ISEN 667 Engineering Economic Analysis: Class 02. Cash Flow and Interest Calculation

ISEN 667
Engineering Economic Analysis
Class 02. Cash Flow and Interest

Calculation
Module 2. Time Value of Money
Principles of Engineering Economic Analysis, 6th edition

Learning Objectives
• Cash flow diagram
• Simple interest and compound interest
• Calculation on single case flow

Cash Flow Diagrams

Cash Flow Diagrams
$5,000 $5,000 $5,000
Receive
(+)
0 1 2 3 4 5
(-) Time
$2,000 Pay
$3,000
$4,000
End of period

Example 2.1
Cash Flow Profiles for Two Investment Alternatives
End of Year
(EOY) CF(A) CF(B)
0 -$100,000 -$100,000
1 $10,000 $50,000
2 $20,000 $40,000
3 $30,000 $30,000
4 $40,000 $20,000
5 $50,000 $10,000
Sum $50,000 $50,000
Although the two investment alternatives have the same “bottom line,”
there are obvious differences. Which would you prefer, A or B? Why?
DCF Rule #2
Money cannot be added or subtracted
unless it occurs at the same point(s)
in time.

$50,000
$40,000
$30,000
(+) $20,000
$10,000
Inv. A 0 1 2 3 4 5
End of Year
(-)
Rule of thumb:
• Receive, sooner better
$100,000 • Pay, later better
$50,000
$40,000
$30,000
(+) $20,000
$10,000
Inv. B 0 1 2 3 4 5
End of Year
(-)
$100,000

Principle #7
Consider only differences in cash
flows among investment alternatives

Example 2.1
Cash Flow Profiles for Two Investment Alternatives
End of Year
(EOY) CF(A) CF(B) CF(B-A)
0 -$100,000 -$100,000 $0
1 $10,000 $50,000 $40,000
2 $20,000 $40,000 $20,000
3 $30,000 $30,000 $0
4 $40,000 $20,000 -$20,000
5 $50,000 $10,000 -$40,000
Sum $50,000 $50,000 $0

$40,000
(+) $20,000
$0
0 1 2 3 4 5
End of Year
(-) $20,000
$40,000
Inv. B – Inv. A

Example 2.2
$3,000 $3,000 $3,000 Alternative C – D:
0: $0
(+) 0 1: $0
Alternative C
2: $3,000
(-) 1 2 3 4 5 6 7 3: -$3,000
4: $3,000
Rule of thumb:
5: -$3,000
• Receive, sooner better
6: $3,000
• Pay, later better
7: -$3,000
$6,000
$3,000 $3,000 $3,000
(+) 0
Alternative D
(-) 1 2 3 4 5 6 7
Which would you

choose?
$6,000
Example 2.3
$3,000
$2,000 $2,000 $2,000
Alternative E (+) 0
(-) 1 2 3 4
$4,000
$3,000
$2,000 $2,000
$1,000
(+) 0
Alternative F
(-) 1 2 3 4
$4,000
Which would you choose?

Example 2.3
$3,000
$2,000 $2,000 $2,000
$2,000
Alternative E (+) 0 $1,000
(-) 1 2 3 4
• E: if received in year 4, it is $2,000

$4,000 • F: if received in year 3, it is $1,000
$3,000
$2,000 $2,000 $1,000
$1,000
(+) 0 $2,000
Alternative F
(-) 1 2 3 4
$2,000
Alternative E-F
$4,000 3
4
Which would you choose? $1,000
Simple Interest and Compound Interest

Example 2.7: simple interest
Robert borrows $4,000 from Susan and agrees to
pay $1,000 plus accrued interest at the end of the
first year and $3,000 plus accrued interest at the
end of the fourth year. What should be the size of
the payments if 8% simple interest is used?
 1st payment = $1,000 + 0.08($4,000)
= $1,320 (interest: $320)
 2nd payment = $3,000 + 0.08($3,000)(3)
= $3,720 (interest: $720)

Simple Interest Cash Flow Diagram
We will only be concerned with compound interest calculations in this course.
This example is provided in order to illustrate the difference in simple and
compound interest calculations.
$720
$320 $3,000
$1,000
1 2 3 4
$4,000
Principal payment
Interest payment

Example 2.7: compound interest
Robert borrows $4,000 from Susan and agrees to
pay $1,000 plus accrued interest at the end of the
first year and $3,000 plus accrued interest at the
end of the fourth year. What should be the size of
the payments if 8% compound interest is used?
 1st payment = $1,000 + 0.08($4,000)
= $1,320
(interest: $320, same to simple interest)
 2nd payment = $3,000 * (1.08^3)
= $3,779.14
(interest: $779.14, larger than simple interest $720)

