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HowHow TimeTime andand InterestInterest AffectAffect MoneMoneyy EngineeringEngineering EconomyEconomy LectureLecture
HowHow TimeTime andand InterestInterest
AffectAffect MoneMoneyy
EngineeringEngineering EconomyEconomy
LectureLecture no.no. 22
Thursday,Thursday, JuneJune 13,13, 20132013
ECONOMIC EQUIVALENCE Two sums of money at two different points in time can be made

ECONOMIC EQUIVALENCE

Two sums of money at two different points in time can be made economically equivalent if:

We consider an interest rate and,

No. of time periods between the two sums

Equality in terms of Economic Value

I n t eres t R a t e  INTEREST - MANIFESTATION OF THE

Interest Rate

INTEREST - MANIFESTATION OF THE TIME VALUE OF MONEY. THE AMOUNT PAID TO USE MONEY.

INVESTMENT

INTEREST = VALUE NOW - ORIGINAL AMOUNT

LOAN

INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT

RENTAL FEE PAID FOR THE USE OF SOMEONE ELSES MONEYEXPRESSED AS A %

Interest R a t es an d R e t urns INTEREST RATE  INTEREST

Interest Rates and Returns

INTEREST RATE

INTEREST PER TIME UNIT

ORIGINAL AMOUNT

Interest can be viewed from two perspectives:

Lending situation

Investing situation

Int eres t – L ending: E xamp l e • You borrow $10,000 for

Interest – Lending: E xamp l e

You borrow $10,000 for one full year

Must pay back $10,700 at the end of one year

Interest Amount (I) = $10,700 - $10,000

Interest Amount = $700 for the year

Interest rate (i) = 700/$10,000 = 7%/Yr

Int eres t Rat e - Nota tion the interest rate is Expressed as a

Interest Rate - Notation

the interest rate is Expressed as a per cent per year

Notation

I = the interest amount is $

i = the interest rate (%/interest period)

N = No. of interest periods (1 for this problem)

Interest – Investing Perspective Assume you invest $20,000 for one year in a venture that

Interest Investing Perspective

Assume you invest $20,000 for one year in a venture that will return to you, 9% per year.

At the end of one year, you will have:

Original $20,000 back

Plus……

The 9% return on $20,000 = $1,800

We say that you earned 9%/year on the investment! This is your RATE of RETURN on the investment

Engineering Economy Factors 1. F/P and P/F Factors 2. P/A and A/P Facto rs 3.

Engineering Economy Factors

1. F/P and P/F Factors

2. P/A and A/P Factors

3. F/A and A/F Factors

4. Interpolate Factor Values

5. P/G and A/G Factors

6. Geometric Gradient

F/P factor  To find F given P F n To Find F given P

F/P factor

To find F given P

F n

F/P factor  To find F given P F n To Find F given P ………….

To Find F given P

…………. N
………….
N
F/P factor  To find F given P F n To Find F given P ………….

P 0

Compound forward in time

F/P factor     F 1 = P ( 1+i ) F 2

F/P factor

F 1 = P(1+i)

F 2 = F 1 (1+i)… but:

F = P(1+i)(1+i) = P(1+i) 2

2

F 3 = F 2 (1+i) =P(1+i) 2 (1+i)

P i

3

= (1+ )

In general:

F N = P(1+i) n F N = P(F/P,i%,n)

P/F factor – discounting back in time  Discounting back from the future F n

P/F factor discounting back in time

Discounting back from the future

F n

back in time  Discounting back from the future F n …………. N P P/F f
back in time  Discounting back from the future F n …………. N P P/F f

………….

 Discounting back from the future F n …………. N P P/F f t ac or

N

P

P/F f

t

ac or

b

i

i

l

r ngs a s ng e

future sum back to a specific

point in time.

Present Worth Factor from F/P  Since F N = P(1+i) n  We solve

Present Worth Factor from F/P

Since F

N = P(1+i) n

We solve for P in terms of F N

P = F{1/ (1+i) n} = F(1+i) -n Thus:

P = F( P/F,i%,n)

where

( P/F,i%,n) = (1+i) -n

Example - F/P Analysis  Example: P = $1,000;n = 3;i = 10%  What

Example- F/P Analysis

Example: P= $1,000;n=3;i=10% What is the future value, F?

P=$1,000

 What is the future value, F? P = $ 1 , 0 0 0 0
 What is the future value, F? P = $ 1 , 0 0 0 0

0

1

2

3

i=10%/year

F = ??

