University:
California State University, Northridge
Course:
MSE 604 | Engineering Economy and Financial Analysis
Academic year:

2024
Views:

69

Pages:

24
Author:

Araceli Cuevas

CHAPTER 3 PRINCIPLES OF MONEYTIME RELATIONSHIPS Capital • Capital refers to wealth in the form of money or property that can be used to produce more wealth • Types of Capital – Equity capital is that owned by individuals who have invested their money or property in a business project or venture in the hope of receiving a profit. – Debt capital, often called borrowed capital, is obtained from lenders (e.g., through the sale of bonds) for investment. Financing Definition Instrument Description • Debt financing • Borrow money • Bond • Promise to pay principle & interest; • Equity financing Exchange • Sell partial • Stock •Exchange sharesfor of ownership of money stock for company; shares of ownership of stock as company; proof of partial ownership Time Value of Money • Time Value of Money • Money can “make” money if Invested • The change in the amount of money over a given time period is called the time value of money • The most important concept in engineering economy Interest Rate • INTEREST - THE AMOUNT PAID TO USE MONEY. RENTAL FEE PAID FOR THE USE OF SOMEONE ELSES MONEY – INVESTMENT • INTEREST = VALUE NOW - ORIGINAL AMOUNT – LOAN • INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT • INTEREST RATE - INTEREST PER TIME UNIT INTEREST PER TIME UNIT INTEREST RATE = ORIGINAL AMOUNT Determination of Interest Rate Interest Rate ie Money Supply MS1 Money Demand Quantity of Money Simple and Compound Interest •Two “types” of interest calculations •Simple Interest •Compound Interest •Compound Interest is more common worldwide and applies to most analysis situations Simple Interest • Simple Interest is calculated on the principal amount only •Easy (simple) to calculate •Simple Interest is: •(principal)(interest rate)(time); $I = (P)(i)(n) •Borrow $1000 for 3 years at 5% per year •Let “P” = the principal sum •i = the interest rate (5%/year) •Let N = number of years (3) •Total Interest over 3 Years... Compound Interest •Compound Interest is much different •Compound means to stop and compute •In this application, compounding means to compute the interest owed at the end of the period and then add it to the unpaid balance of the loan •Interest then “earns interest” Compound Interest: An Example •Investing $1000 for 3 year at 5% per year •P0 = $1000, I1 = $1,000(0.05) = $50.00 •P1 = $1,000 + 50 = $1,050 •New Principal sum at end of t = 1: = $1,050.00 •I2 = $1,050(0.05) = $52.50 •P2=1050 + 52.50 = $1102.50 •I3 = $1102.50(0.05) = $55.125 = $55.13 •At end of year 3 =1102.50 + 55.13 = $1157.63 Parameters and Cash Flows •Parameters •First cost (investment amounts) •Estimates of useful or project life •Estimated future cash flows (revenues and expenses and salvage values) •Interest rate •Cash Flows •Estimate flows of money coming into the firm – revenues salvage values, etc. (magnitude and timing) – positive cash flows--cash inflows •Estimates of investment costs, operating costs, taxes paid – negative cash flows -- cash outflows Cash Flow Diagramming • Engineering Economy has developed a graphical technique for presenting a problem dealing with cash flows and their timing. •Called a CASH FLOW DIAGRAM •Similar to a free-body diagram in statics • First, some important TERMS . . . . Terminology and Symbols • P = value or amount of money at a time designated as the present or time 0. •F = value or amount of money at some future time. •A = series of consecutive, equal, end-of-period amounts of money. •n = number of interest periods; years •i = interest rate or rate of return per time period; percent per year, percent per month • t = time, stated in periods; years, months, days, etc The Cash Flow Diagram: CFD • Extremely valuable analysis tool • Graphical Representation on a time scale •Does not have to be drawn “to exact scale” •But, should be neat and properly labeled •Assume a 5-year problem END OF PERIOD Convention •A NET CASH FLOW is • Cash Inflows – Cash Outflows (for a given time period) • We normally assume that all cash flows occur: •At the END of a given time period •End-of-Period Assumption EQUIVALENCE •You travel at 68 miles per hour •Equivalent to 110 kilometers per hour •Thus: •68 mph is equivalent to 110 kph •Using two measuring scales •Is “68” equal to “110”? •No, not in terms of absolute numbers •But they are “equivalent” in terms of the two measuring scales ECONOMIC EQUIVALENCE •Economic Equivalence •Two sums of money at two different points in time can be made economically equivalent if: •We consider an interest rate and, •No. of Time periods between the two sums Equality in terms of Economic Value More on Economic Equivalence Concept • Five plans are shown that will pay off a loan of $5,000 over 5 years with interest at 8% per year. •Plan1. Simple Interest, pay all at the end •Plan 2. Compound Interest, pay all at the end •Plan 3. Simple interest, pay interest at end of each year. Pay the principal at the end of N = 5 •Plan 4. Compound Interest and part of the principal each year (pay 20% of the Prin. Amt.) • Plan 5. Equal Payments of the compound interest and principal reduction over 5 years with end of year payments Plan 1 @ 8% Simple Interest • Simple Interest: Pay all at end on $5,000 Loan Plan 2 Compound Interest 8%/yr • Pay all at the End of 5 Years Plan 3: Simple Interest Paid Annually • Principal Paid at the End (balloon Note) Plan 4 Compound Interest • 20% of Principal Paid back annually Plan 5 Equal Repayment Plan • Equal Annual Payments (Part Principal and Part Interest Conclusion •The difference in the total amounts repaid can be explained (1) by the time value of money, (2) by simple or compound interest, and (3) by the partial repayment of principal prior to year 5.

Principles of Money-Time Relationships

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