Chapter 4

Time Is Money
Interest: The Cost of
Money
Economic Equivalence
Development of
Interest Formulas
Unconventional
Equivalence
Calculations
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Key Concepts of Last Lecture

1.
2.
3.
4.
5.
6.
7.

Interest
Principal?
Interest rate?
Interest period?- number of interest periods.
Plan for receipts or disbursements
Future amount of money
Simple vs Compound
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Time Value of Money

Money has a time value
because it can earn more
money over time (earning
power).
Time value of money is
measured in terms of
interest rate.
Interest is the cost of
moneya cost to the
borrower and an earning
to the lender
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Elements of Transactions involve

Interest
1.
2.
3.
4.
5.
6.

Initial amount of money in transactions involving debt or

investments is called the principal.
The interest rate measures the cost or price of money and is
expressed as a percentage per period of time.
A period of time, called the interest period, determines how
frequently interest is calculated.
A specified length of time marks the duration of the transactions and
thereby establishes a certain number of interest periods.
A plan for receipts or disbursements that yields a particular cash
flow pattern over a specified length of time.
A future amount of money results from the cumulative effects of
the interest rate over a number of interest periods.

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An = A discrete payment or receipt occurring at the end of some

interest period.
i
= The interest rate per interest period.

= The total number of interest periods.

= a sum of money at a time chosen for purposes of analysis as

time zero, sometimes referred to as the present value or
present worth.

= A future sum of money at the end of the analysis period. This

sum may be specified as Fn.

A
= An end of period payment or receipt in a uniform series that
continues for N periods. This is a special situation where
A1 = A2 = = AN.

V n = An equivalent sum of money at the end of a specified period n that

considers the effect of time value of money.
Note that V0 = P and VN = F.

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Example of an Interest Transaction

Repayment Plans (Table 4.1)
End of Year

Receipts

Payments
Plan 1
Plan 2
Year 0
$20,000.00
$200.00
$200.00
Year 1
5,141.85
0
Year 2
5,141.85
0
Year 3
5,141.85
0
Year 4
5,141.85
0
Year 5
5,141.85 30,772.48
P = $20,000, A = $5,141.85, F = $30,772.48
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Cash Flow Diagram

Represent time by a horizontal line marked off with the number of interest
periods specified. Cash flow diagrams give a convenient summary of all
the important elements of a problem.

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Methods of Calculating Interest

Simple interest: the practice of charging an
interest rate only to an initial sum (principal
amount).
Compound interest: the practice of charging
an interest rate to an initial sum and to any
previously accumulated interest that has not
been withdrawn.
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Simple Interest
P = Principal amount
i = Interest rate
N = Number of interest
periods
Example:

P = $1,000
i = 8%
N = 3 years
I=(iP)N

End of
Year

Beginning
Balance

Interest
earned

Ending
Balance
$1,000

$1,000

$80

$1,080

$1,080

$80

$1,160

$1,160

$80

$1,240

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Compound Interest (Example 4.1)

P = Principal amount
End of
i = Interest rate
Year
N = Number of interest 0
periods
1
Example:

P = $1,000
i = 8%
N = 3 years
F=P(1+i)^N

Beginning
Balance

Interest
earned

Ending
Balance
$1,000

$1,000

$80

$1,080

$1,080

$86.40

$1,166.40

$1,166.40

$93.31

$1,259.71

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Comparing Simple to Compound Interest

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Simple Vs Compound Interest

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Economic Equivalence
What do we mean by economic
equivalence?
Why do we need to establish an economic
equivalence?
How do we establish an economic
equivalence?

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Economic Equivalence (EE)

Economic equivalence exists
between cash flows that
have the same economic
effect and could therefore be
traded for one another.
EE refers to the fact that a
cash flow-whether a single
payment or a series of
payments-can be converted
to an equivalent cash flow at
any point in time.
Even though the amounts
and timing of the cash flows
may differ, the appropriate
interest rate makes them
equal.

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Typical Repayment Plans for a Bank

Loan of $20,000
Repayments
Plan 1

Plan 2

Plan 3

Year 1

$5,141.85

$1,800.00

Year 2

5,141.85

1,800.00

Year 3

5,141.85

1,800.00

Year 4

5,141.85

1,800.00

Year 5

5,141.85

$30,772.48

21,800.00

$25,709.25

$30,772.48

$29,000.00

$5,709.25

$10,772.48

$9,000.00

Total of
payments
Total interest
paid

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 If you deposit P dollars

today for N periods at i,
you will have F dollars
at the end of period N.
F dollars at the end of
period N is equal to a
single sum P dollars
now, if your earning
power is measured in
terms of interest rate i.

F P(1 i) N
0
N

P F (1 i )

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Equivalence Between Two Cash Flows

Step 1: Determine the
base period, say, year 5.
Step 2: Identify the
interest rate to use.
Step 3: Calculate
equivalence value.

