ECONOMIC EQUIVALENCE INVOLVING INTEREST

Why? It is common in engineering to compare alternatives.

THE MEANING OF EQUIVALENCE

In engineering economy two things are said to be equivalent when they have the same
effect. Unlike most individual involved with personal finance, industrial decision
makers using engineering economics are not so much concerned with the timing of a
project's cash flows as with the profitability of that project. This means that
mechanisms are needed to compare projects involving receipts and disbursements
occurring at different times, with the goal of identifying an alternative having the
largest eventual profitability [Lindeberg82].

EQUIVALENCE CALCULATIONS INVOLVING A SINGLE FACTOR

The interest equations are affected by three factors: (a) amounts, (b) times of
occurrence of amounts, and (c) rate of interest.

1. Single-Payment Compound-Amount Factor

F = P.[1 + i]^n

Example 1 : Let P = $1000, i = ??, n = 4 years, and F = $1200. The interest

rate is
F = $1200.00 = $1000.00 [1 + i ]^4

Rearranging terms in this equation gives i = 1.2^0.25 - 1 = 0.046635.

Example 2 : Let P = $1000, i = 10%, n = ?? years, and F = $1200.

F = $1200.00 = $1000.00 [1 + 0.10 ]^n

Rearranging terms in this equation gives n = 1.91 years.

2. Single-Payment Present-Worth Factor

F
P = ---------
[1 + i]^n

Example 1 : Let F = $1000, i = 12%, n = 4 years, and P = ?

 $1000.00
P = ------------ = $635.5
[1 + 0.12]^4

3. Equal-Payment-Series Compound-Amount Factor

[ 1 + i ]^n - 1
F = A * ---------------
i

The derivation of this formula can be found on page 46 of the economics text.

Example 1 : Let A = $100.00, i = 10%, and F = $1000.00. How many years n

are needed ?
[ 1 + 0.12 ]^n - 1
$1000.00 = $100.00 * ------------------
0.12

Rearranging the terms in this equation gives n = 7.27 years.

4. Equal-Payment-Series Sinking-Fund Factor

i
A = F * ---------------
[ 1 + i ]^n - 1

Example 1 : Paying towards a future amount. Let F = $1000.00, i = 12%, and n = 4

years. What is A ?
0.12
A = $1000.00 * ------------------ = $209.20
[ 1 + 0.12 ]^4 - 1

5. Equal-Payment-Series Capital-Recovery Factor

i * [ 1 + i ]^n
A = P * ---------------
[ 1 + i ]^n - 1

Example 1 : Paying back a loan. Let P = $1000, i = 12%, n = 4 years, and A = ?

 0.12 * [ 1 + 0.12 ]^4
A = 1000 * --------------------- = 329.2
[ 1 + 0.12 ]^4 - 1

6. Equal-Payment-Series Present-Worth Factor

[ 1 + i ]^n - 1
P = A * ---------------
i * [ 1 + i ]^n

Example 1 : Let A = 100, i = 10%, and n = 8 years.

[ 1 + 0.10 ]^8 - 1
P = 100 * ---------------------- = 533.49
0.10 * [ 1 + 0.10 ]^8

7. Uniform Gradient-Series Factor

As explained above, the gradient (G) is a value in the cash flow that starts with 0 at
the end of year 1, G at the end of year 2, 2G at the end of year 3, and so on to (n-1)G
at the end of year n.

This can be described as

*- -*
| 1 n |
A = G . | - - --------------- |
| i [ 1 + i ]^n - 1 |
*- -*

Example 1 : Let G = 100, i = 12%, n = 4 years, and A = ??

*- -*
| 1 4 |
A = 100.| ---- - ------------------ | = 135.9.
| 0.12 [ 1 + 0.12 ]^4 - 1 |
*- -*