Time Value of Money

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 Decision Dilemma—Take a Lump Sum or Annual
Installments
 A suburban Chicago couple won the
Power-ball.
 They had to choose between a single
lump sum $104 million, or $312 million
paid out over 15 years.
 Which do you think is the best choice?
 The winning couple opted for the lump
sum.
 Did they make the right choice?
 What basis do we make such an
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economic comparison?
 Why Do We Need to Know?

 To make such comparisons, we

must be able to compare the
value of money at different
point in time.

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 Time Value of Money
Few Important terms

 Interest- Interest represents earning power of

money. It is a cost to the borrower and an
earning to the lender.

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Elements of transactions
involving interest

 Principal amount
 Interest rate (%)
 Interest period (t)

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 Types of Interest
 Simple
 Compound

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 Methods of Calculating Interest
• Simple interest: The practice of charging an interest
rate only to an initial sum (principal amount).
• In this case interest earned is directly proportional to
capital involved in the loan.
If, I= interest earned.
P= Principal amount
i= rate of interest per period
N= number of interest periods (usually years)
Then, I= P * i *N
The total amount the borrower is supposed to pay the
lender,
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F= P + I => P + PiN =>

 Methods of Calculating Interest – Simple Interest

• Note: When N is not a full year we can calculate

simple interest by the following 2 methods.

• Ordinary Simple Interest- Year divided into 12 months

having 30 days periods or a year is considered to
have 360 days (i.e.. 12*30=360).

• Exact Simple Interest- A year has exactly calendar no.

of days, and N is the fraction of no. of days the loan
with its effect in that year.
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 Methods of Calculating Interest – Compound Interest
• Compound interest: The practice of charging an
interest rate to an initial sum and to any previously
accumulated interest that has not been withdrawn.
• Total amount to pay, varies drastically when
compared to simple interest charged.
F= P . (1 + i)n
P- Principal Amount invested at time 0, F-
Future amount,
i- interest rate compounded annually, n-
period of deposits

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 Methods of Calculating Interest – Compound Interest
• Alternatively,
What would be the present worth of a certain amount of
money which you would want to deposite at the end of
 
nth year? P=

P- Principal Amount invested at time 0, F-

Future amount,
i- interest rate compounded annually, n-
period of deposits

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 Methods of Calculating Interest – Compound Interest

Numerical:

i. Find the future sum of money after 2years, if an

amount of Rs. 1000 is deposited now and is charged

at an interest rate of 10%, by using Simple and

compound interest?

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Cash flow diagrams

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Cash Flow Diagram:

• Cash flow diagrams are the simple representation of

income and outlay.

• Generally before constructing the diagram it is very

common to define the time frame over which cash flow
occurs.

• The time frame thus forms the horizontal axis which is

divided into time periods, often in years.

• END-OF-PERIOD convention.
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Economic equivalence
• Refers to the fact that a cash flow – whether single or
multiple payments , can be converted to an
equivalent cash flow at any point in time.
• Following are the required data:
1. Magnitude of the payment
2. Direction of the payment( income/expense)
3. Timing of the payment.
4. Interest rate.

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Types of cash flows
• Single cash flows

• Uniform (equal) series

• Linear gradient series

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Types of Compound Interest Formulas
1. Single payment compound amount:
• Here the objective is to find the single future sum (F)
of initial payment P after n period at interest rate i %
compounded every period.

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Numerical

 If you had Rs.2000 now and invested it at 10%, how

much would it be worth in 8 years?

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Types of Compound Interest Formulas
2. Single Payment Present Worth Amount:
• Here the objective is to find the present worth
amount (P) of a single future sum (F) which will be
received after n periods at an interest rate of i%
compounded at the end of every interest period.

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Numerical

 Suppose Rs.1000 is to be received in 5 years, at an

annual rate of 12%, what is the present worth of this
amount?

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 Suppose you have the alternative of receiving either
$18,000 at the end of 5years or P dollars today.
Currently, you have no need for the money, so you
could deposit the P dollars in a bank that pays 5%
interest. What value of P would you deposit today such
that you could earn $18,000 at the end of 5years?

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 Suppose that you are obtaining a loan from your friend
in the amount of $25,000 (now) to be repaid in 3 years
to cover some of your college expenses. If your friend
earns 8% interest on his money, what minimum lump
sum payment will be done in three years from now?

