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Equivalence

 Making a decision on multiple alternatives requires a common


measure of performance. Costs and benefits 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 benefits with a common measure.
These common measures are
 Net present worth
 Net future worth
 Benefit - cost ratio
 Equivalent Uniform Annual Worth
 Rate of return
 Two or more projects are economically equivalent if they have the
same result when measured by any of the above measures, that is,
the economical consequence of either project is the same.
Principles of Equivalence

1. Equivalence between cash flows: In engineering economy the


meaning of equivalence pertaining to value in exchange is of primary
importance.
For example ,a present sum of birr 300 is equivalent to birr 798 if the
amounts are separated by 7 years and if the interest rate is 15%.This is
so because a person who considers 15% to be satisfactory rate of
interest would be indifferent to receiving birr 300 now or birr 798
seven years from now.

Equivalent cash flows are those that have the same value and the
calculated expression of equivalence can be used as a basis for choice.
A sum of birr 300 in the present is equivalent to:

300(1+0.15)7= birr300(2.660 )= birr 798, in 7 years


Birr 798
Birr 300

Cash flow 1 Cash flow 2

0 1 2 3 4 5 6 7
Years 0 1 2 3 4 5 6 7
Years
Equivalent cash flows at 15%
2.Equivalence can be established at any point in time .

• The equivalent worth of cash flow at the arbitrarily chosen


point in time of n=10 is
(F/P,15,10)
• Birr 300 (4.046)= birr 1,214
• And , for cash flow 2,the equivalent worth at n=3 is
(F/P,15,3)
• Birr 798(1.521)=birr1,214
Equivalence for Different Interest Rates :
In the examples presented to this point it has been assumed
that the interest rate used in the interest formulae remains
fixed over the entire time span of the cash flow.
• In actuality interest rates frequently change over time ,and it
is important that the cash flows be analyzed under these
conditions.
• As cash flows are converted to their equivalences from one
time period to the next , the interest rate associated with
each time period must be reflected in the calculations.
Equivalence Between Receipts and Disbursements:
• A general principle of equivalence states that the actual
interest rate earned on an investment is the one that sets the
equivalent receipts equivalent to equivalent disbursements.

