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How Time and Interest Affect Money

**Ir. Haery Sihombing MT.
**

Pensyarah Pelawat Fakulti Kejuruteraan Pembuatan Universiti Teknologi Malaysia Melaka

BASIC OF A COUNTING RELATED TO COST

INTRODUCTION

COST ACCOUNTING

Accounting is the collection and aggregation of information for decision maker- including managers, investor, regulators, lenders, and the public. Accounting system affect behavior and management and have affects across departments, organizations, and even countries.

Information contained within an accounting system has the power to influence actions. Accounting information systems are particularly strong behavioral drivers within the context of a corporation – where profits and the bottom line are daily concerns.

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COST ACCOUNTING

There are three type of accounting systems

1. NATIONAL ACCOUNTING SYSTEMS

National accounts are national income and production accounts, such Gross National Product (GNP) and Gross Domestic Product (GDP) which aim to measure and track an economy’s contribution to the well-being of its inhabitants. National income accounts show the national demand or goods and services and are used to track and measure economic growth.

Conventional economic thinking has assumed that the increases in goods and services produced domestically (GDP) and national income (GNP) are adequate yardstick to economic health

Example: The world bank uses per capita GNP as a major criterion for classifying national 3 economies

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COST ACCOUNTING

1. NATIONAL ACCOUNTING SYSTEMS

4

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COST ACCOUNTING

2. FINANCIAL ACCOUNTING SYSTEMS

Financial accounts, such as balance sheets and income statements are used to keep track of business incomes and outflows. These financial reports are for use by persons outside the firm – for example: lenders or investors.

There are relevant to the enterprise as a whole and are generally subject to strict government rules The most common financial accounting reports are for external use by are the financial statements in a firm’s annual report to shareholders. In the United States and most developed countries, these reports conform to generally accepted accounting principles developed predominantly by the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC)

5

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COST ACCOUNTING

The overall objective of a firm’s financial accounting statements

1. The overall objective of a fir’s financial accounting statements are: 2. To provide information useful for making rational investment and credit decisions 3. To allow investors and creditors to assess the amount, timing, and uncertainty of cash flows 4. To provide information about the economic resources of a firm and the claims on those resources 5. To provide information about a firm’s operating performance during period 6. To provide information on how a firm obtains and uses money and other financial resources. 7. To provide information on how management ha discharges its stewardship 6 responsibility to owners and the public.

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COST ACCOUNTING

Type of Financial Accounting Statements

7

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COST ACCOUNTING

3. MANAGEMENT or COST ACCOUNTING SYSTEMS

and CAPITAL BUDGETING Management or cost accounting systems are part of an enterprise’s information system and refer to the internal cost tracking and allocation systems to track costs and expenditures. These are internal rather than external accounting systems. There are no fixed rules governing how an entity should keep track of cash flows internally, although there are many formal methods available for users. Capital budgeting is basically a form of predictive cost accounting over a set time frame which is used to analyze the costs of alternative projects or expenditures over the specified period of time

8

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COST ACCOUNTING

The main objectives of managerial/cost accounting are (Hilton, 1998):

Providing managers with information for decision making and planning. Assisting managers in directing and controlling operations. Motivating managers towards the organization’s goals. Measuring the performance of managers and sub-units within the organization.

9

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COST ACCOUNTING

10

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INTRODUCTION

TIME VALUE OF MONEY :

THE ECONOMIC VALUE OF A SUM DEPENDS ON WHEN IT IS RECEIVED.

