Lecture 4

REN505 Project Management and
Engineering Economics
Dr. Tamer A. Mohamed
Effect of Time and
Interest Rate on the value
of Money
Time Value of Money
Outline
2.1 Introduction
2.2 Interest and Interest Rates
2.3 Compound and Simple Interest
2.4 Effective and Nominal Interest Rates
2.5 Continuous Compounding
2.6 Cash Flow Diagrams
2.1 Introduction
 Engineering decisions frequently involve

tradeoffs among costs and benefits that occur at
different times.
– Typically, we invest in a project today in order to gain
benefits in the future.
 This chapter discusses the economic methods
used to compare benefits and costs that occur at
different times.
 The key to making these comparisons is the use
of interest rates.
2.2 Interest and Interest Rates
 Given the choice between having £100 today and

£100 in one year from now, most would prefer the
money today.
– The money can be immediately put to some productive
use.
 In other words, we must be compensated for
giving up money today (i.e. giving a loan)
because of the lost investment opportunity.
2.2 Interest and Interest Rates,
cont’d
 Interest (I) is the compensation for giving up the
use of money for the duration of a loan.
– It is the difference between the amount loaned and the
amount repaid.
 An amount of money today, P, can be related to a
future amount, F, by the interest amount I, or
interest rate i:
F = P + I = P + Pi = P(1 + i)
cont’d
 P is the present worth of F
 F is the future worth of P
 The base period over which the interest is
calculated is called the interest period.
Figure 2.1 Present and Future
Worth
cont’d
 The dimension of an interest rate is
(dollars/dollars)/time.
 A 9% interest rate means that for every dollar
lent, 0.09 dollars is paid in interest for each time
period.
 The base unit of time over which an interest rate
is calculated is called the interest period.
CLOSE-UP 2.1 Interest Periods
2.3 Compound and Simple Interest
 If an amount, P, is lent for one interest period at

the interest rate, i, the amount that must be repaid
at the end of the period is F = P(1 + i).
 How is the quantity of money that must be repaid
computed when the loan is for N interest periods?
F = P(1 + i)N
Table 2.1 Compound Interest
Computations
2.3 Compound and Simple Interest,
cont’d
 If the number of periods is greater than one
interest period, interest is usually compounded
(i.e., at the end of each period, interest is added to
the principal that there was at the beginning of the
period).
cont’d
 The compound interest on an N period loan is:
IC = F  P = P(1 + i)N  P
cont’d
 The interest period over which interest is
calculated is also called the compounding
period.
Practice Problem 2-1
 With i = 8% per year, how much is owed on a loan

of £500 at the end of 3 years?
 What is the compound interest amount?
Answer
F = P(1 + i)N = 500(1 + 0.08)3 = £629.86
IC = F − P = £629.86 − £500.00 = £129.86
The amount owed is £629.86 and the interest amount
is £129.86
 I borrow €100 now and pay you €1000 four years

from now. What is the implied interest rate?
Answer
P = €100, F = € 1000, N = 4
F = P(1 + i)4
i = (F/P)1/4 – 1 = (1000/100)1/4 – 1
= 0.77828  77.8%
cont’d
 Simple Interest
 The interest amount is calculated without
compounding (i.e., interest is not added to the
principal at the end of each period).
 The interest amount, ISS, is called simple interest.
IS = P i N
cont’d
 Compound and simple interest amounts are the
same if N = 1.
 As N increases, the difference between the
accumulated interest amounts for the two methods
increases exponentially.
 Simple interest is rarely used in practice.
 The conventional approach for computing interest
is the compound interest method.
Figure 2.2 Compound and Simple Interest at 24% Per
Year for 20 Years
• With simple interest of i = 8% per year, how much

interest will be paid on a loan of £500 at the end of
3 years?
Answer
The simple interest amount is £120; the amount
repaid is thus £620.
IS = PiN = £500 (0.08) (3) = £120.00
• Manhattan Island was sold for £24 in 1626. At 6%

compounded annually, what was it worth in 2009?
Answer
F = P(1 + i)N
= £24(1 + 0.06)(2009 – 1626) = £24(1.06)383
= £118 129 302 081
2.4 Effective and Nominal Interest Rates
 Interest rates may be stated for some

