ENGINEERING ECONOMICS

(BPK 30905)

CHAPTER 4:

TIME VALUE OF MONEY

DR. NOR HAZREN ABDUL HAMID

FAKULTI TEKNOLO G I KEJURUT ER A A N
CONTENTS:

• Introduction
• Simple interest
• Compound interest
• The concept Equivalence
• Cash flow-diagram table
• Applications of Future and Present values
INTRODUCTION
• Capital refers to wealth in the form of money or property
that can be used to produce more wealth.

• Engineering economy studies involve the commitment

of capital for extended periods of time.

• A dollar today is worth more than a dollar one or more

years from now.

Money has a time value. If money remains

uninvested, value is lost
 INTRODUCTION (CONT.)
Interest: The Cost Of Money
• Interest is the difference between an ending amount of money and
the beginning amount

Interest = amount owed now – original amount

Example: ending amount owed is RM110,000 & Beginning amount owed is

RM100,000, therefore; Interest = RM10,000 (RM110,000 – RM100,000)

When money is borrowed the interest When money is lent or invested,

paid is the charge to the borrower for the interest earned is the lender’s
the use of the lender’s property gain from providing a good to
another use

interest paid interest earned

 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.

• Is not used frequently in modern commercial practice.

 SIMPLE INTEREST (CONT.)

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.

 SIMPLE INTEREST (CONT.)

Example 1:
You borrow RM10,000 for 3 years at 5% simple annual interest. Calculate the interest earned by
the bank.
▪ Interest = (P )(N)(i)
= (10,000)(0 .05)(3)
= RM1,500

Example 2
You borrow RM10,000 for 60 days at 5% simple interest per year (assume a 365 day year). What is
the total amount borrowed by end of 60 days?
 COMPOUND INTEREST

• Compound interest means interest on top of interest.

• Compound interest is calculated each period on the original principal and

all interest accumulated during past periods

• Compound interest is commonly used in personal and professional financial

transactions.
COMPOUND INTEREST (CONT.)
Compound interest reflects both the remaining principal and any
accumulated interest. For RM1,000 at 10%…

(1) (2) (3)

Period Amount owed at Interest amount for Amount owed at
beginning of period period end of period
[(1)x10%] [(1)+(2)]
1 RM1,000 RM100 RM1,100

2 RM1,100 RM110 RM1,210

3 RM1,210 RM121 RM1,331

COMPOUND INTEREST (CONT.)

Another shorter way to calculate the total amount due is by using

this formula:

Total due after

a number of = Principal (1 + interest rate) number of years
years
COMPOUND INTEREST (CONT.)

Therefore,
• Compound interest reflects both the remaining principal and any
accumulated interest. For RM1,000 at 10%…

For year 1 : RM1,000 (1 + 0.1)1 = RM1,100

For year 2 : RM1,000 (1 + 0.1)2 = RM1,210

For year 3 : RM1,000 (1 + 0.1)3 = RM1,331

COMPOUND INTEREST (CONT.)
Example:
If RM100 is placed in an account that earns 8% compounded
quarterly, what will its worth in 8 years?

(1) (2) (3)

Period Amount owed at Interest amount for Amount owed at end
beginning of period period of period
[(1)x8%] [(1)+(2)]
1 100 8.00 108
2 108 8.64 116.64
3 116.64 9.33 125.97
4 125.97 10.08 136.05
5 136.05 10.89 146.94
6 146.94 11.75 158.69
7 158.69 12.70 171.39
8 171.39 13.71 185.11
COMPOUND INTEREST (CONT.)

Example:

OR

100 (1 + 0.08) 8
= RM 185.09
 NOMINAL AND EFFECTIVE INTEREST RATES

• The concepts of nominal and effective are used when interest is

compounded more than once each year.

• Nominal rates:
1. Often states as the annual interest rate for credit cards, loans, and
house mortgages.
2. Also known as Annual Percentage Rate (APR).
3. E.g. an APR of 15% is the same as nominal 15% per year or a nominal
1.25% per month.
 NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)
• Effective rates:
1. Commonly stated as annual rate of return for investments, certificates of deposit, and
savings account.
2. Also known as Annual Percentage Yield (APY).
3. It is used to compare the annual interest between loans with different compounding
terms (daily, monthly, annually, or other).

