Economic Equivalence

Sean Piseth
Economic Equivalence
 What do we mean by “economic
equivalence?”
 Why do we need to establish an economic
equivalence?
 How do we establish an economic
equivalence?
Economic Equivalence

 Economic equivalence exists between cash

flows that have the same economic effect
and could therefore be traded for one
another.
 Even though the amounts and timing of the
cash flows may differ, the appropriate interest
rate makes them equal.
Equivalence from Personal Financing
Point of View
F

 If you deposit P dollars

today for N periods at F  P(1  i) N
i, you will have F
0
dollars at the end of N
period N.

PF P
Alternate Way of Defining Equivalence

P
 F dollars at the end of
period N is equal to a
single sum P dollars
now, if your earning 0 N
power is measured in
terms of interest rate i. = F
N
P  F (1  i )

0 N
Practice Problem
At 8% interest, what is the equivalent worth
of $2,042 now 5 years from now?

$2,042 If you deposit $2,042 today in a savings

account that pays 8% interest annually.
how much would you have at the end of
5 years?

0 1 2 33 4 5
F

=
0 5
Solution

F  $2,042(1  0.08) 5

 $3,000
Example 2.2
At what interest rate
would these two amounts be equivalent?

$2,042
i=? $3,000

0 5
 Equivalence Between Two Cash Flows

 Step 1: Determine the

$2,042 $3,000
base period, say, year 5.
 Step 2: Identify the
interest rate to use.
 Step 3: Calculate
equivalence value. 0 5
i  6%, F  $2,042(1  0.06) 5  $2,733
i  8%, F  $2,042(1  0.08)5  $3,000
i  10%, F  $2,042(1  0.10) 5  $3,289
Example - Equivalence
Various dollar amounts that will be economically
equivalent to $3,000 in 5 years, given an interest
rate of 8%.
$3, 000
P  $2, 042
(1  0.08) 5

P F
$2,042 $2,205 $2,382 $2,572 $2,778 $3,000
0 1 2 3 4 5
Example 2.3

$200 V
=
$150
$120
$100 $100
$80

0 1 2 3 4 5 0 1 2 3 4 5

Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.

Approach
V

$200

$150
$120
$100 $100
$80

0 1 2 3 4 5
 V3  $511.90  $264.46 V
 $776.36

$200
$200(1  0.10)1  $100(1  0.10) 2
$150  $264.46
$120
$100 $100
$80

0 1 2 3 4 5

100(1  0.10)3  $80(1  0.10) 2  $120(1  0.10)  $150

 $511.90
Practice Problem
2P
 How many years would
it take an investment to
double at 10% annual
0
interest?
N=?

P
Solution

2P
F  2 P  P (1  0.10) N
2  1.1N

log 2  N log1.1
0
log 2
N=? N
P
log1.1
 7.27 years
Rule of 72

 Approximating 72
how long it will N
take for a sum of interest rate (%)
money to double 72

10
 7.2 years
Practice Problem
$1,000
$500
Given: i = 10%,
A

Find: C that makes the 0 1 2 3

two cash flow streams
to be indifferent C C

0 1 2 3
 Approach
$1,000
 Step 1: Select the base
period to use, say n = $500
2. A
 Step 2: Find the 0 1 2 3
equivalent lump sum
value at n = 2 for both
A and B. C C
 Step 3: Equate both B
equivalent values and
solve for unknown C. 0 1 2 3
Solution
 For A: $1,000

1
$500
V2  $500(1  0.10)  $1,000(1  0.10)
2

 $1,514.09 A
0 1 2 3
 For B:
V2  C (1  0.10)  C
C C
 2.1C
 To Find C: B
2.1C  $1, 514.09
0 1 2 3
C  $721
Practice Problem
$1,000
$500
At what interest rate
would you be A

indifferent between the 0 1 2 3

two cash flows?
$502 $502 $502

0 1 2 3
Approach
 Step 1: Select the base $1,000
period to compute the
equivalent value (say, n $500
= 3) A
 Step 2: Find the net 0 1 2 3
worth of each at n = 3.

$502 $502 $502

0 1 2 3
Establish Equivalence at n = 3

Option A : F3  $500(1  i)  $1, 000

3

Option B : F3  $502(1  i) 2  $502(1  i)  $502

 Find the solution by trial and error, say i = 8%

Option A : F3  $500(1.08) 3  $1, 000

 $1, 630
Option B : F3  $502(1.08) 2  $502(1.08)  $502
 $1, 630