,i%,N) =
(1+ i)N 1
(F | A,i%,N) =
Single payment compound amount

Single payment present worth
Unifrom series compound amount
Uniform series present worth
(1+ i)N 1
(P | A,i%,N) =
i(1+ i)N
Sinking fund
i(1+ i)N
(A | P,i%,N) =
(1+ i)N 1
Capital recovery
Formulas (contd)
The previous six equations is enough for us to solve most of
the problem:
1. Draw a cash flow diagram
2. Decompose the cash flow diagram such that it can be solved by
some of the previous equations

Note:
The interest rates for all equations are effective interest rates
A Loan Plan
repay the loan and interest after 9 years at 10% interest rate,
how much you can receive after 9 years?
Cash flow diagram:
$F
We need to find:
The future worth = F
We are given:
P = $8,000, i = 10%, N = 9 years
So we use:
F = $8,000 (F / P,i%,N)
= $8,000 (F / P,10%,9)
= $8,000(1+ i)N
$P = $8,000
= $8,000(1+ 10%)9
= $18863.58
An Investment Decision
How much money you need to put into the bank now, with
annual interest rate 7%, in order to get $1,000,000 in 45 years?
Cash flow diagram:
$F = $1,000,000
30
$P
Answer: P = $47,613
Purchasing a Land
An investor has an option to purchase a 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?
Cash flow diagram:
Answer: P = $6,302
An Investment Plan
If you deposit $1,000 in a bank every year starting from the
next year. How much would this amount be after 15 years if
the interest rate is 5% p.a.?
Cash flow diagram:
$F
1
0
14
15
Note
When using (F / A, i%, N), the last
deposit and F are coincident at the
same time. Also, A must begin from
the first year (not now).
A = $10,000
Answer: F = $21,578.60
Become A Millionaire in 30 Years

How much do you need to invest every year if you want to
yield $1,000,000 in 45 years? Assume the interest rate is 7%.
Cash flow diagram:
Answer: A = $3,500
Become a Millionaire By Saving $1 a Day

If you invest $1 each day, how many years would the money
become $1,000,000? Assume that the interest rate is 10%.
Cash flow diagram:
Answer: N = 58.93
Become a Millionaire By Saving $1 a Day (contd)

The Excel function used to solve for N is
NPER(rate, pmt, pv), which will compute the number of
payments of magnitude pmt required to pay off a present
amount (pv) at a fixed interest rate (rate).
Borrowing Money
Your friend borrow money from you and agrees to pay you
$20,000 each year with annual interest rate of 15% for 5 years.
How much money should you lend to him?
Cash flow diagram:
Answer: P = $67,044
Mortgage Plan
You want to buy an apartment at the price of $4,000,000. You
will do this with a mortgage from a Bank at (P 2%) for 30
years. What is your monthly payment?
Cash flow diagram:
Answer: A = $X (Monthly payment = $X/12)

When N is large
For (A | P, i%, N):
i(1+ i)N
(A | P,i%,N) =
(1+ i)N 1
When N is large, the annual payment will be less and less, and
eventually:
A Pi
More About the Formulas

For most of the problems, they are very complex, and we have
to combine the formulas and reformulate the cash flow
diagram to solve these problems.
Thats why cash flow diagram is very useful.
Investment Plan
A father, on the day his son is born, wishes to determine what
amount would have to be put into an account with 12%
interest rate, so that he can withdraw $2,000 during his sons
18th, 19th, 20th and 21st birthdays.
Cash flow diagram:
$F
$A = $2,000
$F
$A = $2,000
Step 1
0
1
17
Step 2
0
18
19
20
21
17
18
19
17
21
20
$P
$P
Answer: P = $884.46
A Loan Question
Smith borrowed $4,000 four years ago when the interest rate
was 4.06%/year. $5,000 was borrowed three years ago at
3.42%/year. Two years ago, she borrowed $6,000 at 5.23%/
year, and last year $7,000 was borrowed at 6.03%/year. Now
she want to consolidate her debt into a single 20-year loan
within 5% fixed annual interest rate. If Smith makes annual
payment (starting in one year later) to repay her total debt,
what is the amount of each payment?
A Loan Question (contd)

