CONSTRUCTION

COST ANALYSIS
AND FINANCES

UNIT – I : TIME VALUE OF MONEY

Col Vivek Mathur, Retd

Time Value of Money
 Time Value of Money
Ø  The time value of money is important when one is
interested either in investing or borrowing money.
Ø  If a person invests his money today in bank savings,
by next year he will have accumulated more money
than his investment.
Ø  This accumulation of money over a specified time
period is called “time value of money”.
Ø  Similarly if a person borrows some money today, by
tomorrow he has to pay more money than the
original loan. This is also explained by time value of
money.
Ø  The time value of money is generally expressed by
interest amount.
 Time Value of Money
Ø  The original investment or the borrowed amount (i.e. loan) is
known as the principal.
Ø  The amount of interest indicates the increase between
principal amount invested or borrowed and the final amount
received or owed.
Ø  In case of an investment made in the past, the total amount
of interest accumulated till now is given by;
Ø  Amount of interest = Total amount to be received – original
investment (i.e. principal amount)
Ø  Similarly in case of a loan taken in past, the total amount of
interest is given by;
Ø  Amount of interest = Present amount owed – original loan (i.e.
principal amount)
Ø  In both the cases there is a net increase over the amount of
money that was originally invested or borrowed.
 Time Value of Money
Ø When the interest amount is expressed as the
percentage of the original amount per unit time,
the resulting parameter is known as the rate of
interest and is generally designated as ‘i’.
Ø The time period over which the interest rate is
expressed is known as the ‘interest period’.
Ø The interest rate is generally expressed per unit
year. However in some cases the interest rate
may also be expressed per quarter or per
month.
 Example
Ø A person deposited Rs.1,00,000 in a bank for
one year and got Rs.1,10,000 at the end of one
year.
Ø Find out the total amount of interest and the
rate of interest per year on the deposited
money.
 Solution
Ø Present Sum (Principal) (P) = Rs 1,00,000
Ø Future Sum (Amount) (F) = Rs 1,10,000
Ø The total amount of interest gained over one
year = F – P = Rs.1,10,000 - Rs.1,00,000
= Rs.10,000
Ø The rate of interest ‘i’ per year is given by;
Ø i(decimal) = 10,000/1,00,000 = 0.01
Ø i (%) = (10,000/1,00,000)x100 = 10%
 Example
Ø If a person borrowed Rs.1,50,000 (P) for one
year and returned back Rs.1,62,000 (F) at the
end of one year.
Ø Then the amount of interest paid and the rate of
interest are calculated as follows;
Ø The total amount of interest paid = F – P
= Rs.1,62,000 - Rs.1,50,000 = Rs.12,000
Ø The rate of interest ‘i’ per year is given by;
Ø  i (%) = (12,000/1,50,000)x100 = 8%
 Simple Interest
Ø  The interest is said to be simple, when the interest is charged
only on the principal amount for the interest period.
Ø  No interest is charged on the interest amount accrued during
the preceding interest periods.
Ø  In case of simple interest, the total amount of interest
accumulated for a given interest period is simply a product of
the principal amount, the rate of interest and the number of
interest periods.
Ø  It is given by the following expression.
Ø  IT = P x i x n Where
Ø  IT = total amount of simple interest
Ø  P = Principal amount
Ø  i = rate of interest in decimal
Ø  n = number of interest periods
 Compound Interest
Ø  The interest is said to be compound, when the interest
for any interest period is charged on principal amount
plus the interest amount accrued in all the previous
interest periods.
Ø  Compound interest takes into account the effect of time
value of money on both principal as well as on the
accrued interest also.
Ø  Formula is F = P x (1 + i/n)nt where
Ø  F = Total amount owed (Future worth)
Ø  P = Principal (Present worth)
Ø  i = rate of interest per year in decimal
Ø  n = number of times per year the interest is compounded.
n=4 for quarterly, =2 for half yearly, = 12 for monthly.
Ø  t = time in years
Ø  Compound Interest = F – P
 Example
Ø A person has taken a loan of an amount of
Rs.10,000 from a bank for a period of 5 years.
Ø Estimate the amount of money, the person will
repay to the bank at the end of 5 years for the
following cases;
Ø a) Considering simple interest rate of 8% per year
Ø b) Considering compound interest rate of 8% per
year.
 Simple Interest
Ø Considering the simple interest @ 8% per year.
Ø Simple Interest = Rs.10,000 x 0.08 = Rs 800 each
year.
Ø The interest for each is year is calculated only on
the principal amount i.e. Rs.10,000. Thus the
interest accumulated at the end of each year is
constant i.e. Rs.800 each year.
Ø The year-by-year details about the interest
accrued and amount owed at the end of each
year are
 Simple Interest
End of Year Amount of Interest Total Amount Owed
(EOY) (Rs) (Rs)

