MINE 396 – ENGINEERING ECONOMICS

Time Value of Money

Norman B. Keevil Institute of Mining Engineering

Background
• The economic value of a cash flow depends on when it occurs (i.e. the
timing of the cash flow).

⇒ $1 today > $1 tomorrow > $1 a year from now > ...

• Present value calculations allow us to determine the value today of a

stream of cash flows to be rec’d/paid in the future, by taking into account
the time value of money.

– Up to now, in Module 1, we ignored the impact of time as it relates to

the value of money.

• Why is the assumption relating to the value of money important?

What does it actually imply?

• This is an important concept which is widely used both in corporate and in

personal financial decision-making.
MINE 396 - Engineering Economics 2
Terminology and Symbols
“Remember that time is money”, B. Franklin (1748)
A dollar today is worth more than a dollar tomorrow.

The equations and procedures of engineering economy utilize the following

terms and symbols:
• P = value or amount of money at a time designated as the present or
time 0. Also P is referred to as present worth (PW), present value (PV),
net present value (NPV), net present worth (NPW), discounted cash
flow (DCF), and capitalized cost (CC); monetary units, such as dollars.
• F = value or amount of money at some future time. Also F is called
future worth (FW) and future value (FV); dollars.
• A = series of consecutive, equal, end-of-period amounts of money. Also
A is called the annual worth (AW), annuity, and equivalent uniform
annual worth (EUAW); dollars per year, euros per month.

The symbols P and F represent one-time occurrences: A occurs with the same
value in each interest period for a specified number of periods.
MINE 396 - Engineering Economics 3
Terminology and Symbols
It is important to note that the symbol A always represents a uniform amount
(i.e., the same amount each period) that extends through consecutive
interest periods. Both conditions must exist before the series can be
represented by A .
• t, n and N (at times used interchangeably) = number of interest
periods; years, months, days, etc.
• i and r (at times used interchangeably) = interest rate per time period;
percent per year, percent per month.
Simple Interest - Interest earned only on the original investment.
Compound Interest - Interest earned on interest.
The interest rate i is expressed in percent per interest period, for example,
12% per year. Unless stated otherwise, assume that the rate applies
throughout the entire n years or interest periods. The decimal equivalent for i
is always used in formulas and equations in engineering economy
computations.
MINE 396 - Engineering Economics 4
Terminology and Symbols
The interest rate per time period is also referred to the Minimum Attractive
Rate of Return (MARR), the discounted rate, the expected return, the
required rate of return (RRR), and the minimum rate of return for the
investment.
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return
established for the evaluation and selection of alternatives. A project is not
economically viable unless it is expected to return at least the MARR. MARR is
also referred to as the hurdle rate, cutoff rate, benchmark rate, and
minimum acceptable rate of return.
All engineering economy problems involve the element of time expressed as
n and interest rate i.
In general, every problem will involve at least four of the symbols P , F , A , n ,
and i , with at least three of them estimated or known.

MINE 396 - Engineering Economics 5

 Principle 1: money has a time value.
The concept of time value of money – a dollar received today, other things being the
same, is worth more than a dollar received a year from now, underlies many
financial decisions faced in business.

Interest: what a lender charges for use of money. It’s the cost of borrowing money.

stuff you need

principal
interest

charged at r%/unit time

MINE 396 - Engineering Economics 6
Time Value of Money

• Interest rate, or the rate of capital growth, is the rate of gain

received from an investment.
• For example, a 11% interest rate indicates that for every
dollar of money used, an additional $0.11 must be returned
as payment for the use of that money.

• The relationship between interest and time leads to the concept

of the time value of money.

• Money has an earning power. A dollar in hand now is worth more

than a dollar received n years from now. This is because having
the dollar now provides the opportunity for investing that dollar
for n years more than the dollar to be received n years hence, i.e.
this investment will earn a return.
MINE 396 - Engineering Economics 7
Time Value of Money (Contd.)

• This can be illustrated as:

• The purchasing power of a dollar changes through time. This is

because the future values are eroded by inflation.

• An entrepreneur expects to gain a premium on her investment,

to allow for the following three factors: inflation, risk taking and
the expectation of a real return.
MINE 396 - Engineering Economics 8
Using timelines to visualize cash flows

A timeline identifies the timing and amount of a stream of cash

flows along with the interest rate.

A timeline is typically expressed in years, but it can also be

expressed in months, days, or any other unit of time.

MINE 396 - Engineering Economics 9

Time line example

i=10%
 Years 0 1 2 3 4

 Cash flow -$100 $30 $20 -$10 $50

 The 4-year timeline illustrates the following:

 The interest rate is 10%.

 A cash outflow of $100 occurs at the beginning of the first year

(at time 0), followed by cash inflows of $30 and $20 in years 1 and
2, a cash outflow of $10 in year 3 and cash inflow of $50 in year 4.

MINE 396 - Engineering Economics 10

Annuities: Ordinary Annuity vs. Annuity Due
 Annuities are essentially a series of fixed payments required from you or paid to you at
a specified frequency over the course of a fixed period of time. The most common
payment frequencies are yearly (once a year), semi-annually (twice a year), quarterly
(four times a year) and monthly (once a month).

 There are two basic types of annuities: Ordinary Annuities and Annuities Due
 Ordinary Annuity: Payments are required at the end of each period. For example,
straight bonds usually pay coupon payments at the end of every six months until
the bond's maturity date. Examples also include mortgage payments and interest.
 Annuity Due: Payments are required at the beginning of each period. Rent is an
example of annuity due. You are usually required to pay rent when you first move
in at the beginning of the month and then on the first of each month thereafter.
Examples also include leases and car insurance.

 Since the present and future value calculations

for ordinary annuities and annuities due are
slightly different.

MINE 396 - Engineering Economics 11

Creating a timeline – try it yourself
Ordinary annuity
or annuity due?

