CHAPTER 3

PRINCIPLES OF MONEYTIME RELATIONSHIPS

Objectives Of This Chapter

Describe the return to capital in the form
of interest
Illustrate how basic equivalence
calculation are made with respect to the
time value of capital in Engineering
Economy

Capital
Capital refers to wealth in the form of money or
property that can be used to produce more wealth
Types of Capital
Equity capital is that owned by individuals who
have invested their money or property in a
business project or venture in the hope of
receiving a profit.
Debt capital, often called borrowed capital, is
obtained from lenders (e.g., through the sale of
bonds) for investment.

Financing

Definition

Instrument Description

Debt
financing

Borrow
money

Bond Promise to
pay
principle &
interest;

Equity
financing

Sell partial Stock Exchange

Exchange
ownership of
sharesfor
of
money
company;
stock for
shares
of
ownership
of
stock
as
company;
proof of
partial
ownership

Time Value of Money

Time Value of Money
Money can make money if
Invested
The change in the amount of
money over a given time period is
called the time value of money
The most important concept in
engineering economy

Interest Rate
INTEREST - THE AMOUNT PAID TO USE MONEY.
RENTAL FEE PAID FOR THE USE OF SOMEONE ELSES
MONEY

INVESTMENT
INTEREST = VALUE NOW - ORIGINAL AMOUNT
LOAN
INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT

INTEREST RATE - INTEREST PER TIME UNIT

INTEREST PER TIME UNIT

INTEREST RATE
ORIGINAL AMOUNT

Determination of Interest Rate

Interest
Rate

Money Supply
MS1

ie
Money Demand
Quantity of Money

Simple and Compound Interest

Two types of interest calculations
Simple Interest
Compound Interest
Compound Interest is more common
worldwide and applies to most
analysis situations

Simple Interest
Simple Interest is calculated on the
principal amount only
Easy (simple) to calculate
Simple Interest is:
(principal)(interest rate)(time); $I = (P)(i)
(n)
Borrow $1000 for 3 years at 5% per year
Let P = the principal sum
i = the interest rate (5%/year)
Let N = number of years (3)

Total Interest over 3 Years...

Compound Interest
Compound Interest is much different
Compound means to stop and
compute
In this application, compounding
means to compute the interest owed
at the end of the period and then add
it to the unpaid balance of the loan
Interest then earns interest

Compound Interest: An Example

Investing $1000 for 3 year at 5% per year
P0 = $1000, I1 = $1,000(0.05) = $50.00
P1 = $1,000 + 50 = $1,050
New Principal sum at end of t = 1: = $1,050.00
I2 = $1,050(0.05) = $52.50
P2=1050 + 52.50 = $1102.50
I3 = $1102.50(0.05) = $55.125 = $55.13
At end of year 3 =1102.50 + 55.13 = $1157.63

Parameters and Cash Flows

Parameters
First cost (investment amounts)
Estimates of useful or project life
Estimated future cash flows (revenues and
expenses and salvage values)
Interest rate

Cash Flows
Estimate flows of money coming into the firm
revenues salvage values, etc. (magnitude and timing)
positive cash flows--cash inflows
Estimates of investment costs, operating costs, taxes
paid negative cash flows -- cash outflows

Cash Flow Diagramming

Engineering Economy has developed a
graphical technique for presenting a
problem dealing with cash flows and their
timing.
Called a CASH FLOW DIAGRAM
Similar to a free-body diagram in statics
First, some important TERMS . . . .

Terminology and Symbols

P = value or amount of money at a time
designated as the present or time 0.
F = value or amount of money at some future
time.
A = series of consecutive, equal, end-ofperiod amounts of money.
n = number of interest periods; years
i = interest rate or rate of return per time
period; percent per year, percent per month
t = time, stated in periods; years, months,
days, etc

The Cash Flow Diagram: CFD

Extremely valuable analysis tool
Graphical Representation on a time scale
Does not have to be drawn to exact
scale
But, should be neat and properly
labeled
Assume a 5-year problem

END OF PERIOD Convention

A NET CASH FLOW is
Cash Inflows Cash Outflows (for
a given time period)
We normally assume that all cash
flows occur:
At the END of a given time period
End-of-Period Assumption