• The nominal rates will never exceeds the effective rate, and similarly APR < APY
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)

Examples of interest statements and interpretations

(1) (2) (3)

Interest Nominal or Compounding
Rate statement Ef fective interest period

15% per year compounded monthly Nominal Monthly

15% per year Effective Yearly

Effective 15% per year compounded monthly Effective Monthly

20% per year compounded quarterly Nominal Quarterly

Nominal 1% per month compounded weekly Nominal Weekly

2% per month Effective Monthly

Effective 6% per quarter Effective Quarterly

1% per week compounded continuously Nominal Continuously

 NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)

We can find the effective interest, i by using the formula below:

r = nominal interest rate

M = number of compounding periods per year
(a.k.a. compounding frequency)
 NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)

Example:

A. A visa credit card carries an interest rate of 1% per month on

the unpaid balance. Calculate the effective rate per
semiannual and annual periods.
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)
Solution:
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)

Example:

B. If the card’s interest rate is stated at 3.5% per quarter,

find the effective semiannual and annual rates.
NOMINAL AND EFFECTIVE INTEREST RATES
(CONT.)
Solution:
 THE CONCEPT OF EQUIVALENCE

Economic equivalence allows us to compare alternatives on a common basis

Each alternative can be reduced to an equivalent basis dependent on:

• Interest rate
• Amounts of money involved
• Timing of the monetary receipts or expenses

Using these elements we can “move” cash flows so that we can compare
them at particular points in time.
THE CONCEPT OF EQUIVALENCE (CONT.)
Different sums of money at different times may be equal in economic
value

Interest rate = 10% per year

-1 0 1

RM110 one
year from now
RM90 last year
RM100 now

Interpretation: RM90 last year, RM100 now, and RM110 one year from
now are equivalent only at an interest rate of 10% per year
 THE CONCEPT OF EQUIVALENCE (CONT.)

Example:
Company X makes auto batteries available to General Motors dealers. In general
the batteries are stored throughout the year, and a 5% cost increase is added
each year to cover the inventory carrying charge for the distributorship owner.
Make calculations to show which of the following statements are true and
which are false about battery costs.

1. The amount RM98 now is equivalent to a cost of RM105.60 one year from now.
2. A truck battery cost of RM200 one year ago is equivalent to RM205 now.
3. A RM38 cost now is equivalent to RM39.90 one year from now.
4. A RM3,000 cost now is equivalent to RM2,887.14 one year ago.
5. The carrying charge accumulated one year on an investment of RM2,000
worth of batteries is RM100.
 THE CONCEPT OF EQUIVALENCE (CONT.)

Solution:
1. The amount RM98 now is equivalent to a cost of RM105.60 one year
from now.

2. A truck battery cost of RM200 one year ago is equivalent to RM205

now.
 THE CONCEPT OF EQUIVALENCE (CONT.)
Solution:
3. A RM38 cost now is equivalent to RM39.90 one year from now.

4. A RM3,000 cost now is equivalent to RM2,887.14 one year ago.

5. The carrying charge accumulated one year on an investment of RM2,000

worth of batteries is RM100.
 CASH FLOW
 Cash flows are inflows and outflows of money.

➢ Cash inflows - receipt, revenue, income, saving

• Samples of cash inflow estimates:
1. Revenues (from sales and contracts)
2. Operating cost reductions (resulting from an alternative)
3. Salvage value
4. Construction and facility cost savings
5. Receipt of loan principal
6. Income tax savings
7. Receipts from stock and bond sales
CASH FLOW (CONT.)

➢ Cash outflows - cost, expense, disbursement, loss

Samples of cash outflow estimates:
1. First cost of assets
2. Engineering design costs
3. Operating costs (annual and incremental)
4. Periodic maintenance and rebuild costs
5. Loan interest and principal payments
6. Major expected/unexpected upgrade costs
7. Income taxes
CASH FLOW (CONT.)
Once the cash inflow and outflow estimates are developed, the
net cash flow can be determined.

Net cash flow = receipts - disbursements

= cash inflows - cash outflows

End-of-period convention: all cash flows

and NCF occur at the end of an interest
period
CONSTRUCTING A CASH FLOW DIAGRAM
 CONSTRUCTING A CASH FLOW DIAGRAM
• Cash flow diagram: a graphical representation of cash flows drawn
on a time scale.

• The diagram includes what is known, what is estimated and what

is needed.

• Once the cash flow diagram is complete, another person should be

able to work the problem by looking at the diagram.

• The time line is a horizontal line divided into equal periods such
as days, months, or years.
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)
• Each cash flow, such as a payment or receipt, is plotted along this
line at the beginning or end of the period in which it occurs.

• Funds that you pay out such as savings deposits or lease payments
are negative cash flows that are represented by arrows which extend
downward from the time line with their bases at the appropriate
positions along the line.

