COURSE TITLE

ENGINEERING ECONOMIC
ANALYSIS

INTEREST AND TIME VALUE OF MONEY

Time value of Money, Interest, Single Cash flow Formula,

Economic Equivalence &Nominal and Effective Interest
Learning Objective
After studying this lecture students will be able to learn:

➢The concept of time value of money.

➢Simple and Compound Interest.
➢The formula required to analyse the single cash flow.
➢Economic Equivalence
➢Nominal and Effective interest rate.
 Time Value of Money

Lets Begin with an Example:

Option 1 : Receiving $1000 today OR

Option 2 : Receiving $ 1000 a year after

Which option would you Prefer??

 Time Value of Money (Cont’d..)

➢Definitely you receive $ 1000 today, because you can

invest this money in some business and the profit can be
earned so that its value is greater that $1000 a year after.

➢The value of money grows when the time is elapsing.

➢The phenomenon of growing the money with respect to

time is called the time value of money.
 Time Value of Money (Cont’d..)
➢ Money has two types of power:

(a) Earning Power

(b) Purchasing Power

➢ Earning power of money is concerned with the ability of a

business to earn a profit on invested capital after paying owners
and employees, servicing obligations, and fully recognizing its
costs while following good accounting practices. [1]
 Time Value of Money (Cont’d..)
• Purchasing Power is concerned with the ability of the
money to buy certain commodity.

• Inflation and Deflation is considered for the analysis.

• If the ability of money to buy some goods decreases then

it is the condition of inflation

• If the ability of money can buy greater quantity than it is

the condition of deflation.
 Time Value of Money (Cont’d..)

➢Time value of money is concerned with earning potential

of the money.

➢The simple concept of time value of money is that the

value of money received today is more than the value of
same money received after a certain period.
 Time Value of Money (Cont’d..)

➢The change in the amount of money over a given time

period is called the time value of money, which is the
important concept in engineering economy. [2]

➢This ability of money to change its value over time is

due to the interest.

➢In another words, Time value of money can be defined

as the relationship between interest and time.
 Time Value of Money (Cont’d..)
➢The value of money can be analysed either on a given future date
or the present date.

➢When the value is calculated at the future date, it is called ‘future

value’ of money

➢Similarly, when the value is calculated on a present date, it is

called the ‘present value’ of money.

➢The calculation on the future date is called the ‘compounding

process’ and calculation on the present date is called the
‘discounting process’.
Time Value of Money (Cont’d..)

Figure :Time value of Money [3]

 Interest
➢In simple terms interest is the fee that is charged for the
use of someone’s else money. [4]

➢The size of the fee will depend upon the total amount of
money borrowed and the length of time over which it is
borrowed. [4]

➢Computationally, interest is the difference between the

ending amount and beginning amount of money.

Interest = End amount – Original amount

 Interest rate

When the interest over a specific time unit is expressed as a

percentage of the original amount (principal), the result is
called the interest rate

Interest Rate = (interest accrued per time unit) * 100%

original amount
 Elements of Interest
1. An initial amount money including loan or investment is
called principal.
2. The rate expressed in a percentage per period of time is
called interest rate
3. A period of time which determines the frequency of
interest is called the interest period.
4. A specified length of time that marks the duration of the
transaction and thereby establishes a certain number of
interest period. [5]
5. The money that results from the cumulative effects of
the interest rate is called Future amount.
Elements of Interest (Cont’d..)
Future amount
Interest rate
Interest period
F
i%

0 N
1 2 3 N -2 N -1

Specified length of time

Principal
 Calculation of Interest
➢Money earns the interest in different ways.

➢The interest earned on the principal amount at the end of

interest period is calculated according to the interest rate. [4]

➢The two types of techniques are used for the calculation of

interest:
1. Simple Interest and
2. Compound Interest
➢However compound interest is used widely and exclusively.
 Simple Interest
➢When the money is borrowed for certain period of time,
the borrower pays interest to the lender, only on the
borrowed amount is the simple interest. [6]

➢In other words , when the interest is earned only on the

principal amount during each interest period is called
simple interest.