EQUIVALENCE
You travel at 68 miles per hour
Equivalent to 110 kilometers per hour
Thus:
68 mph is equivalent to 110 kph
Using two measuring scales
Is 68 equal to 110?
No, not in terms of absolute numbers
But they are equivalent in terms of the
two measuring scales

ECONOMIC EQUIVALENCE
Economic Equivalence
Two sums of money at two different
points in time can be made
economically equivalent if:
We consider an interest rate and,
No. of Time periods between the
two sums
Equality in terms of Economic
Value

More on Economic Equivalence Concept

Five plans are shown that will pay off a loan
of $5,000 over 5 years with interest at 8%
per year.
Plan1. Simple Interest, pay all at the end
Plan 2. Compound Interest, pay all at the end
Plan 3. Simple interest, pay interest at end of
each year. Pay the principal at the end of N = 5
Plan 4. Compound Interest and part of the
principal each year (pay 20% of the Prin. Amt.)
Plan 5. Equal Payments of the compound interest
and principal reduction over 5 years with end of
year payments

Plan 1 @ 8% Simple Interest

Simple Interest: Pay all at end on $5,000
Loan

Plan 2 Compound Interest 8%/yr

Pay all at the End of 5 Years

Plan 3: Simple Interest Paid Annually

Principal Paid at the End (balloon Note)

Plan 4 Compound Interest

20% of Principal Paid back annually

Plan 5 Equal Repayment Plan

Equal Annual Payments (Part Principal and
Part Interest

Conclusion
The difference in the total
amounts repaid can be explained
(1) by the time value of money,
(2) by simple or compound
interest, and (3) by the partial
repayment of principal prior to
year 5.

Finding Equivalent Values of Cash

Flows- Six Scenarios
Given a:

Find its:

Present sum of money

Equivalent future value
Future sum of money
Equivalent present value
Uniform end-of-period series Equivalent present value
Present sum of money
Equivalent uniform end-of-period series
Uniform end-of-period series Equivalent future value
Future sum of money
Equivalent uniform end-of-period series

26

Derivation by Recursion: F/P factor

F

F1 = P(1+i)
F2 = F1(1+i)..but:
F2 = P(1+i)(1+i) = P(1+i)2
F3 =F2(1+i) =P(1+i)2 (1+i)
= P(1+i)3
In general:

P
0

FN = P(1+i)n
FN = P(F/P,i%,n)

Present Worth Factor from F/P

Since FN = P(1+i)n

We solve for P in terms of FN

P = F{1/ (1+i)n} = F(1+i)-n
Thus:
P = F(P/F,i%,n) where
(P/F,i%,n) = (1+i)-n

An Example
How much would you have to deposit now into an
account paying 10% interest per year in order to have
$1,000,000 in 40 years?
Assumptions: constant interest rate; no additional
deposits or withdrawals
Solution:
P= 1000,000 (P/F, 10%, 40)=...

29

Uniform Series Present Worth and Capital

Recovery Factors

Annuity Cash Flow

P
= ??
1
0 n-1

.
..
.

$A per period

..

Uniform Series Present Worth and Capital

Recovery Factors
Write a Present worth expression

1
1
1
1
P A

..

1
2
n 1
n
(1 i )
(1 i)
(1 i ) (1 i )

[1]

P
1
1
1
1
A

..

2
3
n
n 1
1 i
(1

i
)
(1

i
)
(1

i
)
(1

i
)

[2]

Uniform Series Present Worth and

Capital Recovery Factors
Setting up the subtraction

P
1
1
1
1
A

..

2
3
n
n 1
1 i
(1

i
)
(1

i
)
(1

i
)
(1

i
)

1
1
1
1
- P A (1 i)1 (1 i)2 .. (1 i)n1 (1 i) n

i
1
1
P A

n 1
1 i
(1 i )
(1 i )

[2]

[1]

[3]

Uniform Series Present Worth and

Capital Recovery Factors
Simplifying Eq. [3] further

i
1
1
P A

n 1
1 i
(1

i
)
(1

i
)

P / A i %, n factor

(1 i ) n 1
P A
for i 0
n
i (1 i )