Cash flow diagram:
Mortgage Plans
Given the following plans:
Bank 1: (P 2%) for the whole duration
Bank 2: (P 0.5%) for the whole duration + 4% cash rebate
now.
Bank 3: (P 2.5%) for the fist 15 years + (P 1.5%) for the rest
of the time
Developer: (P 2%) for the whole duration for the first 70% of
the price + (P + 2%) for the rest of the purchasing price
Which plan should you choose if you need to borrow
$5,000,000 mortgage for 30 years? Assume the prime rate P is

fixed at 5%.
Mortgage Plans (Contd)

Cash flow diagrams:
Two Saving Plans

Plan 1: You have to deposit $2,000 each year when you are 32
until 65. The annual interest rate is 10%.

Plan 2: You have to deposit $1,000 each year for 15 years. The
interest rate is 10%. You can take your money out when you
are 65. You can join this plan when you are 22.
Answer: $444,500 vs. $504,010

Equivalent Cash Flow Diagram

Determine Q in terms of H, so as to make both cash flow
diagram equivalent
Uniform Gradient Series

Sometimes, we face the problems that involve receipts or
expenses that are projected to increase or decrease by a uniform

amount each period.
(N - 1)G
(N - 2)G
(N - 3)G
3G
..
.
..
.
..
.
N-2
N-1
2G
G
0
Both Time 0 and Time 1 DO NOT contain any cash flows

Uniform Gradient Series (Contd)

The formulas for the uniform gradient series:
(F | G,i%,N) = (F | A,i%,N 1) + (F | A,i%,N 2) +!+ (F | A,i%,1)
(1+ i)N1 1 (1+ i)N2 1
(1+ i)1 1
+
+!+
i
i
i
N1
1
N
= (1+ i)n
i n=0
i
=
1
N
[(1+ i)N 1]
2
i
i
(P | G,i%,N) = (F | G,i%,N)(P | F,i%,N)
=
1 1
1 1
= N +
i i
i (1+ i)N
(A | G,i%,N) = (F | G,i%,N)(A | F,i%,N)
1
N
=
N
i (1+ i) 1
A Simple Example
Suppose the expenses are: $1,000 for the second year, $2,000
for the third year and $3,000 for the forth year. What is the
present worth of the expenses if the interest rate is 15%?
Cash flow diagram:
Answer: P = $3,790 / A = $1,326.3

A Complicated Example
A project will have expenses $8,000, $7,000, $6,000 and
$5,000 in Year 1, 2, 3 and 4, respectively. The interest rate is

15%. What is the total present expense of the project?
Cash flow:
0
$5,000
$6,000
$7,000
$8,000
$P
Answer: P = -$19,050
Geometric Gradient Series

Similar to the idea of uniform gradient series, the geometric
gradient series is used to model the situation that a fixed

percentage is increased in every period.
The following table presents a geometric gradient series. It
begins at the end of year 1 and has a rate of growth 20%.

End of Year
Cash Flows ($)
1,000
1,200
1,440
1,728
Geometric Gradient Series (contd)

Find P when you are given A:
P = A1 (P | F,i%,1) + A 2 (P | F,i%,2) +!+ A N (P | F,i%,N)
= A1 (1+ i)1 + A 2 (1+ i)2 +!+ A N (1+ i) N
= A1 (1+ i)1 + A1 (1+ f )(1+ i)2 +!+ A N (1+ f )N1 (1+ i) N
N
= A1 (1+ f )n1 (1+ i) n

n=1
A1 N 1+ f
1+ i n=1 1+ i
n1
A1[1 (1+ i) N (1+ f )N ]
f i
i f
=
A1N
f =i
(1+ i)
A1[1 (P / F,i%,N)(F / P,i%,N)]
i f
=
A1N(P / F,i%,1)
f i
f =i
A Simple Example
A company predicted that the revenues this year are $1.1
million, and will increase 15% per year for the next 5 years.
What are the present value and equivalent annual amount for
the anticipated revenues if the interest rate is 20%?
Solution:
Use the geometric gradient formula to find the present value,
then convert the present amount to an annual amount.