➢It does not earn additional interest on accumulated

interest, so it ignores the effect of compounding.
 Simple Interest (Cont’d….)
Let,
P = Principal amount (borrowed amount)
i = Interest rate per period of time
N = Specified length of time
The simple interest (I) is calculated as:
I =P*N *i
The Future sum of value at the end of interest period
(N) will be
F=P+I
F =P+P*N*i
F = P (1 + Ni)
 Example of Simple Interest
Suppose that $ 1000 is being deposited into the saving
account which earns 7% simple interest. What is the
accumulated value at the end of 2nd year?
Here, principal amount (P) = $ 1000
interest rate (i%) = 7%
Time (N) = 2 year
Simple Interest = P * N * i = 1000*0.07 *2
= $140
Future Value (F) = 1000 +140 = $1140.
 Compound Interest
➢When the total time period is subdivided into several interest
periods (one year, half yearly, quarterly, monthly etc.),
interest is credited at the end of each interest period.

➢The credited interest is allowed to accumulate from one

interest period to next, then the interest is said to be
compound interest. [4]

➢Suppose that if you invest $ 1000 for 2 years at an interest

rate at 10% for 2 years then:
 Compound Interest (Cont’d….)

➢The interest earned in first year is $1000*0.1 = $ 100

➢Future value after one year is

$1000+100 = $ 1100.

➢In the second year interest is charged for $ 1100 and

the future value will be

$1100 +$1100*0.1 = $1210.

 Single Cash Flow Formula

The single cash flow formula deals with the only two
amount: a single present amount P and Future amount F.
TO FIND F WHEN P IS GIVEN
If P dollar is deposited (invested) today at interest rate of
i%, then
F =?
Interest = i %
0
N

P =Given
 Single Cash Flow Formula (Cont’d..)

For the 1st Interest Period

Interest (I1) = P * i
Total accumulated amount at the end of 1st year
F1 = P+I1 = P + P* i = P (1+i)
For the 2nd Interest Period
Interest (I2) = F1 * i
Total accumulated amount at the end of 2nd year
F2 = F1+I2 = P (1+i) + P (1+i) * i
= P (1+i)(1+i) = P (1+i)2
 Single Cash Flow Formula (Cont’d..)

For the 3rd Interest Period

Interest (I3) = F2 * i

Total accumulated amount at the end of 3rd year

F3 = F2+I3 = P (1+i)2 + P (1+i)2 * i
= P (1+i)3
 Single Cash Flow Formula (Cont’d..)
If we continue compounding until Nth interest period we get:
For the Nth Interest Period
F = P {(1+ i)N}

Single Payment Compound Amount Factor

Functionally,
F = P (F/P, i%, N)
Here F represents what is sought, P is given, i is
interest rate and N is number of periods.
 Single Cash Flow Formula (Cont’d..)
TO FIND P WHEN F IS GIVEN
We can reverse the situation and find out the present
value of the Future value F = Given
Interest = i %
0
N

P =? P= F {(1+ i)-N}

Single Payment Present (Discount) Amount Factor

Functionally,
P= F (P/F, i%, N)
 Single Cash Flow Example
Mr. X deposits $ 10,000 now in a bank which gives 8%
interest per year. He draws $ 4,000 at the end of 2nd
year. What will be the remaining amount at the end of
5th year?

At the end of the 2nd year, the accumulated amount will

be

10,000 (F/P, 8%, 2) = 10,000 (1+0.08)2 = $ 11,664

 Single Cash Flow Example (Cont’d..)
After drawing 4000, the remaining deposit amount at
the end of 2nd year will be,

11,664 – 4,000 = $ 7,664

At the end of the fifth year the total accumulated

amount will be

7,664 (F/P, 8%, 3) = 7,664 (1+0.08)3 = $ 9,654.5

 RULE OF 72 (Doubling of Money)

➢Rule of 72 can determine approximately how long it will

take for a sum of money to ‘double’. The rule states that
“to find the time it takes for the present sum of money to
grow by a factor of 2, we divide 72 by the interest rate”

Approximately n = 72/i

For example, at 5% per year, it takes approximately 72/5

=14.4 years for a current amount to double.
 Economic Equivalence
F =$ 106
Interest = 6 %
0
1

P = $ 100
➢The time value of money and the interest rate helps to
develop the concept of economic equivalence. [2]
➢Economic equivalence means the different sums of money at
different times are equal in economic value.
➢For example, if the interest rate 6% per year, , $ 100 today is
equivalent to $106 one year from today.
 Economic Equivalence (Cont’d..)
➢If you receive $ 100 today or $ 106 one year from today, it
makes no difference. Both the values are same.