Compound Interest Cash Flow Diagram
$779.14
$320 $3,000
$1,000
1 2 3 4
$4,000
Principal payment
Interest payment

Example 2.8 Value of $10,000 Investment Growing
@ 10% per year
Start of Value of Interest End of Value of

Year Investment Earned Year Investment
1 $10,000.00 $1,000.00 1 $11,000.00
2 $11,000.00 $1,100.00 2 $12,100.00
3 $12,100.00 $1,210.00 3 $13,310.00
4 $13,310.00 $1,331.00 4 $14,641.00
5 $14,641.00 $1,464.10 5 $16,105.10

Compounding of Money
Beginning Value of Interest End of Value of
of Period Investment Earned Period Investment
1 P Pi 1 P(1+i)
2 P(1+i) P(1+i)i 2 P(1+i)2
3 P(1+i)2 P(1+i)2i 3 P(1+i)3
4 P(1+i)3 P(1+i)3i 4 P(1+i)4
5 P(1+i)4 P(1+i)4i 5 P(1+i)5
. . . . .
. . . . .
. . . . .
n-1 P(1+i)n-2 P(1+i)n-2i n-1 P(1+i)n-1
n P(1+i)n-1 P(1+i)n-1i n P(1+i)n

Calculation on Single Cash Flow

Discounted Cash Flow Methods
• Based on the mathematical formulas
 Financial calculators can be used
• DCF values are tabulated in the Appendixes
• Financial spreadsheet software is available,
e.g., Excel® financial functions include
 PV, NPV, PMT, FV
 IRR, MIRR, RATE
 NPER

Discounted Cash Flow Methods
• Based on the mathematical formulas
 Financial calculators can be used
• DCF values are tabulated in the Appendixes
• Financial spreadsheet software is available,
e.g., Excel® financial functions include
 PV, NPV, PMT, FV
 IRR, MIRR, RATE
 NPER

Discounted Cash Flow Formulas
F = P (1 + i)n Present Value to Future Value
P = F (1 + i)-n Future Value to Present Value

Discounted Cash Flow Formulas
F = P (1 + i)n Present Value to Future Value
F = P (F|P i%, n) single sum, future worth factor
P = F (1 + i)-n Future Value to Present Value
P = F (P|F i%, n) single sum, present worth factor
Vertical line means “given”

Excel® DCF Worksheet Functions
FV(rate, nper, pmt, pv, type)
 nper: number of periods
 pmt: made each period (no need for single cash flow)
 type: pmt at end if = 0(omitted); at start if = 1
F =FV(i%,n,,-P)
PV(rate, nper, pmt, fv, type)
 nper: number of periods
 pmt: made each period (no need for single cash flow)
 type: pmt at end if = 0(omitted); at start if = 1
P =PV(i%,n,,-F)

F = P(1+i)n P = F(1+i)-n
F = P(F|P i%, n) P = F(P|F i%, n)
F =FV(i%,n,,-P) P =PV(i%,n,,-F) F
0
….
1 2 n-1 n
P occurs n periods before F (F occurs n periods after P)

F | P Examples

F = P(1 + i)n
F = P(F|P i%,n) single sum, future worth
F =FV(i%,n,,-P)
P = F(1 + i)-n
P = F(P|F i%,n) single sum, present worth
P =PV(i%,n,,-F)

Example 2.9
Dia St. John borrows $1,000 at 12% compounded
annually. The loan is to be repaid after 5 years. How
much must she repay in 5 years?

Example 2.9
1. Use tabulated factor Single Sums
F = P(F|P i%, n) To Find F To Find P
F = $1,000(F|P 12%,5) n Given P Given F
= $1,762.34 (F|P,i%,n) (P|F,i%,n)
1 1.12000 0.89286
2 1.25440 0.79719
3 1.40493 0.71178
4 1.57352 0.63552
5 1.76234 0.56743

Example 2.9
1. Use tabulated factor
F = P(F|P i%, n)
F = $1,000(F|P 12%,5)
= $1,762.34
2. Use math formula from definition
F = $1,000(1.12)5 = $1,000(1.76234) = $1,762.34

Example 2.9
1. Use tabulated factor
F = P(F|P i%, n)
F = $1,000(F|P 12%,5)
= $1,762.34
F = $1,000(1.12)5 = $1,000(1.76234) = $1,762.34
3. Use Excel FV function F =FV(i%,n,,-P)
F = FV(12%,5, , -1000) = $1,762.34

Quiz
If you can earn 10% compounded annually on
a $2,000 investment, how much will your
investment be worth after 3 years?

Quiz

Example 2.10
How long does it take for money to double in
value, if you earn (a) 2%, (b) 3%, (c) 4%, (d) 6%, (e)
8%, or (f) 12% annual compound interest?