F 3 = $1,000[F/P,10%,3] = $1,000[1.10] 3 = $1,000[1.3310] = $1,331.00

Uniform Series Present Worth and Capital Recovery Factors  Annuity Cash Flow P = ??

Uniform Series Present Worth and Capital Recovery Factors

Annuity Cash Flow

P = ??

1

2

3

…………

n-1

0

n

$A per period

Uniform Series Present Worth and Capital Recovery Factors  Write a Present worth expression P

Uniform Series Present Worth and Capital Recovery Factors

Write a Present worth expression

P

A

11

12

)

(1 ii)

(1



1

(1 i )

n

1

1

(1 i )

n

[1]

Term inside the brackets is a geometric progression. Mult. This equation by 1/(1+i) to yield a second equation

Uniform Series Present Worth and Capital Recovery Factors  The second equation P  1

Uniform Series Present Worth and Capital Recovery Factors

The second equation

P

1 i

A

11

)

(1



ii

23

(1

)



1

1

(1

)

n

(1

)

n

1



ii

[2]

To isolate an expression for P in terms of A, subtract Eq [1] from Eq. [2]. Note that numerous terms will drop out.

Uniform Series Present Worth and Capital Recovery Factors  Setting up the subtraction   

Uniform Series Present Worth and Capital Recovery Factors

Setting up the subtraction

 

11

 

1

1

P

A



 

 

2

 
 

P

A

(1

23

ii

)

(1

)



11

(1





ii

)

n

(1

)

1

1

n

1

[

]

[1]

-

(1

12

ii

)

(1

)



(1

i

)

n

1

(1

i

)

n

 

i P

A

1

   

1

 
 

 

=

1

i

1

1

ii

n

1

 

[3]

 

( )

(

)

 
Uniform Series Present Worth and Capital Recovery Factors  Simplifying Eq. [3] further  i

Uniform Series Present Worth and Capital Recovery Factors

Simplifying Eq. [3] further

i P

i

1

P

A

i

A

1

1

(1

1

)

n



ii

(1

)

1 1

(1

i

)

n 1

  

PA

f or i

0

i (1

i

)

n

Uniform Series Present Worth and Capital Recovery Factors  This expression will convert an annuity

Uniform Series Present Worth and Capital Recovery Factors

This expression will convert an annuity cash flow to an equivalent present worth amount one period to the left of the first annuity cash flow.

P

A

(1

 

i

)

n

1

i

(1

i

)

n

for i

0

P / A i %, n factor

Capital Recovery Factor: A/P, i%, n  Given the P/A factor     PA 

Capital Recovery Factor:

A/P, i%, n

Given the P/A factor

   

PA

i

(1

i

)

n

f or i 0

Yieldin

 

….

 

(1

 

i

)

n

1

The present worth point of an annuity cash flow is always one period to the left of the first A amount

Solve for A in terms of P

cash flow is always one period to the left of the first A amount Solve for

A/P,i%,n factor

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period

F/A and A/F Derivations

$F

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period Find

Annuity Cash Flow

…………
…………
…………
…………
…………
…………
…………

…………

…………
…………
…………
…………

0

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period Find

N

$A per period

Find $A given the Future amt. - $F

Si nki ng F un d an d S er i es C ompoun d

Sinking Fund and Series Compound amount factors (A/F and F/A)

Recall:

Also:

 n (1  i )  n  i (1  i ) 
n
(1
 i
)
n
i
(1
i
)
A
P
n
(1
i
)
1

Substitute “P” and simplify!

A/F F ac tor  By substitution we see:  Simplifying we have:  Which

A/F Factor

By substitution we see:

Simplifying we have:

Which is the (A/F,i%,n) factor

A F

1

(1

i

)

n

 





i

(1

i

)

n

(1

n

 i )

1

A F  

i

(1 i )

n

1

F/A f ac t or f rom the A/F F ac tor  Given: 

F/A factor from the A/F Factor

Given:

A F

i

(1

i

)

n

1

F =A

 

(1

i

)

n

1

 

i

Solve for F in terms of

A

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period

F/A and A/F Derivations

$F

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period Find

Annuity Cash Flow

…………
…………
…………
…………
…………
…………
…………

…………

…………
…………
…………
…………

0

F/A and A/F Derivations $F  Annuity Cash Flow ………… 0 N $A per period Find

N

$A per period

Find $F given thethe $A amounts

E xamp le  Formasa Plastics has ma j or fabrication plants in Texas and

Example

Formasa Plastics has major fabrication plants in Texas and Hong Kong.

