Money Time Relationships and Equivalence PDF

Chapter 4.
Money-Time
Relationships and
Equivalence
Engineering Economy (Ed.13), Sullivan et. al., 2006, P. H.
Outline
z Return of capital
z Origins of interest Simple interest and compound
interest
z Equivalence
z Cash-flow diagrams / tables
z Interest formulas
z Cash flows
z arithmetic sequences and geometric sequences
z Interest rates that vary with time
z Nominal versus effective interest rates
z Continuous compounding
9530IEEM281: Engineering Economics, NTHU. 2
C.-Y. Kuo, Lab. Soft Computing and Fuzzy Optimization.
4.1 Introduction
z Capital
z refers to wealth in the form of money or property that
can used to produce more wealth
z Money has time value because of the interest

4.2 Why Consider Return to Capital?

z Capital in the form of money for the people, machines,
materials, energy, and other things needed in the
operation of an organization.
z Equity capital owned by individuals
z Debt capital (borrowed capital) obtained form lenders
z Reasons
z Interest and profit pay the providers of capital for forgoing its use
during the time the capital is being used
z Interest and profit are payments for the risk the investor takes in
permitting another person, or an organization, to use his or her
capital
4.3 The Origins of Interest
z In Babylon in 2000 B.C.
z The idea of interest: International bankers in 575
B.C. for financing international trade
z Typical annual rates: 6-25%, or 40% (usury found
in the Bible Exodus 22:21-27)
z John Calvin, 1536, Protestant theory of usury was
established

4.4 - 4.5 Simple and Compound

Interest
z Simple Interest
z Compound Interest
z $1,000 loaned for three periods at an interest rate of 10%
compound each period
Amount Owed
Amount Owed at Interest Amount
Period an End of
Beginning of Period for Period
Period
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

4.6 The Concept of Equivalence
z Comparison of alternatives should consider the
equivalence
z Equivalent basis dependent on
z (1) the interest rate,
z (2) the amount of money involved,
z (3) the timing of monetary receipts or expenses, and
z (4) the interest (profit) on invested capital and the
initial capital recovered

Example
z Borrow $17,000 and repay in 4 months with 1% interest
per month on the unpaid balance of principal
z Plan 1
z Pay interest due at end of each month and principal at end of
forth month.
z Plan 2
z Pay off the debt in for equal end-of-month installments (principal
and interest)
z Plan 3
z Pay principal and interest in one payment at end of forth month.
z The three plans are equivalent

4.7 Notation and Cash-Flow

Diagrams and Tables
z Notations
z i = effective interest rate per interest period;
z N = number of compounding periods;
z P = present sum of money;
z F = future sum of money;
z A = end-of-year period cash flows
z Cash flow diagram: an example
z : Cash inflows (positive cash flow), e.g. receipts
z : Cash outflows (negative cash flow), e.g. expense

F = $17,690.27
0 1 2 3 4=N
Months
i = 1% per month
P = $17,000

Example 4-1
z Cash-flow diagramming
z An investment of $10,000 will produce uniform annual revenue
of $5,310 for 5 years. The market value will be 2,000 at the end
of year 5. Annual expenses will be $3,000 at the end of each year
for operating and maintaining the project. Use the cooperations
viewpoint to draw a cash-flow diagram.

Example 4-2 Developing a net cash
flow table
z Two feasible alternative for upgrading the heating, ventilation, and air
conditioning (HAVC) system
z Alternative A - Rebuild the existing HVAC system
z Equipment, labor, and materials to rebuild $18,000
z Annual cost of electricity 32,000
z Annual maintenance expenses 2,400
z Alternative B - Install a new HAVAC system that utilizes existing
ductwork
z Equipment, labor, and materials to install $60,000
z Annual cost of electricity 9,000
z Annual maintenance 16,000
z Replacement of a major component 4 years hence 9,400
z At the end of 8 years, the estimated market value for Alternative A is
$2,000, and for Alternative B is $8,000

4.8 Interest Formulas Relating Present
and Future Equivalent Values of Single
Cash Flows
z General Cash-Flow Diagram Relating Present Equivalent
and Future Equivalent of Single Payments
F = Future Equivalent (Find)
i = Interest Rate per Period

0
1 2 3 N-2 N-1 N
Period
P = Present Equivalent (Given)

4.8.1 Finding F when Given P

F = P (1 + i )
N
z
The (1 + i ) is called single payment compound amount

N
z
factor with interest rate i%. The functional symbol (F/P, i%,
N) can be used for (1 + i )N .
z Hence,
z F = P(F/P, i%, N).