Suppose you lend a friend $10,000 today to help him

finance a new Jimmy John’s Sub Shop franchise and in
return he promises to give you $12,155 at the end of
the fourth year.

How can one represent this as a timeline? Note that the

interest rate is 5%.

MINE 396 - Engineering Economics 12

Creating a timeline – solution

MINE 396 - Engineering Economics

13
Check yourself

Draw a timeline for an investment of $40,000 today that

returns nothing in one year, $20,000 at the end of year 2,
nothing in year 3, and $40,000 at the end of year 4.

MINE 396 - Engineering Economics 14

Solution… Timeline

r = i = interest rate; not given

Time Period 0 1 2 3 4

Cash flow -$40,000 $0 $20,000 $0 $40,000

MINE 396 - Engineering Economics 15

Simple interest and compound interest

What is the difference between simple interest and

compound interest?
 Simple interest: Interest is earned only on the principal
amount.
 Compound interest: Interest is earned on both the
principal and accumulated interest of prior periods.

Example: Suppose that you deposit $500 in your

savings account that earns 5% annual interest. How
much will you have in your account after two years
using (a) simple interest and (b) compound interest?

MINE 396 - Engineering Economics 16

Example: solution
 Simple Interest
 Interest earned = 5% of $500 = .05×500 = $25 per year
 Total interest earned = $25×2 = $50

 Balance in your savings account:

= Principal + accumulated interest
= $500 + $50 = $550

 Compound Interest (assuming compounding once a year)

 Interest earned in Year 1 = 5% of $500 = $25
 Interest earned in Year 2 = 5% of ($500 + accumulated interest)
= 5% of ($500 + 25) = 0.05×$525 = $26.25

 Balance in your savings account:

= Principal + interest earned = $500 + $25 + $26.25 = $551.25
MINE 396 - Engineering Economics 17
Discounting
• In economic evaluations, “discounted” is equivalent to “present value” or
“present worth” of money.

• As you know, the value of money is dependent on time; you prefer to have 100
dollars now rather than five years from now, because with 100 dollars you can
buy more things now than five years from now, and the value of 100 dollars in
the future is equivalent to a lower present value.

• That's why when you take loan from the bank, the summation of all your
installments will be higher than the loan that you take.

• In an investment project, flow of money can occur in different time intervals.

• In order to evaluate the project, time value of money should be taken into
consideration, and values should have the same base.

• Otherwise, different alternatives can’t be compared.

MINE 396 - Engineering Economics 18
Discounting
• Assume you temporarily worked in a project, and in the end (which is present
time), you are offered to be paid 2,000 dollars now or 2,600 dollars 3 years
from now. Which payment method will you chose?

• In order to decide, you need to know how much is the value of 2,600 dollars
now, to be able to compare that with 2,000 dollars.

• To calculate the present value of a money occurred in the future, you need to
discount that to the present time and to do so, you need discount rate.

• Discount rate, i, is the rate that money is discounted over the time, the rate
that time adds/drops value to the money per time period.

• It is the interest rate that brings future values into the present when
considering MINE 396 - Engineering Economics.

• Discount rate represents the rate of return on similar investments with the
same level of risk. MINE 396 - Engineering Economics 19
Discounting
• So, if the discount rate is I = 10% per year, it mean the value of money that you
have now is 10% higher next year.

• So, if you have P dollars money now, next year you will have P+iP = P(1+i) and if
you have F dollars money next year, your money is equivalent to F/(1+i) dollars
at present time.

• With the following fundamental equation, present value of a single sum of

money in any time in the future can be calculated.

• It means a single sum of money in the

future can be converted to an equivalent
present single sum of money, knowing
the interest rate and the time.

• This is called discounting.

MINE 396 - Engineering Economics 20

Compounding vs. Discounting
• The concept of compounding and discounting are similar.

• Discounting brings a future sum of money to the present time using

discount rate and compounding brings a present sum of money to
future time.

MINE 396 - Engineering Economics 21

Compounding vs. Discounting
• Discounting brings a future sum of money to the present time using
discount rate. The Present Value formula may be shown as:

or

• Compounding brings a present sum of money to future time. The Future

Value formula may be shown as:

or

MINE 396 - Engineering Economics 22

Present Value and Future Value

 Time value of money calculations involve Present value

(what a cash flow would be worth to you today) and Future
value (what a cash flow will be worth in the future).

 Present valuing (discounting) is central to the financial and

economical evaluation process. Since most of the project
costs, as well as benefits, occur in the future, it is essential
that these should be discounted to their present value
(worth) to enable proper evaluation.

 Future value analysis calculates the future worth of an

investment undertaken. Future value is simply the sum to
which a dollar amount invested today will grow given some
appreciation rate.

MINE 396 - Engineering Economics 23

Present Value and Future Value (Contd.)

 In the example, Present Value is $500 and Future Value

is $551.25 (if the yearly compounding rate is 5%).

 The linkage between present value and future value is:

Future Value = Present Value x (1+Interest Rate per period)Number of periods

 For annual compounding (compounding once a year):

Future Value = Present Value x (1+Annual Interest Rate)Number of years

-- If nothing is said, assume annual compounding. --

MINE 396 - Engineering Economics 24

Examples
 Example 1: The future value of $500 in 2 years with annual
compounding interest rate of 5% can be computed directly
from the formula:
FV2 = PV(1+i)2 = $500(1+0.05)2 = $500(1.05)2 = $551.25

 Example 2: Continue the example where you deposit $500

in savings account earning 5% annual interest. Show the
amount of interest earned for the first five years and the
value of your savings at the end of five years.
 you can do the calculation year by year
or
 use the formula for future value: FVn = PV(1+i)n

MINE 396 - Engineering Economics 25

Year by year compounding

YEAR PV or Interest Earned FV or

Beginning Value (5%) Ending
Value
1 $500.00 $500*0.05 = $25 $525.00

2 $525.00 $525*0.05 = $26.25 $551.25

3 $551.25 $551.25*0.05 =$27.56 $578.81

4 $578.81 $578.81*0.05=$28.94 $607.75

5 $607.75 $607.75*0.05=$30.39 $638.14

MINE 396 - Engineering Economics 26

Use the future value equation

• We will obtain the same answer using the future value

equation: FV = PV(1+i)n
= $500(1.05)5 = $638.14

• So the balance in savings account at the end of 5 years will

equal $638.14.
– The total interest earned on the original principal amount
of $500 will equal $138.14 (i.e. $638.14 - $500.00).

