Ambo University Hachalu

Hundessa Campus
Department of Construction Technology & Management

Course: Construction Economics Code: CENG6108

Target Section: M.Sc., Construction Engineering & Management

By: Dr. Leevesh Kumar

Assistant Professor
Department of Construction Technology & Management
Chapter-2 Time Value of Money &
Interest Rate
CONTENT
 Time Value of Value
 Rate of Return
 Simple Interest
 Compound Interest
 Quantifying alternatives for decision making
 Compound interest factor
 Single payment compound amount factor
 Single Payment Present Worth Factor
 Uniform series present worth factor
 Capital recovery factor
 Uniform series compound amount factor
 Sinking fund
 Cash flow involving arithmetic’s gradient payment or receipt
 2.1 Time Value of Money(TVM)

 The change in the amount of money over a

given time period is called time value of
money; it is the most important concept in
engineering economy.
 The time value of money is the concept that
money available at the present time is worth
more than the identical sum in the future
due to its potential earning capacity.
 TVM
 In case of an investment made in the past, the total
amount of interest accumulated till now is given by;

Amount of interest = Total amount to be received –

original investment (i.e. principal amount)
 Similarly in case of a loan taken in past, the total
amount of interest is given by;

Amount of interest = Present amount owed – original loan

(i.e. principal amount)
 Example
 A person deposited Rs.1,00,000 in a bank for one year
and got Rs.1,10,000 at the end of one year. Find out
the total amount of interest and the rate of interest
per year on the deposited money.
Solution-
The total amount of interest gained over one year =
Rs.1,10,000 - Rs.1,00,000 = Rs.10,000
The rate of interest ‘i’
per year is given by =
 Example

Similarly if a person borrowed Rs.1,50,000 for

one year and returned back Rs.1,62,000 at the
end of one year. Then the amount of interest
paid and the rate of interest are calculated as
follows;
The total amount of interest paid =1,62,000 -
1,50,000 = 12,000.
The rate of interest ‘i’ per year is given by;
2.1 Interest Rate (IR)

 Interest is the manifestation (the action or fact of

showing something) of the time value of money.
 It is the difference between an ending amount of
money and the beginning amount.
 Two types of interest:
◦Interest paid ◦Interest earned
 Interest is paid when a person or organization
borrowed money (obtained a loan) and repays a
larger amount over time.
 Interest is earned when a person or organization
saved, invested, or rent money and obtains a return
of a larger amount over time.
2.1 Interest Rate

 The time unit of the rate is called the interest

period.
 The most common interest period used to
state an interest is one year.
 Shorter period such as per cent per month is
also used.
 If time unit is not stated, it is assumed to be
one year.
2.2 Rate of Return (ROR)

 Interest earned over a specific period of

time is expressed as a percentage of the
original amount is called Rate of Return.
 The term Return of Investment (ROI) is used
equivalently with ROR in different industries
and settings especially with large capital
funds.
 The Minimum Attractive Rate of Return
(MARR) is a reasonable rate of return
established for the evaluation and selection
of alternatives.
 Interest Rate and Rate of Return

 The numerical values of interest rate and

rate of return are the same but the term
interest rate paid is more appropriate for the
borrower’s perspective while the rate of
return earned is better for the investor’s
perspective.
 Interest = amount owed now - principal
 Example

 An investment of 6,00,000 birr increased to

1,000,000 birr over 5 year period. What was
the rate of return on the investment?
 solution
Interest = 1,000,000 - 600,000 = 400,000 over 5
years
Interest accrued per unit time = 400,000/5 =
80,000
RR= 80,000/600,000 * 100
= 13.33 % per year.
 Examples
 Calculate the amount deposited 1 year ago to
have $1000 now at an interest rate of 5% per
year. Also calculate the amount of interest
earned during this time period.
Solution:
The total amount accrued ($1000) is the sum of
the original deposit and the earned interest.
If X is the original deposit,
Total accrued = deposit + deposit(interest rate)
$1000 = X + X (0.05) = X (1.05) = 1.05 X
The original deposit is,
X =1000/1.05 = $952.38
Interest = $1000 - 952.38 = $47.62
2.3 Simple Interest

 It is calculated using the principal amount only,

ignoring any interest accrued in preceding interest
periods.
 The total simple interest over several periods is
computed as:
Interest = (principal amount) x(number of periods) x
(rate)
I = (P)(N)(i),
P = principal amount borrowed;
N = number of interest periods (e.g., years, months)
i = interest rate per interest period.
Example-
The amount of money owned at the
beginning of the year is 1000, what will be the
amount of the money after 3 years with simple
interest rate of 10 % per year.

