1.

8 Equation of Values

Suppose we invest an amount of 𝑃 at some time. Then...

 to find the value of the investment 𝑡 years later, you multiply 𝑃 by
(1 + 𝑖)𝑡 ;
 to find the value of the investment 𝑡 years earlier, you multiply 𝑃 by 𝑣 𝑡 .

We will now use these rules to evaluate and compare the values of cash
flows. Here a cash flow means a series of payments.
 Very often, there is a need to replace a set of debts or financial
obligations by another set of different amounts due at different times.
This type of problem is solved by setting up an equation of value.

 To compare two obligations due on different dates, the values of

the obligations must be compared on some common date, which
we shall call the comparison date.
 An equation of value is an equation stating that the sum of the
values, on a certain comparison date , of one set of obligations is
equal to the sum of the values of another set on this date.

P.V. of outgoing cash flows = P.V. of incoming cash flows

 A Time Diagram graphically displays each payment (money

coming in and money going out) at its appropriate time point and
projects each payment to one common time point. It is a very
useful device to set up an equation of value.
 The following steps are suggested when solving these types of
problems.

 Draw a time diagram.

 Choose a comparison date. This is usually set on the date where
there is an unknown payment.
 Bring all amounts (debts, obligations, payments) to the
comparison date by either accumulating or discounting using the
specified rate.
 Set-up the equation and solve for the unknown.
Example 1.
Alexa owes Andrea Php2,500 due in 2 years and Php4,000 due in 5
years. To settle these financial obligations, Alexa agrees to pay
Php1,000 after a year and another payment on the fourth year. How
much is the payment on the fourth year if money is worth 16%
compounded quarterly?
Solution:

STEP 1.
STEP 2: Choose the comparison date on the 4th.

STEP 3: Using the given rate of 16% compounded quarterly (𝑖 = 0.16;

𝑝 = 4), we bring all the amounts to the comparison date, we have

Accumulate Php2,500 for 2 years: 2500(1 + 0.04)8

Discount Php4,000 for 1 year: 4000(1 + 0.04)-4
Accumulate Php1,000 for 3 years: 1000(1 + 0.04)12
STEP 4: Let x be the amount of payment in the 4th year.
We now have the following equation
Total Obligations = Total payments

2500(1 + 0.04)8 + 4000(1 + 0.04)-4 = 1000(1 + 0.04)12 + x

x = Php 5,239.61
F.
 Example 2.
In return for a promise to receive $600 at the end of 8 years, Roger
agrees to pay $100 at once, $200 at the end of 5 years, and to make
a further payment X at the end of 10 years. Assume that the nominal
rate of interest is 8% convertible semiannually. Find the payment at
the end of 10 years.

Solution:
STEP 2. Use today (t = 0) as the point of comparison.

STEP 3. Using the given nominal interest rate of 8% convertible

semiannually v  1
 0.08 
1  
 2 

STEP 4: We now have the following equation

Other solution:

If we choose a different comparison date, say at the end of 10th year,

the equation of value will be
Example 3.
To receive a loan of $500 today and another $500 five years from
today, Sheila agrees to pay $300 at the end of years 3, 6, 9, and the
remainder at the end of year 12. What is the final payment if interest
is accrued at a nominal interest rate of 5% convertible semiannually?

Solution:
STEP 2. Use today (t = 0) as the point of comparison.

STEP 3. Using the given nominal interest rate of 5% convertible

semiannually, 1
v
 0.05 
1  
 2 

STEP 4: We now have the following equation.

500  500v10  300v 6  300v12  300v18  xv18

 x  $391.58
 Your time!!!

1. Alfred has two financial obligations to Allan. One obligations is worth

Php20,000 due in 2 years and another Php60,000 which is due in 5
years. What single payment at the end of the fourth year will settle all
his debts to Allan? Assume that money is worth 10% compounded
semi-annually?

2. Francis owes his Aunt Teresita Php100; 000 which is due in 4.5 years
from now. On the third year, he paid Php30,000. However, he cannot pay
on time for the remaining balance and have made an agreement that he
can pay on the sixth year. How much would he have to pay on the sixth
year to discharge the rest of his obligations to his aunt if they assume
that money is worth 9% compounded semi-annually?
F.
The end..Thank you…