• The Time Value Of Money:

• Because money can earn at a certain interest rate

through its investment for a period of time, a birr
received at some future date is not worth as much as
a birr in hand at present.
• This relationship between interest and time leads to
the concept of the time value of money.
• A birr in hand now is worth more than a birr
received “n ” years from now.
Why ? Because having the birr now provides the opportunity
for investing that birr for “n ”years more than the birr to be
received “n ”years .

Since money has earning power, this opportunity earns a

return , so that after n years the original birr plus interest
will be a larger amount than the birr 1 received at that time.

Thus, the fact that money has time value means that equal
birr amounts at different points in time have different value
as long as the interest rate that can be earned exceeds zero
• This relationship between money and time is illustrated as
• birr1 birr1 + interest

Now 1 2 3 n-1 n

• It is also true that money has time value because the

purchasing power of a birr changes through time.

• During periods of inflation the amount of goods that can be

bought for a particular amount of money decreases as the
time of purchase occurs further out in the future.
• Therefore , when considering the time value of money it is important
to recognize both the earning power of money and the purchasing
power of money .

• The key to these relationships is the purchasing power of future

money in relation to its time value as determined by the interest rate.
The earning power of money:
• Funds borrowed for the prospect of gain are commonly
exchanged for goods, services or instruments of production
• This leads to consideration of the earning power of money that
may make it profitable to borrow.
The purchasing power of money:
• Prices for goods and services are driven upward or downward
because of numerous factors at work within the economy.
• The cumulative effect of these factors determines the amount
of price change
• For example, increase in productivity and in the availability of
goods tend to reduce prices, while the government policies
such as price supports and deficient financing tend to increase
prices
INTEREST RATE AND RATE OF RETURN

Interest is the indicator (manifestation) of the time value of

money.
Computationally, interest is the difference between an ending
amount of money and the beginning amount.

If the difference is zero or negative, there is no interest. There

are always two perspectives to an amount of interest-interest
paid and interest earned.
 Interest is paid when a person or organization borrowed
money (obtained a loan) and repays a larger amount.
 Interest is earned when a person or organization saved,
invested, or lent money and obtains a return of a larger
amount.
 Interest paid on borrowed funds (a loan) is determined by using
the relation.
Interest = amount owed now - original amount

The time unit of the rate is called the interest period.

By far the most common interest period used to state an interest
rate is 1 year. Shorter time periods can be used, such as, 1 % per
month. Thus, the interest period of the interest rate should always
be included.

E.g. A person borrows birr 10,000 on May 1 and must repay a total of
birr 1 0,700 exactly 1 year later. Determine the interest amount and
the interest rate paid.
From the perspective of a saver, a lender, or an investor, interest
earned is the final amount minus the initial amount, or principal.

Interest earned = total amount now - original amount

Interest earned over a specific period of time is expressed as a

percentage of the original amount and is called rate of return (ROR).

(a) Calculate the amount deposited 1 year ago to have birr1000 now at
an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.
SIMPLE AND COMPOUND INTEREST

We have discussed the terms interest, interest period, and interest rate
are useful in calculating equivalent sums of money for one interest
period in the past and one period in the future.

However, for more than one interest period, the terms simple interest
and compound interest become important.

Simple interest is calculated using the principal only, ignoring any

interest occurred in preceding interest periods.
The total simple interest over several periods is computed as

Interest = (principal)x(number of periods)x(interest rate)

ABC Telephone Credit Union loaned money to an engineering staff
member for a radio controlled model airplane. The loan is for birr1000
for 3 years at 5% per year simple interest. How much money will the
engineer repay at the end of 3 years?

Compound interest, the interest occurred for each interest period is

calculated on the principal plus the total amount of interest accumulated
in all previous periods.
Thus, compound interest means interest on top of interest.
Compound interest reflects the effect of the time value of money on the
interest also. Now the interest for one period is calculated as

Interest = (principal + all occurred interest)(interest rate)

If an engineer borrows birr1000 from the company credit union at
5% per year compound interest, compute the total amount due after
3 years.
In general formula form

TERMINOLOGY AND SYMBOLS

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 O. Also P
is referred to as present worth (PW), present value (PV), net present value (NPV),
discounted cash flow (DCF), and capitalized cost (CC); birrs
F = value or amount of money at some future time. Also F is called future worth
(FW) and future value (FV); birrs
A = series of consecutive, equal, end-of-period amounts of money. Also A is called
the annual worth (AW) and equivalent uniform annual worth (EUA W); birrs per
year, birrs per month
n = number of interest periods; years, months, days
i = interest rate or rate of return per time period; percent per year, percent per
month; percent per day
n = time, stated in periods; years, months, days
A new college graduate has a job with airlines . She plans to borrow
birr 10,000 now to help in buying a car. She has arranged to repay the
entire principal plus 8% per year interest after 5 years. Identify the
engineering economy symbols involved and their values for the total
owed after 5 years.
On July 1, 2002, your new employer Ford Motor Company deposits
$5000 into your money market account, as part of your employment
bonus. The account pays interest at5% per year. You expect to
withdraw an equal annual amount for the following 10 years.
identify the symbols and their values.
Effective Rate of Interest

