I.

Principles of Engineering
Economy

Cash Flows and the Time Value

of Money

Key Concepts
Cash Flow Diagram: the financial description
(visual) of a project
Time Value of Money: the value of money
changes with time
Money provides utility (value) when spent
Value of money grows if invested
Value of money decreases due to inflation

Interest: used to move money through time for

comparisons

Cash Flow
Movement of money in (out) of a project
Inflows: revenues or receipts
Outflows: expenses or disbursements
Net Cash Flow:

Cash Flows
Discrete: Movement of cash to or from a
project at a specific point in time.

Continuous: Rate of cash moving from or

to a project over some period of time.

Cash Flow Diagram

Financial representation of a project.
Describes type, magnitude and timing of
cash flows over some horizon.

Cash Flow Diagram

Describes type, magnitude and timing of
cash flows over some horizon
500K

200K

200K
0

50K
100K
500K

200K
4

Cash Flow Diagram

Continuous cash flows define a rate of
movement of cash over time.
500K

200K

200K
0

500K

While good for analysis, not used often.

Cash Flow Diagram

Can describe any investment opportunity.
Typical investment:

Example (Nothing to Sneeze At!)

Tissue paper company Svenska Cellulosa announced
an investment of SEK490 million for a new tissue
machine at its Valls, Spain plant to expand capacity
by 60,000 tons/year. Most product is for retail
private labels.
Assume: Investment in 2006 with operations
beginning in 2007. The machine has a service life of
10 years and a salvage value of SEK25M. Fixed
O&M costs are SEK10 million in year 1, increase 8%
per year. Revenues are SEK6,400/ton against costs
of SEK4,600/ton.
Draw the cash flow diagram.
Source: SCA Invests Around SEK490M in New Tissue Machine in Spain, Dow Jones Newswires, December 22, 2005.

Cash Flow Diagram

10

Cash Flow Diagram

Net Cash Flow Diagram
98.0M 97.2M 96.4M
0

490M

113M

89.5M
9

10

Spreadsheet Basics
Sheet defined by rows and columns of cells.
A
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17

Spreadsheet Basics
Can enter the following into a cell:
Data: Input that is fixed.
Variables: Input that can change.
Accomplished by references.
Absolute references are fixed when copied.
Relative references change when copied.

Functions: Accept input (arguments) and

return pre-defined output.
Combinations: Data, Variables, and Functions.
Labels: Formatting that makes it easy to read!

Good Spreadsheet Form

Give your spreadsheet a title.
Put data in a data center and reference
it (so you can change it easily).
Label units, scales, time, etc.
Use formatting to make it easy to read.

Return to our Example

1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16

A
B
C
Exam ple: Tissue Production Expansio n
Period
0
1
2
3
4
5
6
7
8
9
10

Outflows
SEK 490.00
SEK 286.00
SEK 286.80
SEK 287.66
SEK 288.60
SEK 289.60
SEK 290.69
SEK 291.87
SEK 293.14
SEK 294.51
SEK 295.99

Input
Investm ent
SEK 490 m illion
Annual Capacity
0.06 m illion to ns
Fix ed OM
SEK 10 m illion
Fix ed OM (g)
8% per year
Per Unit OM
SEK 4,600
Per Unit Rev
SEK 6,400
Salvage
SEK 25 m illion
MARR
10% per year
Perio ds
10 years
=C 10-B10
Output
Cash Flow Diagram

Inflows
Net Cash Flow
--SEK 490.00
SEK 384.00
SEK 98.00
SEK 384.00
SEK 97.20
SEK 384.00
SEK 96.34
SEK 384.00
SEK 95.40
SEK 384.00
SEK 94.40
SEK 384.00
SEK 93.31
SEK 384.00
SEK 92.13
SEK 384.00
SEK 90.86
SEK 384.00
SEK 89.49
SEK 409.00
SEK 113.01
=SUM($G$3*$G$7,G8)
=$G$4*(1+$G$5)^(A13-1)+$G$3*$G$6

Cash Flow Analysis

Given that any investment opportunity
can be drawn by a cash flow diagram,
how can we select the best?
Transform all cash flow diagrams into
something similar for comparison.
Use a Common Interest Rate
Use Time Value of Money Calculations

Time Value of Money

Money has value because it gives us
utility.
Generally, money is preferred now, as
opposed to later (same amount)
One can spend it now and get utility
One can invest it and watch it grow with
interest for greater future utility
One can put it under the mattress and watch
it lose purchasing power

Time Value of Money

To describe the same amount of money at
different periods of time requires the use
of an interest rate. With a positive rate:
Money grows (compounds) into larger
future sums in the future.
Money is smaller (discounted ) in the past.

