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Economic Equivalence

Economic Equivalence
Economic equivalence is a fundamental concept upon which engineering economy computations
are based.

Equivalence
Different sums of money at different times may be “equivalent” in economic value.

In fact, economic equivalence exists between cash flows that have the same economic effect and
could therefore be traded for one another.

As an illustration, if the interest rate is 6% per yesr, 100$ today (present time) is equivalent to
106$ one year from today.

Amount accrued = 100 + 100(0.06) = 100(1+0.06) = 106$

The two sums of money are equivalent to each other only when the interest rate is 6% per year.

Bases for comparison of alternatives

In most of the practical decision environments, executives will be forced to select the best
alternative from a set of competing alternatives.

In fact, costs and profits occur at different points in time and, hence, have different values.
Financial analysis methods are tools that will enable us to evaluate the aggregate of these costs
and profits with a common measure.

Let us assume that an organization has a huge sum of money for potential investment and there
are three different projects whose initial annual revenues during their lives are known. The
executive has to select the best alternative among these three competing projects.

There are several bases for comparing the worthiness of the projects. These bases are:

1- Present worth method

2- Future worth method
3- Annual equivalent method
4- Other methods…
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Equivalence is an essential factor in engineering economic analysis. Suppose we wish to select

the better of two alternatives. First, we must compute their cash flows. An example would be:

Alternative

Year A B
0 -2000$ -2800$
1 +800$ +1100$
2 +800$ +1100$
3 +800$ +1100$
The larger investment in Alternative B results in larger subsequent profits, but we have no direct
way of knowing if Alternative B is better than alternative A. Therefore we do not know which
alternative should be selected. To make a decision we must resolve the alternatives into
equivalent sums so they may be compared accurately and a decision made.

Equivalence Calculations
Example:
Suppose that you are offered 2 alternatives:

1- Take 3000$ after 5 years.

2- Take p $ today.

If you can deposit the p $ at an interest rate of 8%. Find the value of p that makes the 2 offers
indifferent.

Solution:

F = P(1 +i)N

 P = 3000 (1 +0.08)-5= 2048$

Are these 2 cash flows equivalent in the third year?
2
Answer: V3(1) = 3000 (1 + 0.08)- = 2572$

V3(2) = 2042 (1 + 0.08)3 = 2572$

 The equivalent cash flows are always equivalent at any time for the same interest rate.
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Equivalent Cash Flows

Equivalent cash flows are cash flows that produce the same result over a specific period of
time.

Equivalence is a function of the following:

-The size of the cash flows

-The timing of the cash flows

-The interest rate.

To simplify the comparison of cash flows at different time periods, it is useful to convert the
cash flows into their equivalent cash flows at a specific point in time based on a specified interest
rate. The point in time may be now, at some time in the future, or a series of periodic cash flows
over a specified period of time (for example, monthly or annual cash flows).

A number of formulas have been developed to convert cash flows as will be explained in the
following paragraphs.

Types of Cash Flows in Engineering Economics

There are different types of cash flows which are mainly the following:

1-Single Cash Flow

2-Equal Payment Series

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3-Linear Gradient Series

4-Geometric Gradient Series

5-Irregular Payment Series

Single Cash Flow

Single Payment Present /Future Worth Amount: Here the objective is to find the present/future
amount (P/F) of a single future/present sum (F/P) which will be received after periods at an
interest rate of i compounded at the end of every interest period.

Cash flow diagram of single-payment present/future worth amount

The single payment compound amount factor (1+i) N is used to compute the future worth F
accumulated after N years from the known present worth P at a given interest rate i per interest
period.
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Cash flow diagram for known P and unknown F

PV = P = Present value

FV = F = Future value.

The generalized formula

Thus, the generalized formula for the future worth at the end of N years is given by:

F = P (F/P, i , N) where (F/P, i , N) is called (single payment Compound amount factor)

Also, the expression for the present worth P can be written as follows:

P = F (P/F, i , N) where (P/F, i , N) is called (Dicount amount factor)

Excel:

Present Value Function: FV (rate, period, 0, P)

Exercise
Suppose that 1000$ is to be received in 5 years. At 12%, what is the present value?

Solution: F = 1000$ ; i = 12% ; N=5

 P = 1000 (1+0.12)-5
 P = F (P/F, i, N)
 P = PV (12%, 5, 0, 1000)

Equal Payment Series

A uniform series is identical to n single payments, where each single payment is the same and
there is one payment at the end of each period.
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Annual worth: It is a method that enables the comparison of alternatives on an average worth
versus time period basis.

A = equal uniform annual value of all expenses and/or revenue over the life of a project.

F = A(1+i)N-1 + A(1+i)N-2 + …+ A(1+i) + A

(1+i) F = A(1+i) + A(1+i) 2 + …+ A(1+i)N

(1+i) F – F = A(1+i)N - A

Where (F/A, i,N) is the equal payment (or uniform) series compound amount factor.