$2,042

$3,000

i 6%, F $2,042(1 0.06) 5 $2,733

i 8%, F $2,042(1 0.08) 5 $3,000
i 10%, F $2,042(1 0.10) 5 $3,289

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Example 4.3 Equivalence

Various dollar
amounts that will
be economically
equivalent to
$3,000 in 5
years, given an
interest rate of
8%
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Example 4.4 (Prnpl:1) Equivalent Cash Flows

are Equivalent at Any Common Point In Time

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The Five Types of Cash Flows

(a) Single cash flow
(b) Equal (uniform)
payment series
(c) Linear gradient
series
(d) Geometric
gradient series
(e) Irregular
payment series
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Single Cash Flow Formula (Example 4.7)

Single payment
-compound amount
factor (growth factor)
Given:
i 10%

F P(1 i )
F P( F / P, i, N )
N

N 8 years

P $2,000

Find:

F $2,000(1 010
. )
$2,000( F / P,10%,8 )
$4,28718
.
8

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Single Cash Flow Formula (Example 4.8)

Single payment
present worth factor
(discount factor)
Given:
i 12%

P F(1 i) N
P F ( P / F , i, N )

0
N

N 5 years
F $1,000

Find:

P $1,000(1 0.12 )

$1,000( P / F,12%,5)
$567.40

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Uneven Payment Series (example 4.11)

P1 $25,000( P / F,10%,1)
P2 $3,000( P / F,10%,2)
P4 $5,000( P / F,10%,4)
P P1 P2 P4
$28,622

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Example 4.12 Calculating the Actual Worth of a Long-Term Contract

Beginning
of Season

0
1
2
3
4
5
6
7
8
9

Contract
Prorated
Salary Signing Bonus

2001 $ 21,000,000
2002
21,000,000
2003
21,000,000
2004
21,000,000
2005
25,000,000
2006
25,000,000
2007
27,000,000
2008
27,000,000
2009
27,000,000
2010
27,000,000

$ 2,000,000
2,000,000
2,000,000
2,000,000
2,000,000

Total
Annual Payment

$ 23,000,000
23,000,000
23,000,000
23,000,000
27,000,000
25,000,000
27,000,000
27,000,000
27,000,000
27,000,000

P $23 M ( P / F,6%,1) $23M ( P / F,6%,2) . . . $27 M ( P / F,6%,9)

$215.75 M

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Equal Payment Series

A

N-1

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Equal Payment Series Compound Amount Factor

F
0

3
N

(1 i ) N 1
FA
i
A( F / A, i , N )

Example 4.13:
Given: A = $3,000, N = 10 years, and i = 7%
Find: F
Solution: F = $3,000(F/A,7%,10) = $41,449.20
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Sinking Fund Factor

is an interest-bearing account into which a fixed sum is deposited each
interest period; it is commonly established for the purpose of replacing
fixed assets.

F
0

3
N

i
A F
N
(1 i ) 1
F ( A / F ,i, N )

Example 4.15:
Given: F = $5,000, N = 5 years, and i = 7%
Find: A
Solution: A = $5,000(A/F,7%,5) = $869.50
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Sinking fund
Sinking fund: 1) A fund accumulated by
periodic deposits and reserved exclusively
for a specific purpose, such as retirement of
a debt or replacement of a property. 2) A
fund created by making periodic deposits
(usually equal) at compound interest in
order to accumulate a given sum at a given
future time for some specific purpose.
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Capital Recovery Factor

P

i (1 i )
A P
N
(1 i ) 1
P( A / P, i , N )
N

Example 4.16:
Given: P = $250,000, N = 6 years, and i = 8%
Find: A
Solution: A = $250,000(A/P,8%,6) = $54,075
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Capital Recovery Factor

(Annuity Factor)
Annuity: 1) An amount of money payable to a
recipient at regular intervals for a prescribed
period of time out of a fund reserved for that
purpose. 2) A series of equal payments occurring
at equal periods of time. 3) Amount paid annually,
including reimbursement of borrowed capital and
payment of interest.
Annuity factor: The function of interest rate and
time that determines the amount of periodic
annuity that may be paid out of a given fund.
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Equal Payment Series Present Worth Factor

Present worth: The equivalent value at the present, based on time value
of money.

P
1

(1 i ) N 1
P A
i (1 i ) N
A( P / A, i , N )

Example 4.18:
Given: A = $32,639, N = 9 years, and i = 8%
Find: P
Solution: P = $32,639(P/A,8%,9) = $203,893
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Linear Gradient Series

Engineers frequently meet situations involving periodic payments that
increase or decrease by a constant amount (G) from period to period.
refer to book, Equation 4.17

i (1 i ) iN 1
PG
2
N
i (1 i )
G( P / G, i, N )
N

P
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Gradient Series as a Composite Series

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Example 4.20

$2,000

$1,000

$1,250 $1,500

$1,750

0
1

P =?

How much do you have to deposit

now in a savings account that
earns a 12% annual interest, if
you want to withdraw the annual
series as shown in the figure?
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Method 1:

$2,000
$1,000

$1,250 $1,500

$1,750

0
1

P =?

$1,000(P/F, 12%, 1) = $892.86

$1,250(P/F, 12%, 2) = $996.49
$1,500(P/F, 12%, 3) = $1,067.67
$1,750(P/F, 12%, 4) = $1,112.16
$2,000(P/F, 12%, 5) = $1,134.85
$5,204.03
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Method 2:
P1 $1,000( P / A,12%,5)
$3,604.80

P2 $250( P / G,12%,5)
$1,599.20
P $3,604.08 $1,599.20
$5,204

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Geometric Gradient Series

Many engineering economic problems, particularly those relating to
construction costs, involve cash flows that increase over time, not by a
constant amount, but rather by a constant percentage (geometric), called
compound growth.

1 (1 g ) N (1 i ) N
A1
, if i g
P
ig
NA1 / (1 i ),
if i g
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Geometric Gradient: Find P, Given A1,g,i,N

Given:
g = 7%
i = 12%
N = 5 years
A1 = $54,440

Find: P
Using equation 4.26 in the
text, we obtain
P=$222,283

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Summary
Money has a time value because it can earn more
money over time.
Economic equivalence exists between individual
cash flows and/or patterns of cash flows that have
the same value. Even though the amounts and
timing of the cash flows may differ, the
appropriate interest rate makes them equal.
The purpose of developing various interest
formulas was to facilitate the economic
equivalence computation.
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