CHAPTER 3

PRINCIPLES OF MONEY-
TIME 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
Equity
financing
Borrow
money
Sell partial
ownership of
company;
Bond
Stock
Promise to
pay
principle &
interest;
Exchange
shares of
stock for
ownership of
company;
Exchange
money for
shares of
stock as
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.

INVESTMENT
INTEREST = VALUE NOW - ORIGINAL AMOUNT
LOAN
INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT
INTEREST RATE - INTEREST PER TIME UNIT

RENTAL FEE PAID FOR THE USE OF SOMEONE ELSES MONEY
AMOUNT ORIGINAL
UNIT TIME PER INTEREST
RATE INTEREST =
Interest
Rate
Quantity of Money
i
e
Money Demand
Money Supply
MS
1
Determination of Interest Rate
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
P
0
= $1000, I
1
= $1,000(0.05) = $50.00
P
1
= $1,000 + 50 = $1,050
New Principal sum at end of t = 1: = $1,050.00
I
2
= $1,050(0.05) = $52.50
P
2
=1050 + 52.50 = $1102.50
I
3
= $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-of-period
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.

26
Finding Equivalent Values of Cash
Flows- Six Scenarios
Given a:
Present sum of money
Future sum of money
Uniform end-of-period series
Present sum of money
Uniform end-of-period series
Future sum of money
Find its:
Equivalent future value
Equivalent present value
Equivalent present value
Equivalent uniform end-of-period series
Equivalent future value
Equivalent uniform end-of-period series
Derivation by Recursion: F/P factor
F
1
= P(1+i)
F
2
= F
1
(1+i)..but:
F
2
= P(1+i)(1+i) = P(1+i)
2

F
3
=F
2
(1+i) =P(1+i)
2
(1+i)

= P(1+i)
3

In general:
F
N
= P(1+i)
n

F
N
= P(F/P,i%,n)



P
0

F
n

N

.
Present Worth Factor from F/P
Since F
N
= P(1+i)
n

We solve for P in terms of F
N

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
29
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)=...
Uniform Series Present Worth and Capital
Recovery Factors
Annuity Cash Flow
$A per period
P = ??
0
..
n
1 2 3 .. .. n-1
Uniform Series Present Worth and Capital
Recovery Factors
Write a Present worth expression
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i

(
= + + + +
(
+ + + +

[1]
2 3 1
1 1 1 1
..
1 (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i
+
(
= + + + +
(
+ + + + +

[2]
Uniform Series Present Worth and
Capital Recovery Factors
Setting up the subtraction
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i

(
= + + + +
(
+ + + +

[1]
[2]
-
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
(
=
(
+ + +

=
[3]
2 3 1
1 1 1 1
..
1 (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i
+
(
= + + + +
(
+ + + + +

Uniform Series Present Worth and
Capital Recovery Factors
Simplifying Eq. [3] further
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
(
=
(
+ + +

(1 )
(1 ) 1
n
n
i i
A P
i
(
+
=
(
+

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

/ %, P A i n factor
A/P,i%,n factor
The present worth point of
an annuity cash flow is
always one period to the
left of the first A amount
34
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
Sinking Fund and Series Compound
amount factors (A/F and F/A)
Annuity Cash Flow
0
..
N
$A per period
$F
Find $A given the
Future amt. - $F
1
(1 )
n
P F
i
(
=
(
+

(1 )
(1 ) 1
n
n
i i
A P
i
( +
=
(
+

(1 ) 1
n
A
i
i
F =
(
(
+

)
=A
(1 1
F
n
i
i
( +
(

36
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


37
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%.
38
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) = $
Basic Setup for Interpolation
Work with the following basic relationships
Estimating for i = 7.3%
Form the following relationships
41
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?
42
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?
43
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
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
Assume the following:
0 1 2 3 n-1 N
A
1
+G
A
1
+2G
A
1
+n-2G
A
1
+n-1G
This represents a positive, increasing arithmetic gradient
Present Worth: Gradient Component
General CF Diagram Gradient Part Only
0 1 2 3 4 .. n-1 n
1G
2G
3G
(n-2)G
(n-1)G
0G
We want the PW at time t = 0 (2 periods to the left of 1G)
To Begin- Derivation of P/G,i%,n
( / , %, 2) 2 ( / , %, 2) ...
...+ [(n-2)G](P/F,i,n-1)+[(n-1)G])P/F,i,n)
P G P F i G P F i = + +
( / , %, 2) 2( / , %, 2) ...
...+ [(n-2)](P/F,i,n-1)+[(n-1)])P/F,i,n)
{
}
P G P F i P F i = + +
2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
(
+ + + +
(