• If the receipts and disbursements of cash flow are equivalent


for some interest rate ,the cash flows of any equivalent
portion of the investment are equal at that interest rate to the
negative (-) of the equivalent amount of the cash flows that
constitute the remaining portion of the investment.
Bonds equivalence Involving
• A bond is a financial statement setting forth the conditions under
which money is borrowed.
• It consists of a pledge(pay) by a borrower of funds to pay a stated
amount or percent of interest on the par(equal or balance) or face
value at stated intervals and to repay the par value at a stated time.
• A typical birr 1000 bond may ,for example ,embrace a promise to pay
its holder birr 60 one year after purchase and each succeeding year
until the principal amount or par value of birr 1000 is repaid on
designated date.
• Such a bond would be referred to as a 6% bond with interest payable
annually. Bonds may also provide for interest payments to be made
semiannually or quarterly.
Bond price and interest : Bonds are bought and sold , since they
represent pledges to pay and have value .
• The market price of a bond may range above or below its par or face
value depending upon prevailing and anticipated market conditions.
• The bond prices change over time, because they are influenced by the
risk of nonpayment of interest or par value , supply and demand, and
the future outlook regarding inflation.
• These factors act with the current yield and the yield to maturity to
establish the price at which a bond will change hands.
Equivalence Involving Loans:
A loan is an agreement between a borrower and a lender
stipulating the amount of money to be provided , the manner
by which the money is to be repaid, the collateral to be used
and other pertinent information.
• Although there are classes of standard loan agreements ,the
variety of loan arrangements are numerous, owing to the
practice of negotiations between the borrower and the
lender.
Effective Interest on a Loan
• Borrowers should be aware of the difference between the
actual interest cost of a loan and the interest rate stated
by the lender.
• Consider the “add-on” loan used to finance many
purchases of consumer goods .
• In this type of loan, the total interest to be paid is pre-
calculated and added to the principal
• Principal plus this interest amount is then paid in equal
monthly payments.
• The effective interest rate that sets the receipts equal to
the disbursements on an equivalent basis is the rate that
properly reflects the true interest cost of the loan.
Remaining balance of a loan:
• The remaining balance of a loan is known by various names
such as the amount owed , the unrecovered balance ,the
unpaid balance and the principal owed.
• To calculate the remaining balance of a loan after a specified
number of payments have been made ,it is necessary to find
the equivalent of the original amount borrowed less the
amount repaid up to and including the last payment made.
Principal and interest payments:
• The repayment schedule for most loans is made up of a
portion for the payment of principal and a portion for the
payment of interest on the unpaid balance.
• The amount upon which the interest for this period is charged
is the remaining balance at the beginning of the period.
Equivalence Involving Working Capital:
• When investments are made in fixed assets such as a
machine or production line, it is frequently necessary to
have additional funds to finance any cash needs,
accounts receivable, or inventories that arise from the
project.
• This additional investment in working capital must not
be ignored, or the actual cost of the project will be
underestimated.
• Net working capital is defined by the accountant as a
firm’s short term or current assets less its current
liabilities.
• The primary elements of these short term assets include
cash , customers’ unpaid bills ,inventories of raw materials ,
work-in-process and finished goods
• Each of these elements requires a commitment of funds
,which can either be borrowed ( usually on a short term
basis) or financed from earnings.
• If the funds are borrowed , the cost of these working capital
requirements is explicit
Inflation
 Inflation is a reality that we deal with nearly everyday in professional
and personal life.
 The annual inflation rate is closely watched and historically analyzed
by government units, businesses, and industrial corporations.
 An engineering economy study can have different outcomes in an
environment in which inflation is a serious concern compared to one
in which it is of minor consideration.
 Inflation rate is sensitive to real, as well as perceived, factors of the
economy.
 Factors such as the cost of energy, interest rates, availability and cost
of skilled people, scarcity of materials, political stability, and other,
less tangible factors have short-term and long-term impacts on the
inflation rate. In some industries, it is vital that the effects of inflation
be integrated into an economic analysis.
 Inflation is an increase in the amount of money necessary to
obtain the same amount of product or service before the inflated
price was present.

 Inflation occurs because the value of the currency has changed-it


has gone down in value. The value of money has decreased, and
as a result, it takes more birrs for the same amount of goods or
services. This is a sign of inflation.

 To make comparisons between monetary amounts which occur


in different time periods, the different-valued birrs must first be
converted to constant-value birrs in order to represent the same
purchasing power over time. This is especially important when
future sums of money are considered, as is the case with all
alternative evaluations.
Inflation reflects the buying power of money. Suppose you
buy a unit of a certain commodity, e.g. cost of commodity
A is birr X, today and at some future time its price changes
to birr Y. If Y>X then the buying power of your money has
been reduced, that is, you have to pay more money to buy
the same commodity.
Deflation
In some economic circumstances, the price of certain goods falls as
the years go by. This most occurs in the case of new product,
especially when incorporation of new technology is involved.
A case in point is the case of personal computers where the prices
fall almost monthly. If we consider capability per birr, the
reduction is very noticeable.
The communication industry is also experiencing a price reduction.
The effect of this reduction in price is called deflation. Deflation
can be considered a negative inflation.
1.A local bank announces that a deposit over $1,000 will
receive a monthly interest of 0.5%. If you leave $10,000 in
this account, how much would you have at the end of one
year? a)simple interest b) compounded interest
2.The annual interest rate is 6%, and the interest is
compounded quarterly. What is the quarterly nominal interest
rate? What is the effective annual interest rate if compounded
quarterly?
3.Your friend borrows birr 4000 from you in order to finish
his private project. Your agree to charge him simple interest
at the rate of 6% per year and 4.5% per year for compounded
interest . Suppose your friend waits 6 years and then repays
the entire loan. Which agreement is suitable for him?
4. A man who will inherit birr 10000 in 10 years has a savings
account that pays 10% per year, compounded annually. What is the
present worth of the person’s inheritance?