The present worth

point of an annuity
cash flow is always one
period to the left of the
first A amount

i (1 i ) n
A P

n
(1 i ) 1

A/P,i%,n factor

Section 3.9 Lotto Example

If you win $5,000,000 in the California lottery, how
much will you be paid each year? How much money
must the lottery commission have on hand at the time of
the award? Assume interest = 3%/year.
Given: Jackpot = $5,000,000, N = 19 years (1st payment
immediate), and i = 3% year
Solution: A = $5,000,000/20 payments =
$250,000/payment (This is the lotterys calculation of A
P = $250,000 + $250,000(P | A, 3%, 19)
P = $250,000 + $3,580,950 = $3,830,950
34

Sinking Fund and Series Compound

amount factors (A/F and F/A)
Annuity Cash Flow

1
PF
n
(1

i
)

Find $A given the

Future amt. - $F

$A per period
.
.

i (1 i ) n
A P

n
(1

i
)

$F

i
AF

n
(1

i
)

(1 i ) n 1
F=A

Example - Uniform Series Capital

Recovery Factor
Suppose you finance a $10,000 car over 60
months at an interest rate of 1% per month. How
much is your monthly car payment?
Solution:
A = $10,000 (A | P, 1%, 60) = $222 per month

36

Example: Uniform Series Compound

Amount Factor
Assume you make 10 equal annual deposits of $2,000
into an account paying 5% per year. How much is in
the account just after the 10th deposit? 12.5779

Solution:
F= $2,000 (F|A, 5%, 10) = $25,156
Again, due to compounding, F>NxA when i>0%.

37

An Example
Recall that you would need to deposit $22,100 today
into an account paying 10% per year in order to have
$1,000,000 40 years from now. Instead of the single
deposit, what uniform annual deposit for 40 years
would also make you a millionaire?

Solution:
A = $1,000,000 (A | F, 10%, 40) = $

38

Basic Setup for Interpolation

Work with the following basic
relationships

Estimating for i = 7.3%

Form the following relationships

Interest Rates that vary over time

In practice interest rates do not stay the same
over time unless by contractual obligation.
There can exist variation of interest rates
over time quite normal!
If required, how do you handle that situation?

41

Section 3.12 Multiple Interest Factors

Some situations include multiple unrelated sums
or series, requiring the problem be broken into
components that can be individually solved and
then re-integrated. See page 93.
Example: Problem 3-95
What is the value of the following CFD?

42

Problem 3-95 Solution

F1 = -$1,000(F/P,15%,1) - $1,000 = -$2,150

F2 = F 1 (F/P,15%,1) + $3,000 = $527.50
F4 = F 2 (F/P,10%,1)(F/P,6%,1) = $615.07
43

Arithmetic Gradient Factors

An arithmetic (linear) Gradient is a cash
flow series that either increases or decreases
by a contestant amount over n time periods.
A linear gradient is always comprised of
TWO components:
The Gradient component
The base annuity component
The objective is to find a closed form
expression for the Present Worth of an
arithmetic gradient

Linear Gradient Example

A1+n1G

A1+n2G

Assume the following:

A1+2G
A1+G

1
N

n-1

This represents a positive, increasing arithmetic

gradient

Present Worth: Gradient Component

General CF Diagram Gradient Part Only

3G
1G

(n2)G

(n1)G

2G

0G
We want the PW at time t = 0 (2 periods to the left of
1G)
0
1
2
3
4
.. n-1
n

To Begin- Derivation of P/G,i%,n

P G ( P / F , i %, 2) 2G ( P / F , i %, 2) ...
...+ [(n-2)G](P/F,i,n-1)+[(n-1)G])P/F,i,n)

P G{( P / F , i %, 2) 2( P / F , i %, 2) ...
...+ [(n-2)](P/F,i,n-1)+[(n-1)])P/F,i,n)}

1
2
n-2
n-1
P=G

...

2
3
n-1
n
(1+i)
(1+i)
(1+i) (1+i)
Multiply both sides by (1+i)

Subtracting [1] from [2]..

1
2
n-2
n-1
P(1+i) =G

...

1
2
n-2
n-1
2
(1+i)
(1+i)
(1+i)
(1+i)

1
2
n-2
n-1
P=G

...