Multiply both sides by (1+i)
2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
(
+ + + +
(

Subtracting [1] from [2]..
1
1 2 n-2 n-1
1 2 n-2 n-1
P(1+i) =G ...
(1+i) (1+i) (1+i) (1+i)
(
+ + + +
(

-
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
(
+

(
+ +

2
1
( / , %, ) 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 =
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
(
+

(
+ +

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

1
(1 ) 1
N
n
G
i i
(

(
+

A/G,i,n =
50
Gradient Example
$700
$600
$500
$400
$300
$200
$100
0 1 2 3 4 5 6 7
PW(10%)
Base Annuity
= $379.08
PW(10%)
Gradient Component
= $686.18
Total PW(10%) = $379.08 + $686.18
Equals $1065.26
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 A
1
= the first cash flow in the series
0 1 2 3 4 .. n-1 n
A
1

A
1
(1+g)
A
1
(1+g)
2

A
1
(1+g)
3
A
1
(1+g)
n-1

Geometric Gradients: Starting
P
g
= The A
j
s time the respective (P/F,i,j) factor
Write a general present worth relationship to
find P
g
.
2 1
1 1 1 1
1 2 3
(1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
A A g A g A g
P
i i i i

+ + +
= + + + +
+ + + +
Now, factor out the A1 value and rewrite as..
Geometric Gradients
1 2 1
1
2 3
1 (1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i

(
+ + +
= + + + +
(
+ + + +

(1)
(1+g)
Multuply both sides by to create another equation
(1+i)
1 2 1
1
2 3
(1+g) (1+g) 1 (1 ) (1 ) (1 )
...
(1+i) (1+i) (1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i

(
+ + +
= + + + +
(
+ + + +

(2)
Subtract (1) from (2) and the result is..
Geometric Gradients
1
1
1+g (1 ) 1
1
1+i (1 ) 1
n
g
n
g
P A
i i
+
(
+
| |
=
| (
+ +
\ .

Solve for P
g
and simplify to yield.
1
1
1
1
g i
n
g
g
i
P A
i g
(
+
| |

(
|
+
\ .
(
= =
(

(
(

1
(1 )
g
nA
P
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
0 1 2 3 4 5 6 7
$1700
$1700(1.11)
1

$1700(1.11)
2
$1700(1.11)
3
$1700(1.11)
5
PW(8%) = ??
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 interest rate
equates these two cash flows?
0 1 2 3 4 5
$3,000
$5,000
F = P(1+i)
n
(1+i)
5
= 5,000/3000 = 1.6667
(1+i) = 1.6667
0.20

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 in
value if the discount rate is 5% per year?
Draw the cash flow diagram as.
0 1 2 . . . . . . . n
P = $1,000
F
n
= $2000
i = 5%/year; n is unknown!
Unknown Number of Years
Solving we have..
0 1 2 . . . . . . . n
P = $1,000
F
n
= $2000
(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
61
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.
62
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

63
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 ...
64
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:
i
eff
= (1+0.169/365)
365
-1=0.184 or 18.4% per year
65
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
-1 and
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.
66
Example: 12% Nominal
No. of EAIR EAIR
Comp. Per. (Decimal) (per cent)
Annual 1 0.1200000 12.00000%
semi-annual 2 0.1236000 12.36000%
Quartertly 4 0.1255088 12.55088%
Bi-monthly 6 0.1261624 12.61624%
Monthly 12 0.1268250 12.68250%
Weekly 52 0.1273410 12.73410%
Daily 365 0.1274746 12.74746%
Hourly 8760 0.1274959 12.74959%
Minutes 525600 0.1274968 12.74968%
seconds 31536000 0.1274969 12.74969%
12% nominal for various compounding periods
67
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
68
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
69
Derivation of Continuous Compounding
We can state, in general terms for the EAIR:
(1 ) 1
m
r
i
m
= +
Now, examine the impact of letting m approach
infinity.
70
Derivation of Continuous Compounding
We re-define the general form as:
(1 ) 1 1 1
r
m
r
m
r r
m m
(
| |
(
+ = +
|
(
\ .

From the calculus of limits there is an important limit that
is quite useful.
1
lim 1 2.71828
h
h
e
h

| |
+ = =
|
\ .
lim 1 ,
m
r
m
r
e
m

| |
+ =
|
\ .
i
eff.
= e
r
1
71
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 e
0.18
1 = 1.1972 1 = 19.72%/year
The 19.72% represents the MAXIMUM effective
interest rate for 18% compounded anyway you
choose!
72
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:
e
r
1 = 0.15
e
r
= 1.15
ln(e
r
) = ln(1.15)
r = ln(1.15) = 0.1398 = 13.98%