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Time Value of Money Lecture No. 4 Chapter 3 Contemporary Engineering Economics Copyright © 2016 Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Chapter Opening Story Take a Lump Sum or Annual Installments Dearborn couple claimed Missouri’s largest jackpot: $293.75 millionin 2012. They had two options. Option 1: Take a lump sum cash payment of $192.37 M. Option 2: Take an annuity payment of $9.79 M a year for 30 years. Which option would you recommend? Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved What Do We Need to Know? o Be able to compare the value of money at different points in time. o A method for reducing a sequence of benefits and costs to a single point in time Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Time Value of Money 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). Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved The Market Interest Rate o Interest is the cost of money, a cost to the borrower and a profit to the lender. o Time value of money is measured in terms of market interest rate, which reflects both earning and purchasing power in the financial market. Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Cash Flow Diagram (A Graphical Representation of Cash Transactions over Time) Borrow $20,000 at 9% interest over 5 years, requiring $200 loan origination fee upfront. The required annual repayment is $5,141.85 over 5 years. o n = 0: $20,000 o n = 0: $200 o n = 1 ~ 5: $5,141.85 Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved End-of-Period Convention Convention: Any cash flows occurring during the interest period are summed to a single amount and placed at the end of the interest period. Logic: This convention allows financial institutions to make interest calculations easier. Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Methods of Calculating Interest Simple interest: Charging an interest rate only to an initial sum (principal amount) Compound interest: Charging an interest rate to an initial sum and to any previously accumulated interest that has not been withdrawn Note: Unless otherwise mentioned, all interest rates used in engineering economic analyses are compound interest rates. Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Simple Interest Formula F P (iP)N • P = $1,000, i = 10%, N = 3 years End of Year where P = Principal amount Beginning Balance Interest Earned 0 i = simple interest rate Ending Balance $1,000 N = number of interest periods F = total amount accumulated at the end of period N • Contemporary Engineering Economics, 6e, GE Park 1 $1,000 $100 $1,100 2 $1,100 $100 $1,200 3 $1,200 $100 $1,300 F = $1,000 + (0.10)($1,000)3 = $1,300 Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Compound Interest Formula n 0:P n 1: F1 P(1 i) n 2: F2 F1 (1 i) P(1 i)2 n N : F P(1 i)N • P = $1,000, i = 10%, N = 3 years End of Year Beginning Balance Interest Earned 0 Ending Balance $1,000 1 $1,000 $100 $1,100 2 $1,100 $110 $1,210 3 $1,210 $121 $1,331 • F = $1,000(1 + 0.10)3 = $1,331 Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Compounding Process $1,100 $1,210 0 $1,331 1 $1,000 2 3 $1,100 $1,210 Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved The Fundamental Law of Engineering Economy Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Warren Buffett’s Berkshire Hathaway Went public in 1965: $18 per share Worth today (May 29, 2015): $214,800 per share Annual compound growth: 20.65% Current market value: $179.5 billion If his company continues to grow at the current pace, what will be his company’s total market value when he reaches 100? (He is 85 years old as of 2015.) Contemporary Engineering Economics, 6e, GE Park Assume that the company’s stock will continue to appreciate at an annual rate of 20.65% for the next 15 years. The stock price per share at his 100th birthday would be F = 214,800(1 + 0.2065)15 = $3,588,758 Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Example 3.2: Comparing Simple with Compound Interest In 1626, American Indians sold Manhattan Island to Peter Minuit of the Dutch West Company for $24. Given: If they saved just $1 from the proceeds in a bank account that paid 8% interest, how much would their descendents have in 2010? Find: As of 2015, the total U.S. population would be close to 308 million. If the total sum would be distributed equally among the population, how much would each person receive? Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved Solution P $1 i 8% N 384 years F $1(1 0.08)384 $164,033,801,073,200 $164,033,801,073,200 Amount per person 308,000,000 $532,577 Contemporary Engineering Economics, 6e, GE Park Copyright © 2016, Pearson Education, Ltd. All Rights Reserved