Because money has both EARNING as well as PURCHASING POWER over time (it can be put to work, earning more money for its owner)

A Ringgit received today has a gerater value than Ringgit received at some future time

11

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1. Foundations: Overview

1. F/P and P/F Factors 2. P/A and A/P Factors 3. F/A and A/F Factors 4. Interpolate Factor Values 5. P/G and A/G Factors 6. Geometric Gradient 7. Calculate i 8. Calculate “n” 9. Spreadsheets

12

F/P and P/F Factors

Section 1

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**1 Basic Derivations: F/P factor
**

F/P Factor To find F given P

Fn To Find F given P …………. n P0 Compound forward in time

14

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**1 Basic Derivations: F/P factor
**

F1 = P(1+i) F2 = F1(1+i)…..but: F2 = P(1+i)(1+i) = P(1+i)2 F3 =F2(1+i) =P(1+i)2 (1+i) = P(1+i)3 In general:

Fn = P(1+i)n Fn = P(F/P,i%,n)

15

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**1 Present Worth Factor from F/P
**

Since Fn = P(1+i)n We solve for P in terms of FN P = F{ 1/ (1+i)n} = F(1+i)-n Thus: P = F(P/F,i%,n) where (P/F,i%,n) = (1+i)-n

Thus, the two factors are: 1. F = P(1+i)n finds the future worth of P; 2. P = F(1+i)-n finds the present worth from F

16

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**1 P/F factor –Discounting back in time
**

Discounting back from the future

Fn

**…………. n P P/F factor brings a single future sum back to a specific point in time.
**

17

P/A and A/P Factors

Section 2

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2 Example- F/P Analysis

Example: P= $1,000;n=3;i=10% What is the future value, F?

F = ??

0

1

2

3

P=$1,000

i=10%/year

**F3 = $1,000[F/P,10%,3] = $1,000[1.10]3 = $1,000[1.3310] = $1,331.00
**

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2 Example – P/F Analysis

Assume F = $100,000, 9 years from now. What is the present worth of this amount now if i =15%?

F9 = $100,000

i = 15%/yr

0 1 2 3

…………

8

9

**P= ?? P0 = $100,000(P/F, 15%,9) = $100,000(1/(1.15)9) = $100,000(0.2843) = $28,430 at time t = 0
**

20

**2 Uniform Series Present Worth and Capital Recovery Factors
**

Annuity Cash Flow

P = ??

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1

0

2

3

…………..

..

..

n-1

n

**$A per period
**

21

**2 Uniform Series Present Worth and Capital Recovery Factors
**

Desire an expression for the present worth – P of a stream of equal, end of period cash flows - A

P = ??

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0

1

2

3

n-1

n

A = given

22

**2 Uniform Series Present Worth and Capital Recovery Factors
**

Write a Present worth expression

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P

A

1 (1 i )1

1 (1 i ) 2

1 .. (1 i ) n

1

1 (1 i ) n

[1]

**Term inside the brackets is a geometric progression. Mult. This equation by 1/(1+i) to yield a second equation
**

23

**2 Uniform Series Present Worth and Capital Recovery Factors
**

The second equation

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P 1 i

1 A (1 i)2

1 1 .. 3 (1 i) (1 i)n

1 (1 i)n 1

[2]

To isolate an expression for P in terms of A, subtract Eq [1] from Eq. [2]. Note that numerous terms will drop out.

24

**2 Uniform Series Present Worth and Capital Recovery Factors
**

Setting up the subtraction

P (1 i ) 1 A (1 i ) 2 1 1 (1 i )3 (1 i ) 4 1 1 ... (1 i ) n (1 i ) n

1

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[2]

-P

=

A

1 (1 i )

1

1 (1 i ) 2

1 .. (1 i ) n

1

1 (1 i ) n

[1]

1 1 P A n 1 1 i (1 i) (1 i)

i

[3]

25

**2 Uniform Series Present Worth and Capital Recovery Factors
**

Simplifying Eq. [3] further

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i 1 i

P

1 A n (1 i )

1

1

(1 i )

P

A 1 n i (1 i )

1

1

P

(1 i ) n 1 A for i n i (1 i )

26

0

F/A and A/F Factors

Section 3

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3 F/A and A/F Derivations

Annuity Cash Flow

$F

…………..

0

N

$A per period

**Find $A given the Future amt. - $F
**

28

**3 Sinking Fund and Series Compound amount factors (A/F and F/A)
**

Take advantage of what we already have Recall:

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Also:

1 P F n (1 i)

i(1 i)n A P (1 i)n 1

Substitute “P” and simplify!

