GEN TECH 3EE3

WEEK 3 LECTURE

CASH FLOW ANALYSIS

Uniform Annuities, Continuous

Compounding and Excel Functions

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 Administrative Items
• Online Quiz 1:
o Starts, Wednesday May 20 at 11:00 PM
o Ends, Wednesday May 27 at 11:59 PM
o Chapters 1, 2 and up to annuities in Chapter 3 (not including mortgages, bonds
and non-uniform annuities).
o Chapters 1, 2 & 3 including general concept of EE, decision making, time
value of money, interest rate calculations, cash flow diagram, and annuities.

• Online Quiz 2:
o Starts, Wednesday May 27 at 11:00 PM
o Ends, Wednesday June 3 at 11:59 PM
o Chapters 3
o Chapter 3 including non-uniform annuities, bonds and mortgages; there
will also be a small number of 'review-type' questions from Chapter 2.

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 Learning Objectives
• Compound interest factors recap
• Relationships between compound interest factors recap
• Uniform annuities:
o White board problems
o Annuity due
o Capital recovery formula
o Mortgages and loans
o Linear interpolation
o Bonds
• Non standard annuities
• Continuous compounding with uniform annuities
• Spreadsheet functions

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Compound Interest Factors Recap

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Relationships between Compound Interest
Factors
• Single Payment
o Compound amount factor = 1/Present Worth Factor
o (F/P, i, n) = 1/(P/F, i, n)

• Uniform Series (Annuities)

o Capital recovery factor = 1/Present Worth Factor
o (A/P, i, n) = 1/(P/A, i, n)

o Compound amount factor = 1/Sinking Fund Factor

o (F/A, i, n) = 1/(A/F, i, n)

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Relationships between Compound Interest
Factors

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 Uniform Annuities
Problem 1
• A Ford Mustang costs $17 000. It can be financed at
5.9% for 48 months, with monthly compounding.
How much will the monthly payments be?

Answer
i = 0.059/12 = 0.00492 per month
A = P(A/P, i, N) = $17 000(A/P, 0.00492, 48)
= $398.50

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 Uniform Annuities
Problem 2

Solution
1. What interest rate is used? ie = (1 + r/m)k – 1 = (1 + 0.08/52)26 – 1 = 0.0408

2. What happens from 0 – 3 years? Nothing occurs

3. What happens from 3 – 13 years? Annuity calculation

F13 = A(F/A,ie,n) = 10,000(F/A,4.08%,20) = 10,000[(1+0.0408)20 – 1]/0.0408 = $300,264.76
= $300,264.76
4. What happens from 13 – 30 years? Compound interest calculation
F30 = P(F/P,ie,n) = 300,264.76(F/P,4.08%,34) = 300,264.76(1+0.0408)34
= $1,169,478
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 Uniform Annuities: Annuity Due
Problem 3
• What is the present worth of a series of 15 annual
payments of $1000 each, when the first payment is
now and the interest rate is 5%, compounded
yearly?

• This is an example of an annuity due  the

payments of an annuity are made at the start of
each period rather than at the end.

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 Uniform Annuities: Annuity Due
Problem 4
• Method 1: Count the first payment as a present
worth and the next 14 payments as a regular
annuity:
P = 1000 + A(P/A, i, N) where
A = 1000, i = 5% and N = 14
P = 1000 + 1000(P/A, 5%, 14)
= 1000 + 1000(9.8986) = 1000 + 9898.6
= $10 898.60

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 Uniform Annuities: Annuity Due
Problem 4

• Method 2: Determine the

present worth of a standard P1  A(P / A, i , N ) = 1000(P/A,5%,15)
annuity at time 1 and then = 1000(10.380)
find its worth at time 0
= 10 380
(now). The worth at time 1
is:

• Then the present worth now P0  P1(F/P, i , N )

(time 0) is:  10 380(F/P,5%,1)  10 380 (1.05)
 10 899

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 Uniform Annuities: Capital Recovery Formula

Industrial equipment and other assets are often

purchased at a cost of P on the basis that they will
incur a savings of A per cash flow period for the firm.

At the end of the their useful life, the asset will be sold
for some salvage value S.