MINE 396 - Engineering Economics 27

Power of TIME

• Future Value and Compound Interest illustrated:

Future value of original investment increases with time,

unless interest rate is zero.
MINE 396 - Engineering Economics 28
Power of INTEREST RATE

• Future Value and Compound Interest illustrated:

An increase in interest rate leads to an increase in future

value.
MINE 396 - Engineering Economics 29
Example 3: calculating the Future Value of a Cash Flow

You are put in charge of managing your firm’s working capital.

Your firm has $100,000 in extra cash on hand and decides to put
it in a savings account paying 7% interest compounded annually.

How much will you have in your account in 10 years?

Again, what does compounded

annually imply?
Working capital is the capital (money) of a business
that is used in its day-to-day trading operations
(will elaborate further in MINE 406 / MINE 554).

MINE 396 - Engineering Economics 30

Example 3 (solution)

 Draw the time line:

 It is a simple future value problem. Use the future value equation:

FV10 = PV(1 + i)10 = $100,000 * (1.07)10 = $196,715

 Check for yourself: What’s future value in 20 years? What if the annual
return (interest rate) on the cash is 12%?
 $386,968; $964,629

MINE 396 - Engineering Economics 31

Summary: simple interest
Let:
V(t) = value at time t
r = interest rate, %/unit time (percent per unit of time)

Given principal V(a) at time t = a, what is V(b), b > a?

V{b) = V(a) + interest earned on V(a) during the time b – a

V ( b=
) V (a) 1 + r ( b − a )

Future Value Present Value

Linear growth
MINE 396 - Engineering Economics 32
Summary: compound interest
Let:
V(t) = value at time t
r = interest rate, %/unit time (percent per unit of time)

Given principal V(a) at time t = a, what is V(b), b > a?

The principal is redefined by adding the interest earned

in each time step
b −a
V ( b ) V ( a )(1 + r )
=

Future Value Present Value

Geometric growth
MINE 396 - Engineering Economics 33
Notes: simple and compound interest
The interest rate is stated as a percentage per unit time. Simple interest
is a linear extrapolation in which interest is earned on the original
principal. Compound interest is a case of geometric growth in which
interest is added to the principal at each time step to redefine the
principal.

To first order, compound interest is the same as simple interest.

V ( b=
) V ( a )(1 + r ) ≈ V ( a ) 1 + r ( b − a ) 
b −a

MINE 396 - Engineering Economics 34

 Present Value
Visual: Example 2
Assume: V(0) = $1,000; r = 10%/year; a = 0, b = 20 years

Geometric Growth

Linear Growth

Often referred to as the “magic of compound interest”, but there is no magic.

MINE 396 - Engineering Economics 35

 The notation (F/P, N, r) or (F/P, t, r) is a functional style
Introduce notation which is interpreted as “a factor that gives the future
value for a unit present value for a given interest rate
Let: V(a) = P (present value) and time period.”
V(b) = F (future value) We may also express that factor in functional notation
a=0 as (F/P, t, r), which is read as “find F, given P, t, and r.”
b=t>0 This is known as the single-payment compound-
amount factor.

When we incorporate the table factor into the formula, it is expressed as:
t
Ft = P (1 + r ) = P ( F P , t , r )
Be careful with
Commonly, t = N, an integer number of periods the brackets.
More to come...
N
FN = P (1 + r ) = P ( F P , N , r )

Note: The units of t or N must be consistent with the units used in r (in some
textbooks r is sometimes expressed as i)
e.g., t in days if r expressed as %/day
MINE 396 - Engineering Economics 36
Pseudo-functional notation
The notation (F/P, N, r) or (F/P, t, r) is a functional style which is
interpreted as “a factor that gives the future value for a unit present
value for a given interest rate and time period”, i.e.,

F 
F = P  ,N, r 
P 

a kind of dimensional correctness. Similar notation will be used for other

interest rate factors defined later.

MINE 396 - Engineering Economics 37

Example: you cannot afford to retire
You are 22, just graduated from university
Guaranteed Investment Certificates (GICs) giving r = 1%/year
How much to invest to yield $50,000 in 43 years (65 years old)
F = $50,000, r = 0.01, N = 43, P = ?

F $50,000 Difficult unless you

=P = N 43
≈ $32,595 give up all habits
(1 + r ) 1.01 including eating

but at r = 5%/year (not a GIC!)

F $50,000
=P = 43 43
≈ $6,135 Possible…

(1 + r ) 1.05

MINE 396 - Engineering Economics 38

 Compounding within the unit time interval
Banks frequently offer savings account that compound interest every day,
month, or quarter. More frequent compounding will generate higher
interest income for the savers if the annual interest rate is the same.

r by itself is known as a nominal rate (“in name only”) quoted without the
effect of compounding.
How it is compounded is important

Interest rates may be quoted as: “r% per unit time compounded m-ly”
Compounding occurs more than once during the interval

t=1
Interest rate m compounding
r/unit time periods within t = 1

1/m ≤ 1
MINE 396 - Engineering Economics 39
Generalized compound interest formula

There are m compounding periods within the unit time interval

The interest rate per compounding period is rm = r/m
rm is sometimes called the periodic rate
The total number of compounding periods in time t is mt
The compound interest formula becomes
mt
 r  mt
F=
P 1 +  P (1 + rm )
=
 m
The periodic rate r/m is the interest rate within each of the mt
periods. The time units of mt are consistent with the units used in r.