➢If the interest rate is varied, $ 100 is not equivalent to $106

one year from today .

➢Calculations for determining the economic effects of one or

more cash flows are based on the concept of economic
equivalence. [4]

➢Economic equivalence exists between cash flows that have

same economic effect.
 Economic Equivalence Principles

Principle 1: Equivalence calculations made to compare

alternatives requires a common time basis.
• If we had been given magnitude of each cash flow and
had been asked to determine their equivalency, we
should choose the reference point and find the value of
each cash flow at that point.
• For selecting the reference point, commonly present
time (present worth) or some point in future (future
worth) is used.
• The choice of point is chosen as per convenience.
 Economic Equivalence Principles (Contd..)
Figure (a)
$2572
$2042
2042 (1+0.08)3
0 1 2 3 4 5
Figure (b) $ 2572 $3000
3000(1+0.08)-2

0 1 2 3 4 5
Figure Source: [5]

➢Here receiving $2042 is equivalent to receiving $3000 after 5 years at

an interest rate of 8%.
➢These two values are also equivalent at the common time period i.e.
year 3.
 Economic Equivalence Principles (Cont’d..)
Principle 2 Equivalence depends on interest rate
➢The equivalence between two cash flows is a function of
both the cash flow pattern and the interest rate that
operates on those cash flows. [4]
➢Change in the interest rate will destroy the equivalence
between these two sums.
➢In previous example the two cash flows were equal at
8%.
➢If the interest is changed to 10%, the Future sum of
$2042 will be $3829 which is greater than $3000
 Economic Equivalence Principles (Contd..)
Principle 3 Equivalence Calculations may require the
conversion of multiple payment cash flows to a single
cash flow.
0 1 2 3 0 1 2 3

$100 $ 100 $100

$331
Option 1
Option 2

Figure Source: [5]

Since option 2 is already a single payment at n=3 years, it
is simplest to convert option 1 cash flow pattern to a
single value at n=3, which is $331 at 10% interest rate.
 Nominal interest rate
➢If a financial institution uses a unit of time other than a
year – a month or a quarter or semi annual etc. (e.g.
when calculating interest payments), the institution
usually quotes the interest rate on an annual basis.
➢Commonly this rate is stated as
r% Compounded M-ly
Where, r = the nominal interest rate per year
M = the compounding frequency or the
number of interest periods per year
r/M = the interest rate per compounding
period.
 Nominal interest rate (Cont’d..)
➢Suppose that if a bank express the interest rate as
“18% compounded monthly”,
➢We say that 18% is the nominal interest rate or annual
percentage rate (APR) and the compounding frequency
is monthly i.e. number of interest period per year is 12.
➢A nominal interest rate r may be stated for any time
period – 1 year, 6 months, quarter, month, week, day
etc.
 Nominal Interest rate example
“ 18 % compounded monthly”
We say 18% is the nominal interest rate or annual
percentage rate (APR) and compounding period is
monthly (12) i.e. 1.5% per month.

