Ma.

Brida Lea Diola

Environment and Energy Engineering Group
UP Institute of Civil Engineering
Discussion Topics
 Recall: Simple and Compound Interest
 Economic Equivalence and Principles
 Interest formulas for
 Single Cash Flows
 Equal Payment Series
 Gradient Series

2
 If receiving 100 today is not the same thing as receiving
100 at any future point how do we compare and measure
various cash flows?
What is “Economic Equivalence?”
 Economic equivalence exists between cash
flows that have the same economic effect and
could therefore be traded for one another.
 Even though the amounts and timing of the
cash flows may differ, the appropriate interest
rate makes them equal in economic sense.

4
Principles of Economic Equivalence
PRINCIPLE 1:
 Equivalence calculations made to compare alternatives require a
common time basis

PRINCIPLE 2:
 Equivalence depends on Interest Rate.

PRINCIPLE 3:
 Equivalence calculations may require the conversion of multiple
payment cash flows to a single cash flow.

PRINCIPLE 4:
 Equivalence is maintained regardless of Point-of-View
5
Equivalence
Equivalence from Personal Alternate Way of Defining
Financing Point of View Equivalence
 If you deposit P dollars today for N  F dollars at the end of period N is
periods at i, you will have F dollars equal to a single sum P dollars now,
at the end of period N. if your earning power is measured in
terms of interest rate i.
F
P

F  P(1  i) N
0
0 N
N
F

P  F (1  i ) N
P
0 N

6
 Example 1: Equivalence
 If you deposit $2,042 today in a  Various dollar amounts that will be
savings account that pays an 8% economically equivalent to $3,000 in five
interest annually, how much would
you have at the end of 5 years?
years, at an interest rate of 8%
 At an 8% interest, what is the
equivalent worth of $2,042 now in 5
years?
F  $2,042(1  0.08)5
 $3,000

$2,042

0 1 2 3 4 5
F

=
0 5

7
Example 2: Equivalent Cash Flows

 $2,042 today was

equivalent to receiving
$3,000 in five years, at an
interest rate of 8%. Are
these two cash flows also
equivalent at the end of
year 3?

 Equivalent cash flows

are equivalent at any
common point in time, as
long as we use the same
interest rate (8%, in our
example).
8
Example 2: Equivalent Cash Flows

 $2,042 today was

equivalent to receiving PRINCIPLE 1:
$3,000 in five years, at an Equivalence calculations made to
interest rate of 8%. Are compare alternatives require a common
these two cash flows also time basis.
equivalent at the end of
year 3? PRINCIPLE 2:
Equivalence depends on Interest Rate.

 Equivalent cash flows PRINCIPLE 3:

are equivalent at any Equivalence calculations may require the
common point in time, as conversion of multiple payment cash
long as we use the same flows to a single cash flow.
interest rate (8%, in our
example).
9
 Example 3:

 Compute the equivalent  Approach:

value of the cash flow series
at n = 3, using i = 10%. V3

$200
$200 V
$150
$150
$100
$120
$100
= $100
$120
$100
$80
$80

0 1 2 3 4 5 0 1 2 3 4 5

0 1 2 3 4 5

ANSWER: V = $776.36
10
Practice Problem 1
 Find C that makes the two  Approach:
cash flow transactions  Step 1: Select a base period to use, say n = 2.
equivalent at i = 10%  Step 2: Find the equivalent lump sum value at n = 2
for both A and B.
 Step 3: Equate both equivalent values and solve for
$1,000
unknown C.
$500
A $1,000

0 1 2 3 $500
A
0 1 2 3
C C

B C C

B
0 1 2 3
0 1 2 3

ANSWER: $721
11
Practice Problem 2
 Approach:
 At what interest rate  Step 1: Select a base period to compute the
would you be indifferent equivalent value (say, n = 3)
between the two cash flows?  Step 2: Find the equivalent worth of each cash
flow series at n = 3.
$1,000
$500
A $1,000
0 1 2 3 $500
A
$502 $502 $502 0 1 2 3
B
$502 $502 $502
0 1 2 3
B
ANSWER: i = 8%
0 1 2 3
12
Types of Common Cash
Flows in Engineering
Economics

 Single cash flow

 Equal (uniform)
payment series at regular
intervals
 Linear gradient series
 Geometric gradient
series
 Irregular (random)
payment series

13
Equivalence
Relationship
Between P and F

Compounding Process –
Finding an equivalent
future value of current
cash payment

Discounting Process –
Finding an equivalent
present value of a future
cash payment

15
Example 1 - Single Amounts: Find F, Given i, N, and P
Given: P = $2,000, i =  Single Cash Flow Formula –
10%, N = 8 years Compound Amount Factor
Find: F

F  $2,000(1  0.10)8 F
 $2,000(F / P ,10%,8)
F  P(1  i) N

 $4,287.18 F  P(F / P , i , N)
0
 Excel Solution:
N

16
A Typical Compound Interest
Table – say 12%

To find the compound

interest factor when the
interest rate is 12% and
the number interest
periods is 10, we could
evaluate the following
equation using the
interest table.