MINE 396 - Engineering Economics 40

Example 1: invest $100

Future value of $100 deposited in an account for two years

and earns interest at a rate of r = 7% compounded monthly.

m = 12 compounding periods per year

Number of compounding periods mt = 12 × 2 = 24
Periodic rate rm = 0.07/12 = 0.0058

(2*12 )
 0.07 
F=
$100  1 +  $114.98
=
 12 

MINE 396 - Engineering Economics 41

Example 2: compound interest with shorter (other)
compounding periods

You invest $500 for seven years to earn an annual

interest rate of 8%, and the investment is compounded
semi-annually. What will be the future value of this
investment?

 Use the more general formula:

FV=PV(1 + rate per period)Number of periods

 Rate per half year period is 8%/2 = 4%.

 Number of half-year periods in 7 years is 7 x 2 = 14 half years.
 FV = $500*(1 + 0.04)14 = $865.84
MINE 396 - Engineering Economics 42
Example 2 (continued)

Another way to write the future value equation, in terms of

annual rates and years:

Example 2, again:
FV = PV(1 + i/2)m*2 = $500(1 + 0.08/2)7*2 = $500*(1.04)14
= $865.84

MINE 396 - Engineering Economics 43

Example 3: given the same rate and time period, the
more frequent the compounding, the higher the future
value

MINE 396 - Engineering Economics 44

 Discounting and Present Value
 What is value today of cash flow to be received in the future?
The answer to this question requires computing the present value,
i.e., again, the value today of a future cash flow, and the process of
discounting, determining the present value of an expected future
cash flow.

 Since we know how to compound to get future value: FVn=PV(1+i)n

 We can get PV from FV: PV = FVn/(1+i)n

 Compound (multiply) to get future value; discount (divide) to get

present value.

 Present value is smaller than future value with positive rate.

MINE 396 - Engineering Economics 45

Present Value: example

 How much will $5,000 to be received in 10 years be worth today

if the interest rate is 7%?

 PV = FV /(1+i)n = $5,000 /(1.07)10 = $2,541.50

 To calculate present value, the interest rate is often referred to

as the “discount rate.”

 The PV formula (for annual compounding) can be represented as

follows:

MINE 396 - Engineering Economics 46

Impact of interest rates on PV

 If the interest rate (or discount rate) is higher (say 9%), the PV
will be lower.
PV = $5,000*(1/(1.09)10) = $5,000*(0.4224)
= $2,112.00

 If the interest rate (or discount rate) is lower (say 2%), the PV
will be higher.
PV = $5,000*(1/(1.02)10) = $5,000*(0.8203)
= $4,101.50

Note the slight variation in which the formula is written.

MINE 396 - Engineering Economics 47

Example 2
Solving for the Present Value of a Future Cash Flow

 Your firm has just sold a piece of property for $500,000, but
under the sales agreement, it won’t receive the $500,000 until
ten years from today. What is the present value of $500,000 to
be received ten years from today if the discount rate is 6%
annually?
 Verify the answer: $279,197.39

 What is the present value of $100,000 to be received at the end

of 25 years given a 5% discount rate?
 Verify the answer: $29,530.28

MINE 396 - Engineering Economics 48

Example 3: Quarterly compounding to retire
You are 22, just graduated from university
Investment giving 5%/year compounded quarterly (m = 4)
How much to invest to yield $50,000 in 43 years (65 years old)
F = $50,000; rm = 0.05/4 = 0.0125; mt = 43 × 4 = 172; P = ?

F $50,000
=P = mt 172
≈ $5,902
(1 + r m ) 1.0125
compared to $6,135 with annual compounding.

r = 5% is the nominal rate. Quarterly compounding means that

interest earned is added to the principal every 3 months.

MINE 396 - Engineering Economics 49

Solving for the number of periods

 Key Question: How long will it take to accumulate a specific amount in

the future?

 It is easier to solve for “n” using the financial calculator or Excel rather
than mathematical formula:

 FV = PV(1+i)n
 (FV/PV) = (1+i)n  Move PV to the left
 ln(FV/PV) = n ln(1+i)  Take the natural logs (ln) on both sides
 n = [ln(FV/PV)]/[ln(1+i)]  Move ln(1+i) to the left, switch sides

MINE 396 - Engineering Economics 50

Example 1

 How many years will it take for an investment of $7,500 to

grow to $23,000 if it is invested at 8% annually?

 n = ln(FV/PV)/ln(1+i)
= [ln(2,300/7,500)]/[ln(1.08)] = 1.12/0.077
= 14.56 years

MINE 396 - Engineering Economics 51

Examples 2 & 3

Solving for the Number of Periods, n

 Let’s assume that Honda Corporation has guaranteed that the

price of a new fully-loaded Civic will always be $20,000, and you’d
like to buy one but currently have only $7,752. How many years
will it take for your initial investment of $7,752 to grow to $20,000
if it is invested so that it earns 9% compounded annually?

 How many years will it take for $10,000 to grow to $200,000 given
a 15% compound growth rate?

 Verify the answers: 11years; 21.43 years.

MINE 396 - Engineering Economics 52

Valuation and Characteristics of Bonds

 Bonds make up one of the largest markets in the financial

world.

 Here we will discover how to price them and their

relationships to yield and return.

 Since bonds usually have clear beginning and ending times,

they can be easier to value than stocks.

