Lecture No4c3.ppt - Contemporary Engineering Economics 4 th...

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Contemporary Engineering Economics, 4 th edition ©2007 Time Value of Money Lecture No.4 Chapter 3 Contemporary Engineering Economics Copyright © 2006
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Contemporary Engineering Economics, 4 th edition © 2007 Chapter Opening Story —Take a Lump Sum or Annual Installments Mrs. Louise Outing won a lottery worth $5.6 million. Before playing the lottery, she was offered to choose between a single lump sum $2.912 million , or $5.6 million paid out over 20 years (or $280,000 per year). She ended up taking the annual installment option, as she forgot to mark the “Cash Value box”, by default. What basis do we compare these two options?
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Contemporary Engineering Economics, 4 th edition © 2007 Year Option A (Lump Sum) Option B (Installment Plan) 0 1 2 3 19 $2.912M $283,770 $280,000 $280,000 $280,000 $280,000
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Contemporary Engineering Economics, 4 th edition © 2007 What Do We Need to Know? To make such comparisons (the lottery decision problem), we must be able to compare the value of money at different point in time . To do this, we need to develop a method for reducing a sequence of benefits and costs to a single point in time . Then, we will make our comparisons on that basis.
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Contemporary Engineering Economics, 4 th edition © 2007 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 ). Time value of money is measured in terms of interest rate . Interest is the cost of money —a cost to the borrower and an earning to the lender This a two-edged sword whereby earning grows, but purchasing power decreases (due to inflation), as time goes by.
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Contemporary Engineering Economics, 4 th edition © 2007 The Interest Rate
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