Month 1 2 3 4 5 6 7 8 9 10 11 12
Interest 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5 1.5
rate (% )
 Example
18% compounded monthly
r = 18%, M=12, & i = r/M = 18/12 = 1.5% per month
12% compounded semi annually
r = 12%, M=2, & i = r/M = 12/2 = 6% per 6 month
12% compounded quarterly
r = 12%, M=4, & i = r/M = 12/4 =3% per 3 month
15% compounded weekly
r = 15%, M=52, & i = r/M = 15/52=0.29% per week
 Effective Interest Rate
➢Suppose that $ 1,000 to be invested at a nominal rate of
12% compounded semiannually.
➢The interest rate per compounding period is r/M =
12%/2 = 6% per six months.
➢The interest earned during first six months is 1,000*
0.12/2 = $ 60
➢Total principal at the end of the first six months =
$ (1,000+60) = $ 1,060
➢Interest earned during the second six months is
$ 1,060*0.12/2 = $ 63.60
 Effective Interest Rate
➢Total interest at the end of 1 year = $ 60+ $ 63.60
= $ 123.60
➢The effective annual interest rate for the entire year
= 123.60/1,000 * 100 = 12.36%
➢The exact or the actual rate of interest earned on the
principal during one year is known as the effective
interest (i).
➢The effective interest rates are always expressed on an
annual basis unless specifically stated otherwise.
 Relation between effective (i) and
nominal (r) interest rate

𝐢𝒆𝒇𝒇 = (𝟏 + 𝐌
𝐫/𝐌) -1,

M is the compounding period per year.

r is the annual interest expressed on an annual basis.
• As from the above example, the effective interest rate for 12%
compounded semi annually,
• 𝒊 = (𝟏 + 𝒓/𝑴)𝑴 -1 = (1+0.12/2) 2 -1 = 12.36%
 Difference Between Nominal and Effective
Interest rate
➢Nominal interest rate is expressed on an annual basis
but the compounding period is less than annual where as
effective interest rate is expressed on an annual basis
and compound is also on annual basis.

➢Nominal interest rate is always less than effective

interest rate on an annual basis where as Effective
interest rate is always greater than the nominal interest
rate.
 Numerical Example

What is the effective interest rate of the nominal interest

rate 9% per year if the compounding is a) yearly b)

quarterly c) monthly (d) daily

➢For compounding yearly,
i = (1+0.09/1) 1 -1 = 0.09 = 9%
➢For compounding quarterly,
i = (1+0.09/4) 4 -1 = 0.09308 = 9.308%
➢For compounding monthly,
i = (1+0.09/12) 12 -1 = 0.09380 = 9.380%
➢For compounding daily,
i = (1+0.09/365) 365 -1 = 0.0941 = 9.41%
Here the annual interest rate grows on when the compounding
period is less.
 Numerical Example

A person deposits a sum of $ 5,000 in a bank at a nominal

interest rate of 12% for 10 years. The compounding is
quarterly. Find the maturity of the deposit after 10 years.

Given Parameters,

Initial Principal (P) = $ 5,000,

Length of Time (N) = 10 years,

Interest rate ( i%) =12%compounded quarterly

Numerical Example (Cont’d…..)

As Interest is compounded quarterly, Interest period in a

year = 4
Total interest period for 10 years = 40
Interest per period (i%) = 12%/4 = 3%

Using single payment compound amount factor

F = P (F/P, 3%, 40) = 5,000 (1+0.03)40 = $ 16,310.
Numerical Example (Cont’d….)

Alternatively

ieffective = (1+0.12/4)4 -1 = 12.5508% per year

N =10 years

F = 5,000 (F/P, 12.55%, 10) = 5,000 (1+0.125508)10

= $ 16,310.
 References

[1]https://marketbusinessnews.com/financial-
glossary/earning-power/ (Viewed September 2022)

[2] Basics of Engineering Economy: Leland Blank and

Anthony Tarquin, Indian Edition, Tata McGraw Hill
Education Private Limited, New Delhi, India, 2013.
[3] https://corporatefinanceinstitute.com/ (Viewed
September 2022)
 References (Cont’d….)

[4]Engineering Economics : Jose A. Sepulveda, William E.

Souder and Byron S. Gottfried, Tata McGraw – Hill
Publishing Company Limited, New Delhi, India, 2005.

[5] Contemporary Engineering Economics, Chan S. Park

Second Edition, Addison-Wesley Publishing Company, 1997.

[6] Engineering Economics and Costing : Dr. K.K. Patra &

Dhiraj Bhattacharjee, First Edition, S. Chand and Company
Ltd, 2013
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