Interest
Cost of Money
Rental amount charged by lender for use of money
In any transaction, someone earns and someone
pays interest

Savings Account:

bank pays you;

1.5% fee to depositor

Home/Auto Loan:

borrower pays bank;

7.5% fee to bank

Interest
Interest Rate comprised of many factors
Example: Home Mortgage: 7.5%
Prime Rate : (Banks borrow money at this rate from
the Federal Reserve banks when needed) 5%
Risk Factor : 1%
Administration Fees : 0.5%
Profit : 1%

May inflate more for higher risk client.

Definitions
Principal (capital): P
Amount invested or loaned

Interest Rate: i
Rental charge for money defined as a percentage
of principal per time period

Compounding Period
Defines how often interest is calculated (may not
be paid, however)

Length of loan/investment: N periods

Simple Interest
Interest earned/paid is directly proportional to
capital involved.

Simple Interest
Interest earned/paid is directly
proportional to capital involved.
=(Principal)(Interest Rate)(Periods)

Example
Keystone Cement Co. announced a $165
million expansion of its Lehigh Valley PA
plant. The state Machinery and Equipment
Loan Fund is supplying a $4.5 million loan to
be paid at a rate of 3.25 percent over 10 years
and the states Development Authority is
providing a $2 million loan at 4.25 percent
over 15 years.
Consider the machinery loan. What is owed
after 10 years assuming simple annual interest?
Source: Penton, K., Keystone gets $7 million funding, The Morning Call, p. D1, January 13, 2006.

Compound Interest
Interest is paid on both the capital and
accrued interest.
Must compute interest owed periodically.

Revisit the Example

Repeat example assuming 3.25%
compounded annually. How much is
owed after two years if no payments are
made?

Revisit the Example

Assuming 3.25% compounded annually:
After the first year:
Balance
Interest
$4.50M
(.0325)($4.5M)
After the second year:
Balance
Interest
$4.65M
(.0325)($4.65M)

Compound Interest and

Cash Flow Diagrams
Example: P=$1000, i=10%
How much accrued after one year?
Principal: P = $1000
Interest Earned: I = Pi = $1000(0.10) = $100
Total: F1 = P + I = P + Pi =

So if I pulled out the money after one period:

Compound Interest and

Cash Flow Diagrams
How much accrued after two years?
Principal: F1 = $1100
Interest Earned:
I2 = F1i = P(1+i)i = $1100(0.10) = $110

Total:
F2 = P + I1 + I2 = P + Pi + (P+Pi)i =

So if I pulled out the money after two periods?

Compound Interest and

Cash Flow Diagrams
How much accrued after N years?
Generalizes to:
So if I pulled out the money after N periods:

Interest Rates
Nominal: Annual interest rate that
ignores the effects of compounding.
Effective: Interest rate charged per period
which includes compounding.
Need effective interest rate for analysis.
Nominal rates have no analytical use!

Nominal Interest Rates (APR)

Annual interest rate that does not
incorporate the effects of compounding
Nominal interest rate: r
r % per year compounded periodically
r % compounded periodically
Number of compounding periods in the
year: M

Converting Nominal Interest Rates

Always convert nominal rates to effective
rates.
The effective rate i per compounding
period M is:

From here, we can convert as needed.

Effective Interest Rates

Rate of interest charged for a given
period (includes compounding)
i % per period
Interpretations:
True cost of a loan
Yield to maturity
Return on an investment

Converting Effective Interest Rates

Cash flows occur every month. Given
annual interest rate of 12%.
Annual Rate
0

F=P(1+ia)

1 year
1 2 3

12 months

Monthly Rate
P

F=P(1+im)12

Converting Effective Interest Rates

Cash flows occur every year. Given
quarterly interest rate of 4 %.
Annual Rate

F=P(1+ia)

1 year
1

4 quarters

Quarterly Rate
P

F=P(1+iq)4

Nominal to Effective Rates

Effective Rate: i = r/M per period M
Can then convert to necessary period.
In general:

is the effective rate per period l.

(Or convert as we did with CFD.)

Continuous Compounding
It is common to have an infinite number
of compounding periods.
To find the annual effective rate:

The effective rate over l periods (fraction

or multiple of a year):
i e lr 1.

Nominal vs. Effective Interest Rates

For comparison: compare effective
interest rates over a common period

Example: Comparing Rates

Back to original example. Assume the
following three loans are possible:
State rate: 3.25% (per year) compounded
continuously
Bank rate: 0.80% per quarter
Internet bank rate: 3.35% compounded monthly

Which is the best rate (for Keystone)?

