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CH 3 Note

# CH 3 Note - CHAPTER 3 THE TIME VALUE OF MONEY MONETARY FLOW...

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49 CHAPTER 3 T H E T I M E V A L U E O F M O N E Y MONETARY FLOW Definition Engineering projects are characterized by outflows or negative flows (investments and oper- ating expenses) and inflows or positive flows (revenues) of funds that occur over their lives. The monetary flow at a particular point in time is the difference between the inflows and out- flows that occur at that time. MONETARY FLOW = MONETARY INFLOWS - MONETARY OUTFLOWS A monetary flow profile describes a particular project by its stream of monetary inflows and outflows over time. 0 12345 End-of-Period Convention Monetary inflows and outflows occur intermittently, at irregular intervals over the life of a project. To facilitate economic analysis, all inflows and outflows occurring during a particu- lar time period – typically one year – are summed up and the net amount is assumed to occur at the end of that time period. Thus, a monetary flow distribution is represented by up (posi- tive flows) and down (negative flows) pointing arrows occurring at equally spaced intervals over time.

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CHAPTER 3 50 1 2345 0 TIME VALUE OF MONEY A money lender normally requires compensation for foregoing the use of his own wealth. We suppose here that the lender would have derived benefits from the use of his wealth had he kept it. The money borrower must pay this compensation to the lender, and eventually repay the amount borrowed as well. The compensation is known as interest . The absolute amount of interest is proportional to: ± The amount of money borrowed (or lent) ± The length of time over which the money is borrowed (or lent) For instance, which of the following alternatives is preferable? ± Receive \$100 now ± Receive \$100 one year from now The first alternative is preferable, because the money received now can be put to use; e.g. invested in a bank account. Suppose that the following alternatives are available: ± Receive \$100 now ± Receive \$125 one year from now
CHAPTER 3 51 The choice is not that obvious. It depends on the intended use of the money. .. If the money were deposited in a bank account earning 10% interest per year, \$110 would be available in one year's time. Here, the time value of money is represented by \$10, its earning power over the period of one year. All other conditions being equal, the last alternative is preferable because the absolute monetary difference of \$25 between the two alternatives is greater than the time value of \$10. However, if the money were deposited in a bank account earning 25% interest per year, \$125 would be available in one year's time. The time value of money here is \$25. All other condi- tions being equal, both alternatives are of equal value, i.e., an investor should be indifferent to these two alternatives. In this case, the values are said to be equivalent , because the abso- lute monetary difference is equal to the time value.

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CH 3 Note - CHAPTER 3 THE TIME VALUE OF MONEY MONETARY FLOW...

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