4.8.2 Finding P when Given F
P = F (1 + i )
z N
The (1 + i ) is called single payment present worth factor and

N
z
the functional symbol is (P/F, i%, N).
z Hence,
z P = F(P/F, i%, N).


4.9 Interest Formulas Relating a Uniform

Series (Annuity) to Its Present and Future
Equivalent Values
A = Uniform Amount (Given)

A A A A A A
0
1 2 3 N-2 N-1 N
Period
i = Interest Rate per Period
P = Present Equivalent (Find) F = Future Equivalent (Find)

4.9.1 Finding F when Given A
z (1 + i )N 1
F = A
i
The quantity [(1 + i ) 1 i ] is called the uniform series
N
z
compound amount factor and the functional symbol is
(F/A, i%, N), hence,
z F = A(F/A, i%, N)

z Example 4-5
z Suppose you make 15 equal annual deposits of $1,000
each into a bank account paying 5% interest per year.
How much money can be withdrawn from this bank
account immediately after the 15th deposit?
z Example 4-6
z If you are 20 years of age and save $1.00 each day,
you can become a millionaire. Assumption: live to 80
years old, and the annual interest rate is 10%.

4.9.2 Finding P when Given A
z (1 + i )N 1
P = A N
i (1 + i )
z The quantity in brackets is called the uniform series

present worth factor and the functional symbol is
(P/A, i%, N), hence,
z P = A(P/A, i%, N)

z Example 4-7
z i = 15% per year. Maintain a machine can add $20,000
revenue at the end of each year of 5 years. How much is the
investment?
z P = A(P/A, i%, N) = 20,000(P/A, 15%, 5) = 20,000(3.3522)
= 67,044
z Example 4-8
z Suppose that your uncle has $1,000,000 that he wishes to
distribute to his heirs at the rate of $100,000 per year. If the
$1,000,000 is deposited in a bank account that earns 6% interest
per year,
z How many years will it take to completely deplete the
account?
z How long will it take if the account earns 8% interest per
year instead of 6%?
1,000,000 = 100,000(P/A, i%, N) = 10,000(P/A, 6%, N)
(P/A, 6%, N) = 10,
(P/A, 6%, 15) = 9.7122 , (P/A, 6%, 16) = 10.1059

4.9.3 Finding A when Given F
i
z A = F
(1 + i ) N
1
z The quantity in brackets is called the sinking fund
factor and the functional symbol is (A/F, i%, N), hence,
z A = F(A/F, i%, N).

z Example 4-9
z One who is 20 years old now hopes to have 1,000,000 savings
when she at age 65. what equal end-of-year amount must she
save over the next 45 years with annual 7% interest rate?

4.9.4 Finding A when Given P
i (1 + i )N
z A = P
(1 + i ) N
1
z The quantity in brackets is called the capital recovery
factor and the functional symbol is (A/P, i%, N), hence,
z A = P(A/P, i%, N)
z Ex. Plan 2 in Table 4-1
z A = $17,000(A/P, 1%, 4) = $17,000(0.2563) = $4,357.10

4.10 Interest Formulas for Discrete

Compound and Discrete Cash Flows

4.11 Deferred Annuities (Uniform
Series
Time Present
0 1 J-1 J J+1 J+2 N-1 N

Period
i%
z All annuities discussed to this point involve the first cash

flow being made at the end of the first period, and they are
called ordinary annuities. If the cash flow does begin until
some later date, the annuity is known as a deferred annuity.
z P0 = A(P/A, i%, N - J)(P/F, i%, J)
z Example 4-10
z 12% per year interest. One day a new baby born. His father
wishes to determine what lump amount could provide
$2,000 on his 18th, 19th, 20th, and 21st birthdays.
z Example 4-11
z Determine the equivalent worth of the four $2,000 as of the sons
24th birthday.