Exercise
Suppose that you make an annual contribution of 3000$ to your saving account at the end of
each year for 10 years. If the account earns 7% annually, how much money will be drawn at the
end of year (EOY) 10?

Solution: A = 3000$ ; i = 7% ; N=10

 F = 3000 (F/A, 7 , 10) = 41449.2$

Excel: FV (7%, 10, -3000).

The amount of uniform series of end-of-period deposits for N periods to provide F at the end of
N periods:
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(A/F, i, N) is the Sinking Fund Factor.

Excel: PMT (rate, nper, PV, [FV], [type] ).

Uniform Series Present Worth Factor

Consider the following cash flow Diagram:

Lender’s point of view Borrower’s point of view

The annual worth A equivalent to a present worth can be calculated from the expression:

Where (A/P, i, N) is the Capital Recovery Factor.

F = A (F/A, i, N)

A = F (A/F, i, N) = P (F/P, i, N) (A/F, i, N)

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Present value of Uniform Annual Series

P = A (P/A, i, N)

Where (P/A, i, N) is the uniform series present worth factor.

A is the annual cost or benefit.

Functional Notations

As a summary for functional notations, the uniform annual series factors are:

Compound Amount (F/A, i,N)

Sinking Fund (A/F, i, N)

Capital Recovery (A/P, i, N)

Present Worth (P/A, i, N)

Exercise:

Back to the economic decision propsed at the beginning of chapter 1:

167 million$ now v/s 10.57 million$ per year over 26 years.

P = 10.57 million (P/A, 5%, 26) = 152045228$.

Hence, taking 167 million$ now is better since the present value of the 167 million$ is greater
than the present value of the other option.

Linear Gradient Series

Some cash flows involve the payments or receipts in gradients by same amount. In other words,
the expenditure or the revenue increases or decreases by same amount. The cash flow involving
such payments or receipts is known as uniform gradient series.

The corresponding cash flow diagram is shown in the following figures:

G>0 increasing
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G<0 deccreasing

Strict gradient series

The future worth of the cash flow of the gradient series can be determined by finding out the
individual future worth of the gradient values (i.e. in multiples of gradient amount G) at the end
of different years at interest rate of i per year and then taking the sum of these individual future
values. Then, F is given as follows:

F={G(1+i)N-2 + 2G(1+i)N-3 + 3G(1+i)N-4 + 4G(1+i)N-5 +…+ (N-4)G(1+i)3 + (N-3) G(1+i)2 +

(N-2) G(1+i) + (N-1) G}

The expression for future worth F can be written as follows:

The present worth of the cash flow of the gradient series can be determined as follows:

P = 0 + G (1+i)-2 + 2G (1+i)-3 +…+ (N-1) G (1+i)-N

–
=

Thus, the expression of the present worth P can be written as follows:

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Gradient to equal payment Series

Similarly, the annual worth factor of a uniform gradient series can be obtained by multiplying
the uniform gradient future worth factor with the sinking fund factor and the functional
representation is presented as follows:

(A/G, i, N) = (F/G, i, N) x (A/F, i, N) =>

(A/G, i, N) is known as the uniform gradient annual worth factor.

Geometric Gradient Series

Many engineering economic problems, particularly those related to construction costs, involve
cash flows that increase or decrease over time not by a constant amount but rather by a constant
percentage (ex: price changes caused by inflation).
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g>0 or g<0

An = A1 (1 + g)N-1
g = uniform rate of period-by-period change, the geometric gradient stated as a decimal.

A1 = value of A at year 1

An = value of A at any year n

Pn = An (1 + i)-N = A1 (1 + g)N-1 (1 + i)-N

Geometric series present worth Formulas:

P = A1 (P/ A1, g, i, N)

Exercise:

It is likely that airplane tickets will increase 8% in each of the next four years. The cost of a
plane ticket at the end of the first year will be 180$. How much money would need to be placed
in a savings account now to have money to pay a man’s travel home at the end of each year for
the next four years? Assume the savings account pays 5% annual interest.
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Solution:

The problem describes a geometric gradient where g=8% and i=5%.

Thus, 715,67$ would need to be deposited now.

As a check, the problem can be solved without using the geometric gradient:

Year Ticket

1 A1= 180$
2 A2=180+8%(180)= 194.4$
3 A3=194.4+8%(194.4)= 209.95$
4 A4=209.95+8%(209.95)= 226.75$

P=180(P/F, 5%, 1) + 194.4(P/F, 5%, 2) + 209.95(P/F, 5%, 3) + 226.75(P/F, 5%, 4)

=180(0.9524) + 194.4(0.9070) + 209.95(0.8638) + 226.75(0.8227)

=715.67$.