29

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3 F/A and A/F Derivations

Annuity Cash Flow

$F

…………..

0

N

$A per period

**Find $F given the $A amounts
**

30

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3 Example -1

Formosa Plastics has major fabrication plants in Texas and Hong Kong. It is desired to know the future worth of $1,000,000 invested at the end of each year for 8 years, starting one year from now. The interest rate is assumed to be 14% per year.

31

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3 Example-1

•A = $1,000,000/yr; n = 8 yrs, i = 14%/yr •F8 = ??

32

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3 Example-1

Solution: The cash flow diagram shows the annual payments starting at the end of year 1 and ending in the year the future worth is desired. Cash flows are indicated in $1000 units. The F value in 8 years is

**F = l000(F/A,14%,8) = 1000( 13.23218)
**

= $13,232.80 = 13.232 million 8 years from now.

33

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3 Example-1

How much money must Carol deposit every year starting, l year from now at 5.5% per year in order to accumulate $6000 seven years from now?

34

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3 Example -2

Solution The cash How diagram from Carol's perspective fits the A/F factor. A= $6000 (A/F,5.5%,7) = 6000(0.12096) = $725.76 per year The A/F factor Value 0f 0.12096 was computed using the A/F factor formula

35

Interpolation in Interest Tables

Section 4

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4

•

Interpolation of Factors

All texts on Engineering economy will provide tabulated values of the various interest factors usually at the end of the text in an appendix Refer to the back of your text for those tables.

•

37

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4 Interpolation of Factors

• Typical Format for Tabulated Interest Tables

38

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**4 Interpolation (Estimation Process)
**

• • • At times, a set of interest tables may not have the exact interest factor needed for an analysis One may be forced to interpolate between two tabulated values Linear Interpolation is not exact because: • • The functional relationships of the interest factors are non-linear functions Hence from 2-5% error may be present with interpolation.

39

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4 An Example

• • • • Assume you need the value of the A/P factor for i = 7.3% and n = 10 years. 7.3% is most likely not a tabulated value in most interest tables So, one must work with i = 7% and i = 8% for n fixed at 10 Proceed as follows:

40

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**4 Basic Setup for Interpolation
**

•Work with the following basic relationships

41

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**4 i = 7.3% using the A/P factor
**

• For 7% we would observe:

COMPOUND N 10 AMT. FACTOR F/P 1.9672 PRESENT WORTH P/F 0.5083 SINKING FUND A/F 0.0724 COMPOUND AMOUNT F/A 13.8164 CAPITAL RECOVERY A/P 0.14238

A/P,7%,10) = 0.14238

42

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**4 i = 7.3% using the A/P factor
**

•

N 10

For i = 8% we observe:

COMPOUND AMT. FACTOR F/P 2.1589 PRESENT WORTH P/F 0.4632 SINKING FUND A/F 0.0690 COMPOUND AMOUNT F/A 14.4866 CAPITAL RECOVERY A/P 0.14903

(A/P,8%,10) = 0.14903

43

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4 Estimating for i = 7.3%

• Form the following relationships

44

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**4 Final Estimated Factor Value
**

• • Observe for i increasing from 7% to 8% the A/P factors also increases. One then adds the estimated increment to the 7% known value to yield:

45

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**4. The Exact Value for 7.3%
**

• Using a previously programmed spreadsheet model the exact value for 7.3% is:

46

P/G and A/G Factors

Section 5

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**5 Arithmetic Gradient Factors
**

• In applications, the annuity cash flow pattern is not the only type of pattern encountered •Two other types of end of period patterns are common •The Linear or arithmetic gradient •The geometric (% per period) gradient

**•This section presents the Arithmetic Gradient
**

48

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**5 Arithmetic Gradient Factors
**

• An arithmetic (linear) Gradient is a cash flow series that either increases or decreases by a constant amount over n time periods. •A linear gradient is always comprised of TWO components:

49

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**5 Arithmetic Gradient Factors
**

•The Two Components are: •The Gradient component •The base annuity component •The objective is to find a closed form expression for the Present Worth of an arithmetic gradient