With some algebra, the formula to determine A for a

given P and S can be derived that combines the
capital recovery factor with the sinking fund factor as
follows: A = (P - S)(A/P,i,N) + Si

A is often called the Capital Recovery Cost 12

 Uniform Annuities: Capital Recovery Formula
Problem 4
• A supplier of laboratory equipment is looking at a
mobile demonstration unit which will cost $71 000. It
will have a useful life of 5 years and the salvage value
at that time is estimated at $8 000.

a) If the cost of capital is 15% per year, what are the

equivalent annual costs (i.e., the annual capital
recovery costs) of purchasing the equipment?

b) If the mobile demonstration unit is estimated to

produce extra profits of $23 000 per year, is it
economically justified?
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 Uniform Annuities: Capital Recovery Formula
Problem 4
Answer

a) A = (P − S)(A/P, i, N) + Si
= (71 000 − 8000)(A/P, 15%, 5) + 8000(0.15)
= 63 000(0.29832) + 1200 = $19 994

The equivalent annual costs (capital recovery costs)

are $19 994.

b) Since the savings per year exceed the equivalent

annual costs, the purchase is justified.

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 Uniform Annuities: Mortgages in Canada

• The legal document:

o Long-term amortized loan that is used for buying property
o If payments are not made, the lender can seize the property
and sell it to recover the debt
o Legal document outlines the terms and conditions for
repayment of the loan (amortization period, interest rate,
penalties, etc.)
• Amortization:
o Length of time it takes to pay off loan assuming:
 Payments are made on time with no additional payments
 Interest rate doesn’t change

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 Uniform Annuities: Mortgages in Canada

Mortgage calculations require a defined amortization period

and term.

• Amortization period is the duration over which the

original loan is calculated to be repaid.

• Term is the duration over which the loan agreement is

valid – otherwise called the maturity.

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 Uniform Annuities: Mortgages in Canada

• Amortization periods are typically between 5 years and

35 years
o The norm is 20 or 25 years
• Terms
o A mortgage is often made up of smaller periods called “terms”
and a term is the period in which the interest rate “term” is
fixed.
o At the end of the term, the mortgage can be renewed for a
another term at the current interest rate.

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 Uniform Annuities: Mortgages in Canada

• “Conventional”:
o For 75% or less of the appraised value
• “High-ratio” mortgages:
o Higher than 75% and usually require an outside agency such
as the CMHC (Central Mortgage and Housing Corporation) to
insure the mortgage.
• Some Others:
o variable and fixed rate options…

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 Uniform Annuities: Mortgages in Canada

• Equity
o The value remaining in a property after all mortgage and
loans registered against the title are subtracted from its value.
• Interest Rate
o Interest rate is expressed as:
 % compounded semi-annually
o Nominal rate mortgage at 6% is actually 3% semi-annually
o To determine actual effective monthly rate for this example
 (1+i)6 = 1.03
 In this case: i = 0.49%/month

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 Uniform Annuities: Mortgages in Canada
Problem 5
A rental property was recently purchased for $350,000. The
down payment amount was $50,000 and the remaining
amount was obtained from a mortgage. The mortgage has a
nominal interest rate of 6%, compounded monthly with a
30-year amortization period. The term of the mortgage is 5
years. What are the couple’s current monthly payments?
How much will they owe in 5 years?

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 Uniform Annuities: Mortgages
Problem 5
Answer

A = (350,000 – 50,000)(A/P,0.5%,360)
A = 300,000[0.005(1+0.005)^360/[(1+0.005)^360 – 1]]
A = $1,798.65

F = 300,000(F/P,0.5%,60) – A(F/A,0.5%,60)
F = 300,000(1+0.005)^60 – 1798.65[(1+0.005)^60 –
1)/0.005]
F = $279,163.18

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 Uniform Annuities: Linear Interpolation
Linear interpolation is the process of approximating a
complicated function by a straight line to estimate a
value for the independent variable based on two
sample pairs of independent and dependent variables
and an instance of the dependent variable.

Linear interpolation is used in EE for approximating

the interest rate based on a set of conditions as
described by the mathematical model developed from
a cash flow analysis.

