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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

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:

Birr 798

Birr 300

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 .

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.

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.

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.

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?

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.

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?

now at an interest rate of 5% per year.

(b) Calculate the amount of interest earned during this time period.

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?

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?

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?

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.

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