4.12 Equivalence Calculations Involving
Multiple Interest Formulas

Example 4-12
z Cash flows over 8 years. The amounts are $100 for the
first year, $200 for the second year, $500 for the third
year, and $400 for each year from the 4th through the 8th.

Example 4-13
z Transform the cash flows on the left-hand side to their
equivalent cash flows on the right-hand side.
2H Q
7
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6
End of Year (EOY) End of Year (EOY)

4.13 Interest Formulas for A Uniform

(Arithmetic) Gradient of Cash Flows
z Receipts or expenses are projected to increase or decrease by a
uniform amount each period, thus constituting an arithmetic
sequence of cash flows. This situation can be modeled as a
uniform gradient of cash flows
z Notice: the first cash flow occurs at the end of period 2
(N-1)G
(N-2)G
(N-3)G
3G
2G
G
0 1 2 3 4 N-2 N-1 N
z 4.13.1 Finding F when Given G
z F = G(F/A, i%, N - 1) + G(F/A, i%, N - 2) +
+ G(F/A, i%, 2) + G(F/A, i%, 1)
z G NG
F= ( F/A, i%, N )
i i
z 4.13.2 Finding A when Given G

z The quantity in brackets is called the gradient to
uniform series conversion factor and the functional
symbol is (A/G, i%, N), hence
z A = G(A/G, i%, N)
4.13.3 Finding P when Given G

z 1 (1 + i )N 1 N
P = G .
i i (1 + i ) (1 + i )N
N
z The quantity in braces is called the gradient to

present equivalent conversion factor and the
functional symbol is
z (1/i)[(P/A, i%, N) - N(P/F, i%, N)]
z also can be expressed as (P/G, i%, N), hence,
z P = G(P/G, i%, N)
Example 4-15
z End-of-year cash flows are expected to be $1,000 for the
2nd year, $2,000 for the 3rd year, and $3,000 for the 4th
year. If the interest is 15% per year, find that
z (a) present equivalent value at the beginning of the first year,
z (b) uniform annual equivalent value at the end of the four years.

Example 4-16
z Calculate the present equivalent at i = 15% per year, using
arithmetic gradient interest factors
End of Year Cash Flows ($)
1 -8,000
2 -7,000
3 -6,000
4 -5,000

4.14 Interest Formulas Relating A
Geometric Sequence of Cash Flows to Its
Present and Annual Equivalents
z The cash flow patterns change at an average rate f . And the
resultant end-of-period cash flow pattern is referred to a
geometric gradient series.
A1 [1 ( P / F , i %, N )( F / P, f %, N )]
f i
P= i f
A N ( P / F , i %,1) f = i.
1

Example 4-20
z Consider the end-of-year geometric sequence of cash flow
and determine the P, A, and F equivalent values. The rate
of increase is 20% per year after the first year, and the
3
interest rate is 25% per year. $1,000(1.2)
$1,000(1.2)2
$1,000(1.2)1
$1,000
0 1 2 3 4
End of Year

Example 4-19
z As the same in Example 4-18, suppose that the geometric
gradient decreases by 20% per year after the first year.
Determine P, A, and F under this condition.

4.15 Interest Rates That Vary with

Time
z Example 4-21
z A person has made an arrangement to borrow $1,000 now and
another $1,000 two years hence. If the projected interest rates in
years one, two, three, and four are 10%, 12%, 12%, and 14%,
respectively, how much will be repaid as a lump-sum amount at
the end of four years.