Nominal Interest Rate

The nominal interest rate is the annual interest rate divided by the
number of compounding periods in the year. If the yearly rate of
interest is compounded quarterly, the quarterly nominal interest rate is
the yearly interest rate divided by 4.

The annual interest rate is 6%, and the interest is compounded

quarterly. What is the quarterly nominal interest rate? What is the
effective annual interest rate if compounded quarterly?
CASH FLOWS
 Cash flows are described as the inflows and outflows of money.
These cash flows may be estimates or observed values.

 Every person or company has cash receipts-revenue and income

(inflows); and cash disbursements expenses, and costs (outflows).
These receipts and disbursements are the cash flows, with a plus
sign representing cash inflows and a minus sign representing cash
outflows. Cash flows occur during specified periods of time, such
as 1 month or 1 year.

 Of all the elements of the engineering economy study approach

cash flow estimation is likely the most difficult and inexact. Cash
flow estimates are just that-estimates about an uncertain future.
Samples of Cash Inflow
Revenues , Operating cost reductions , Asset salvage value., Receipt of
loan principal, Income tax savings, Receipts from stock and bond
sales ,Construction and facility cost savings, Saving or return of
corporate capital funds.
Samples of Cash Outflow
First cost of assets, Engineering design costs, Operating costs (annual
and incremental). Periodic maintenance and rebuild costs, Loan
interest and principal payments, Major expected/unexpected upgrade
costs , Income taxes. ,Expenditure of corporate capital funds.

Once the cash inflow and outflow estimates are developed, the net
cash flow can be determined.

Net cash flow = receipts - disbursements

= cash inflows - cash outflows
Cash Flow Diagram
The graphic presentation of the costs and benefits over the time is called
the cash flow diagram. This is the time profile of all the costs and
benefits. It is a presentation of what costs have to be incurred and what
benefits are received at all points in time.
The following conventions are used in the construction of the cash flow
diagram:
* The horizontal axis represents time
* The vertical axis represents costs and benefits
* Costs are shown by downward arrows
* Benefits are shown by upward arrows
• All the benefits and/or costs incurred during a period are assumed to
have been incurred at the end of that period. Since the period is
normally a year, this is called the ''end of the year" rule.
 The cash flow diagram is a very important tool in an economic
analysis, especially when the cash flow series is complex.

 That is, once the cash flow diagram is complete, another person
should be able to work the problem by looking at the diagram.
Cash flow diagram time n = 0 is the present, and n = 1 is the end
of time period 1. We assume that the periods are in years for now.
Example
A car leasing company buys a car from a wholesaler for $24,000 and
leases it to a customer for four years at $5,000 per year. Since the
maintenance is not included in the lease, the leasing company has to
spend $400 per year in servicing the car. At the end of the four years,
the leasing company takes back the car and sells it to a secondhand
car dealer for $15,000. For the moment, in constructing the cash
flow diagram, we will not consider tax, inflation, and depreciation.

Each year Mobil company expends large amounts of funds for

mechanical safety features throughout its worldwide operations.
Carla Ramos, a lead engineer for Mexico and Central American
operations, plans expenditures of $1 million now and each of the next
4 years just for the improvement of field-based pressure-release
valves. Construct the cash flow diagram to find the equivalent value
of these expenditures at the end of year 4, using a cost of capital
estimate for safety-related funds of 12% per year.
Class work
1. In a housing project the following sequence of events occurs.
• At the start of the project (time zero), land is bought at birr1,000,000
• Two months later, birr 100,000 is paid to the architect for preparing the
design
• In month 4, construction is started and the cost of construction (labor and
material) is birr 150,000 per month
• Every month, one house is built (a total of 12 houses); the first one is ready
for sale in month 6
• During every month starting from month 8, one house is sold for a price of
birr 150,000 each
• After all of the houses are built and before all are sold, the cost of
maintaining the site is birr 10,000 per month .Draw the cash flow diagram.

2. Mr. X design a project and wants to purchase a machine for the project
for birr120,000. Its operation will result in a net income of birr 15,000/Yr for
the first year, increasing by birr 2,000 each year after year 1. At the end of the
fifth year, the Mr.X is sold the machine for birr 155,000. Draw the cash flow
diagram for this project.