Period Amount Interest Amount

Owned at Amount Owned at End
Beginning Year
1 1000 100 1100

2 1000 100 1200

3 1000 100 1300

2.4 Compound Interest

 The interest accrued for each interest period is

calculated on the principal amount plus the total
amount of interest accumulated in all previous
periods.
 Compound interest is most commonly used in
practice
Interest = (principal + all accrued interest)x(interest
rate)
 2.5 Quantifying alternatives for decision making

 Quantifying (express or measure the quantity)

alternatives for any item is the most important aspect of
decision making for selecting the best option.
 For example, a construction company is planning to
purchase a new concrete mixer for preparing concrete
at a construction site. Let's say there are two
alternatives available for purchasing the mixer; a) an
automatic concrete mixer and b) a semi-automatic
concrete mixer. Then the task is to find out best
alternative that the company will purchase that will
yield more profit.
 For this purpose one has to quantify both the alternatives
by the following parameters;
 Cont.…..

 The initial cost that includes purchase price, sales

tax, cost of delivery and cost of assembly and
installation.
 Annual operating cost. (labour, fuel etc.)
 Annual profit which will depend on the productivity
i.e. quantity of concrete prepared.
 The expected useful life.
 The expected salvage value.
 Other expenditure or income (if any) associated
with the equipment.
 Income tax benefit
 Cont.…

 Then on the basis of the economic criteria, the best

alternative is selected by calculating the present worth
or future worth or the equivalent uniform annual worth
of both alternatives by incorporating the appropriate
interest rate per year and the number of years (i.e. the
comparison must be made over same number of years
for both alternatives). Then the concrete mixer with
least cost or higher net income is considered for
purchase. In addition to economic parameters as
mentioned above, the non-economic parameters
namely environmental, social, and legal and the
related regulatory and permitting process must also be
considered for the evaluation and selection of the best
alternative.
 Cont.….
 These non-economic parameters are essentially
required (in addition to the economic factors) for
the selection of the best alternative for the
infrastructure and heavy construction projects like
dams, bridges, roadways etc. and other publicly
and privately funded projects namely office
buildings, hospitals, apartment building and
shopping malls etc. When the available
alternatives exhibit the same equivalent cost or
same net income, then the non-economic
parameters may play a vital role in the selection of
the best alternative. It may be noted here that the
non-economic parameters cannot be expressed in
numerical values.
 2.6 Compound Interest Factor

 The compound interest factors and the corresponding formulas

are used to find out the unknown amounts at a given interest rate
continued for certain interest periods from the known values of
varying cash flows.
 The following are the notations used for deriving the compound
interest factors.
P = Present worth or present value
F = Future worth or future sum
A = Uniform annual worth or equivalent uniform annual worth of
a uniform series continuing over a specified number of interest
periods
n = number of interest periods (years or months)
i = rate of interest per interest period i.e. % per year or % per
month Unless otherwise stated, the rate of interest is
compound interest and is for the entire number of interest
periods i.e. for ‘n’ interest periods.
 Cont….

 The present worth (P), future worth (F) and uniform

annual worth (A) are shown in Fig. 1.6.
 In this figure the present worth, P is at the
beginning and the uniform annual series with
annual value “A” is from end of year 1 till end of
year 5. Both “P” and “A” are cash outflows. It may
be noted that the uniform annual series with
annual value “A” may be also continued
throughout the entire interest periods i.e. from
beginning till end of year 10 or for some
intermediate interest periods like commencing
from end of year 3 till end of year 8.
 Compound Interest Factor

The future worth “F” is occurring at end of year

4 (cash outflow), at end of year 6 (cash inflow)
and at the end of year 10 (cash inflow).
 Compound Interest Factor

While deriving the different compound interest

factors, it is assumed that the interest is
compounded once per interest period i.e.
discrete compounding. Further the cash flows
are assumed to be discrete i.e. they occur at
the end of interest period.
2.7 Single Payment Compound Amount Factor (SPCAF)

