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Unformatted text preview: Principles of Engineering Principles of Engineering Economy Economy Time Value of Money, Interest and Interest Rates Part I Key Concepts • Last Module: Cash Flow Diagram • This Module: • Time Value of Money: the value of money changes with time – Money provides utility (value) when spent – Value of money grows if invested – Value of money decreases due to inflation • Interest: used to move money through time for comparisons Cash Flow Analysis • Given that any investment opportunity can be drawn by a cash flow diagram, how can we select the best? • Transform all cash flow diagrams into something similar for comparison. – Use a Common Interest Rate – Use Time Value of Money Calculations Time Value of Money Time Value of Money • Money has value because it gives us utility. • Generally, money is preferred now, as opposed to later (same amount) – One can spend it now and get utility – One can invest it and watch it grow with interest for greater future utility – One can put it under the mattress and watch it lose purchasing power Time Value of Money • To describe the same amount of money at different periods of time requires the use of an interest rate. With a positive rate: – Money grows (compounds) into larger sums in the future. – Money is smaller (discounted ) in the past. Interest • Cost of Money – Rental amount charged by lender for use of money – In any transaction, someone “earns” and someone pays interest • Savings Account: bank pays you; 1.5% fee to depositor • Home/Auto Loan: borrower pays bank; 7.5% fee to bank Interest • Interest Rate comprised of many factors • Example: Home Mortgage: 7.5% – Prime Rate : ( Banks borrow money at this rate from the Federal Reserve banks when needed) 5% – Risk Factor : 1% – Administration Fees : 0.5% – Profit : 1% Definitions • Principal (capital): P – Amount invested or loaned • Interest Rate: i – Rental charge for money defined as a percentage of principal per time period • Compounding Period – Defines how often interest is calculated (may not be paid, however) • Length of loan/investment: N periods Simple Interest • Interest earned/paid is directly proportional to capital involved. Simple Interest • Interest earned/paid is directly proportional to capital involved. =(Principal) (Interest Rate) (Periods) Simple Interest • Interest earned/paid is directly proportional to capital involved. =(Principal) (Interest Rate) (Periods) I = Pi N Example • Taiwan High Speed Rail Corp. was looking to refinance its loan of NT$382 billion for owning and operating the high speed rail link between Taipei and Kaohsiung, Taiwan. The current rate is 2.6% per year, but it is looking to lower it to 1.8% per year....
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 Fall '08
 tufecki
 Interest Rates, time value, cash flow diagrams

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