Interest and Equivalence: GoingUp in Smoke.

State governments throughout theUnited States agreed to a largefinancialwindfall in 1998. Tobaccocompaniesagreedtopayinperpetuityto settleclaimsarisingfromthe healtheffects of smoking. Payments over the first 25 years are estimated to be nearly $250 billion.

State officials announced they would earmark these funds for goals such as health care, education and, of course, antismoking campaigns. But several states involved in the settlement were chronically short of money and were desperate to plug budget deficits. If only they could get their hands on the full value of that tobacco settlementnow, instead of waiting for the payments to dribble in year by year.

That's when someonehit on the idea ofraising instant money by issuing "tobacco bonds": the states would sell bonds to investors and paythem interest out of the tobacco settlement payments the states were receiving.

State governments could get thewhole sale price of the bond up front; investors would get ongoing income
fromthe bond.

A growing number of states are now selling these bonds, and pocketing quick billions.To attract buyers, however, the states have to pay a high rate of interest on their tobacco bonds, since investors view them as riskier than other government-backed securities. Investors reason that tobacco companies could go broke, after all--especially if the no-smoking laws being passed allover the country cause enough people to snuff out their cigarette habit for good.

In the first chapter,we discussed the engineeringeconomic decision process. We describedmodels used to estimate the costs and benefits that are summarized in cash flow diagrams.Formany of the situationswe examined, the economic consequencesof an alternativewere immediate or took place in a very short period of time, as in Example 1-2 , (the decision on the design of a concrete aggregate mix) or Example 1-3 (the change of manufacturing method). In such relatively simple situations,we total the various positive and negativeaspects, compare our results, and quickly reach a decision.But canwe do the same if the economic consequencesoccur over a considerableperiod of time?

No we cannot, because money has value over time. Would you rather: (1) receive $1000 today or (2) receive $1000 ten years from today? Obviously, the $1000 today has more value.Money's value over time is expressed by an interest rate. In this chapter, we describe two introductory concepts involving the time value of money: interest and cash flow equivalence.


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