50

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**5 Linear Gradient Example
**

A1+(n-1)G A1+(n-2)G

**Assume the following:
**

A1+2G A1+G

0

1

2

3

n-1

N

This represents a positive, increasing arithmetic gradient

51

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**5 Example: Linear Gradient
**

• Typical Negative, Increasing Gradient: G=$50

The Base Annuity = $1500

52

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**5 Example: Linear Gradient
**

• Desire to find the Present Worth of this cash flow

The Base Annuity = $1500

53

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**5 Arithmetic Gradient Factors
**

• The “G” amount is the constant arithmetic change from one time period to the next. •The “G” amount may be positive or negative! •The present worth point is always one time period to the left of the first cash flow in the series or, •Two periods to the left of the first gradient cash flow!

54

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**5 Derivation: Gradient Component Only
**

Focus Only on the gradient Component

(n-1)G (n-2)G

“0” G

+2G G

**Removed Base annuity
**

0 1 2 3 n-1 N

55

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**5 Present Worth Point…
**

The Present worth point of a linear gradient is always:

2 periods to the left of the “1G” point or, 1 period to the left of the very first cash flow in the gradient series.

**DO NOT FORGET THIS!
**

56

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**5 Present Worth Point…
**

$700 $600 $500 $400 $300 $200 $100

X 0

1

2

3

4

5

6

7

**The Present Worth Point of the Gradient
**

57

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5 Gradient Component

•The Gradient Component

$500 $400 $300 $200 $100 $0 $600

X 0

1

2

3

4

5

6

7

**The Present Worth Point of the Gradient
**

58

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**5 Present Worth Point…
**

•PW of the Base Annuity is at t = 0 •PWBASE Annuity=$100(P/A,i%,7)

Base Annuity – A = $100

X 0

1

2

3

4

5

6

7

**The Present Worth Point of the Gradient
**

59

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**5 Present Worth: Linear Gradient
**

The present worth of a linear gradient is the present worth of the two components:

1. The Present Worth of the Gradient Component and, 2. The Present Worth of the Base Annuity flow Requires 2 separate calculations!

60

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**5 Present Worth: Gradient Component
**

The PW of the Base Annuity is simply the Base Annuity –A{P/A, i%, n} factor What is needed is a present worth expression for the gradient component cash flow. We need to derive a closed form expression for the gradient component.

61

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**5 Present Worth: Gradient Component
**

General CF Diagram – Gradient Part Only

(n-1)G (n-2)G 3G 2G 1G

0G We want the PW at time t = 0 (2 periods to the left of 1G) 0 1 2 3 4 ……….. n-1 n

62

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5 To Begin- Derivation of P/G,i%,n

P G ( P / F , i %, 2) 2G ( P / F , i %,3) ... [(n-2)G](P/F,i%,n-1) + [(n-1)G](P/F,i%,n)

Next Step: Factor out G and re-write as …..

63

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5 Factoring G out….

P/G factor

P=G (P/F,i%,2)+2(P/F,i%,3) +...(n-1)(P/F,i%,n)

What is inside of the { }’s?

64

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**5 Replace (P/F’s) with closed-form
**

1 P=G 2 (1+i) 2 3 (1+i) n-2 ... n-1 (1+i) n-1 n (1+i)

[1]

Multiply both sides by (1+i)

65

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**5 Mult. Both Sides By (n+1)…..
**

1 P(1+i) =G (1+i)1

1

2 (1+i) 2

n-2 ... (1+i) n-2

n-1 (1+i) n-1

[2]

•We have 2 equations [1] and [2]. •Next, subtract [1] from [2] and work with the resultant equation.

66

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5 Subtracting [1] from [2]…..

