II.

The Time Value of Money

The term capital refers to wealth in the form of money or property that can be used to produce
more wealth. The majority of engineering economy studies involves commitment of capital for extended
periods of time, so the effect of time must be considered. In this regard, it is recognized that a peso today is
worth more than a peso one or more years from now because of the interest (or profit) it can earn. Therefore,
money has a time value. It has been said that often the riskiest thing a person can do with money is nothing!
Money has value, and if money remains uninvested (like in a large bottle), value is lost. Money changes in
value not only because of interest rates—inflation (or deflation) and currency exchange rates also cause
money to change in value.

Why Consider Return to Capital?

There are fundamental reasons why return to capital in the form of interest and profit are an
essential ingredient of engineering economy studies. First, interest and profit pay the providers of capital for
forgoing its use during the time the capital is being used. The fact that the supplier can realize a return on
capital acts as an incentive to accumulate capital by savings, thus postponing immediate consumption in
favor of creating wealth in the future. Second, interest and profit are payments for the risk the investor takes
in permitting another person, or an organization, to use his or her capital. In typical situations, investors
must decide whether the expected return on their capital is sufficient to justify buying into a proposed
project or venture. If capital is invested in a project, investors would expect, as a minimum, to receive a
return at least equal to the amount they have sacrificed by not using it in some other available opportunity of
comparable risk. This interest or profit available from an alternative investment is the opportunity cost of
using capital in the proposed undertaking. Thus, whether borrowed capital or equity capital is involved,
there is a cost for the capital employed in the sense that the project and venture must provide a sufficient
return to be financially attractive to suppliers of money or property. In summary, whenever capital is
required in engineering and other business projects and ventures, it is essential that proper consideration be
given to its cost (i.e., time value). The remainder of this chapter deals with time value of money principles,
which are vitally important to the proper evaluation of engineering projects that form the foundation of a
firm’s competitiveness, and hence to its very survival.

The Origins of Interest

Like taxes, interest has existed from earliest recorded human history. Records reveal its existence
in Babylon in 2000 B.C. In the earliest instances, interest was paid in money for the use of grain or other
commodities that were borrowed; it was also paid in the form of grain or other goods. Many existing interest
practices stem from early customs in the borrowing and repayment of grain and other crops. History also
reveals that the idea of interest became so well established that a firm of international bankers existed in 575
B.C., with home offices in Babylon. The firm’s income was derived from the high interest rates it charged
for the use of its money for financing international trade. Throughout early recorded history, typical annual
rates of interest on loans of money were in the neighborhood of 6% to 25%, although legally sanctioned
rates as high as 40% were permitted in some instances. The charging of exorbitant interest rates on loans
was termed usury, and prohibition of usury is found in the Bible. (See Exodus 22: 21–27.) During the
Middle Ages, interest taking on loans of money was generally outlawed on scriptural grounds. In 1536, the
Protestant theory of usury was established by John Calvin, and it refuted the notion that interest was
unlawful. Consequently, interest taking again became viewed as an essential and legal part of doing
business. Eventually, published interest tables became available to the public.
 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 for which the principal is committed, the
interest and interest rate are said to be simple. Simple interest is not used frequently in modern commercial
practice. When simple interest is applicable, the total interest, I, earned or paid may be computed using the
formula:
I = (P)(N)(i),
where 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. Thus, if ₱10,000 were loaned for
three years at a simple interest rate of 10% per year, the interest earned would be
I= ₱10,000 × 3 × 0.10 = ₱3,000.
The total amount owed at the end of three years would be ₱10,000 + ₱3,000 = ₱13,000. Notice that
the cumulative amount of interest owed is a linear function of time until the principal (and interest) is repaid
(usually not until the end of period N).

Compound Interest
Whenever the interest charge for any interest period (a year, for example) is based on the
remaining principal amount plus any accumulated interest charges up to the beginning of that period, the
interest is said to be compound. The effect of compounding of interest can be seen in the following table for
$1,000 loaned for three periods at an interest rate of 10% compounded each period:

As you can see, a total of $1,331 would be due for repayment at the end of the third period. If the
length of a period is one year, the $1,331 at the end of three periods (years) can be compared with the $1,300
given earlier for the same problem with simple interest.
A graphical comparison of simple interest and compound interest is given in Figure 2.1.
 Figure 2.1. Illustration of Simple versus Compound Interest

The difference is due to the effect of compounding, which is essentially the calculation of interest
on previously earned interest. This difference would be much greater for larger amounts of money, higher
interest rates, or greater numbers of interest periods. Thus, simple interest does consider the time value of
money but does not involve compounding of interest.