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Uniform Annuities: Linear Interpolation

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 Uniform Annuities: Linear Interpolation
Problem 6
• A new machine costing $8000 will reduce annual
production costs by $2100. The machine will operate
for 5 years, at which time it will have no resale value.
What rate of return is being earned on this
investment?
Restated: For what interest rate will a cash flow of
$2100 per year for 5 years be equivalent to a present
amount of $8000?

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 Uniform Annuities: Linear Interpolation
Problem 7
Answer

Find i in: 2100(P/A, i, 5) = 8000

(P/A, i, 5) = P/A = 8000/2100 = 3.8095
where:
N
(1  i )  1
(P / A, i , N ) 
i (1  i )N

which is not easy to solve for i.

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 Uniform Annuities: Linear Interpolation
Problem 6
Answer (cont’d)

Compound interest factor tables may not be

available for all combinations of i and N
From before: (P/A, i, 5) = 3.8095
From tables: (P/A, 10%, 5) = 3.7908
(P/A, 9%, 5) = 3.8897
The interest rate we are looking for must be
between 9% and 10%.

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 Uniform Annuities: Linear Interpolation
Problem 6
Answer (cont’d)

(P/A, 10%, 5) = 3.7908  (x1, y1) = (0.10,

3.7908)
(P/A, 9%, 5) = 3.8897  (x2, y2) = (0.09,
3.8897)

Want to find i: (x*, y*) = (i, 3.8095)

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 Uniform Annuities: Linear Interpolation
Problem 6
Answer (cont’d)

By interpolation…
 y *  y1 
x*  x1  ( x2  x1 ) 
 y2  y1 
 3.8095  3.7908 
 0.10  (0.09  0.10) 
 3.8897  3.7908 
 0.09811
 9.8%

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 Uniform Annuities: Bonds
Bonds are investments that provide an annuity and a
future value in return for a cost today. There is a par
or face value at time of maturity.

They also have a coupon rate in form of an annuity that is

calculated as a percentage of the face value.

Bonds can be sold at more or less than the face value at

anytime before the maturity date, depending on how
buyers perceive them as investments.

To calculate the present worth of a bond, sum together

the present worth of the face value (a future amount) and
the coupons (an annuity) at an appropriate interest rate.
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 Uniform Annuities: Bonds

• When Bonds are purchased, the fixed items:

o Face Value (e.g., $1000)
 Amount paid out when the bond matures
o A nominal interest rate (e.g., 8% semi-annually)
 Sometimes called “coupon rate”
 The amount of interest paid out to the bond holder per compounding
period
• The purchase price can vary depending on the current
market interest rate as the present worth of a bond is
determined from the fixed values above (the interest
paid out per compounding period and the final face
value paid out in the future).
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 Uniform Annuities: Bonds
Problem 7
• What is the present worth of a bond available today
if money can earn 12% compounded semiannually,
the bond maturing in 15 years with a face value of
$5,000 and a 7% coupon rate?

Answer
P = 5000(P/F,6%,30) + (5000 X 0.07/2)(P/A,6%,30)
P = 5000(0.17411) + 175(13.765)
P = 3279.43

The bond is worth $3,279.43 today.

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 Non Standard Annuities
• When compounding interest periods and payment periods differ,
an adjustment is required in order to utilize the formulas.
• This is usually done by:
1. Computing the equivalent payment amounts for each compounding
period and applying the interest rate

2. Computing an effective interest rate for the payment periods

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 Non Standard Annuities: Problem 8

Solution
What interest rate is used? ie = (1 + r/m)k – 1 = (1 + 0.12/12)3 – 1 = 0.0303
A = $1,000, n = 8
F = A(F/A,ie,n) = 1,000(F/A,3.03%,8) = 1,000[(1+0.0303)8 – 1]/0.0303
= $8,901.88

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Continuous Compounding at Nominal Rate
r per period
• Continuous Compounding Sinking Fund

• Continuous Compounding Capital Recovery

• Continuous Compounding Series Compound

Amount

• Continuous Compounding Series Present Worth

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 Spreadsheet Annuity Functions

• To find the equivalent P:

o −PV(i, n, A, F, Type)

• To find the equivalent A:

o −PMT(i, n, P, F, Type)

• To find the equivalent F

o −FV(i, n, A, P, Type)

• To find n:
o NPER(i, A, P, F, Type)

• To find i:
o RATE(n, A, P, F, Type, guess) 35
Questions Period

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