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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 economically equivalent if:

We consider an interest rate and,

No. of time periods between the two sums

Equality in terms of Economic Value

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 Rates and Returns

INTEREST RATE

INTEREST PER TIME UNIT

ORIGINAL AMOUNT

Interest can be viewed from two perspectives:

Lending situation

Investing situation

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

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 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 Factors

3. F/A and A/F Factors

4. Interpolate Factor Values

5. P/G and A/G Factors

F/P factor

To find F given P

F n

To Find F given P

………….
N

P 0

Compound forward in time

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

………….

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 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 is the future value, F?

P=\$1,000

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 = ??

 1 2 3 ………… n-1

0

n

\$A per period

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 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

  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 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 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    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

A/P,i%,n factor

F/A and A/F Derivations

\$F

Annuity Cash Flow

…………

0

N

\$A per period

Find \$A given the Future amt. - \$F

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

Recall:

Also:

n
(1
 i
)
n
i
(1
i
)
A
P
n
(1
i
)
1

Substitute “P” and simplify!

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 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

Find \$F given thethe \$A amounts

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.

Example

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

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 various interest factors usually at the end of the text in an appendix

Refer to the back of your text for those tables.

Interpolation of Factors

Typical Format for Tabulated Interest Tables

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 geometric (% per period) gradient

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 base annuity component

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

A 1 +n-1G

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

The Base Annuity
= \$1500

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(

/ Gin, ,

How to do it…………

)( A / Pin, ,

)

Consider the following cash flow

\$500

\$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

First, The Base Annuity of \$100/period

A = +\$100

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

\$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

,

,

,

,

\$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
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.

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

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

PW(10%) Base Annuity = \$379.08

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
3
4
5
Is equivalent to \$1065.26 at time 0 if the interest rate
is 10% per year!

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

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

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

\$3,000

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

0

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

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.

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

P = \$1,000

F n = \$2000

Unknown Number of Years

Solving we have…

0

1

2

.

.

.

…….

n

P = \$1,000

F = \$2000

n

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

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)