Example 2.10
There are six ways to solve this problem:

1) Solve using the Rule of 72
2) Use the interest tables; look for F|P factor equal to 2.0
3) Solve numerically; n = log(2)/log(1+i)
4) Solve using Excel® NPER function
5) Solve using Excel® GOAL SEEK tool
6) Solve using Excel® SOLVER tool

Example 2.10
RULE OF 72
Divide 72 by interest rate (after dropping %)
to determine how long it takes for money to
double in value.
(Quick, but not always accurate.)

Example 2.10
Rule of 72 solution
(a) 72/2 = 36 yrs
(b) 72/3 = 24 yrs
(c) 72/4 = 18 yrs
(d) 72/6 = 12 yrs
(e) 72/8 = 9 yrs
(f) 72/12 = 6 yrs

Example 2.10
Using interest tables & interpolating Single Sums
To Find F To Find P
n Given P Given F
(a) 34.953 yrs 1
(F|P,i%,n)
1.04000
(P|F,i%,n)
0.96154
2 1.08160 0.92456
(b) 23.446 yrs 3

4
1.12486
1.16986
0.88900
0.85480
5 1.21665 0.82193
(c) 17.669 yrs 6

7
1.26532
1.31593
0.79031
0.75992
8 1.36857 0.73069
(d) 11.893 yrs 9

10
1.42331
1.48024
0.70259
0.67556
11 1.53945 0.64958
(e) 9.006 yrs 12

13
14
1.60103
1.66507
1.73168
0.62460
0.60057
0.57748
15 1.80094 0.55526
(f) 6.111 yrs 16
17
1.87298
1.94790
0.53391
0.51337
18 2.02582 0.49363
19 2.10685 0.47464
20 2.19112 0.45639

Example 2.10
Mathematical solution: F = $2 = $1(1 + i)n or
log 2 = n log (1 + i) or n = log 2/log (1 + i)
(a) log 2/log 1.02 = 35.003 yrs
(b) log 2/log 1.03 = 23.450 yrs
(c) log 2/log 1.04 = 17.673 yrs
(d) log 2/log 1.06 = 11.896 yrs
(e) log 2/log 1.08 = 9.006 yrs
(f) log 2/log 1.12 = 6.116 yrs
Example 2.10
How long does it take for money to double in value,
if you earn (a) 2%, (b) 3%, (c) 4%, (d) 6%, (e) 8%, or (f)
12% annual compound interest?
Using the Excel® NPER function:
NPER(rate,pmt,pv,fv,type)
(a) n =NPER(2%,,-1,2) = NPER(2%,,1,-2) = 35.003 yrs
(b) n =NPER(3%,,-1,2) = NPER(3%,,1,-2) = 23.450 yrs
(c) n =NPER(4%,,-1,2) = NPER(4%,,1,-2) = 17.673 yrs
(d) n =NPER(6%,,-1,2) = NPER(6%,,1,-2) = 11.896 yrs
(e) n =NPER(8%,,-1,2) = NPER(8%,,1,-2) = 9.006 yrs
(f) n =NPER(12%,,-1,2) = NPER(12%,,1,-2) = 6.116 yrs
Example 2.10
Using the Excel® GOAL SEEK tool
(a) n =34.999 yrs
(b) n =23.448 yrs
(c) n =17.672 yrs
(d) n =11.895 yrs
(e) n =9.008 yrs
(f) n =6.116 yrs
Solution obtained differs from that obtained mathematically; red digits differ

Example 2.10
Using the Excel® SOLVER tool
(a) n =35.003 yrs
(b) n =23.450 yrs
(c) n =17.673 yrs
(d) n =11.896 yrs
(e) n =9.006 yrs
(f) n =6.116 yrs
Solution differs from mathematical solution, but at the 6th to 10th decimal place
Triple Value
How long does it take for money to triple in
value, if you earn (a) 4%, (b) 6%, (c) 8%, (d)
10%, (e) 12%, (f) 15%, (g) 18% interest?
No more heuristic rule like 72 rule

Triple Value
How long does it take for money to triple in
value, if you earn (a) 4%, (b) 6%, (c) 8%, (d)
10%, (e) 12%, (f) 15%, (g) 18% interest?
(a) n =NPER(4%,,-1,3) = 28.011
(b) n =NPER(6%,,-1,3) = 18.854
n = log(3)/log(1+0.08)
(c) n =NPER(8%,,-1,3) = 14.275 n = 14.27491
(d) n =NPER(10%,,-1,3) = 11.527
(e) n =NPER(12%,,-1,3) = 9.694
(f) n =NPER(15%,,-1,3) = 7.861
(g) n =NPER(18%,,-1,3) = 6.638

Quiz
Approximately, how long will it take for money
to quadruple in value when money compounds
at an annual rate of 6%?