The Concept of Equivalence

Alternatives should be compared when they produce similar results, serve the same purpose, or
accomplish the same function. This is not always possible in some types of economy studies (as we shall
see later), but now our attention is directed at answering the question: How can alternatives for providing
the same service or accomplishing the same function be compared when interest is involved over extended
periods of time? Thus, we should consider the comparison of alternative options, or proposals, by reducing
them to an equivalent basis that is dependent on (1) the interest rate, (2) the amounts of money involved,
and (3) the timing of the monetary receipts or expenses.
To better understand the mechanics of interest and to explain the concept of equivalence,
suppose you have a ₱17,000 balance on your credit card. ―This has got to stop!‖ you say to yourself. So
you decide to repay the ₱17,000 debt in four months. An unpaid credit card balance at the beginning of a
month will be charged interest at the rate of 1% by your credit card company.
For this situation, we have selected three plans to repay the ₱17,000 principal plus interest owed.∗
These three plans are illustrated in the table below, and we will demonstrate that they are equivalent (i.e.,
the same) when the interest rate is 1% per month on the unpaid balance of principal.
Plan 1 indicates that none of the principal is repaid until the end of the fourth month. The
monthly payment of interest is ₱170, and all of the principal is also repaid at the end of month four.
Because interest does not accumulate in Plan 1, compounding of interest is not present in this situation. In
the table below, there are 68,000 peso-months of borrowing (₱17,000×4 months) and ₱680 total interest.
Therefore, the monthly interest rate is (₱680 ÷ 68,000 peso-months) × 100% = 1%.
Plan 2 stipulates that we repay ₱4,357.10 per month. Later we will show how this number is
determined. For our purposes here, you should observe that interest is being compounded and that the
₱17,000 principal is completely repaid over the four months. From Table 4-1, you can see that the monthly
interest rate is (₱427.10 ÷ 42,709.5 peso-months of borrowing) ×100% = 1%. There are fewer dollar-
months of borrowing in Plan 2 (as compared with Plan 1) because principal is being repaid every month
and the total amount of interest paid (₱427.10) is less.
 Finally, Plan 3 shows that no interest and no principal are repaid in the first three months. Then at
the end of month four, a single lump-sum amount of ₱17,690.27 is repaid. This includes the original
principal and the accumulated (compounded) interest of ₱690.27. The dollar-months of borrowing are very
large for Plan 3 (69,026.8) because none of the principal and accumulated interest is repaid until the end of
the fourth month. Again, the ratio of total interest paid to dollar-months is 0.01.
This brings us back to the concept of economic equivalence. If the interest rate remains at 1% per
month, you should be indifferent as to which plan you use to repay the ₱17,000 to your credit card company.
This assumes that you are charged 1% of the outstanding principal balance (which includes any unpaid
interest) each month for the next four months. If interest rates in the economy go up and increase your credit
card rate to say, 1 % per month, the plans are no longer equivalent. What varies among the three plans is the
rate at which principal is repaid and how interest is repaid.
Notation and Cash-Flow Diagram
The following notation is utilized in formulas for compound interest calculations:
i = effective interest rate per interest period;
N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more cash flows at a reference point in
time called the present;
F = future sum of money; the equivalent value of one or more cash flows at a reference point in time
called the future;
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series continuing for
a specified number of periods, starting at the end of the first period and continuing through the last
period.
The use of cash-flow (time) diagrams or tables is strongly recommended for situations in which the
analyst needs to clarify or visualize what is involved when flows of money occur at various times. The
difference between total cash inflows (receipts) and cash outflows (expenditures) for a specified period of
time (e.g., one year) is the net cash flow for the period.
 The cash-flow diagram employs several conventions:
1. The horizontal line is a time scale, with progression of time moving from left to right. The period
(e.g., year, quarter, month) labels can be applied to intervals of time rather than to points on the time scale.
Note, for example, that the end of Period 2 is coincident with the beginning of Period 3. When the end-of-
period cash-flow convention is used, period numbers are placed at the end of each time interval, as
illustrated in the figure below.