1 800 10,800

2 800 11,600

3 800 12,400

4 800 13,200

5 800 14,000 *

* The amount repaid to the bank at the end of year 5 (since the
person has to repay at EOY 5).
 Compound Interest
Ø  Considering the compound interest @ 8% per year
Ø  The year-by-year values of amount of interest and
the total amount owed are calculated as follows;
Ø  Amount of interest accumulated at the end of year
one = 10,000 x 0.08 = Rs 800.
Ø  Amount of interest accumulated at the end of year
two = 10,800 x 0.08 = Rs 864.
Ø  The total amount owed after the end of two years
is = 10,800 + 864 = Rs 11,664.
Ø  The interest amount and the total amount owed at
the end of year 3, year 4 and year 5 can be
calculated in the same manner.
 Compound Interest
End of Year Amount of Interest Total Amount Owed
(EOY) (Rs) (Rs)

1 800 10,800.00

2 864 11,664.00

3 933.12 12,597.12

4 1007.77 13,604.89

5 1088.39 14,693.28 *

* The amount repaid to the bank at the end of year 5 (since the
person has to repay at EOY 5).
 Equivalence
Ø Equivalence indicates that different amount of
money at different time periods are equivalent
by considering the time value of money.
 Example
Ø What are the equivalent amounts of Rs.10000
(today) at an interest rate of 10% per year for
the following cases?
Ø a) 1 year from now (future)
Ø b) 1 year before (past)
 Solution
Ø  a) At interest rate of 10% per year, Rs.10000 (now) will
be equivalent to Rs.11000 one year from now
Ø  Amount accumulated at the end of one year
= 10,000 x 1.10 = Rs 11,000. (F=P+I, = P(1+in))
Ø  b) Similarly Rs.10000 now was equivalent to
Rs.9090.90 one year ago at interest rate of 10% per year.
Ø  Amount one year before = (10,000/1.10)
= Rs 9090.90 (F=P(1+i/n)nt )
Ø  Thus due to the effect of time value of money, these
amounts Rs.9090.90 (one year before), Rs.10000 (today)
and Rs.11000 (one year from now) are equivalent at the
interest rate of 10% per year.
 Equivalence
•  The equivalent value of an amount that is
borrowed now, at a future time period and at a
given interest rate depends on
–  the type of interest whether simple or compound
–  the different loan repayment arrangements like
•  payment of accumulated interest annually and principal at
the end of the stipulated interest period or
•  payment of both the principal and interest at the end of
interest period or
•  payment of uniform amounts annually that comprises a
portion towards the payment of principal amount and
remaining for the accumulated interest throughout the
interest periods.
 Time
Time Value
Value of
of Money
Money 67
67

TABLE
TABLE 3-1
3-1 Four
Four Plans
Plans for
Equivalence
for Repayment
Repayment of
of $5000
$5000 in
in 55 Years
Yearswith
with Interest
Interest at
at 8%
8%
(a)
(a) (b)
(b) (c)
(c) (d)
(d) (e)
(e) (f)
(f)
Amount
Amount Owed
Owed Interest
Interest Owed
Owed for
for Total
Total Owed
Owed at
at Total
Total
at
at Beginning
Beginning of
of That-Year,
That-Year, End
Endof
of Year,
Year, Principal
Principal End-of-Year
End-of-Year
Year
Year Year
Year 8%
8% xx (b)
(b) (b)
(b)++ (c)
(c) Payment
Payment Payment
Payment

Plan
Plan 1:1: At
Atend
endof
ofeach
eachyear
yearpay
pay$1000
$1000principalplus
principalplus interestdue.
interestdue.
11 $5000
$5000 $$ 400
400 $5400
$5400 $1000
$1000 $1400
$1400
22 4000
4000 320
320 4320
4320 1000
1000 1320
1320
33 3000
3000 240
240 3240
3240 1000
1000 1240
1240
44 2000
2000 160
160 2160
2160 1000
1000 1160
1160
55 1000
1000 80
80 1080
1080 1000
1000 1080
1080
$1200
$1200 $5000
$5000 $6200
$6200

Plan
Plan 2:2: Pay
Payinterest
interestdue
dueatatend
endof
ofeach
eachyear
yearand
andprincipalat
principalat end
endof
of55 years.
years.
11 $5000
$5000 $$ 400
400 $5400
$5400 $$ oo $$ 400
400
22 5000
5000 400
400 5400
5400 oo 400
400
33 5000
5000 400
400 5400
5400 oo 400
400
44 5000
5000 400
400 5400
5400 oo 400
400
55 5000
5000 400
400 5400
5400 5000
5000 5400
5400
$2000
$2000 $5000
$5000 $7000
$7000
 $1200 $5000 $6200
Time Value of Money 67

1
2 3-1 Four
TABLE
$5000 Equivalence
Plan 2: Pay interest due at end of each year and principalat end of 5 years.
$ 400
5000Plans for Repayment
400
$5400
of $50005400
$ o
in 5 Years with Interest
o at 8%
$ 400
400
3 (a) 5000 (b) 400 (c) 5400 (d) o(e) (f)
400
4 5000
Amount Owed 400 Owed for
Interest 5400
Total Owed at o Total400
5 5000
at Beginning of
400That-Year, 5400
End of Year,
5000 5400
Principal End-of-Year
Year Year $20008% x (b) (b) + (c) $5000
Payment $7000
Payment