MINE 396 - Engineering Economics 53

Valuation and Characteristics of Bonds

Pricing of Bonds
 We need to find 1) the present value of the coupons and 2) the
present value of the par value.
Given:
P = price (in $)
n = number of periods (number of years x 2)
C = semiannual coupon payment (in $)
r = periodic interest rate (required annual yield x 2)
M = maturity value
t = time period when the payment is to be received

with the present value of the coupon payments found by the

following annuity formula
MINE 396 - Engineering Economics 54
Valuation and Characteristics of Bonds

General Valuation: The following comments are valid for all kind
of assets.

 Book Value
 Stated value from the firm’s Balance Sheet
 Market Value
 The price for the asset at any given time--determined by supply and
demand in the marketplace. Asset can be bought or sold at this price.
 Intrinsic Value
 Present value of the asset’s expected cash flow
 Investor estimates cash flows
 Investor determines required rate based on risk of asset and market
conditions.
MINE 396 - Engineering Economics 55
Valuation and Characteristics of Bonds

 In a perfect market where all investors have the same

expectations & risk aversion:

Market Value = Intrinsic Value

 Par Value
 Usually $1,000. Also called the Face Value
 Coupon Interest Rate
 Borrowers (firms) typically make periodic payments to the
bondholders. Coupon rate is the percent of face value paid every
year.
 Maturity
 Time at which the maturity value (Par Value) is paid to the
bondholder. MINE 396 - Engineering Economics 56
Valuation and Characteristics of Bonds

Bond Valuation Model

 Bond Valuation is an application of Present Value.

 The Value of the bond is the present value of all the cash flows
the investor receives as a result of holding the bond.
 3 Cash Flows
 Amount that is paid to purchase the bond (PV)
 Periodic Interest Payments made to the bondholders (PMT)
 Payment of maturity value at end of Bond’s life.
 Other Terminology
 Time frame for cash flows (N) = Bond’s Maturity
 Interest Rate for Time Value is the rate at which future cash flows are
being discounted to present.
MINE 396 - Engineering Economics 57
The Bond Pricing Equation

 1 
1 -
 (1 + r) t  F
Bond Value = C  + t
 r  (1 + r)
 

MINE 396 - Engineering Economics 58

 Bond Valuation Model
Compute Bond’s Intrinsic Value
2014 2015 2016 2017 2018 2019

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00
$59.03
$54.66
$50.61
$46.86
$43.39
$1000
(1.08) 5
$680.58
$935.12
Compute the Intrinsic Value for the IBM Bond given that you require a 8% return
on your investment.
 Bond Valuation Model
Compute Bond’s Intrinsic Value
2014 2015 2016 2017 2018 2019

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00
$63.75 Annuity for 5 years

$1000 Lump Sum in 5 years

Vb = I(PV of Annuity) + PV of Par

 Bond Valuation Model
Compute Bond’s Intrinsic Value
2014 2015 2016 2017 2018 2019

0 1 2 3 4 5

63.75 63.75 63.75 63.75 63.75

1000.00
$63.75 Annuity for 5 years

$1000 Lump Sum in 5 years

Vb = I(PV of Annuity) + PV of Par

= $63.75(3.9927) + $680.58
= $254.54 + $680.58 = $935.12
 Bond Valuation Model
Some Bonds Pay Interest Semi-Annually:
2014 2015 2016 2017 2018 2019

0 1 2 3 4 5

45 45 45 45 45 45 45 45.00
1000.00
Compute the Intrinsic Value for the Kroger Bond given that you require a 10%
return on your investment.

Since interest is received every 6 months, need to use semi-annual compounding

Vb = 45(6.4632) + 676.84
= 290.85 + 676.84 = 967.68
Doubling your money
Using the Rules of 69, 70 & 72

 The "Rule of 69," "Rule of 70," and "Rule of 72" refer to

shortcuts for estimating the doubling time of a process that
increases at a constant rate.

 If the growth rate is R% and you select the "Rule of N" (N = 69,
70, or 72), then it requires approximately N/R periods for the
quantity to grow to twice its original size.

 Below we explain how to choose the appropriate value of N

and why the method yields accurate estimates.

MINE 396 - Engineering Economics 63

Doubling your money
Using the Rules of 69, 70 & 72

When to Use N = 69 (aka: Rule of 69.3)

 Use N = 69 when dealing with any continuous growth process

(that is, it is more accurate for continuous compounding), or
when you have a periodic growth process and the rate is
between 0% and 0.5%.

 Rule of 69: N = 69 / interest rate in percentage

 Example: A culture of cells grows at a continuous rate of 0.40%

per day. In how many days will the number of cells double?
Solution: Simply calculate 69/0.40 = 172.5, so the answer
is about 172.5 days.
MINE 396 - Engineering Economics 64
Doubling your money
Using the Rules of 69, 70 & 72

When to Use N = 70

 Use N = 70 to approximate the doubling time when the

periodic rate is between 0.5% and 4.9% (Rule of 70 is used in
instances of semi-annual compounding.).

 Rule of 70: N = 70 / interest rate in percentage

 Example: You invest money in a savings account that earns

3.5% interest compounded yearly. How long must you wait for
your money to double if you never add or subtract funds?
Solution: Calculate 70/3.5 = 20, so the answer is roughly
20 years.
MINE 396 - Engineering Economics 65
Doubling your money
Using the Rules of 69, 70 & 72
When to Use N = 72

 Use N = 72 when the growth rate is between 4.9% and 11%

(Rule 72 works well in common interest situations and is more
easily divisible. Is the basic thumb rule to be used in case of
annual compounding.).