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 You have just purchased 100 shares of Citigroup stock
at $60 per share. You will sell the stock when its market
price is doubled. If you expect the stock price to
increase 20% per year, how long do you anticipate
waiting before selling the stock?

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 Wilson technology , a growing machine shop, wishes to
set aside money now to invest over the next 4 years
to use to automate its customer service department.
The company can earn 10% on a lump sun deposited
now, and wishes to withdraw the money in the
following increments:
Year1: $25,000 to purchase a computer and database
software designed for customer service use.
Year2: $3000 to purchase additional hardware to
accommodate anticipated growth in use of the system.
Year3: no expenses
Year4: $5000 to purchase software upgrades.
How much money must be deposited now to cover the
anticipated payments over the next 4 years?

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 A local news paper headline read ’Bo Smith signed for
$30M’. A reading of the article revealed that on April
1,2010, Bo Smith, signed a package with the Dallas
Rangers. The terms of the contract were $3M
immediately, $2.4M per year for the first 5 years, and
$3M per year for the next 5 years. If B0’s interest is 8%
per year, what would his contract be worth at the time
he signs it?

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 Suppose you have a savings account with your federal
credit union. By looking at the account, you learned the
interest rate in each period during the last 5years was
as shown in the fig. Calculate the balance at the end of
5years.

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 Types of Compound Interest Formulas
3. Equal Payment Series Compound Amount:
• Here the objective is to find the future worth of n
equal payments which are made at the end of every
interest period till the end of nth interest period at an
interest rate of i % compounded at the end of each
interest period.

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 Suppose you make an annual contribution of Rs.3000 to
your savings account at the end of each year for
10years, if your account earns 7% interest annually, how
much can be withdrawn at the end of 10 years?

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Types of Compound Interest Formulas
4. Equal Payment Series Sinking Fund:
• Here the objective is to find the equal amount (A)
that should be deposited at the end of every interest
period for n period to realize a future sum (F) at the
end of nth period at an interest rate of i %.

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 A person estimates an expenditure of Rs.10,00,000 for
about 8years from now. He plans to deposit an equal
amount at the end of every year for the next 8years at
12% compounded annually. Find the equivalent amount
that must be deposited at the end of every year for the
next 8years.

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Types of Compound Interest Formulas
5. Equal Payment Series Present Worth:
• Objective is to find present the worth of an equal
payment made at end of every interest period for n
periods.

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 A person wants to give scholarships to poor students,
which is Rs.25,000 every year. He wants to deposit in
the bank, which makes him receive the required
amount for the next 20years. The reserve is assumed to
grow annually at the rate of 9%. Find the single
payment that must be made now as the reserve
amount?

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 A company has borrowed Rs.2,50,000 to purchase a lab
equipment. The loan carries an interest rate of 8% per
year & is to be repaid in equal installments over next 6
years. Compute the amount of equal annual repayment.

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 A person plans to have a retirement policy which will
give him a return when he reaches an age of 50.For this
person whose age is 35years now has to make annual
premium payment of Rs.19760 till he reaches an age of
49.If the interest rate is 8%, what is the lump sum he
is getting on the maturity of this policy?

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 Suppose that you have savings plan covering the next
10years, according to which you put aside $600 today ,
$800 at the end of every year for the next 5years, and
$2000 at the end of each year for the remaining 5years.
As a part of the plan, you expect to withdraw $300 at
the end of every year for the first 3years, and $350
thereafter till the 10th year.
 i=12%
1. draw CFD
2. Find the amount accumulated at the end of 10years.

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 How much money will be accumulated in 25years if
Rs.800 is deposited at the end of 2nd year from now,
Rs.2400, 6years from now
Rs.3300, 8years from now?
all at an interest rate of 18% PA. Find the equivalent
annual worth for the time period of 25years.

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 You have just purchased 100 shares of General
Electric stock at $60 per share. You will sell the
stock when its market price has doubled. If you
expect the stock price to increase 20% per year, how
long do you anticipate waiting before selling the
stock

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 A clever industrial engineer found that by spending
$16,000 now to reconfigure the production line and
reprogram two of the robotic arms, the cost will go
down to $58,000 next year and $52,000 in years 2
through 5. Using an interest rate of 10% per year,
determine ( a) the equivalent annual cost of the
manufacturing operations.