2
3
n-1
n
(1+i)
(1+i)
(1+i) (1+i)

G (1 i ) 1
N
P=

N
N
i i (1 i )
(1 i )
N

( P / G, i %, N ) factor

The A/G Factor

Convert G to an equivalent A

A G ( P / G, i, n)( A / P, i, n)
N

G (1 i ) 1
N
P=

N
N
i i (1 i )
(1 i )

A/G,i,n
=

i (1 i )

N
(1 i ) 1

1
n
G

N
i (1 i ) 1

Gradient Example
$700
$600
$500
$400
$300
$200
$100

PW(10%)Base Annuity = $379.08

PW(10%)Gradient Component= $686.18
Total PW(10%) = $379.08 + $686.18
Equals $1065.26

50

Geometric Gradients
An arithmetic (linear) gradient changes by
a fixed dollar amount each time period.
A GEOMETRIC gradient changes by a fixed
percentage each time period.
We define a UNIFORM RATE OF CHANGE (%)
for each time period
Define g as the constant rate of change
in decimal form by which amounts increase
or decrease from one period to the next

Geometric Gradients: Increasing

Typical Geometric Gradient Profile
Let A1 = the first cash flow in the series

..

n-1

A1

A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1

Geometric Gradients: Starting

Pg = The Ajs time the respective (P/F,i,j)
factor
Write a general present worth relationship
to find Pg.
2
n 1

A1
A1 (1 g ) A1 (1 g )
A1 (1 g )
Pg

...
1
2
3
(1 i )
(1 i )
(1 i )
(1 i ) n
Now, factor out the A1 value and rewrite
as..

Geometric Gradients

1
(1 g )1 (1 g ) 2
(1 g ) n 1
Pg A1

...
2
3
n
(1

i
)
(1

i
)
(1

i
)
(1

i
)

Multuply both sides by

(1)

(1+g)
to create another equation
(1+i)

(1+g)
(1+g) 1
(1 g )1 (1 g ) 2
(1 g ) n 1 (2)
Pg
A1

...

2
3
(1+i)
(1+i) (1 i) (1 i)
(1 i)
(1 i) n

Subtract (1) from (2) and the result is..

Geometric Gradients

Pg

(1 g ) n
1+g
1
1 A1

n 1
1+i
1 i
(1 i )

Solve for Pg and simplify to yield.

Pg A1

1 g
1

ig

gi

nA1
Pg
(1 i )
For the case i =
g

Geometric Gradient: Example

Assume maintenance costs for a particular
activity will be $1700 one year from now.
Assume an annual increase of 11% per year
over a 6-year time period.
If the interest rate is 8% per year,
determine the present worth of the future
expenses at time t = 0.
First, draw a cash flow diagram to
represent the model.

Geometric Gradient Example (+g)

g = +11% per period; A1 = $1700; i = 8%/yr

1
7
$1700

$1700(1.11)1
$1700(1.11)2
$1700(1.11)3

PW(8%) = ??
$1700(1.11)5

Example: i unknown
Assume on can invest $3000 now in a
venture in anticipation of gaining $5,000 in
five (5) years.
If these amounts are accurate, what
$5,000
interest rate equates these two
cash flows?
0
5

$3,000

F = P(1+i)n
(1+i)5 = 5,000/3000 = 1.6667
(1+i) = 1.66670.20
i = 1.1076 1 = 0.1076 =
10.76%

Unknown Number of Years

Some problems require knowing the
number of time periods required given the
other parameters
Example:
How long will it take for $1,000 to double
F = $2000
in value if the discount rate is 5% per year?
n

Draw the cash

flow diagram
as.
i = 5%/year;
n is unknown!
0
.

1
n

P = $1,000

...

...

Unknown Number of Years

Fn = $2000

Solving we have..
0
.

1
n

...

...

P = $1,000

(1.05)x = 2000/1000
Xln(1.05) =ln(2.000)
X = ln(1.05)/ln(2.000)
X = 0.6931/0.0488 = 14.2057 yrs
With discrete compounding it will take 15 years

Section 3.16.
Nominal and Effective Interest Rates
Nominal interest (r) = interest compounded more than
one interest period per year but quoted on an annual
basis.
Example: 16%, compounded quarterly
Effective interest (i) = actual interest rate earned or
charged for a specific time period.
Example: 16%/4 = 4% effective interest for each of the
four quarters during the year.
61

Relationship
Relation between nominal interest and effective
interest: i=(1+r/M)M -1, where
i = effective annual interest rate
r = nominal interest rate per year
M = number of compounding periods per year
r/M = interest rate per interest period

62

Nominal and Effective Interest Rates Examples

Find the effective interest rate per year at a nominal rate
of 18% compounded (1) quarterly, (2) semiannually,
and (3) monthly.
(1) Quarterly compounding; i=(1+0.18/4)4 -1=0.1925 or
19.25%
(2) Semiannual compounding; i=(1+0.18/2)2 -1=0.1881
or 18.81%
(3) Monthly compounding ...