It is desired to know the future worth of $1,000,000 invested at the end of each year for 8 years, starting one year from now. The interest rate is assumed to be 14% per year.

E xamp le • A = $1 , 000 , 000/ y r ; n

Example

A = $1,000,000/yr; n = 8 yrs, i = 14%/yr F 8 = ??

E xamp le • A = $1 , 000 , 000/ y r ; n =
E xamp le  Solution: The cash flow diagram shows the annual payments starting at

Example

Solution:

The cash flow diagram shows the annual payments starting at the end of year 1 and ending in the year the future worth is desired. Cash flows are indicated in $1000 units. The F value in 8 years is

F = l000(F/A,14%,8) = 1000( 13.23218) = $13,232.80 = 13.232 million 8 years from now/

Interpolation of Factors • All texts on Engineering economy will provide tabulated values of the

Interpolation of Factors

All texts on Engineering economy will provide tabulated values of the various interest factors usually at the end of the text in an appendix

Refer to the back of your text for those tables.

Int erpo la tion o f F ac t ors • Typical Format for Tabulated

Interpolation of Factors

Typical Format for Tabulated Interest Tables

Int erpo la tion o f F ac t ors • Typical Format for Tabulated Interest
Arithmetic Gradient Factors • In a pp lications, the annuit y cash flow p attern

Arithmetic Gradient Factors

In applications, the annuity cash flow pattern is not the only type of pattern encountered

Two other types of end of period patterns are common

The Linear or arithmetic gradient

The geometric (% per period) gradient

Arithmetic Gradient Factors • An arithmetic (linear) Gradient is a cash flow series that either

Arithmetic Gradient Factors

An arithmetic (linear) Gradient is a cash flow series that either increases or decreases by a contestant amount over n time periods.

A linear gradient is always comprised of TWO components:

The Gradient component

The base annuity component

The objective is to find a closed form expression for the Present Worth of an arithmetic gradient

Linear Gradient Example  A 1 +n-1G A 1 +n-2G Assume the following: A 1

Linear Gradient Example

A 1 +n-1G

A 1 +n-2G Assume the following: A 1 +2G A 1 +G 0 1 2
A 1 +n-2G
Assume the following:
A 1 +2G
A 1 +G
0
1
2
3
n-1
N

This represents a positive, increasing arithmetic gradient

E xamp l e: Li near G ra dien t • Typical Negative , Increasing

Example: Linear Gradient

Typical Negative, Increasing Gradient: G=$50

The Base Annuity = $1500
The Base Annuity
= $1500
Ar ith me ti c G ra dien t F ac t ors • The

Arithmetic Gradient Factors

The “G” amount is the constant arithmetic change from one time period to the next.

The “G” amount may be positive or negative!

The present worth point is always one time period to the left of the first cash flow in the series or,

Two periods to the left of the first gradient cash flow!

The A/G Factor  Convert G to an equivalent A A  GP ( /

The A/G Factor

Convert G to an equivalent A

A GP(

/ Gin, ,

How to do it…………

)( A / Pin, ,

)

Gradient Example • Consider the following cash flow $500 $400 $300 $200 $100 0 1

Gradient Example

Consider the following cash flow

$500

$400 $300 $200 $100 0 1 2 3 4 5 Present Worth Point is here!
$400
$300
$200
$100
0
1
2
3
4
5
Present Worth Point is here!
And the G amt. = $100/period

Find the present worth if i = 10%/yr; n = 5 yrs

Gradient Example - Base Annuity • First , The Base Annuity of $100/period A =

Gradient Example- Base Annuity

First, The Base Annuity of $100/period

A = +$100

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

PW(10%) of the base annuity = $100(P/A,10%,5)

PW Base = $100(3.7908)= $379.08

Not Finished: We need the PW of the gradient component and then add that value to the $379.08 amount

The Gradient Component $400 $300 $200 $100 $0 0 1 2 3 4 5 We

The Gradient Component

$400 $300 $200 $100 $0 0 1 2 3 4 5
$400
$300
$200
$100
$0
0
1
2
3
4
5

We desire the PW of the Gradient Component at t = 0

P = G(P/G 10% 5) = $100(P/G 10% 5)

G@t=0

,

,

,

,

Th e G ra dien t C omponen t $400 $300 $200 $100 $0 0

The Gradient Component

$400 $300 $200 $100 $0 0 1 2 3 4 5
$400
$300
$200
$100
$0
0
1
2
3
4
5

P G@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

G  (1  i )  1 N P=     N
G
(1
i
)
1
N
P=
N
N
i
ii
(1
)
(1
i
)

Could substitute n=5 i=10%

,

and G = $100 into the P/G closed form to get the value of the factor.