 Rule of 72: N = 72 / interest rate in percentage

 Example: Since 2007, a business has grown annually by 8%. At

this rate, when will the business double?
Solution: We compute 72/8 = 9, so the business will
double in size in about 9 years. This means in 2016 it will
be roughly twice as large as it was in 2007.
MINE 396 - Engineering Economics 66
Rule of 72: Examples 1 & 2
Example 1: How long does it take to double your money given an
interest rate r?
P (1 + r ) or 2 =( )
t t
F= 2P = 1 + r
ln ( 2 ) 0.69 69 72
t
= ≈ = or
ln (1 + r ) r 100r 100r
Use r expressed as a percentage.
Express r in
About 7 years at r = 10%; 36 years at r = 2% decimal form

Example 2: Using Rule of 72, determine how long it will take to double
your investment of $10,000 if you are able to generate an annual
return of 9%.
 Exact n = ln(2)/ln(1.09) = 0.693/0.086 = 8.04 years
 Approximate n = 72/9 = 8
MINE 396 - Engineering Economics 67
Rule of 72: Example 3
Example 3: An investment account earns 8.3% per year. How
many years is it until $80,000 will be in the account for
$20,000 investment?
 Exact n = ln(80,000/20,000)/ln(1.083) = 17.3863 years

 Approximate n = 2* (72/8.3) = 17.3494 years

Why? Hint…
See definition
of Rule of 72

MINE 396 - Engineering Economics 68

Solving for rate of interest

 Key Question: What rate of interest will allow your investment

to grow to a desired future value?

 FV = PV(1+i)n
 (FV/PV) = (1+i)n  Move PV to the left
 (FV/PV)(1/n) = 1+i  Take (1/n) root on both sides
 i = (FV/PV)(1/n)-1  Move 1 to the left, switch sides

MINE 396 - Engineering Economics 69

Example 1

 At what rate of interest must your savings of $10,000 be

compounded annually for it to grow to $22,000 in 8 years?

i = (FV/PV)(1/n) - 1 = ($22,000/$10,000)(1/8) - 1 = 0.1036 = 10.36%

MINE 396 - Engineering Economics 70

Examples 2 & 3

Solving for the Interest Rate, i

 Let’s go back to that Honda Civic example. Recall that the Civic
always costs $20,000. In 10 years, you’d really like to have
$20,000 to buy a new Civic, but you only have $11,167 now. At
what rate must your $11,167 be compounded annually for it to
grow to $20,000 in 10 years?

 At what rate will $50,000 have to grow to reach $1,000,000 in 30

years?

Verify the answers: 6%; 10.5%.

MINE 396 - Engineering Economics 71

Making interest rates comparable
 The Annual Percentage Rate (APR) indicates the amount
of interest paid or earned in one year without
compounding. APR is also known as the nominal or stated
interest rate. This is the posted rate required by law.

 We cannot compare two loans based on APR if they do

not have the same compounding period (i.e.: assume one
is compounded semi-annually while the other is
compounded daily).

 To make them comparable, we calculate their equivalent

rate using an annual compounding period. We do this by
calculating the Effective Annual Rate (EAR).

MINE 396 - Engineering Economics 72

In other words… APR vs EAR
 The most common way to quote interest rates is in
terms of Annual Percentage Rate (APR).
 It does not incorporate the effects of compounding.

 The most appropriate way to quote interest rates is in

terms of Effective Annual Rate (EAR).
 It incorporates the effects of compounding.

MINE 396 - Engineering Economics 73

In other words… APR vs EAR

Annual Percentage Rate (APR)

 APR reflects the nominal rate of interest to be repaid
or earned each year.
 If you borrow $1,000 for one year at an APR of 12
percent, the estimated interest can be calculated
as (1,000 times 0.12), or $120.
 In most cases, however, you will actually pay
slightly more than $120 in interest.

MINE 396 - Engineering Economics 74

In other words… APR vs EAR

Effective Annual Rate (EAR)

 To calculate the true interest you will pay, you must
consider the EAR.
 EAR helps you determine not only the amount of
interest you pay on your principal, but also the
amount of interest you'll pay on the interest owed
with each payment.
 A $1,000 loan with an APR of 12 percent actually
results in an EAR of 12.55 annually.
 This means you will pay a total of $125.50 in
interest over the year.
MINE 396 - Engineering Economics 75
In other words… APR vs EAR

The Effective Annual Interest Rate

 Anna is charged 1% interest when she borrows
$2,000 for one week.
 What is the Annual Percentage Interest Rate (APR) on
the loan?

𝐴𝐴𝐴𝐴𝐴𝐴 = 0.01 × 52 = 0.52, 𝑜𝑜𝑜𝑜 52%

MINE 396 - Engineering Economics 76

In other words… APR vs EAR

Effective Annual Interest Rate (EAR)

 EAR accounts for the number of compounding
periods and adjusts the annualized interest rate for
the time value of money
 EAR is a more accurate measure of the rates involved
in lending and investing

𝑚𝑚
𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄𝑄 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅
𝐸𝐸𝐸𝐸𝐸𝐸 = 1 + −1
𝑚𝑚

MINE 396 - Engineering Economics 77

In other words… APR vs EAR

Effective Annual Rate (EAR) Example

 Anna is charged 1% interest when she borrows
$2,000 for one week.
 What is the effective annual interest rate (EAR)?

𝐸𝐸𝐸𝐸𝐸𝐸 = 1 + 0.01 52 − 1 = 0.6777, 𝑜𝑜𝑜𝑜 67.77%

MINE 396 - Engineering Economics 78

In other words… APR vs EAR

Effective Annual Rate (EAR) Example

 Your credit card has an APR of 12 % (1% per month).
 What is the EAR?

12
0.12
𝐸𝐸𝐸𝐸𝐸𝐸 = 1 + − 1 = 0.1268, 𝑜𝑜𝑜𝑜 12.68%
12

MINE 396 - Engineering Economics 79

Linking APR to EAR

 APR is the quoted annual rate with a pre-specified

compounding frequency. Let m be the number of
compounding periods per year for this APR.

 EAR is the effective annual rate at an annual

compounding frequency [one compounding per year].