17
Example 2. Single Amounts: Find P, Given i, N, and F

Given: F = $1,000, i =  Single Cash Flow Formula –

12%, N = 5 years
Present Worth Amount Factor
Find: P
N F
P  $1,000(1  0.12)5
P  F (1  i)
 $1,000(P / F ,12%,5)
 $567.43 P  F (P / F , i , N)
0
N

18
 Example 3 - Single Amounts: Find N, Given P, F, and i
Given: P = $6,000, F = $12,000,  Solving for N
and i = 20%
Find: N

F  2P  P(1  0.20)N
2  1.2N
log2  N log1.2
log2
N
log1.2
 3.80 years

 Excel Solution:

20
Practice Problem 3 - Uneven Payment
Series
How much do you need to deposit today (P) to
withdraw $25,000 at n =1, $3,000 at n = 2, and $5,000 at
n =4, if your account earns 10% annual interest?

$25,000

$3,000 $5,000
0
1 2 3 4

P
ANSWER: $28,622

What is the future worth (n = 4) of your deposit? 21

Practice Problem 4: Future Value of an Uneven Series
with Varying Interest Rates
 Given: Deposit series as given over 5 years

 Find: Balance at the end of year 5

ANSWER: $1,372
22
Practice Problem 4: Future Value of an Uneven Series
with Varying Interest Rates
 Given: Deposit series as given
over 5 years

 Find: Balance at the end of

year 5

23
Recall: Objectives:
 Single payment  To define interest formulas
compound amount for:
factor  Uniform series (Equal
 Single payment present payment series) cash
worth factor flows
 Uniform/Linear gradient
series cash flows
 Geometric sequence of
cash flows

24
Equal Payment Series F

0 1 2 N
A A A

P
0 1 2 N

0 N

26
An Alternate Way of Calculating the
Equivalent Future Worth, F F
A

A(1+i)N-2
A A A

A(1+i)N-1

0 1 2 N 0 1 2 N

 (1  i)N  1 
F  A(1  i)N 1  A(1  i)N 2   A  A 
 i 
27
Equal-Payment Series Compound Amount Factor

F
 Formula

A A A

0 1 2 N
0 1 2 N

0 1 2
= N

A A A

28
Example 1 - Uniform Series: Find F, Given i, A, & N
Suppose you make an annual contribution of $3,000 to your savings account
at the end of each year for 10 years. If your savings account earns 7% interest
annually, how much can be withdrawn at the end of 10 years?
 Given: A = $3,000, N = 10
years, and i = 7% per year

 Find: F

 Excel Solution:

29
Example 2: Uniform Series: Find A, Given i, N, & F
To help you reach a $5,000 goal 5 years from now, you make five deposits at
the end of each year (the first deposit is made at the end of the first year). If
all your money is deposited in a bank that pays 7% interest, how large must
your annual deposit be?

 Given: F = $5,000, N = 5
 Formula – Sinking Fund Factor
years, and i = 7% per year

 Find: A

A  $5,000(A / F ,7%,5) $5,000

 $869.50 0 1 5

 Excel Solution:
A
=PMT(7%,5,0,5000)

30
 Example 3: Uniform Series: Find P, Given A, I, N
GM Corp. would like to start off its new line production with the construction
of a new plant through a 26-year loan. Its target budget for the annual loan
payment is $10,576,923. From a bank’s point of view, how much should be
loaned?
 Given: A = $10,576,923, N =
26 years, and i = 5% per year  Present Worth Factor
 Find: P
 Formula to use:

31
Example 4: Uniform Series: Find A, Given P, i, & N
BioGen Company, a small biotechnology firm, has borrowed $250,000 to
purchase laboratory equipment for gene splicing. The loan carries an interest
rate of 8% per year and is to be repaid in equal installments over the next 6
years. Compute the amount of this annual installment.

 Given: P = $250,000, N = 6
 Capital Recovery Factor
years, and i = 8% per year
 Find: A
 Formula to use:

 Excel Solution:
32
Practice Problem 1: Deferred Annuity
In the previous example, suppose BioGen
wants to negotiate with the bank to defer
the first loan repayment until the end of
year 2 (but still desires to make six equal
installments at 8% interest). If the bank
wishes to earn the same profit in as in the
previous scenario, what should be the
annual installment?

