ChE/MGMT 597

Financial Analysis and

Management of Projects

Equivalence and Financial

Calculations
Homework
Charlie Smith

1
 Introduction

Mr. Charlie Smith

B.S. Chem Eng Purdue University, 1980

(317) 432-4285
Charlie4129@yahoo.com

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Equivalence

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 Equivalence

• The rate of return on a guaranteed one-year

bank deposit is 3%.
• Decision: $1,000 now or $1,030 in one year?
• In this example, the two options are
equivalent.

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 Example 1

Your company takes a $10,000 loan to buy a piece of

equipment.
Loan must be repaid in 10 years.
Interest rate is 6% per year.

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 Equivalence Problem 1
What conditions must an acceptable repayment plan
meet?
– At the end of 10 years, the loan must be paid off
– At any point within the 10 years, the unpaid portion of the
loan accumulates interest at 6%
– Loan payments pay down the accumulated interest and a
portion of the principle

1) What are acceptable re-payment plans based on the

terms presented on the following page?
2) If you could choose, which alternative would you
prefer and why?
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 Problem 1, Continued - Alternatives

• Plan I – Repay Interest Annually & Principle in

Year 10
• Plan II – Repay Interest Annually plus $1000
per Year
• Plan III – Constant Payments to Repay at Year
10
• Plan IV – Pay the Entire Debt at the End of Year
10

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Interest Rates

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 Simple Interest Rate (i)
Facts
Loan or investment: I = $100
Annual interest rate: i = 10%
Payback Time: n = 3 years

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 Pay the Interest Rate Each Period

interest rate, Interest not Total Still

N Investment, I i Interest Paid Paid Payment Owed
0 $ 100
1 $ 100 10% $ 10 $ 10 $ 100
2 $ 100 10% $ 10 $ 10 $ 100
3 $ 100 10% $ 10 $ 110
Total $ 130

This is called Simple Interest because

interest owed is paid each period (n), and
is not compounded.

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 Simple Interest Examples

• Car loans
• Mortgage loans

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 Compounding Interest Rate (i)
Facts
Loan or investment: I = $100
Annual interest rate: i = 10%
Payback Time: n = 3 years

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 How the Interest Rate Works
interest rate, Interest not Total Still
N Investment, I i Interest Paid Paid Payment Owed
0 $ 100
1 $ 100 10% $ 10 $ - $ 110
2 $ 110 10% $ 11 $ - $ 121
3 $ 121 10% $ 12 $ 133
Total $ 133

This is called Compound Interest.

Interest owed is added until the end.
Note interest is paid on unpaid interest.
In essence, you are borrowing your unpaid interest.
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 Compounded Interest Examples

• Unpaid credit card balances

• Student loan debt, post graduation

• Most scenarios you experience in business will

be determined by the lender.

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Net Present Value (NPV)

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 DCF Models

Models that consider the time value of money are called

discounted cash flow (DCF) models.

The time value of money (i) is typically set by an entity’s

expectations on earning a minimum return on its endeavors.

For these models, “i” is always compounded.

Net Present Value (NPV) is the most common DCF model.

NPV = - (Initial cash outlay) + (Present Value of future net cash

flows)

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 Compounding

If investment is $100, and i is 10%

Period 0 Period 1 Period 2 Period 3

$100 $110 $121 $133

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 Compounding
n = time i = interest

n=0 $100
n=1 $100 x .1 = $110
n=2 $110 x .1 = $121
n=3 $121 x .1 = $133

Because of interest at 10%, the Future Value of

$100 today will be $133 in three years.
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 Future Value (FV)

• Future Value is the value of an asset at a

specific date

• FV is calculated based on an interest rate i

• FV = PV (1+i)n (1+i)n

Compound Factor

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 Compound Factor
For Different Rates and Years

• The compound factor is always higher than one.

• It increases when the rate goes up and the time goes up.
• How long will it take for an investment to double at 15%?

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 Effect of Compounding

http://financesolutions.org/about-compound-interest/
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 Compounding and Discounting

• Compounding is the • Discounting is the

mechanism that reverse of compounding.
provides the future • Discounting is the
value of a current mechanism that provides
amount of money. the current value of a
• Compounding future amount of money.
converts present • Discounting converts
value into future future value into present
value. value.

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 Discounting; Compounding in Reverse

Since an entity expects a return on investments,

money in the future is discounted (worth less)
than money today.

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 Discounting

If future value is $133, and i is 10%

Period 0 Period 1 Period 2 Period 3

$100 $110 $121 $133

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 Present Value

0 __________________________ n
1 2 3 ……
PV FV

 
PV =
Discount Factor

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 Present Value Calculation

 
PV =

PV = $100

The present value of $133 when n = 3 and i = 10% is $100.