Figure 2.2 Cash Flow Diagram of Plan 3 of Table 2.1 (Creditcard Company’s viewpoint)

Figure 2.3 Cash Flow Diagram of Plan 2 of Table 2.1 (Lender’s viewpoint)

2. The arrows signify cash flows and are placed at the end of the period. If a distinction needs to
be made, downward arrows represent expenses (negative cash flows or cash outflows) and upward arrows
represent receipts (positive cash flows or cash inflows).

3. The cash-flow diagram is dependent on the point of view. For example, the situations shown in
Figures 4-2 and 4-3 were based on cash flow as seen by the lender (the credit card company). If the
directions of all arrows had been reversed, the problem would have been diagrammed from the borrower’s
viewpoint.

Example of Cash-flow Diagramming

Before evaluating the economic merits of a proposed investment, 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.
 Solution

As shown in the figure below, the initial investment of ₱10,000 and annual expenses of ₱3,000 are cash
outflows, while annual revenues and the market value are cash inflows.

Relating Present and Future Equivalent Values of Single Cash-Flows

Figure 2.4 shows a cash-flow diagram involving a present single sum, P, and a future single sum,
F, separated by N periods with interest at i% per period. Throughout this lesson, a dashed arrow, such as that
shown in Figure 2.4, indicates the quantity to be determined.

Figure 2.4 General Cash-Flow Diagram Relating Present Equivalent and Future Equivalent of Single Payments

Finding F when given P

If an amount of P dollars is invested at a point in time and i% is the interest (profit or growth) rate
per period, the amount will grow to a future amount of P + Pi = P(1+i) by the end of one period; by the end
of two periods, the amount will grow to P(1 + i)(1 + i) = P(1 + i)2; by the end of three periods, the amount
will grow to P(1 + i)2(1 + i) = P(1 + i)3; and by the end of N periods the amount will grow to
Example 1. Future Equivalent of a Present Sum
Suppose that you borrow $8,000 now, promising to repay the loan principal plus accumulated interest in
four years at i = 10% per year. How much would you repay at the end of four years?

Solution 1 (using table)

The quantity (1 + i)N in Equation 1 is commonly called the single payment compound amount
factor. We shall use the functional symbol (F/P, i%, N) for (1 + i)N . Hence Equation 2 can be expressed as

F = P(F/P, i%,N). Eq. 2

where the factor in parentheses is read ―find F given P ati% interest per period for N interest
periods.‖

Solution 2 (using Eq. 1)

Finding P when given F

From Eq. 2, F = P(1 + i)N, solving this for P gives the relationship

( ) Eq. 3

The quantity is called the single payment present worth factor.

Example

An investor (owner) has an option to purchase a tract of 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 for
this property?

Solution

Using Eq. 3

= 10,000 (1 + 0.08)-6

P = ₱6, 301.70
Finding Interest Rate given P, F and N

From Eq. 1 we can derive the formula for interest rate (i).

(get the Nth root of both sides)

√ = √

√ = Therefore,

=( √ ) Eq. 4

Example 1.

If we want to turn ₱500 into ₱1,000 over a period of 10 years, at what interest rate would we have to invest
it?

Solution

Given: P = ₱500 F = ₱1,000 N = 10 years

Using Equation 4 by direct substituting the given data, we will have:

=(√ )

=( √ )

= 7.177% or 7.18%

Example 2. The Inflation Price of Gasoline

The average price of gasoline in 2005 was ₱2.31 per gallon. In 1993, the average price was ₱1.07. What
was the average annual rate of increase in the price of gasoline over this 12-year period?

Solution

Given: P = ₱1.07 F = ₱2.31 N = 12 i= ?

i=(√ )

=( √ )

i =6.62%
 Finding N given P, F and i

From Eq. 1 and using logarithms we will obtain

(using logarithms)

therefore

Example

How long would it take for ₱500 invested today at 15% interest per year to be worth ₱1,000?

Solution

Given: P = ₱500 i= 15%= 0.15 F = ₱1,000

= 4.959 or 5 years.