Example: Comparing Rates

3.25% compounded continuously

0.80% per quarter

3.35% compounded monthly

r .0335
im

.00279 0.279% per month.

M
12

Example
Software firm IDX Systems Corp. recently
signed an agreement for a credit line of up to
$150 million. The first $50 million is charged
the highest of:
The bank's prime rate
The secondary market rate for 3-month CDs +1%
The federal funds effective rate plus 0.5%
Source: Dow Jones Newswires, IDX Systems Corp In Pact For Up To $150M Loan, December 29, 2004.

Example: Comparing Rates

Assume:
Bank's prime rate: 4.5% compounded continuously
3-month CDs +1%: 0.75% per quarter
Federal funds rate plus 0.5%: 5.1% compounded
bi-annually

Which is the best rate for IDX?

Example: Comparing Rates

4.5% compounded continuously

0.75% per quarter

5.1% compounded bi-annually

isa

r .051

.0255 2.55% per six months.

M
2

Interest Rates and Cash Flow

Diagrams
Match the effective interest rate (per
period) to the time period of the cash
flows

Compound Interest and

Cash Flow Diagrams
To perform any analysis, cash flows and
compounding periods for effective interest
rates must be the same (i.e. years, months,
etc.)
Years on axis

Annual effective
rate

Cash Flow Timing

Compounding More Frequent than Cash
Flows:
Convert interest rate to appropriate period
Or just be careful in analysis

Cash Flows Occur More Frequently than

Compounding Period
Assume that money deposited between
compounding periods does not earn interest
Merely aggregate cash flows

Example
Woodside Petroleum Ltd. is seeking approval
from the Western Australian government for a
A$2 billion expansion of its North West Shelf
liquefied natural gas facility. The new
expansion would lift annual LNG output to
around 16 million tons (from 11.7) by late
2008. Korea Gas Corp. (is looking to buy six
million tons per year of LNG over two
decades, starting in early 2008.
Source: Bell, S. UPDATE:Australia's Woodside Ready To Expand NW Shelf Gas, Dow Jones Newswires,
January 10, 2005.

Example
Assume weekly shipments (115,384 tons). If
payments made on delivery and interest rate is
0.75% per month, what do you do?
Assume monthly shipments (500,000 tons). If
payments made on delivery and interest rate
is.002% per day, what do you do?

Time Value of Money

Money has value because it gives us
utility.
Generally, money is preferred now, as
opposed to later (same amount)
One can spend it now and get utility
One can invest it and watch it grow with
interest for greater future utility
One can put it under the mattress and watch
it lose purchasing power

Inflation
Inflation and deflation affect cash flows and
must be accounted for in analysis.
Measure inflation with Price Index
ratio of price of some commodity or service at
some point in time to the price at some earlier
point in time

Price indices exist for numerous products,

commodities, etc. CPI is most commonly
known and used. (www.bls.gov)

Measuring Inflation
One Period
CPIt 1 CPIt
f
CPIt

1992: 140.3
1993: 144.5

Measuring Inflation
Multiple Periods
Must include the effects of compounding.
n

CPIt n CPI t (1 f )

f is a periodic inflation rate.

Measuring Inflation
Multiple Periods

CPIt n CPI t (1 f )

1984: 103.7
1993: 144.5

Purchasing Power
Inflation erodes our purchasing power:
the worth of our money.
To analyze the loss of purchasing power,
we can analyze cash flow diagrams with
and without inflation.

Terminology
Real Dollars:
These dollars are NOT inflated. (Nominal or Constant.)

Current Dollars:
Are inflated out of pocket money. (Future or Actual.)

Market Interest Rate (i):

Value includes inflation rate that reflects opportunity for
investments

Inflation-Free (or Real) Rate (i'):

Market rate with inflation effects removed

Inflation Rate (f):

Annual inflation rate

Converting Cash Flows

Current Dollars: Money that comes out of, or
into, your pocket
Real Dollars: Uninflated money -- a fictitious
term used for comparisons
To convert between the two -- use the inflation
rate
Divide out inflation for Current to Real
Multiply in inflation for Real to Current

Real and Current Dollars

No effects of inflation.

Includes effects of inflation.

Real Dollars

Current Dollars
(1 + f)N
F'

F
0

P
FN FN(1 f )N

Real and Current Dollars

No effects of inflation.

Includes effects of inflation.