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 You plan to retire 33years from now. You expect that you
will live 27years after retiring. You want to have enough
money upon reaching retirement age to withdraw
Rs.1,80,000 from the account at the end of each year you
expect to live, and yet still have Rs.25,00,000 left in the
account at the time of your expected death. You plan to
accumulate the retirement fund by making equal annual
deposits at the end of each year for the next 33 years.
You expect that you will be able to earn 12% per year on
your deposits. however, you only expect to earn 6% per
year on your investment after you retire since you will
choose to place the money in less risky investments.
What equal annual deposits must you make each year to
reach your retirement goal?

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Gradient series

 A uniform gradient is a cash flow series which either

increases or decreases uniformly.

 The amount of increase or decrease is the gradient.

 The value of G (gradient) may be positive or negative.

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 Uniform Gradient series annual equivalent
amount (A/G,i,n)
 The objective of this type of investment is to find the
annual equivalent mode of a certain series with an
amount A, at the end of 1st year and with an
equivalent increment G at the end of each of the
following (n-1) years with the interest rate i%
compounded annually.

Engineering Economics
 Problems
1. Mr. A has 10 years of service before he retires. He
now plans to deposit Rs. 25000 at the end of first year
and thereafter an annual increase of Rs.500 for the
remaining 9 years. If he can expect a return of 10%,
find the future amount at the end of 10th year.
2. A new piece of material handling equipment costs
Rs.20000 and is expected to save Rs.7500 in the first
year of operation. Maintenance and operating costs
are expected to reduce the net savings by Rs.500 per
year for each additional year of operation until the
equipment is worn out at the end of 8 years.
Determine the net present worth of the machine at an
interest rate of 12%.
Engineering Economics
 It is estimated that the maintenance cost on a new
car will be $40 the first year. Each subsequent year,
this cost is expected to increase by $10. How much
would you need to set aside when you bought a new
car to pay all future maintenance costs if you planned
to keep the vehicle for 7 years? Assume interest is
5%per annum.

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 A man is purchasing a small garden tractor. There will
be no maintenance cost during the first 2 years
because the tractor is sold with 2 years free
maintenance. For the third year, the maintenance is
estimated at $20. In subsequent years the
maintenance cost will increase by $20 per year (i.e.,
fourth-year maintenance will be $40, fifth-year $60,
etc.). How much would need to be set aside now at
8% interest to pay the maintenance costs on the
tractor for the first 6 years of ownership?

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 A textile mill has just purchased a lift truck
that has a useful life of 5years. The engineer
estimates that maintenance costs for the truck
during the first year will be Rs.1000. as the
truck ages , maintenance costs are expected
to increase at a rate of Rs250 per year over
the remaining life. Assume that the
maintenance costs occur at the end of each
year. The firm wants to set up a maintenance
account that earns 12% annual interest. All
future maintenance expenses will be paid out
of this account. How much does the firm have
to deposit in the account now? 49
 John and Barbara have just opened two
savings accounts at their credit union. The
accounts earn 10% annual interest. John wants
to deposit $1000 in his account at the end of
the first year from now and increase this
amount by $300 for each of the next five years.
Barbara wants to deposit an equal annual
deposit so that the two accounts will have
equal amount each year for the next six years.
What should be the size of Barbara’s annual
deposit so that the two accounts will have
equal balances at the end of six years?

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 Suppose that you make a series of annual deposits into
a bank account that pays 10% interest. The initial
deposit at the end of 1st year from now is Rs.1,200.The
deposit amount declines by Rs.200 in each of the next
4years. How much would you have immediately after 5 th
deposit?

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 Wonder la entertainment company is evaluating an
investment that will provide the following returns at
each of the following years. Wonder la believes that it
should earn an annual rate of 9% on this investment.
How much can it pay for this investment now?

YEAR Returns(Rs)
2 12,500
3 10,000
4 7,500
5 5,000
6 2,500
7 1,200
8 12,500

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Nominal & effective interest
rate
 Effective interest rate is given by:

i(eff)= (1+r/ck)^c – 1
Where: r – nominal interest rate
c – no. of interest periods per payment period
k – no. of payment periods per year

Where: ck is equal to M
i.e. M=ck
Where M= No of compounding periods
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Problems

 Suppose that you make quarterly payments in a savings

account that earns 9% interest compounded monthly.
Compute the effective interest rate per quarter.