 The two should generate the same amount of money

in one year:

(1 + APR/m)m = (1 + EAR)  EAR = (1 + APR/m)m - 1

MINE 396 - Engineering Economics 80

Effective rate
Written differently:
An effective annual rate re equivalent to an annual (nominal)
rate r compounded m-ly

Compounding at rm for m periods/year must be equivalent to

compounding at re over one year

P (1 + rm ) =P (1 + re )
m

⇒ re = (1 + rm ) − 1
m

MINE 396 - Engineering Economics 81

Example 1: invest $100 again (for two years)

The effective rate corresponding to compounding at

rm = 0.07/12 for 12 periods/year

12
 0.07 
re =  1 +  − 1 = 0.0723
 12 
2
F=$100 (1 + 0.0723) =$114.98

The extra 0.0023 (that is, 0.0723 – 0.0700) on the

interest rate accounts for the monthly compounding.

MINE 396 - Engineering Economics 82

Example 2: Credit card balance

Typical credit card interest rate is 18%/year, i.e., r = 0.18 (nominal)

Transactions reconciled monthly, so m = 12 and r12 = 0.18/12 = 0.015
What is re (effective annual rate (EAR))?

1 + re = (1 + r12 )
12

=re 1.01512=
− 1 0.1956 or 19.56%

Credit card companies used to report interest rates as “18%

compounded monthly” which is equivalent to EAR = re = 19.56%
They (VISA, MasterCard, etc.) are now required to report re.

MINE 396 - Engineering Economics 83

Examples 3 & 4

Calculating an EAR (Effective Annual Rate)

 Assume that you just received your first credit card

statement and the APR, or annual percentage rate listed on
the statement, is 21.7%. When you look closer you notice
that the interest is compounded daily.

 What is the EAR, or Effective Annual Rate, on your credit

card?

 What is the EAR on a quoted or stated rate of 13% that is

compounded monthly?

Verify the answers: 24.23%; 13.80%

MINE 396 - Engineering Economics 84
Notes: effective, periodic, nominal interest rates
There are several terms used to describe interest rates (or
discount rates):

1. The nominal interest rate is a quoted rate that does not

include the effects of compounding (APR). The classic
example is credit card interest which might be quoted as
a nominal 18% but which is actually compounded
monthly.

2. The periodic interest rate is the rate that applies for a

period of time. Thus 18%/year corresponds to an
periodic rate of 18%/12 = 1.5% per month. The periodic
rate is sometimes called the effective rate, but that can
become confused with the effective annual rate or simply
what is called the effective rate in these notes.
MINE 396 - Engineering Economics 85
Notes: effective, periodic, nominal interest rates
3. The effective rate per time interval is the interest rate
which corresponds to compounding at the periodic rate
for the number of periods within the time interval
(EAR). Thus compounding at 1.5% for 12 periods is
equivalent to an effective (annual) rate of 19.56%.

Usually in project economics the discount rate quoted is an

annual rate with no mention of how often compounding
occurs, although annual compounding is the common
assumption.

Often one may wish to model a cash flow that occurs within the
year so that the periodic rate corresponding to the annual rate
is needed, e.g., the monthly rate corresponding to an annual
rate. The annual rate is then the effective rate.
MINE 396 - Engineering Economics 86
As the number of compounding periods increases …

1.106 FV = PV(1+i)n => FV = PV er*t

exp(rt) = 1.1052
1.105
Compounding factor (1+r/m)mt

1.104
r = 10%
1.103 t = 1 year

1.102 daily compounding

1.101

1.100
1 10 100 1000
Number of compounding periods m/year
MINE 396 - Engineering Economics 87
Continuous compounding: in the limit as m → ∞
1st year calculus
m m t
 r  r
  r  
lim= 1 +  e so that  lim =1 +   e rt
m→∞  m 
m→∞  m  

Substitute into compound interest formula to get continuous

compounding formula:
F Pe
= = rt
P [F P , t , r ]
Note: the square brackets denotes continuous compounding.

From the graph on the previous slide, daily compounding is almost

equivalent to continuous compounding.

MINE 396 - Engineering Economics 88

Continuous compounding

 When the time intervals between when interest is paid are

infinitely small, we call it continuous compounding. In this case,
future value and present value is linked as:
 FV = PV er t
 r is the continuous compounding rate, t is number of years.
 e is the “natural number” ("Natural" Exponential) 2.71828.
Specifically:

 Continuous compounding rate is linked to EAR as:

 EAR = er - 1, again obtained by matching the one-year future
value from the two compounding frequencies.
MINE 396 - Engineering Economics 89
Example 1: effective rate for continuous compounding

Assuming t = 1 year, the effective annual interest rate (EAR) equivalent

to continuous compounding at a rate r is given by:

Pe
= r
P (1 + re )
r
r=
e e −1

For r = 0.1, re = 0.1052

MINE 396 - Engineering Economics 90

Example 2

What is the EAR on your credit card with continuous

compounding if the APR is 18%?

EAR = e0.18 – 1
= 1.1972 – 1
= 0.1972 or 19.72%

MINE 396 - Engineering Economics 91

Return on investment (ROI)
What investors expect by contributing their money:

Project or Company

F
Return= −1
P

MINE 396 - Engineering Economics 92

Discounting

The present value of predicted future values is of interest for

valuation of a project.

Given F solve compound interest formula for P:

F
Discrete:
= P = t
F (P F , t , r )
(1 + r )
s: P Fe
Continuou= = − rt
F [P F , t , r ]

MINE 396 - Engineering Economics 93

Continuous Compounding and Discounting
“Money is invested continuously and earns interest every instant that you have
the money invested.” Continuous Compounding

Discrete payments: if interest is compounded continuously but payments are

made annually, the following equations can be used:

Future Value

Continuous Compounding=
: F Pe
= rt
P [F P , t , r ]

Present Value

Continuous Discountin=
g: P Fe
= − rt
F [P F , t , r ]

MINE 396 - Engineering Economics 94

Continuous Compounding and Discounting
Present Value - Example

What is the present value of $10,000 to be received in two years if the interest
rate is 8% and continuous discounting is employed?