Real Dollars

Current Dollars
1/(1 + f)N
F'

F
0

P
FN
FN
(1 f ) N

Example: Real to Current

Cazaly Resources and Echelon Resources
signed an agreement to deliver 5 million wet
tons per annum of primary crushed iron ore
from the Shovelanna Project to BHP Billiton.
The price is to be determined by the Mt
Newman Lump and Fines benchmark.
If delivery is expected to start in three years
and last for 10, what are the real and current
dollar cash flow diagrams given the
benchmark prices?
Cazaly, Echelon sign MOU with BHP on Shovelanna, Ralph Wragg Australian Business News, November 29,2005

Example: Real to Current

Mt Newman Fines benchmark ($/ton)
98

99

00

01

02

29.9

26.63

27.79

28.98

28.28

03

04

05

30.83 36.67 62.89

Assume 2005 is time zero. Delivery starts in

2008 and lasts through 2018.

Souce: Iron Ore Industry Trends and Analysis, Baffinland Iron Mines Corporation, September 30,2005.

Example: Real to Current

Ignoring inflation, the time zero price stays
constant.
The Real dollar cash flow diagram is then:

Example: Real to Current

Assume annual inflation rate stays constant
over time (although it hasnt recently!)
Inflation rate:
Bench t n Bench t (1 f )n

Example: Real to Current

Current Dollars, year 3:
FN FN(1 f )N

Current Dollar Cash Flow Diagram:

13

Example: Current to Real

A little known patent-holding company, Rates
Technology Inc., is claiming that Googles
Google Talk (VoIP service) infringes on its
patents. The company is seeking $5 billion in
damages if Google doesnt settle.
Assume Google settles now (beginning 2006)
by agreeing to pay $50 million per year for the
next five years. Payments start at the end of
2006 and the inflation rate is 3.5%.
Source: Google facing patent suit over `Google Talk -- report, Total Telecom, December 30, 2005.

Current to Real
Dollars are Current as it is a contract.
Current dollar cash flow diagram:

50M
06

50M
07

08

10

Real and Current Dollars

When you pull money out of your pocket and
pay, those are current dollars.
Estimates which ignore inflation are real
dollars.
Signed contracts signify current dollars that
are to be made.
Bonds and/or loans are contracts. They signify
current dollars to come.
Assuming costs wont change with time are
real dollars.

Market and Real Interest Rates

(i)

(i')

To convert the inflation free rate to the market rate -compound (multiply) inflation in:

To convert the market rate to the inflation free rate -- discount

(divide) inflation out:

Economic Analysis
Current Dollars use i (inflation in both
cash flows and interest rate)
Real Dollars use i' (no inflation in either
cash flows or interest rate)

Real and Current Dollars

No effects of inflation.

Includes effects of inflation.

Real Dollars
(1 +
0

Current Dollars
i')N

F'
N

(1 +
0

i)N

F
N

Economic Analysis
Do the Real and Current cash flow analyses
lead to the same conclusion?
Yes (we will see this later):
Current dollars use i
Real dollars use i'
The values of i and i' differ according to f, just as
the cash flows!

Economic Analysis
Pre-tax analyses are equivalent:
Real Dollars with i'
Current Dollars with i

Use straightforward approach (one that

requires minimal conversion)
After-tax analysis requires current dollars
Must include inflation
Use the market interest rate

Exchange Rates
Exchange rates are similar to inflation and
deflation as the movement of money between
currencies alters the cash flows.
In theory, an exchange between currencies at
the same point in time results in no loss of
purchasing power. However, a fee is generally
paid to exchange currencies.
Exchanges over time can result in loss (or
gain) of purchasing power.

Example
Texas energy firm Gulfmark Offshore Inc.
ordered six anchor handling and supply
vessels to be built by Singapores Keppel
Corp. at the price of S$230 million. Deliveries
are to begin at the end of 2007 (third quarter)
through the third quarter of 2008.
Assume five payments of S$46 million made
in 3rd quarter 2007 through 3rd quarter of
2008. What are the payments in US dollars
(assume constant exchange $1=S$1.6208)?
Singapore Bureau, Singapore Keppel Unit to Build 6 Vessels for S$230M, Dow Jones Newswires, November 14, 2005.

Example
US dollar payments:

Example
According to www.x-rates.com, the exchange
rate (monthly average) has moved from
S$1.6377 to $1 in January of 2005 to
S$1.63558 to $1 in January of 2006.
What would the expected payments be if this
trend continues?
Bench t n Bench t (1 f )n

Example
This translates to -.0324% per quarter.
Exchange at time zero (end 2005) is:
$1=S$1.6208
Exchange at end third quarter year 2007 is:

So, the first US dollar payment is:

Exchange Rates
An exchange rate provides the conversion
from one currency to another currency at the
same point in time.
Movements in currencies are effected by
numerous factors but must be accounted for
(or at least estimated) to perform currency
exchanges over time.