period, like a year.
 The computation of interest is based on
shorter compounding subperiods such as
months.
2.4 Effective and Nominal Interest
Rates, cont’d
 In the section we consider the relation between:
– The nominal interest rate that is stated for the full
period.
– The effective interest rate that results from the
compounding based on the subperiods.
 Unless otherwise specified, stated rates are
nominal annual rates.
Rates, cont’d
 Suppose that:
r is the nominal rate stated for a period (1 year,
unless otherwise specified) consisting of
m equal compounding periods (sub-periods).
Rates, cont’d
 By convention, the compound interest rate per
sub-period is:
is = r/m.
• After m periods:
F = P(1 + iS)m
• If the compounding period is 1 year, then:
F = P(1 + r)
• For a daily interest bank account (i = 3%), if we
deposit €1000, how much will we have after one
year?
Answer
The subperiod interest rate is 0.00823% per day:
is = r/m = 0.03/365 = 0.0000823
The future amount after one year of daily compounding is
thus:
F = P(1 + iS)m = £1000(1 + 0.0000823)365 = €1030.45
• What would we have earned if there was only one
compounding period during the year?
Answer
Here, m = 1 subperiod per year : i = r/m = 0.03

s
And thus:
F = P(1 + iS)m = €1000(1 + 0.03)1= €1030.00
Interest is €30.00
Rates, cont’d
 Question: What interest rate, compounded
annually, will give the same amount of interest as
3% compounded daily?
 This interest rate is called the effective interest
rate, iee.
 Since F = P(1 + iSS)mm = P(1 + iee)
 We get iee = (1 + iSS)mm  1
Rates, cont’d
 The effective interest rate, iee, gives the same
future amount, F, after 1 full period as if a
subperiod interest rate, iSS, is compounded over m
subperiods.
 What is the effective (annual) interest rate for a

bank account that pays a 3% nominal rate with
daily compounding?
Answer
is = r/m = 0.03/365 = 0.0000823
ie = (1 + iS)m  1 = (1 + 0.0000823)365 - 1 = 0.03045
The daily compounding leads to an effective interest rate of
about 3.05%.
2.5 Continuous Compounding
 Suppose that the nominal interest rate is 12% and

interest is compounded semi-annually.
 We compute the effective interest rate as follows:
r = 0.12, m = 2
iee = (1 + iSS)mm  1 = (1 + 0.06)22  1 = 0.1236
 The effective interest rate is 12.36% per year.
2.5 Continuous Compounding,
cont’d
 What if interest were compounded
monthly?
r = 0.12, m = 12
iee = (1 + iSS)mm  1 = (1 + 0.01)12
12  1 = 0.1268
 The effective interest is 12.68% with monthly

compounding.
 Daily? iee = 0.127475 or about 12.75%
cont’d
 What if the compounding period is made
infinitesimally small?
– Applicable where cash flows are large and accrue
continuously
 The effective interest rate under continuous
compounding is:
m
 r 
i e  lim 1    1  er  1
m  m
Figure 2.3 Growth in Value at £1
at 30% Interest for Various
Compounding Periods
cont’d
 Now, we may compute the effective interest rate
for a nominal interest rate of 12% under
continuous compounding:
iee = err  1 = e0.12
0.12  1 = 0.12750 = 12.75%
 Although continuous compounding makes sense

in some circumstances, it is not often used —
discrete compounding is the norm.
2.6 Cash Flow Diagrams
 A cash flow diagram is a graphical summary of

the timing and magnitude of a set of cash flows
 Assumptions:
– Cash flows occur at the ends of periods.
– End of time period 1 = beginning of time period 2, etc.
– “Now” is (usually) time 0.
Figure 2.4 Cash Flow Diagram
Beginning and Ending of Periods
• Draw a cash flow diagram for the following situation:
• You have just paid £5000 in cash for a car. Insurance costs
for the year are £600 now and again at the end of 6
months. Gas costs will be £100 at the end of each month,
starting at the end of month 1. You expect to sell the car at
the end of the year for £3000. A pre-sale tune-up in 11
months is estimated to cost £400.
Practice Problem 2-8, cont’d
Answer

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REN505 Project Management and

 Engineering decisions frequently involve

 Given the choice between having £100 today and

 If an amount, P, is lent for one interest period at

 With i = 8% per year, how much is owed on a loan

 I borrow €100 now and pay you €1000 four years

• With simple interest of i = 8% per year, how much

• Manhattan Island was sold for £24 in 1626. At 6%

 Interest rates may be stated for some

Here, m = 1 subperiod per year : i = r/m = 0.03

 What is the effective (annual) interest rate for a

 Suppose that the nominal interest rate is 12% and

 The effective interest is 12.68% with monthly

 Although continuous compounding makes sense

 A cash flow diagram is a graphical summary of

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