1 P(1+i) =G 1 (1+i)

1

2 2 (1+i)

n-2 ... n-2 (1+i)

n-1 n-1 (1+i)

1 P=G (1+i) 2

2 (1+i)3

n

n-2 ... (1+i)n-1

n-1 (1+i)n

P

G (1 i ) 1 n n n i i (1 i ) (1 i )

67

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**5 The P/G factor for i and N
**

G (1 i ) 1 n n n i i (1 i ) (1 i )

n

P

( P / G, i %, N ) factor

68

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5 Further Simplification on P/G

( P / G, i %, N )

(1 i ) iN 1 N 2 i (1 i )

N

Remember, the present worth point of any linear gradient is 2 periods to the left of the 1-G cash flow or, 1 period to the left of the “0-G” cash flow.

P=G(P/G,i,n)

69

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**5 Extension – The A/G factor
**

Some authors also include the derivation of the A/G factor. A/G converts a linear gradient to an equivalent annuity cash flow. Remember, at this point one is only working with gradient component There still remains the annuity component that you must also handle separately!

70

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5 The A/G Factor

Convert G to an equivalent A

A G ( P / G, i, n)( A / P, i, n)

How to do it…………

71

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**5 A/G factor using A/P with P/G
**

P G (1 i ) 1 n n n i i (1 i ) (1 i )

n

i (1 i ) n (1 i ) 1

(A/P,i,n)

n

The results follow…..

72

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5 Resultant A/G factor

P G (1 i ) n 1 n i i (1 i ) n (1 i ) n

i (1 i ) n (1 i ) n 1

(A/P,i,n)

(A/G,i,n) =

1 n A G n i (1 i ) 1

73

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5 Gradient Example

• Consider the following cash flow

$500 $400 $300 $200 $100

0

1

2

3

4

5

Present Worth Point is here! And the G amt. = $100/period

**Find the present worth if i = 10%/yr; n = 5 yrs
**

74

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**5 Gradient Example- Base Annuity
**

• First, The Base Annuity of $100/period

A = +$100

0

1

2

3

4

5

•PW(10%) of the base annuity = $100(P/A,10%,5) •PWBase = $100(3.7908)= $379.08 •Not Finished: We need the PW of the gradient component and then add that value to the $379.08 amount

75

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**5 Focus on the Gradient Component
**

$400 $300 $200 $0 $100

0

1

2

3

4

5

**We desire the PW of the Gradient Component at t = 0 PG@t=0 = G( P/G,10%,5 ) = $100( P/G,10%,5 )
**

76

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5 The Set Up

$400 $300 $200 $0 $100

0

1

2

3

4

5

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

G (1 i)N 1 N P= i i(1 i)N (1 i)N

Could substitute n=5, i=10% and G = $100 into the P/G closed form to get the value of the factor.

77

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**5 PW of the Gradient Component
**

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5) P/G,10%,5)

G (1 i ) N 1 P= i i (1 i ) N N (1 i ) N

Sub. G=$100;i=0.10;n=5

6.8618

Calculating or looking up the P/G,10%,5 factor yields the following: Pt=0 = $100(6.8618) = $686.18 for the gradient PW

78

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**5 Gradient Example: Final Result
**

• PW(10%)Base Annuity = $379.08 •PW(10%)Gradient Component= $686.18 •Total PW(10%) = $379.08 + $686.18 •Equals $1065.26 •Note: The two sums occur at t =0 and can be added together – concept of equivalence

79

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5 Example Summarized

This Cash Flow…

$400 $300 $200 $100 $500

0

1

2

3

4

5

Is equivalent to $1065.26 at time 0 if the interest rate is 10% per year!

80

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**5 Shifted Gradient Example: i = 10%
**

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450 $500 $550 $600

**1. This is a “shifted” negative, decreasing gradient. 2. The PW point in time is at t = 3 (not t = o)
**

81

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**5 Shifted Gradient Example
**

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450 $500 $550 $600

**•The PW @ t = 0 requires getting the PW @ t =3; •Then using the P/F factor move PW3 back to t=0
**

82

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**5 Shifted Gradient Example
**

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450 $500 $550 $600

**•The base annuity is a $600 cash flow for 3 time periods
**

83

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**5 Shifted Gradient Example: Base Annuity
**