Plan 1:
Plan 3: At
Pay in of
end five equal
each end-of-yearpayments.
year pay $1000 principalplus interestdue.
11 $5000
$5000 $$ 400
400 $5400
$5400 $ 852
$1000 $1252*
$1400
22 4148
4000 331
320 4479
4320 921
1000 1252
1320
33 3227
3000 258
240 3485
3240 994
1000 1252
1240
44 2233
2000 178
160 2411
2160 1074
1000 1252
1160
55 1159
1000 93
80 1252
1080 1159
1000 1252
1080
$1260
$1200 $5000
$5000 $6260
$6200
Plan 2:
Plan 4: Pay
Payinterest
principal and
due at interest in one
end of each payment
year at end of 5end
and principalat years.
of 5 years.
11 $5000
$5000 $$ 400
400 $5400
$5400 $$ o0 $$ 4000
22 5400
5000 432
400 5832
5400 oo 400o
33 5832
5000 467
400 6299
5400 oo 400o
44 6299
5000 504
400 6803
5400 oo 400o
55 6803
5000 544
400 7347
5400 5000
5000 7347
5400
$2347
$2000 $5000
$5000 $7347
$7000
*The3:exact
Plan Pay value
in fiveisequal
$1252.28, which has been rounded to an even dollar amount.
end-of-yearpayments.
 Quantifying Alternatives
Ø A construction company is planning to purchase
a new concrete mixer for preparing concrete at
a construction site.
Ø Let’s say there are two alternatives available for
purchasing the mixer;
Ø a) An automatic concrete mixer and
Ø b) A semi-automatic concrete mixer.
Ø The task is to find out best alternative for the
company to purchase that will yield more profit.
 Quantifying Alternatives
Ø  For this purpose one has to quantify both the
alternatives by the following parameters;
Ø The initial cost that includes purchase price, sales tax,
cost of delivery and cost of assembly and installation.
Ø Annual operating cost.
Ø Annual profit which will depend on the productivity i.e.
quantity of concrete prepared.
Ø The expected useful life.
Ø The expected salvage value.
Ø Other expenditure or income (if any) associated with the
equipment.
Ø Income tax benefit.
 Quantifying Alternatives
Ø  Then on the basis of the economic criteria, the best
alternative is selected by calculating the
Ø present worth or
Ø future worth or
Ø the equivalent uniform annual worth
Ø  Calculation done for both alternatives by
incorporating the appropriate interest rate per year
and the number of years (i.e. the comparison must
be made over same number of years for both
alternatives).
Ø  Then the concrete mixer with least cost or higher
net income is considered for purchase.
 Quantifying Alternatives
Ø  In addition to economic parameters the non-
economic parameters namely environmental,
social, legal and the related regulatory and
permitting process must also be considered for the
evaluation and selection of the best alternative.
Ø  When the available alternatives exhibit the same
equivalent cost or same net income, then the non-
economic parameters may play a vital role in the
selection of the best alternative.
Ø  The non-economic parameters cannot be
expressed in numerical values.
 Cash Flow Diagrams
•  The graphical representation of the cash flows i.e. both
cash outflows and cash inflows with respect to a time
scale is generally referred as ‘cash flow diagram’.
•  The cash outflows (i.e. costs or expense) are generally
represented by vertically downward arrows
•  The cash inflows (i.e. revenue or income) are represented
by vertically upward arrows.
•  In the cash flow diagram, number of interest periods is
shown on the time scale. The interest period may be a
quarter, a month or a year.
•  Since the cash flows generally occur at different time
intervals within an interest period, for ease of calculation,
all the cash flows are assumed to occur at time 0 or at
the end of an interest period.
on the time scale represent the end of year (EOY).
Cash Flow Diagrams
Cash inflow End of year 1 35000 80000 45000

End of year 10

Time 0 1 2 3 4 5 6 7 8 9 10

Year 1 Year 7

Cash outflow 100000 15000 25000

•  Cash outflows are Rs.1,00,000, Rs.15,000 and Rs.25,000

occurring at end Fig of 1.5year
Cash flow (EOY)
diagram ‘0’ i.e. at the beginning,
EOY 4 and EOY 7 respectively.
•  Similarly the cash inflows Rs.35,000, Rs.80,000 and
In Fig. 1.5Rs.45,000
the cash outflows
are areoccurring
Rs.100000, Rs.15000
at EOY and Rs.25000
3, EOY occurring
6 and at end
EOY of 10
respectively.
year (EOY) „0‟ i.e. at the beginning, EOY „4‟ and EOY „7‟ respectively. Similarly the
 Cash Flow Diagrams
•  Cash Outflows
–  Initial Cost. Cost to build or buy and install
–  Cost for operation and maintenance
–  Cost of overhaul/major repairs
–  Cost of replacement
•  Cash Inflows
–  Revenue generated by annual sale of products /
services
–  Salvage value
Types of Interest

Interest

Simple Compound

Discrete Continuous

Fixed Variable