How about with annual discounting (discrete)?

(Continuous)
PV0 = $10,000e-0.08(2) = $10,000[P/F, 8%, 2] = $10,000[0.8521] = $8,521
Check out the Interest and Annuity Tables for Continuous Compounding

(Discrete)
PV0 = $10,000[1/(1 + 0.08)]2 = $10,000(P/F, 8%, 2) = $10,000(0.8573) = $8,573
Check out the Interest and Annuity Tables for Discrete Compounding

MINE 396 - Engineering Economics 95

Discounted Cash Flow (DCF)

• If future cash flow is discounted, we can have cash flow in terms of

present value, which is called Discounted Cash Flow (DCF).

• DCF considers the time value of money and applies it to the inflow
and outflow of money occurred in the future.

• DCF is a tool that enables us to compare the future cash flow with
the present value of money.

• Different investment projects have different cash flows that

happen in different time intervals in the future and DCF can give an
assessment to decide which project is more profitable.

MINE 396 - Engineering Economics 96

Discounted Cash Flow (DCF)

• DCF brings the future amounts to a same base that is easily

understandable for decision makers.

• For example, assume you have two options: investing your

money in Project A that gives you $1,000 every year from 2025
to 2035 or investing in Project B that gives you $1,500 every
year from 2030 to 2040.

• Which project will you choose?

• DCF is a tool that can help you finding the answer.

• DCF can also be used to estimate the value of a company based

on its future performance.

MINE 396 - Engineering Economics 97

Discounted Cash Flow (DCF)

• Please calculate the discounted cash flow, assuming:

1) Discount rate = 10%

2) Discount rate = 12%
3) Discount rate = 15%

• Assuming discount rate = 10%:

Cash flow in year 0: -20[1/(1 + 0.1)0] = -20
Cash flow in year 1: -15[1/(1 + 0.1)1] = -13.6
.
.
.
Cash flow in year 7: 12[1/(1 + 0.1)7] = 6.2
Cash flow in year 8: 11[1/(1 + 0.1)8] = 5.1
MINE 396 - Engineering Economics 98
Discounted Cash Flow (DCF)

• We can repeat the same procedure for discount rate = 12% and 15%.
The following shows the results.

Table: Cash Flow in millions of dollars

aka: Net Present Value

MINE 396 - Engineering Economics 99

Values at the same time point can be added

P = P1 + P2 + P3 +  = ∑ Pi
F = F1 + F2 + F3 +  = ∑ Fi
P1+P2+P3
3
1

0 T
2 F1+F2+F3

MINE 396 - Engineering Economics 100

Discrete and continuous Present Value

Given N discrete cash flows fj, 1 ≤ j ≤ N occurring at times tj

For discrete discounting:

N N fj
=Pd fj (P F , t j , r ) ∑
∑= tj
=j 1 =j 1 (1 + r )

For continuous discounting:

N N
− rt j
=Pc ∑=
f j P F , t j , r  ∑ fje
=j 1 =j 1

Note: The units of tj must be consistent with the units used in r

e.g., tj in months, r expressed as %/month

MINE 396 - Engineering Economics 101

Example: Monthly construction expenses/1

Manulife Place, Edmonton Alberta, Concrete slab foundation

Month
0 2 4 6 8 10 12 14 16 18 20 22 24 26
0

-1,000
Cash flow per month ($000)

-2,000

-3,000

-4,000

-5,000

MINE 396 - Engineering Economics 102

Example: Monthly construction expenses/2

Suppose the discount rate r = 8%/year

This is an effective annual rate re = 8%/year

An equivalent monthly rate is needed:

1 + re = (1 + r12 )
12

r12 1.081 12=

= − 1 0.00643 or 0.643%

MINE 396 - Engineering Economics 103

Example: Monthly construction expenses/3

The total present value of the 25 monthly cash flows is:

discrete Pd = −$61,611,277
discounting
Pc = −$61,404,597
continuous
discounting
The total cash spent is:
25

∑ f = −$67,125,000
j =1
j

The total cash is the present value for r = 0 (no discounting).

MINE 396 - Engineering Economics 104

Different discounting, different present value
Let r = 10%/year and FV = $1,000.

For single period discounting, PV equals to:

$1,000
= P = $909.09
1.1
For continuous discounting , PV equals to:

$1,000
=P = 0.1
$904.84
e
For a given future value the present value computed using continuous
discounting is always less than the present value computed using
single period discounting.

MINE 396 - Engineering Economics 105

Interest and Annuity Tables - Discrete Compounding

Example: Finding Future Value

A person deposits $5,000 into an account which pays interest at

a rate of 8% per year. Calculate the amount in the account after
10 years.

The cash flow diagram is: Solution:

F = P(F/P, i, n)
= 5,000(F/P, 8%, 10)
= 5,000(2.1589)
= $10,794.50

MINE 396 - Engineering Economics 106

Interest and Annuity Tables - Discrete Compounding

From Table 11 (Single Payment)

MINE 396 - Engineering Economics 107

Interest and Annuity Tables - Discrete Compounding

Example: Uniform Series Involving P/A (an annuity illustration)

A chemical engineer believes that by modifying the structure of a

certain water treatment polymer, his company would earn an extra
$5,000 per year. At an interest rate of 10% per year, how much could
the company afford to spend now to just break even over a 5 year
project period?

The cash flow diagram is as follows:

A = $5000 Solution:
P = 5,000(P/A,10%, 5)
4 5
= 5,000(3.7908)
0 1 2 3
i =10% = $18,954
P=?

MINE 396 - Engineering Economics 108

Interest and Annuity Tables - Discrete Compounding

From Table 13 (Uniform Series)

MINE 396 - Engineering Economics 109

MINE 396 - Engineering Economics 110