• PW of the Base Annuity: 2 Steps

0 1 2 3 4 5 6 7

**P3=-600(P/A,10%,4)
**

P0=P3(P/F,10%,3)

P3

39 01 A = -$600 .6 .5 1 7 9 3

P0

**P0= [-600(P/A,10%,4)](P/F,10%,3)
**

P 0-base annuity = -$1428.93

84

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**5 Shifted Gradient Example: Gradient
**

• PW of Gradient Component: G = -$50

0 1 2 3 4 5 6 7

P3-Grad = +50(P/G,10%,4)

P0=P3(P/F,10%,3)

P3

0G

1G

0 . 7 5 1 3

P0

4 . 3 7 8 1

2G

3G

=-$164.46

**P0-grad = {+50(P/G,10%,4)}(P/F,10%,3)
**

85

Geometric Gradient

Section 6

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

6 Geometric Gradients

• An arithmetic (linear) gradient changes by a fixed dollar amount each time period. •A GEOMETRIC gradient changes by a fixed percentage each time period. •We define a UNIFORM RATE OF CHANGE (%) for each time period •Define “g” as the constant rate of change in decimal form by which amounts increase or decrease from one period to the next

87

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**6 Geometric Gradients: Derivation
**

• First Major Point to Remember: •A1 does NOT define a Base Annuity; •There is no BASE ANNUITY for a Geometric Gradient! •The objective is to determine the Present Worth one period to the left of the A1 cash flow point in time •Remember: The PW point in time is one period to the left of the first cash flow – A1!

88

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradients: Derivation
**

• For a Geometric Gradient the following parameters are required: •The interest rate per period – i •The constant rate of change – g •No. of time periods – n •The starting cash flow – A1

89

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient P/A factor
**

•Note: If g = i we have a division by “0” – undefined. •For g = i we can derive the closed form PW factor for this special case. •We substitute i for g into the Pg relationship to yield:

90

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient: Notes
**

•The geometric gradient requires knowledge of: •A1, i, n, and g •There exist an infinite number of combinations for i, n, and g: Hence one will not find tabulated tables for the (P/A, g,i,n) factor.

91

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient: Notes
**

•You have to calculated either from the closed form for each problem or apply a preprogrammed spreadsheet model to find the needed factor value •No spreadsheet built-in function for this factor!

92

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient: Example
**

•Assume maintenance costs for a particular activity will be $1700 one year from now. •Assume an annual increase of 11% per year over a 6-year time period.

93

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**6 Geometric Gradient: Example
**

•If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0. •First, draw a cash flow diagram to represent the model.

94

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient Example (+g)
**

•g = +11% per period; A1 = $1700; i = 8%/yr

0

1

$1700

2

3

4

5

6

7

$1700(1.11)1 $1700(1.11)2 $1700(1.11)3

PW(8%) = ??

$1700(1.11)5

95

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

6 Geometric Gradient ( -g )

• Consider the following problem with a negative growth rate – g.

A1 = $1000 $900 $810 $729 0 1 2 3 4

P0=??

g = -10%/yr; i = 8%; n = 4

**We simply apply a “g” value = -0.10
**

96

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**6 Geometric Gradient (-g value)
**

• Evaluate:

For a negative g value = -0.10

1 P A g 1

1 g 1 i i g

n

g i

303: Use "g" 667: use f-bar Geometric Gradients "E" or g or f-bar = -10% i= 8% N= 4 2.87637 P/A,g,i,n factor is…… First Amt= P. Value = $ $ 1,000.00 2,876.37

97

Determination of an Unknown Interest Rate

Section 7

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**7 When the i – rate is unknown
**

• A class of problems may deal with all of the parameters know except the interest rate. •For many application-type problems, this can become a difficult task •Termed, “rate of return analysis” •In some cases: •i can easily be determined •In others, trial and error must be used

99

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7 Example: i unknown

• Assume on can invest $3000 now in a venture in anticipation of gaining $5,000 in five (5) years. •If these amounts are accurate, what interest rate equates these two cash flows?

