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    Lecture3 Economic Equivalence

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    Ganda Ganda
    Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

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    Lecture3 Economic Equivalence

    Uploaded by

    Ganda Ganda
    36 views22 pages
    Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

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    Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    36 views22 pages

    Lecture3 Economic Equivalence

    Uploaded by

    Ganda Ganda
    Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

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    Economic Equivalence

    Lecture No.3
    E-Eco: Engineering Economy
    Economic Equivalence
    ◼ What do we mean by “economic
    equivalence?”
    ◼ Why do we need to establish an economic
    equivalence?
    ◼ How do we establish an economic
    equivalence?
    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.
    Equivalence from Personal Financing
    Point of View
    F

    ◼ If you deposit P dollars


    today for N periods at F = P(1 + i) N
    i, you will have F
    0
    dollars at the end of N
    period N.

    PF P
    Alternate Way of Defining Equivalence

    P
    ◼ F dollars at the end of
    period N is equal to a
    single sum P dollars
    now, if your earning 0 N
    power is measured in
    F
    terms of interest rate i.
    −N
    P = F (1 + i)

    0 N
    Practice Problem
    At 8% interest, what is the equivalent worth
    of $2,042 now 5 years from now?

    $2,042 If you deposit $2,042 today in a savings


    account that pays 8% interest annually.
    how much would you have at the end of
    5 years?

    0 1 2 3 4 5
    F

    =
    0 5
    Solution

    F = $2,042(1 + 0.08) 5

    = $3,000
    Example 2.2
    At what interest rate
    would these two amounts be equivalent?

    $2,042
    i=? $3,000

    0 5
    Equivalence Between Two Cash Flows

    ◼ Step 1: Determine the


    $2,042 $3,000
    base period, say, year 5.
    ◼ Step 2: Identify the
    interest rate to use.
    ◼ Step 3: Calculate
    equivalence value. 0 5
    i = 6%, F = $2,042(1 + 0.06)5 = $2,733
    i = 8%, F = $2,042(1 + 0.08)5 = $3,000
    i = 10%, F = $2,042(1 + 0.10)5 = $3,289
    Example - Equivalence
    Various dollar amounts that will be economically
    equivalent to $3,000 in 5 years, given an interest
    rate of 8%.
    $3,000
    P= = $2,042
    (1 + 0.08) 5

    P F
    $2,042 $2,205 $2,382 $2,572 $2,778 $3,000
    0 1 2 3 4 5
    Example 2.3

    $200 V
    $150

    $100
    $120
    $100
    =
    $80

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

    Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.


    Approach
    V

    $200

    $150
    $120
    $100 $100
    $80

    0 1 2 3 4 5
    V3 = $511.90 + $264.46 V
    = $776.36

    $200
    $200(1 + 0.10)−1 + $100(1 + 0.10) −2
    $150 = $264.46
    $120
    $100 $100
    $80

    0 1 2 3 4 5

    100(1 + 0.10)3 + $80(1 + 0.10) 2 + $120(1 + 0.10) + $150


    = $511.90
    Practice Problem
    2P
    ◼ How many years would
    it take an investment to
    double at 10% annual
    0
    interest?
    N=?

    P
    Solution

    2P F = 2 P = P(1 + 0.10) N
    2 = 1.1
    N

    log 2 = N log1.1
    0
    log 2
    N=? N=
    P
    log1.1
    = 7.27 years
    Rule of 72

    ◼ Approximating 72
    how long it will N
    take for a sum of interest rate (%)
    money to double 72
    =
    10
    = 7.2 years
    Practice Problem
    $1,000
    $500
    Given: i = 10%,
    A

    Find: C that makes the 0 1 2 3


    two cash flow streams
    to be indifferent C C

    0 1 2 3
    Approach
    $1,000
    ◼ Step 1: Select the base
    period to use, say n = $500
    2. A
    ◼ Step 2: Find the 0 1 2 3
    equivalent lump sum
    value at n = 2 for both
    A and B. C C
    ◼ Step 3: Equate both B
    equivalent values and
    solve for unknown C. 0 1 2 3
    Solution

    ◼ For A: $1,000

    −1
    $500
    V2 = $500(1 + 0.10) + $1,000(1 + 0.10)
    2

    = $1,514.09 A
    0 1 2 3
    ◼ For B:
    V2 = C (1 + 0.10) + C
    C C
    = 2.1C
    ◼ To Find C: B
    2.1C = $1, 514.09
    0 1 2 3
    C = $721
    Practice Problem
    $1,000
    $500
    At what interest rate
    would you be A

    indifferent between the 0 1 2 3


    two cash flows?
    $502 $502 $502

    0 1 2 3
    Approach

    ◼ Step 1: Select the base $1,000


    period to compute the
    equivalent value (say, n $500
    = 3) A
    ◼ Step 2: Find the net 0 1 2 3
    worth of each at n = 3.

    $502 $502 $502

    0 1 2 3
    Establish Equivalence at n = 3

    Option A : F3 = $500(1 + i) + $1, 000


    3

    Option B : F3 = $502(1 + i)2 + $502(1 + i ) + $502

    ◼ Find the solution by trial and error, say i = 8%

    Option A : F3 = $500(1.08)3 + $1, 000


    = $1, 630
    Option B : F3 = $502(1.08) 2 + $502(1.08) + $502
    = $1, 630

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