PW o f the G ra dien t C omponen t P G @ t

PW of the Gradient Component

P G@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

P/G,10%,5)

Sub. G=$100;i=0.10;n=5

= $100(P/G,10%,5) P/G,10%,5) Sub. G=$100;i=0.10;n=5 6.8618 Calculating or looking up the P/G,10%,5 factor
= $100(P/G,10%,5) P/G,10%,5) Sub. G=$100;i=0.10;n=5 6.8618 Calculating or looking up the P/G,10%,5 factor
= $100(P/G,10%,5) P/G,10%,5) Sub. G=$100;i=0.10;n=5 6.8618 Calculating or looking up the P/G,10%,5 factor

6.8618

Calculating or looking up the P/G,10%,5 factor yields the following:

P t=0 = $100(6.8618) = $686.18 for the gradient PW

G ra dien t E xamp l e: Fi na l R esu lt •

Gradient Example: Final Result

PW(10%) Base Annuity = $379.08

PW(10%) Gradient Component = $686.18

Total PW(10%) = $379.08 + $686.18

Equals $1065.26

Note: The two sums occur at t =0 and can be added together – concept of equivalence

Example Summarized This Cash Flow … $500 $400 $300 $ 200 $100 0 1 2

Example Summarized

This Cash Flow

$500

$400 $300 $ 200 $100 0 1 2 3 4 5 Is equivalent to $1065.26
$400
$300
$ 200
$100
0
1
2
3
4
5
Is equivalent to $1065.26 at time 0 if the interest rate
is 10% per year!
Wh en the i – ra t e i s un k nown • A

When the i – rate is unknown

A class of problems may deal with all of the parameters know except the interest rate.

For many application-type problems, this can become a difficult task

Termed, “rate of return analysis”

In some cases:

i can easily be determined

In others, trial and error must be used

E xamp l e: i un k nown • A ssume one can invest $

Example: i unknown

Assume one can invest $3000 now in a venture in anticipation of gaining $5,000 in five (5) years.

If these amounts are accurate, what interest

rate equates these two cash flows?

$5,000

0

1

2

3

4

5

these two cash flows? $5,000 0 1 2 3 4 5 • F = P( 1+i

F = P(1+i) n 5,000 = 3,000(1+i) 5 (1+i) 5 = 5,000/3000 = 1.6667

$3,000

E xamp l e: i un k nown • A ssume on can invest $

Example: i unknown

Assume on can invest $3000 now in a venture in anticipation of gaining $5,000 in five (5) years.

If these amounts are accurate, what interest rate equates these two cash flows?

$5,000

what interest rate equates these two cash flows? $5,000 0 1 2 3 4 5 •

0

what interest rate equates these two cash flows? $5,000 0 1 2 3 4 5 •

1

2

3

4

5

(1+i) 5 = 5,000/3000 = 1.6667

(1+i) = 1.6667 0.20

i = 1.1076 – 1 = 0.1076 = 10.76%

$3,000

F or “i” un k nown • In g eneral , solvin g for “i”

For “i” unknown

In general, solving for “i” in a time value formulation is not straight forward.

More often, one will have to resort to some form of trial and error approach as will be shown in future sections.

A sample spreadsheet model for this problem follows.

Unk nown N um b er o f Y ears • Some p roblems re

Unknown Number of Years

Some problems require knowing the number of time periods required given the other parameters

Example:

How long will it take for $1,000 to double in

value if the discount rate is 5% per year?

Draw the cash flow diagram as….

i = 5%/year; n is unknown!

0

1

2

.

.

.

…….

n

diagram as…. i = 5%/year; n is unknown! 0 1 2 . . . ……. n

P = $1,000

F n = $2000

Unk nown N um b er o f Y ears • Solvin g we have…

Unknown Number of Years

Solving we have…

0

1

2

.

.

.

…….

n

we have… 0 1 2 . . . ……. n P = $1,000 F = $2000

P = $1,000

F = $2000

n

F n=? = 1000(F/P,5%,x): 2000 = 1000(1.05) x Solve for “x” in closed form……

Unk nown N um b er o f Y ears • Solvin g we have…

Unknown Number of Years

Solving we have…

(1.05) x = 2000/1000

Xln(1.05) =ln(2.000)

X = ln(1.05)/ln(2.000)

X = 0.6931/0.0488 = 14.2057 yrs

With discrete compounding it will take 15 years to amass $2,000 (have a little more that

$2,000)