5. A father wants to deposit an unknown lump-sum amount for his son


into an investment opportunity 2 years from now that is large enough
to withdraw birr 4000 per year for state university tuition for 5 years
starting 3 years from now. If the rate of return is estimated to be 10%
per year, construct the cash flow diagram.

6. An industrial engineer received a bonus of birr12,000 that he will


invest now. He wants to calculate the equivalent value after 24 years,
when he plans to use all the resulting money as the down payment on
an island vacation home. Assume a rate of return of 8% compounded
annually. Find the amount he will pay.
7. ABC Telephone Credit Union loaned money to an engineering
staff member for a radio controlled model airplane. The loan is for
birr1000 for 3 years at 5% per year simple interest. How much
money will the engineer repay at the end of 3 years?

8. (a) Calculate the amount deposited 1 year ago to have birr1000


now at an interest rate of 5% per year.
(b) Calculate the amount of interest earned during this time period.

9.Mr. X design a project and wants to purchase a machine for the


project for birr120,000. Its operation will result in a net income of
birr 15,000/Yr for the first year, increasing by birr 2,000 each year
after year 1. At the end of the fifth year, the Mr.X is sold the
machine for birr 150,000. Draw the cash flow diagram for this
project.
Exercise :
1.A person deposits a sum of birr 20,000 at the interest rate of
10% compounded annually for 10 years. Find the maturity value after
10 years.
2.A credit card company announces that its interest rate is 1.5% per
month. What is the corresponding effective annual interest rate?

3. You are deposited birr1,500 in a savings account at the local bank


and went on assignment somewhere. After two years, you returned
and noticed you had birr1,800 in your account. What annual effective
rates of interest had the bank given you if they compounded the
interest quarterly? What if they compounded annually?
4. The Awash bank advertised an investment program with an annual
5.5% interest rate, compounded quarterly. You can also choose to
invest your money at the local branch of wegagen bank that
will give you an annual interest rate of 5.5% semi annually. How
much more will you gain or lose per year if you invest birr 10,000 at
the Awash bank instead of at wegagen bank?
5.An electrical engineer wants to deposit an amount P now such that she can
withdraw an equal annual amount of A1 = birr 2000 per year for the first 5 years
starting 1 year after the deposit, and a different annual withdrawal of A2 = birr
3000 per year for the following 3 years. How would the cash flow diagram appear
if i = 8.5% per year?

6.A medium-size consulting engineering firm is trying to decide whether it should


replace its office furniture now or wait and do it 1 year from now. If it waits 1
year, the cost is expected to be birr 16,000. At an interest rate of 10% per year,
what would be the equivalent cost now?

7. A company that manufactures an electrical components for bulk manufacturing


is considering borrowing birr17.5 million to update a production line. If it borrow
the money now, it can do so at an interest rate of7.5% per year simple interest for
5 years. If it borrows next year, the interest rate will be 8% per year compound
interest, but it will be for only 4 years. (a) How much interest (total) will be paid
under each scenario, and (b) would you advised the company to borrow now or 1
year from now? Assume the total amount due will be paid at the end of 5 and 4
year respectively.
8. An individual wants to have birr 2000 at the end of three years.
How much would the individual have to invest at a 10% per year
interest rate, compounded annually, in order to obtain a net of birr
2000 after paying a birr 250 early withdrawal fee at the end of the
third year? Draw a cash flow diagram for the individual.

9. A first year DEC student needs a sum of birr. 20,000 for his
marriage which will take place 6 years from now. Find the amount
of money that he should deposit now in a bank if the bank gives
5.5% interest, compounded annually.

10. A person who is just 30 years old is planning for his retired life.
He plans to invest an equal sum of birr 10,000 at the end of every
year for the next 30 years starting from the end of next year. The
bank gives 5.5% interest rate, compounded annually. Find the
maturity value of his account when he is 60 years old.