 The single payment compound amount factor is used

to compute the future worth (F) accumulated after “n”
years from the known present worth (P) at a given
interest rate ‘i’ per interest period. It is assumed that the
interest period is in years and the interest is
compounded once per interest period.
 The known present worth (P), unknown future worth (F)
and the total interest period “n” years are shown in Fig.
1.7.
Single Payment Compound Amount
Factor (SPCAF)
Single Payment Compound Amount
Factor (SPCAF)
 2.8 Single Payment Present Worth
Factor (SPPWF)
 The single payment present worth factor is used to
determine the present worth of a known future worth
(F) at the end of “n” years at a given interest rate ‘i’
per interest period.
 The present worth (P), future worth (F) and the total
interest period “n” years are shown in Fig. 1.8. From
equation (7), the expression for the present worth (P)
can be written as follows;
Single Payment Present Worth Factor (SPPWF)
2.9 Uniform Series Present worth Factor (USPWF)

The uniform-series present worth factor is used to

determine the present worth of a known uniform
series. Let “A” be the uniform annual amount at the
end of each year, beginning from end of year “1” till
end of year “n”.
The known “A”, unknown “P”, and the total interest
period “n” years are shown in Fig. 1.9. This cash flow
diagram refers to the case; if a person wants to get
the known uniform amount of return every year, how
much he has to invest now.
Uniform Series Present worth Factor (USPWF)
The present worth (P) of the uniform series can be
calculated by considering each “A” of the uniform
series as the future worth. Then by using the formula
in equation (8), the present worth of these future
worth can be calculated and finally taking the sum
of these present worth values.
Uniform Series Present worth Factor (USPWF)
The factor within the bracket in equation (13)
is known as uniform series present worth factor
(USPWF). Thus if the value of “A” in the uniform
series is known, then the present worth P at
interest rate of “I” (per year) can be
calculated by multiplying the uniform annual
amount “A” with uniform series compound
amount factor.
 2.10 Capital Recovery Factor (CRF)
The capital recovery factor is generally used to find
out the uniform annual amount “A” of a uniform series
from the known present worth at a given interest rate
‘i’ per interest period.
The cash flow diagram is shown in Fig. 1.10. This cash
flow diagram indicates, if a person invests a certain
amount now, how much he will get as return by an
equal amount each year.
Capital Recovery Factor (CRF)
2.11 Uniform Series Compound Amount Factor (USCAF)

The uniform series compound amount factor is used

to determine the future sum (F) of a known uniform
annual series with uniform amount “A”. The cash flow
diagram is shown in Fig. 1.11. This cash flow diagram
states that, if a person invests a uniform amount at
the end of each year continued for “n” years at
interest rate of “i” per year, how much he will get at
the end of “n” years.
Uniform Series Compound Amount Factor (USCAF)

The factor within bracket in equation (19) is known as

uniform series compound amount factor (USCAF). Hence
the future worth “F” can be computed by multiplying the
uniform annual amount “A” with the uniform series
compound amount factor.
2.12 Sinking Fund (SF)
The sinking fund factor is used to calculate the annual
amount “A” of a uniform series from the known future
sum “F”. The cash flow diagram is shown in Fig. 1.12.
This cash flow diagram indicates that, if a person
wants to get a known future sum at the end of ‘n’
years at interest rate of ‘i’ per year, how much he has
to invest every year by an equal amount.
Sinking Fund Factor (SFF)
b
Sinking Fund (SF)
2.13 Cash Flow Involving Arithmetic Gradient
Payment or Receipt
 Some cash flows involve the payments or receipts in gradients
by same amount. In other words, the expenditure or the income
increases or decreases by same amount. The cash flow
involving such payments or receipts is known as uniform
gradient series.
For example, if the cost of repair and maintenance of a piece of
equipment increases by same amount every year till end of its
useful life, it represents a cash flow involving positive uniform
gradient. Similarly if the profit obtained from an investment
decreases by an equal amount every year for a certain number
of years, it indicates a cash flow involving negative uniform
gradient. The cash flow diagrams for positive gradient and
negative gradient are shown in Fig. 1.3 and Fig. 1.4 respectively.
 Cash Flow Involving Arithmetic
Gradient Payment or Receipt
The generalized cash flow diagram involving a
positive uniform gradient with base value “B” and the
gradient “G” is shown in Fig. 1.15a. The cash flow
shown in Fig. 1.15a can be split into two cash flows;
one having the uniform series with amount “B” and
the other having the gradient series with values in
multiples of gradient amount “G” and is shown in Fig.
1.15b. This gradient series is also know as the
arithmetic gradient series as the expense or the
income increases by the uniform arithmetic amount
“G” every year.
Cash Flow Involving Arithmetic
Gradient Payment or Receipt
Arithmetic Gradient Present Worth Factor
Arithmetic Gradient Uniform Series Factor
Example
Example
Example
Example
Example
Example
Next Chapter….