• Funds that you receive such as proceeds from a mortgage or

withdrawals from a saving account are positive cash flows
represented by arrows extending upward from the line.
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)

+ Cash flow

- Cash flow
CONSTRUCTING A CASH FLOW DIAGRAM
: LENDER VIEWPOINT
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)

 Example:

Construct a cash flow diagram for the following cash flows: RM10,000
outflow at time zero, RM3,000 per year inflow in years 1 through 5 at an
interest rate of 10% per year, and an unknown future amount in year 5.
CONSTRUCTING A CASH FLOW DIAGRAM
(CONT.)
CONSTRUCTING A CASH FLOW DIAGRAM Example 4-1

 The XYZ Corporation insists that its engineers develop a cash-flow diagram
of the proposal.
 An investment of $10,000 can be made that will produce uniform annual
revenue of $5,310 for five years and then have a market (recovery) value of
$2,000 at the end of year (EOY) five.
 Annual expenses will be $3,000 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.
CONSTRUCTING A CASH FLOW DIAGRAM Example 4-1 (Solution)
 CONSTRUCTING A CASH FLOW TABLE Example 4-2

 Two feasible alternatives for upgrading the heating, ventilation, and air
conditioning (HVAC) system have been identified. Either Alternative A or
Alternative B must be implemented.
 At the end of eight years, the estimated market value for Alternative A is $2,000
and for Alternative B it is $8,000.
 Assume that both alternatives will provide comparable service (comfort) over an
eight-year period, and assume that the major component replaced in Alternative
B will have no market value at EOY eight.
 (1) Use a cash-flow table and end-of-year convention to tabulate the net cash
flows for both alternatives.
 (2) Determine the annual net cash-flow difference between the alternatives (B −
A).
CONSTRUCTING A CASH FLOW TABLE Example 4-2

 The costs are as follows:

 Alternative A Rebuild (overhaul) the existing HVAC system

• Equipment, labor, and materials to rebuild . . . . . . . . . . . $18,000

• Annual cost of electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
• Annual maintenance expenses . . . . . . . . . . . . . . . . . . . . . . . 2,400

 Alternative B Install a new HVAC system that utilizes existing

ductwork
• Equipment, labor, and materials to install . . . . . . . . . . . . $60,000
• Annual cost of electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
• Annual maintenance expenses . . . . . . . . . . . . . . . . . . . . . . . 16,000
• Replacement of a major component four years hence . . 9,400
CONSTRUCTING A CASH FLOW TABLE Example 4-2 (Solution)
TERMINOLOGY AND SYMBOLS
➢ i = effective interest rate per interest period; % per year

➢ N = number of compounding (interest) periods; years, months

➢ P = present sum of money; equivalent value of one or more cash flows at a

reference point in time; the present; $ (a.k.a. present worth)

➢ F = future sum of money; equivalent value of one or more cash flows at a

reference point in time; the future; $ (a.k.a. future worth)

➢ 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;
currency per period, $ per year (a.k.a. annual worth)
SINGLE-PAYMENT FACTORS
SINGLE-PAYMENT FACTORS (CONT.)

Functional
symbol

1. The quantity (1 + i)-N is called the single payment present

worth factor.
2. The term on is read “P given F at i% interest per period for N interest
periods.”
SINGLE-PAYMENT FACTORS (CONT.)

Description: Formula:

Finding the interest rate, i given P, F

and N

Finding N given P,F, and i

SINGLE-PAYMENT FACTORS (CONT.)
Example 1:
 If RM100 is placed in an account that earns 8% interest per year, what will its worth in 8
years?

▪ P = RM100, i = 8%, N = 8, F = ?
F = P (1 + i)N
= 100 (1 + 0.08)8
= 100 (1.08)8
= 100 (1.8509)
= RM185.09

▪ F = P (F/P, i%, N)
= 100 (F/P, 8%, 8)
= 100 (1.8509)
= RM185.09
SINGLE-PAYMENT FACTORS (CONT.)
Example 2:

 What is the present worth of RM30,000 in year 8 at an interest rate of 10%

per year?

▪ F = RM30,000, N = 8, i = 10%, P = ?
P = F (1 + i)-N
= 30,000 (1 + 0.10)-8
= 30,000 (1.10)-8
= 30,000 (0.4665)
= RM13,995

▪ P = F (P/F, i%, N)
= 30,000 (P/F, 8%, 10)
= 30, 000 (0.4665)
= RM13,995
SINGLE-PAYMENT FACTORS (CONT.)
Example 3:

 If an engineer invested RM15,000 on 1.1.1991 into a retirement account that

earned 6% per year interest, how much money will be in the account on
1.1.2016?
Example 4:

 The average price of gasoline in 2005 was RM2.31 per

gallon. In 1993, the average price was RM1.07. what was
the average annual rate of increase in the price of gasoline
over this 12-year period?
Example 4 (cont.):

 The average price of gasoline in 2005 was RM2.31 per gallon. 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 RM5.00
per gallon?