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Lesson 02c Time Value of Money

This document discusses time value of money concepts related to gradient series, or cash flows that increase or decrease by a constant amount or percentage over time. It provides examples of linear gradient series, where payments change by a fixed dollar amount each period, and geometric gradient series, where payments change by a fixed percentage each period. The document also discusses how to calculate present and future values for mixed cash flows using multiple interest factors.

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Vjion Belo
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57 views

Lesson 02c Time Value of Money

This document discusses time value of money concepts related to gradient series, or cash flows that increase or decrease by a constant amount or percentage over time. It provides examples of linear gradient series, where payments change by a fixed dollar amount each period, and geometric gradient series, where payments change by a fixed percentage each period. The document also discusses how to calculate present and future values for mixed cash flows using multiple interest factors.

Uploaded by

Vjion Belo
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Time Value of Money

Gradients
NCE 4103
Dealing with Gradient Series
Engineers frequently encounter situations involving
periodic payments that increase or decrease by a
constant amount G or constant percentage (growth
rate) from period to period. We can easily develop a
series of interest formulas for this situation, but Excel will
be a more practical tool to calculate equivalent
values for these types of cash flows.
Handling Linear Gradient Series
Sometimes, cash flows will increase or decrease by a
set amount G, the gradient amount. This type of series
is known as a strict gradient series, as seen in Figure
2.25. Note that each payment is An = (n - 1)G. Note
also that the series begins with a zero cash flow at the
end of period 1. 1f G > 0, the series is referred to as an
increasing gradient series. If G < 0, it is referred to as a
decreasing gradient series.
Linear Gradient Series as Composite Series
Unfortunately, the strict form of the increasing or
decreasing gradient series does not correspond to the form
that most engineering economic problems take. A typical
problem involving a linear gradient series includes an initial
payment during period 1 that increases by G during some
number of interest periods. a situation illustrated in Figure
2.26. This configuration contrasts with the strict form
illustrated in Figure 2.25. in which no payment is made
during period 1 and the gradient is added to the previous
payment beginning in period 2.
In order to use the strict gradient series to solve typical
problems, we must view cash flows as shown in Figure 2.26
as a composite series, or a set or two cash flows, each
corresponding to a form that we can recognize and easily
solve. Figure 2.26 illustrates that the form in which we find a
typical cash flow can be separated in to two components:
a uniform series of N payments of amount A1 and a
gradient series of increments of a constant amount G. The
need to view cash flows that involve linear gradient series
as composites of two series is very important for the solution
of problems. as we shall now see.
Present-Worth Factor: Linear Gradient: Find P, Given G, N, and i
Example-Creating a Graduated Loan Repayment with a Linear Gradient Series

You borrowed $10,000 from a local bank with the


agreement that you will pay back the loan according
to a graduated payment plan. If your first payment is
set at $1,500, what would the remaining payment look
like at a borrowing rate of 10% over five years?
Example-Equivalent Cash Value
So what could be better than winning a SuperLotto
Plus jackpot? Choosing how to receive your winnings!
Before playing a SuperLotto Plus jackpot, you have a
choice between getting the entire jackpot in 26
annual graduated payments or receiving one lump
sum that will be less than the announced jackpot.
(See Figure 2.29.) What would these choices come out
to for an announced jackpot of $7 million?
• Lump-sum cash-value option: The winner would receive the present cash
value of the announced jackpot in one lump sum. In this case, the winner
would receive about 49.43%, or $3.46 million, in one lump sum (less tax
withholdings).
This cash value is based on average market costs determined by U.S. Treasury
zero-coupon bonds with 5.3383% annual yield.
• Annual-payments option: The winner would receive the jackpot in 26
graduated annual payments. In this case, the winner would receive $175,000
as the first payment (2.5% of the total jackpot amount) immediately. The
second payment would be $189,000. Over the course of the next 25 years,
these payments would gradually increase each year by $7,000 to a final
payment of $357,000.
If the U.S. Treasury zero-coupon rate is reduced to 4.5% (instead of 5.338%) at the
time of winning, what would be the equivalent cash value of the lottery?
Handling Geometric Gradient Series
Another kind of gradient series is formed when the series in
a cash flow is determined, not by some fixed amount like
$500 but by some fixed rate expressed as a percentage.
Many engineering economic problems, particularly those
relating to construction costs or maintenance costs. involve
cash flows that increase or decrease over time by a
constant percentage (geometric), a process that is called
compound growth . Price changes caused by inflation are
a good example o f such a geometric series.
EXAMPLE-Required Cost-of-Living Adjustment Calculation
Suppose that your retirement benefits during your first year
of retirement are $50,000. Assume that this amount is just
enough to meet your cost of living during the first year.
However, your cost of living is expected to increase at an
annual rate of 5% due to inflation. Suppose you do not
expect to receive any cost-of-living adjustment in your
retirement pension. Then, some of your future cost of living
has to come from savings other than retirement pension. If
your savings account earns 7% interest a year, how much
should you set aside in order to meet this future increase in
the cost of living over 25 years?
More on Equivalence Calculations
So far most of our equivalence calculations involve
constant or systematic changes in cash flows. We
calculate the equivalent present values or future
values of these cash flows. However, many financial
transactions contain several components of cash
flows that do not exhibit an overall standard pattern
that we have examined in earlier section.
Consequently, it is necessary to expand our analysis to
handle situations with mixed types of cash flows.
To illustrate, consider the cash flow stream shown in
Figure 2.32. We want to compute the equivalent
present worth for this mixed-payment series at an
interest rate of 15%. Three different methods are
presented.
EXAMPLE-Retirement Planning: Composite Series That Requires Multiple Interest Factors

You want to supplement your retirement income through IRA


contributions. You have 15 years left until retirement and you are
going to make 15 equal annual deposits into your IRA until you
retire with the first deposit being made at the end of year 1. You
need to save enough so that you can make 10 annual
withdrawals that will begin at the end of year 16. The first
withdrawal will be $10,000, and each subsequent withdrawal will
increase at a rate of 4% over the previous year's withdrawal in
line with expected increase in cost-of-living. Your last withdrawal
will be at the end of year 25.
What is the amount of the equal annual deposit amount ( C) for
the first 15 years? Assume the interest rate is 8% compounded
annually before and after you retire.
SUMMARY
SUMMARY
SUMMARY

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