100

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7 Example: i unknown

• The Cash Flow Diagram is…

$5,000

0

1

2

3

4

5

$3,000

**•F = P(1+i)n •5,000 = 3,000(1+i)5 •(1+i)5 = 5,000/3000 = 1.6667
**

101

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7 Example: i unknown

• Solution:

0 1 2 3

$5,000

4

5

$3,000

**•(1+i)5 = 5,000/3000 = 1.6667 •(1+i) = 1.66670.20 •i = 1.1076 – 1 = 0.1076 = 10.76%
**

102

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**7 For “i” unknown
**

• In general, solving for “i” in a time value formulation is not straight forward. •More often, one will have to resort to some form of trial and error approach as will be shown in future sections. •A sample spreadsheet model for this problem follows.

103

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

7 Example of the IRR function

=IRR($D7:$D12)

104

Determination of Unknown Number of Years

Section 8

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**8 Unknown Number of Years
**

• Some problems require knowing the number of time periods required given the other parameters •Example: •How long will it take for $1,000 to double in value if the discount rate is 5% per year? •Draw the cash flow diagram as….

106

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**8 Unknown Number of Years
**

Fn = $2000

0

1 P = $1,000

2

...

. . . …….

n

i = 5%/year; n is unknown!

107

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**8 Unknown Number of Years
**

• Solving we have…..

Fn = $2000

0

1

2

...

. . . …….

n

P = $1,000

**•Fn=? = 1000(F/P,5%,x): 2000 = 1000(1.05)x •Solve for “x” in closed form……
**

108

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**8 Unknown Number of Years
**

• Solving we have….. •(1.05)x = 2000/1000 •Xln(1.05) =ln(2.000) •X = ln(1.05)/ln(2.000) •X = 0.6931/0.0488 = 14.2057 yrs •With discrete compounding it will take 15 years to amass $2,000 (have a little more that $2,000)

109

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**8 No. of Years – NPER function
**

• From Excel one can formulate as:

**=NPER(C23,C22,C20,C21)
**

110

Spreadsheet Application – Basic Sensitivity Analysis

Section 9

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**9 Basic Sensitivity Analysis
**

• Sensitivity analysis is a procedure applied to a formulated problem whereby one can assess the impact of each input parameter relating to the output variable. •Sensitivity analysis is best performed using a spreadsheet model. •The procedure is to vary the input parameters within certain ranges and observe the change on the output variable.

112

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**9 Basic Sensitivity Analysis
**

• By proper modeling, one can perform “what-if” analysis on one or more of the input parameters and observe any changes in a targeted output (response) variable •Commercial add-in packages are available that can be linked to Excel to perform such an analysis •Specifically: Palisade Corporation’s TopRank Excel add-in is most appropriate.

113

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**9 Basic Sensitivity Analysis
**

• When you build your own models, devise an approach to permit varying at least one of the input parameters and store the results of each change in the output variable…then plot the results. •If a small change in one of the input parameters represents a significant change in the output variable then… •That input variable is “sensitive”

114

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**9 Basic Sensitivity Analysis
**

• If an input parameter is deemed “sensitive” then some effort should go into the estimation of that parameter •Because it does influence the response (output) variable. •Less sensitive input parameters may not have as much effort required to estimate as those input parameters do not have that much impact on the targeted response variable. 115

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

**9 Basic Sensitivity Analysis
**

• When you build your own models, devise an approach to permit varying at least one of the input parameters and store the results of each change in the output variable…then plot the results. •If a small change in one of the input parameters represents a significant change in the output variable then… •That input variable is “sensitive”

116

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Summary

• This chapter presents the fundamental time value of money relationships common to most engineering economic analysis calculations •Derivations have been presented for: •Present and Future Worth- P/F and F/P •Annuity Cash flows – P/A, A/P, F/A and A/F •Gradients – P/G, A,G and P/A,g,i,n

117

Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Summary

• One must master these basic time value of money relationships in order to proceed with more meaningful analysis that can impact decision making. •These relationships are important to you professionally and in your personal lives. •Master these concepts!!!

118

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