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 Discount Factor
For Different Rates and Years

• The discount factor is always less than one because a dollar tomorrow
is worth less than a dollar today.
• The discount factor decreases when the interest rate goes up and the
number of years time rises.
• One dollar in 10 years at an interest rate of 3% is worth 74 cents today

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 Key Formulas

•   PV =
Discount Factor

(1+i)n
FV = PV (1+i)n
Compound Factor

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Cash Flows of a Typical Project

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 Problem 2

• $50 million investment end in year 0.

• $10 million expected net cash flow end of
years 1 through 10.
• 10% Discount Rate.
• Determine Net Present Value as of year 0.
• Determine the project Rate of Return, which is
the discount rate results in a net present value
of zero.

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Questions

31
Problem 1

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Plan I – Repay Interest Annually & Principle in Year 10
Interest due Total Money Money owed
(6% of money Owed before Year-end after year-end
End of year owed at start Year-End payment payment
of year) payment
0 $10,000
1 600 10,600 600 10,000
2 600 10,600 600 10,000
3 600 10,600 600 10,000
4 600 10,600 600 10,000
5 600 10,600 600 10,000
6 600 10,600 600 10,000
7 600 10,600 600 10,000
8 600 10,600 600 10,000
9 600 10,600 600 10,000
10 600 10,600 10,600 0

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Plan II – Repay Interest Annually plus $1000 per Year
Interest due Total Money Money owed
(6% of money Owed before Year-end after year-end
End of year owed at start Year-End payment payment
of year) payment
0 $10,000
1 600 10,600 1,600 9,000
2 540 9,540 1,540 8,000
3 480 8,480 1,480 7,000
4 420 7,420 1,420 6,000
5 360 6,360 1,360 5,000
6 300 5,300 1,300 4,000
7 240 4,240 1,240 3,000
8 180 3,180 1,180 2,000
9 120 2,120 1,120 1,000
10 60 1,060 1,060 0

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 Plan III – Constant Payments to Repay at Year 10
Interest due Total Money Money owed
(6% of money Owed before Year-end after year-end
End of year owed at start Year-End payment payment
of year) payment
0 $10,000.00
1 600.00 10,600.00 1,358.68 9,241.32
2 554.48 9,795.80 1,358.68 8,437.12
3 506.23 8,943.35 1,358.68 7,584.67
4 455.08 8,039.75 1,358.68 6,681.07
5 400.86 7,081.93 1,358.68 5,723.25
6 343.40 6,066.65 1,358.68 4,707.98
7 282.48 4,990.45 1,358.68 3,631.77
8 217.91 3,849.68 1,358.68 2,491.00
9 149.46 2,640.46 1,358.68 1,281.78
10 76.90 1,358.68 1,358.68 0

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Plan IV – Pay the Entire Debt at the End of Year 10
Interest due Total Money Money owed
(6% of money Owed before Year-end after year-end
End of year owed at start Year-End payment payment
of year) payment
0 $10,000.00
1 600.00 10,600.00 0.00 10.600.00
2 636.00 11,236.00 0.00 11,236.00
3 674.16 11,910.16 0.00 11,910.16
4 714.61 12,624.77 0.00 12,624.77
5 757.49 13,382.26 0.00 13,382.26
6 802.94 14,185.20 0.00 14,185.20
7 851.11 15,036.31 0.00 15,036.31
8 902.18 15,938.49 0.00 15,938.49
9 956.31 16,894.80 0.00 16,894.80
10 1,013.69 17,908.49 17,908.49 0

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Five Financially Equivalent Series of Payments for i=10%
Year Investment I II III IV

0 $10,000
1 600 1,600 1,359
2 600 1,540 1,359
3 600 1,480 1,359
4 600 1,420 1,359
5 600 1,360 1,359
6 600 1,300 1,359
7 600 1,240 1,359
8 600 1,180 1,359
9 600 1,120 1,359
10 10,600 1,060 1,359 $17,910

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Problem 2

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 Problem 2 Result
Discount Rate, % 10.0%

Year 0 1 2 3 4 5 6 7 8 9 10
Cash Flow, $MM $ (50.0) $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0 $ 10.0
Discount Factor 1.000 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386
Discounted Values, $MM $ (50.0) $ 9.1 $ 8.3 $ 7.5 $ 6.8 $ 6.2 $ 5.6 $ 5.1 $ 4.7 $ 4.2 $ 3.9
Total Net Present Value, $MM $ 11.45
Rate of Return, % 15.1%

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