63

Nominal and Effective Interest Rates Example

A credit card company advertises an A.P.R. of
16.9% compounded daily on unpaid balances.
What is the effective interest rate per year being
charged? r = 16.9% M = 365
Solution:
ieff = (1+0.169/365)365 -1=0.184 or 18.4% per year

64

Nominal and Effective Interest Rates

Two situations well deal with in Chapter 3:
(1) Cash flows are annual. Were given r per year and
M. Procedure: find i/yr = (1+r/M)M-1and
discount/compound annual cash flows at i/yr.
(2) Cash flows occur M times per year. Were given r
per year and M. Find the interest rate that corresponds
to M, which is r/M per time period (e.g., quarter,
month). Then discount/compound the M cash flows per
year at r/M for the time period given.

65

Example: 12% Nominal

Annual
semi-annual
Quartertly
Bi-monthly
Monthly
Weekly
Daily
Hourly
Minutes
seconds

No. of
Comp. Per.
1
2
4
6
12
52
365
8760
525600
31536000

EAIR
(Decimal)
0.1200000
0.1236000
0.1255088
0.1261624
0.1268250
0.1273410
0.1274746
0.1274959
0.1274968
0.1274969

EAIR
(per cent)
12.00000%
12.36000%
12.55088%
12.61624%
12.68250%
12.73410%
12.74746%
12.74959%
12.74968%
12.74969%

12% nominal for various compounding periods

66

Interest Problems with Compounding more

often than once per Year Example A
If you deposit $1,000 now, $3,000 four years from now followed
by five quarterly deposits decreasing by $500 per quarter at an
interest rate of 12% per year compounded quarterly, how much
money will you have in you account 10 years from now?

r/M = 3% per quarter and year 3.75 = 15th Quarter

P @yr. 3.75 = P qtr. 15
= 3000(P/A, 3%, 6) - 500(P/G, 3%, 6) = $9713.60
F yr. 10 = F qtr. 40
= 9713.60(F/P, 3%, 25) + 1000(F/P, 3%, 40) =
= $23,600.34
67

Interest Problems with Compounding more

often than once per Year Example B
If you deposit $1,000 now, $3,000 four years from
now, and $1,500 six years from now at an interest rate
of 12% per year compounded semiannually, how much
money will you have in your account 10 years from
now?
i per year = (1+0.12/2)12-1 = 0.1236
F = $1,000(F/P, 12.36%, 10) + $3,000(F/P, 12.36%, 6) +
$1,500(F/P, 12.36%, 4) or r/M = 6% per half-year
F = 1000(F/P, 6%, 20) + 3000(F/P, 6%, 12)+ 1500(F/P, 6%, 8)
= $11,634.50
68

Derivation of Continuous Compounding

We can state, in general terms for the EAIR:

r m
i (1 ) 1
m
Now, examine the impact of letting m approach
infinity.

69

Derivation of Continuous Compounding

We re-define the general form as:

r m
r

(1
) 1 1

m
m

m
r

From the calculus of limits there is an important limit that

is quite useful.

1
lim 1 e 2.71828
h
h

m
r
r

lim 1
e,

m
m

ieff.= er 1
70

Derivation of Continuous Compounding

Example:

What is the true, effective annual interest rate

if the nominal rate is given as:
r = 18%, compounded continuously
Solve e0.18 1 = 1.1972 1 = 19.72%/year
The 19.72% represents the MAXIMUM effective
interest rate for 18% compounded anyway you
choose!
71

Example

An investor requires an effective return of at least

15% per year. What is the minimum annual nominal
rate that is acceptable if interest on his investment is
compounded continuously?

Solution:
er 1 = 0.15
er = 1.15
ln(er) = ln(1.15)
r = ln(1.15) = 0.1398 = 13.98%
72