 Given: P = $250,000, N = 6
years, and i = 8% per year, but
the first payment occurs at
the end of year 2

 Find: A

ANSWER: $ 58,401
33
 Practice Problem 1
Comparison of Three Different Investment Plans
 Given: Three investment
plans and i = 8%, compounded
annually
 Find: Balance after 41 years
ANSWERS:

Plan A - $314,870.34
Plan B - $246,691.74
Plan C - $561,562.08

What if all investments are

made at beginning of each
year?
34
Linear Gradient Series
Gradient Series as a Composite Series of a Uniform
Series of N Payments of A1 and the Gradient Series of
Increments of Constant Amount G.

Strict gradient
series

36
Linear Gradient Series
A Strict Gradient Series

P
Gradient Series Present-
Worth factor
37
Total Present Worth
Increasing Gradient Series Decreasing Gradient Series

PT = PA + PG PT = PA - PG
PT = A1(P/A, i, n) + G(P/G, i, n) PT = A1(P/A, i, n) - G(P/G, i, n)

38
Example
 A textile mill has just purchased a lift truck that has a
useful life of five years. The engineer estimates that
maintenance costs for the truck during the first year
will be $1,000. As the truck ages, maintenance costs are
expected to increase at a rate of $250 per year over the
remaining life. Assume that the maintenance costs
occur at the end of each year. The firm wants to set up
a maintenance account that earns 12% annual interest.
All future maintenance expenses will be paid out of
this account.
 How much does the firm have to deposit in the
account now?
39
Example: Linear Gradient: Find P, Given A1, G, N, and i

 Given: A1 = $1,000, G = $250, N

= 5 years, and i = 12% per year
 Find: P

ANSWER: $ 5,204
40
Gradient-to-Equal-Payment Series Conversion Factor,
(A/G, i, N)
 Cash Flow Series

 Factor Notation

Gradient-to-equal payment
series conversion factor

41
Find A, Given Ai, G, I, and N

 Given: G = $1,000, N = 10 years, i = 12%

 Find: A

 Solution:

A  $1,000(A / G ,12%,10)
 $1,000(3.5847)
 $3,584.70

42
Example – Linear Gradient: Find A, Given A1, G, i, N
John and Barbara have just
opened two savings
accounts at their credit
union. The accounts earn
10% annual interest. John
wants to deposit $1,000 in
his account at the end of the
first year and increase this
amount by $300 for each of
the next five years. Barbara
wants to deposit an equal
amount each year for the
next six years. What should
be the size of Barbara’s
annual deposit so that the
two accounts will have ANSWER: $1,667.08
equal balances at the end of
six years? 43
Example Declining Linear Gradient Series

Suppose that you make a series of annual deposits into a

bank account that pays 10% interest. The initial deposit at the
end of the first year is $1,200. The deposit amounts decline by
$200 in each of the next four years. How much would you
have immediately after the fifth deposit?
F

ANSWER:$5,115.92

44
Geometric Gradient Series

Geometric-gradient-series
present-worth factor

45
Example
 In a geometric sequence of annual cash flows
starting at end of year zero, the value of A0 is
$1,304.35 (which is a cash flow). The value of the
last term in the series, A10, is $5,276.82. What is the
equivalent value of A for years 1 through 10? Let i =
20% per year.

 ANS = $2,790.73

46
47
TRUE OR FALSE
1. Interest is money paid for the use of equity capital
2. Simple interest ignores the time value of money
principle.
3. $1943 ten years from now is equivalent to $900 now if
the interest rate is 8% per year.
4. Cash flow body diagrams are analogous to free body
diagrams for mechanics problems.
5. For a fixed amount, F dollars, that is received at EOY
N, the “A equivalent” increases as the interest rate
increases.
48
Practice Problem

ANSWER: $ 867.27
Practice Problem

ANSWER: $ $15, 442.3795

50
 Practice Problem
 On the day his baby was born, a father decided to establish
a savings account for his child's college education. Any
money that is put into the account will earn an interest rate
of 8% compounded annually. The father will make a series
of annual deposits in equal amounts on each of his child's
birthdays from the 1st birthday through the 18th birthday
so that the child can make four annual withdrawals from
the account in the amount of P20,000 on each of his 18th,
19th, 20th, and 21st birthdays. Assuming that the first
withdrawal will be made on the child's 18th birthday. What
should be the annual deposit A?

ANSWER: P 1,910.32
51
Practice Problem
Find the present worth of the following cash flow sequence:

ANSWER: −2276.1
52