P0 =
$1, 100, 000[1
(P/F, 20%, 5)(F/P, 20%, 5)]

= $4, 216, 974
0.20 0.15
A = $4, 216, 974(A/P, 20%, 5) = $1, 410, 071
Continuous Interest Rate

So far, we assume that the interest period is a fixed interval
E.g. 1 year, 6 months, etc.
How about if
The interest is accumulated in every minute, every second, every
mini-second,... Or continuously (The interest period is

toooooooooo short)?
Question:
If we borrowed $1,000 with a nominal interest rate of 20%
compound continuously, then what should we paid 10 years later?
Continuous Interest Rate (contd)

Let the nominal interest rate be r. Assume that there are M
periods.
For one year:
F = P(F | P,
For N years:
r
%,M)
M
r
= P 1+
M
F = Pe rN
r
= lim P 1+ ,since M is continuous
M
M
= Pe r
Formulas for Continuous Compounding

(F | P,r%,N) = e rN
1
e rN
e rN 1
(F | A,r%,N) = r
e 1
er 1
(A | F,r%,N) = rN
e 1
e rN 1
(P | A,r%,N) = rN r
e (e 1)
(P | F,r%,N) =
e rN (e r 1)
(A | P,r%,N) = rN
e 1
Single payment compound amount

Single payment present worth
Unifrom series compound amount
Uniform series present worth
Sinking fund
Capital recovery
Compounded Quarterly
If $100 is invested for 10 years at a nominal interest rate of 6%
compounded quarterly. How much is it worth at the end of

the 10th year?
Solution 1:
There are four compounding periods per year.
Total interest periods are 40 (4 x 10)
The interest rate per interest period is (6% / 4) = 1.5%

So, F = P (F | P, 1.5%, 40) =
Solution 2:
The effective interest rate is 6.14%.
So, F = (F | P, 6.14%, 10) =
Computing a Monthly Auto Payment

There is a loan of $10,000 to be repaid in equal end-of-month
installments for five years with a nominal interest rate of 12%

compounded monthly. What is the amount of payment?
Solution:
Number of installment, N =
Interest rate per month, i% =
A = P ( A | P, i%, 60) =

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SEEM2440

Present Value, Future Value and Annuity

What is this amount?

Time 0 is the base year

You lend $100,000 to your friend.

This is a cash flow diagram

Present Value, Future Value and Annuity (contd)

repay the loan and interest to you at 10% interest rate in 9

What is this amount?

You lend $100,000 to your friend.

Present Value, Future Value and Annuity (contd)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

precious definition of interest rate

Copyright (c) 2015. Gabriel Fung. All rights reserved.

principal (i.e., loan).

years with an annual simple interest rate of 10%?

principal amount plus any accumulated interest charges up to

for 3 years with an annual interest rate of 10%?

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Compound Interest (contd)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Nominal and Effective Interest Rate

period is 6%, then we will say: The interest rate is 12%

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Nominal and Effective Interest Rate (contd)

real interest is 12.36%.

Nominal and Effective Interest Rate (contd)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Nominal and Effective Interest Rate (contd)

only 1.375%/month for any unpaid balance. What is the

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Nominal and Effective Interest Rate (contd)

rates are Effective Interest Rates.

Copyright (c) 2015. Gabriel Fung. All rights reserved.

The Concept of Equivalence

for their customers if they borrow $1M from her at 15%

Copyright (c) 2015. Gabriel Fung. All rights reserved.

We need to do identify $F given $P ($1M), N (10 years) and i

that can help us to identify the necessary component for

End of each year

We need to do identify $A given $P ($1M), N (15 years) and i

that can help us to identify the necessary component for

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Annuity (A), hence we will have six equation:

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Single payment compound amount

Copyright (c) 2015. Gabriel Fung. All rights reserved.

some of the previous equations

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Become A Millionaire in 30 Years

Become a Millionaire By Saving $1 a Day

Become a Millionaire By Saving $1 a Day (contd)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Answer: A = $X (Monthly payment = $X/12)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

More About the Formulas

Copyright (c) 2015. Gabriel Fung. All rights reserved.

Copyright (c) 2015. Gabriel Fung. All rights reserved.

A Loan Question (contd)

Copyright (c) 2015. Gabriel Fung. All rights reserved.

$5,000,000 mortgage for 30 years? Assume the prime rate P is

Copyright (c) 2015. Gabriel Fung. All rights reserved.