4.15 Interest Rates That Vary with
Time
z Obtaining the present equivalent of a series of
future cash flows subjected to vary interest rates
FN
P= .
k =1 (1 + ik )
N
z For instance, if F4 = $1,000 and i1 = 10%, i2 = 12%, i3

= 13%, i4 = 10%, then
z P = $1,000[(P/F, 10%, 1)(P/F, 12%, 1) (P/F, 13%, 1)(P/F,
10%, 1)]
4.16 Nominal and Effective Interest

Rate
z The interest period is less than one year
z E.g. 6% interest rate per half-year v.s. 12% per year
z 12% is the nominal, but effective rate is larger than 12%
z 1st half-year
$1,000 + $1,000 (0.12/2) = $1,000 + $60 = $1,060
z 2nd half-year
$1,060 + $1,060 (0.12/2) = $1,060 + $63.6 = $1,123.6
z The effective annual interest rate for the entire year is
$123.6
100% = 12.36%.
$1,000


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Chapter 4.

Engineering Economy (Ed.13), Sullivan et. al., 2006, P. H.

9530IEEM281: Engineering Economics, NTHU. 3

4.2 Why Consider Return to Capital?

9530IEEM281: Engineering Economics, NTHU. 5

4.4 - 4.5 Simple and Compound

1 $1,000 $100 $1,100

9530IEEM281: Engineering Economics, NTHU. 6

9530IEEM281: Engineering Economics, NTHU. 7

z The three plans are equivalent

4.7 Notation and Cash-Flow

9530IEEM281: Engineering Economics, NTHU. 10

9530IEEM281: Engineering Economics, NTHU. 11

9530IEEM281: Engineering Economics, NTHU. 12

9530IEEM281: Engineering Economics, NTHU. 14

i = Interest Rate per Period

P = Present Equivalent (Given)

9530IEEM281: Engineering Economics, NTHU. 15

4.8.1 Finding F when Given P

The (1 + i ) is called single payment compound amount

z F = P(F/P, i%, N).

9530IEEM281: Engineering Economics, NTHU. 16

The (1 + i ) is called single payment present worth factor and

z P = F(P/F, i%, N).

9530IEEM281: Engineering Economics, NTHU. 17

9530IEEM281: Engineering Economics, NTHU. 18

4.9 Interest Formulas Relating a Uniform

A = Uniform Amount (Given)

P = Present Equivalent (Find) F = Future Equivalent (Find)

9530IEEM281: Engineering Economics, NTHU. 20

9530IEEM281: Engineering Economics, NTHU. 21

9530IEEM281: Engineering Economics, NTHU. 22

z The quantity in brackets is called the uniform series

9530IEEM281: Engineering Economics, NTHU. 23

9530IEEM281: Engineering Economics, NTHU. 24

z A = F(A/F, i%, N).

9530IEEM281: Engineering Economics, NTHU. 25

9530IEEM281: Engineering Economics, NTHU. 26

9530IEEM281: Engineering Economics, NTHU. 27

4.10 Interest Formulas for Discrete

9530IEEM281: Engineering Economics, NTHU. 28

0 1 J-1 J J+1 J+2 N-1 N

z All annuities discussed to this point involve the first cash

9530IEEM281: Engineering Economics, NTHU. 30

9530IEEM281: Engineering Economics, NTHU. 31

9530IEEM281: Engineering Economics, NTHU. 32

9530IEEM281: Engineering Economics, NTHU. 33

4.13 Interest Formulas for A Uniform

z 4.13.2 Finding A when Given G

4.13.3 Finding P when Given G

z The quantity in braces is called the gradient to

9530IEEM281: Engineering Economics, NTHU. 37

9530IEEM281: Engineering Economics, NTHU. 38

9530IEEM281: Engineering Economics, NTHU. 39

9530IEEM281: Engineering Economics, NTHU. 40

9530IEEM281: Engineering Economics, NTHU. 41

4.15 Interest Rates That Vary with

9530IEEM281: Engineering Economics, NTHU. 42

z For instance, if F4 = $1,000 and i1 = 10%, i2 = 12%, i3

4.16 Nominal and Effective Interest

9530IEEM281: Engineering Economics, NTHU. 44

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