Quiz
Approximately, how long will it take for money
to quadruple in value when money compounds
at an annual rate of 6%? n
To Find F
Given P
(F|P,i%,n)
1 1.06000
2 1.12360
3 1.19102
4 1.26248
5 1.33823
6 1.41852
7 1.50363
8 1.59385
9 1.68948
10 1.79085
11 1.89830
Answer: 24 years. By the Rule of 72, 12

13
14
2.01220
2.13293
2.26090
15 2.39656
it takes 12 years for money to double 16

17
2.54035
2.69277
18 2.85434
in value. Therefore, it will take 24

19 3.02560
20 3.20714
21 3.39956
22 3.60354
years for it to quadruple in value. 23

24
25
3.81975
4.04893
4.29187

P | F Examples

F = P(1 + i)n
F = P(F|P i%,n) single sum, future worth
F =FV(i%,n,,-P)
P = F(1 + i)-n
P = F(P|F i%,n) single sum, present worth
P =PV(i%,n,,-F)

Example 2.11
How much must you deposit, today, in order to
accumulate $10,000 in 4 years, if you earn 5%
compounded annually on your investment? P
=PV(5%,4,,-10000)
P = $8227.02

Example 2.11
compounded annually on your investment?
1. Use tabulated factors Single Sums
P = F(P|F i%, n) To Find F To Find P
P = $10,000(P|F 5%,4) n Given P Given F
= $8,227.00 (F|P,i%,n) (P|F,i%,n)
P =PV(5%,4,,-10000) 1 1.05000 0.95238
2 1.10250 0.90703
P = $8227.02
3 1.15763 0.86384
4 1.21551 0.82270
5 1.27628 0.78353

Example 2.11
1. Use tabulated factors
P = F(P|F i%, n)
P = $10,000(P|F 5%,4)
= $8,227.00
P = $10,000(1.05)-4 = $10,000(0.82270) = $8,227.00
P =PV(5%,4,,-10000)
P = $8227.02

Example 2.11
1. Use tabulated factors
P = F(P|F i%, n)
P = $10,000(P|F 5%,4)
= $8,227.00
2. Use math formulation from definition
P = $10,000(1.05)-4 = $10,000(0.82270) = $8,227.00
3. Use Excel PV function P =PV(i%,n,,-F)
P = PV(5%,4, , -10000) = $8,227.02
P =PV(5%,4,,-10000)
PrinciplesPof=Engineering
$8227.02Economic Analysis, 6th edition
Pit Stop #2 — Hang On!
1. True of False: If money is worth 5% compounded annually to you, then you
should prefer to receive $2,750 today than to receive $3,500 five years from
today.
2. True or False: If money is worth 7% compounded annually to you, then you
should prefer to receive $1,000,000 thirty years from now than to receive
$200,000 today.

Pit Stop #2 — Hang On!
1. True of False: If money is worth 5% compounded annually to you, then you
should prefer to receive $2,750 today than to receive $3,500 five years from
today. True PV(5%,5,,-3500) = $2,742.34 < $2,750.00
2. True or False: If money is worth 7% compounded annually to you, then you
should prefer to receive $1,000,000 thirty years from now than to receive
$200,000 today. False $1,000,000.00 < FV(7%,30,,-200000) = $1,522,451.01

ISEN 667 Engineering Economic Analysis: Class 02. Cash Flow and Interest Calculation

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ISEN 667

Engineering Economic Analysis

Class 02. Cash Flow and Interest

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Which would you

Which would you choose?

• E: if received in year 4, it is $2,000

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Start of Value of Interest End of Value of

2 $11,000.00 $1,100.00 2 $12,100.00

3 $12,100.00 $1,210.00 3 $13,310.00

4 $13,310.00 $1,331.00 4 $14,641.00

5 $14,641.00 $1,464.10 5 $16,105.10

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

P = F (1 + i)-n Future Value to Present Value

Principles of Engineering Economic Analysis, 6th edition

F = P (F|P i%, n) single sum, future worth factor

P = F (1 + i)-n Future Value to Present Value

P = F (P|F i%, n) single sum, present worth factor

Vertical line means “given”

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

P occurs n periods before F (F occurs n periods after P)

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

There are six ways to solve this problem:

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

(b) 23.446 yrs 3

(c) 17.669 yrs 6

(d) 11.893 yrs 9

(e) 9.006 yrs 12

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

No more heuristic rule like 72 rule

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Principles of Engineering Economic Analysis, 6th edition

Answer: 24 years. By the Rule of 72, 12