Engineering Economics and Financial

Management

Lecture 3
Time value of money
 We will learn
 Interest and Interest rate
 2 view points on interest
 Meaning of Time Value of Money
 Cash Flow Diagrams (CFDs)
 Simple and compound interest
 INTEREST AND INTEREST RATE
Interest:
is the rental amount charged by the financial
institutions for the use of money.

Interest rate:
is the rate at which interest is paid by a borrower for
the use of money that they borrow from a lender.

Generally, Interest rates are stated on a per year basis.

 2 aspects of interest
1. Money received as a result of investing.
GAIN or PROFIT
2. Money paid out as a result of borrowing funds.
COST

3. Lender’s viewpoint
4. Borrower’s viewpoint
 Factors influencing the interest rate
LENDER’S VIEWPOINT
i. Opportunity cost, that is, compensation for being
deprived of electing other alternatives.
ii. Probability that the borrower will repay the loan.
iii. Expenses incurred in investigating the borrower,
transferring funds or collecting it back.
iv. Probability that the interest rate may change due to
inflationary effects.
 Factors influencing the interest rate
Borrower’s viewpoint
Alternatives open to the borrower for the use of funds
are limited by the lender.

a) If the borrower uses funds for personal use

Interest rate < Privilege of having
satisfaction immediately
b) If borrower uses funds to finance business
operations
Interest rate< expected gain
 Why does money have time value?
 Money has a time value
because it can earn more
money over time (earning
power).

 Money has a time value

because its purchasing power
changes over time (inflation).

 Time value of money is

measured in terms of interest
rate.
The relationship between _____ and _______
is the concept of Time Value of Money (TVM)
The relationship between time and interest rate
is the concept of Time Value of Money (TVM)
 Simple Interest
 P = Principal amount
 i = Interest rate End of Beginning Interest Ending
Year Balance earned Balance
 N = Number of interest
0 $1,000
periods
 Example: 1 $1,000 $80 $1,080
 P = $1,000 2 $1,080 $80 $1,160
 i = 8%
 N = 3 years 3 $1,160 $80 $1,240
 Simple Interest Formula
F  P  (iP ) N
where
P = Principal amount
i = simple interest rate
N = number of interest periods
F = total amount accumulated at the end of period N

F  $1, 000  (0.08)($1, 000)(3)

 $1, 240
 Compound Interest
 P = Present (Principal) amount
 i = Interest rate End Beginning Interest Ending
of Balance earned Balance
 n = Number of interest periods Year
 Example: 0 $1,000
 P = $1,000
1 $1,000 $80 $1,080
 i = 8%
 n = 3 years 2 $1,080 $86.40 $1,166.40

3 $1,166.40 $93.31 $1,259.71

 Compound Interest
Years Initial Amount at the Interest Final amount at the end of year
beginning of year
0 -------- --------- P
1 P i* P P + i * P= P(1+i)
2 P(1+i) i * P(1+i) P(1+i) + i*P(1+i) =

3 *i + *i=

4 *i + *i=
5 *i + *i=
n Results in a final
amount of

Engineering Economics
 Example:
In 1626, Peter Minuit of DWI Co., paid $24 to purchase
Manhattan Island in NY from the Indians. In retrospect,
if Minuit had invested the $ 24 in a savings account that
earned 8% interest, how much it would be worth in
2020?
Calculate using both SI and CI.
 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.

0 i% 10
End-of-Period Convention

0
1

Beginning of End of interest

Interest period period

0 1
Cash Flow Diagram (CFD)
 Cash Flow Diagram
(a) Borrower’s viewpoint

Loan in Rs

+ 1 2 3
time
- 0 10
Payment (expenditures)
Rs Rs Rs

(b) Lender’s viewpoint

Rs Rs Rs Payment (receipt)

+
0 time
- i% 10

Loan in Rs
Example : Cash Flow diagram (CFD)

Engineering Economics
 Ex 1: Draw CFDs
• If $1,500 is invested now, $1,800 two years from now, and $2,000 four
years from now at an interest rate of 6% compounded annually, what
?
will be the total amount in 15 years?

0 И 15 Years
1 2 3 4

6%
$1500
$1800
$2000

Engineering Economics
 Ex 2: Draw CFDs
• A student is buying an automobile that costs $12,000 and she will borrow the
money from a bank, and pay the loan off in five annual instalments. At 15% interest
rate, what is the installment amount ? Prepare a cash flow diagram to represent this
situation.

$12000
15%

5 years
0 1 2 3 4

A A A A A

Engineering Economics
 Ex 3: Draw CFDs

a) Suppose you make an annual contribution of $3000 to your

savings account at the end of each year for 10 years. If the
account earns 7% interest annually, how much can be
withdrawn at the end of 10 years?

b) Suppose the ten deposits were made at the beginning of each

period, what is the balance at the end of period 10?
Engineering Economics
a)

=?

7%

И
0 1 2 3 4 5 10 years
1

3000 3000 3000 3000 3000 3000

Engineering Economics
b)

=?

И
0 1 2 3 4 9 10 years
1

3000
3000 3000 3000 3000 3000

Engineering Economics
 Ex 4: Draw CFDs

• Suppose that you have a savings plan covering the next ten years,
according to which you put aside $600 today, $800 at the end of
every year for the next five years, and $2000 at the end of each
year for the remaining five years. As part of this plan, you expect to
withdraw $300 at the end of every year for the first 3 years, and an
amount A at the end of every year thereafter till the 10 th year. Draw
your cash flow diagram.
Engineering Economics
 A=?

300

0 1 2 10 years
3 4 5 6 7 8 9
600
800 800 800 800 800

2000 2000 2000 2000 2000

Engineering Economics
 Practice Problem
• Arun buys a car, making an initial payment of Rs. 1,00,000/- and
taking a loan of Rs. 1,50,000 from ICFC Bank. He makes equal
monthly repayments of Rs.8000 to ICFC Bank, to clear the loan in
full for a period of 2 years. After making the last payment, he sells
the car for Rs. 1,50,000. Draw two CFD’s one for Arun and one for
ICFC Bank for the above cash flow.

Engineering Economics