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 Find the effective interest rate of per quarter payments
at a nominal rate of 8% compounded
1. quarterly
2. monthly
3. Weekly
4. Daily

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 Suppose you make equal quarterly deposits of $1,500
into a fund that pays interest at a rate of 6%
compounded monthly. Find the balance at the end of
year2.

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 Suppose you make $500 monthly deposits to a tax
deferred retirement plan that pays interest at a rate of
10% compounded quarterly, compute the balance at the
end of 10years.

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 A series of monthly cash flows is deposited into an
account that earns 12% nominal interest compounded
monthly. Each monthly deposit is equal to $2100. the
first monthly deposit occurred on june1,1998 and the
last monthly deposit will be on January 1, 2005. the
account also has equivalent quarterly withdrawals from
it. The first quarterly withdrawal is equal to $5000 and
occurred on October 1, 1998. the last $5000 withdrawal
will occur on january1,2005. how much remains in the
account after the last withdrawal?

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 A person deposits $5,000 for the three years starting
from end of this year in a savings account that pays 6%
interest compounded monthly. At the 6th year, he
deposits $4000.Two years after the $4000 deposit, he
makes another 2 equal deposits of $2,500 semi-
annually. Six years after the previous deposit, half of
the accumulated fund is transferred to a fund that pays
8% interest compounded quarterly. How much money
will be accumulated in each account after one year of
this transfer?

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 The Scott and White Health Plan (SWHP) has purchased a
robotized prescription fulfilment system for faster and more
accurate delivery to patients with stable, pill-form
medication for chronic health problems, such as diabetes,
thyroid, and high blood pressure.
Assume this high volume system costs $3 million to install and
an estimated $2,00,000 per year for all materials, operating,
personnel, and maintenance costs. The expected life is 10 years.
SWHP biomedical engineer wants to estimate the total revenue
requirement for each 6-month period that is necessary to
recover the investment, interest, and annual costs. Find this
semi-annual ‘A’ value, if capital funds are evaluated at 8% per
year, compounded semi-annually.

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 Heyden Motion Solutions ordered $7 million
worth of seamless tubes for its drill collars
from the Timken Company of Canton, Ohio.
(A drill collar is the heavy tubular connection
between a drill pipe and a drill bit.) At 12%
per year, compounded semi-annually, what is
the equivalent uniform cost per semi-annual
period over a 5-year period?

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 Loadstar Sensors is a company that makes load force
sensors based on capacitive sensing technology. The
company wants to have $28 million for a plant
expansion 4 years from now. If the company has already
set aside $12 million in an investment account for the
expansion now, how much more must the company add
to the account next year (i.e., 1 year from now) so that
it will have the $28 million 4 years from now? The
account earns interest at 12% per year, compounded
quarterly.

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 A structural engineering consulting company is
examining its cash flow requirements for the next 7
years. The company expects to replace office machines
and computer equipment at various times over the 7-
year planning period. Specifically, the company expects
to spend $21,000 for two years from now, $24,000
during the 3rd year, which decreases by $2000 from 4
through 6 and $30,000 during the 7th year. What is the
present worth of the planned expenditures at an
interest rate of 10% per year, compounded semi-
annually?

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 Find the value of x below such that the positive cash
flows will be exactly equivalent to the negative cash
flows, if the interest rate is 14% per year.

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 An Electric Cooperative company estimates that the
present worth now of income from an investment in
renewable energy sources is $12,475,000. There will be
no income in years 1 and 2, but in year 3 income will be
$250,000, and thereafter it will increase according to
an arithmetic gradient through year 15. What is the
required gradient, if the interest rate is 15% per year?

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 You borrowed $15,000 for buying a new car from a bank
at an interest rate of 12% compounded monthly. This
loan will be repaid in 48 equal monthly instalments over
four years. Immediately after the 20th payment, you
desire to pay the remainder of the loan in a single
payment. Compute this lump-sum amount of that time.

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What equal series of payments must be paid into a
sinking fund to accumulate the following amount? (a)
$21,000 in 10 years at 6.45% compounded semi-
annually when payments are quarterly. (b) $9,000 in 15
years at 9.35% compounded quarterly when payments
are annually. (c) $24,000 in 5 years at 6.55%
compounded monthly when payments are monthly

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