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University of Toronto
Course: CHE349
File: CHE349/CashFlowA4
Course:
Economic Equivalence
How do we measure and compare economic worth of
various cash flow profiles? We need to know:
Magnitude of cash flows
Their direction (receipt or disbursement)
Timing (when does transaction occur)
Applicable interest rate(s) during time period under consideration
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An Example of Equivalence
Suppose you are offered the alternative of receiving
either $3,000 at the end of 5 yrs (guaranteed) or P
dollars today. You would deposit the P dollars into an
account that pays 8% interest. What value of P would
make you indifferent to your choice between P dollars
today and the $3,000 at the end of 5 yrs?
Determine the present amount that is economically
equivalent to $3,000 in 5 yrs given the investment
potential of 8% per year.
F = $3,000, N = 5 years, i = 8% per year
Find P
P = F/(1+i)N = $2,042
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Economic Equivalence:
General Principles
Equivalence calculations to compare alternatives
require a common time basis
Equivalence depends on the interest rate
May require conversion of multiple payment cash flow
to a single cash flow
Equivalence is maintained regardless of the individual's
point of view (borrower or lender)
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Equivalence - A Factor
Approach
Now we can look at organizing the approach to
Engineering Economy by defining its language and
notations.
Engineering Economy Factors apply compound interest
to calculate equivalent cash flow values. The tabulated
values at the end of the book (or you can use the
functions in spreadsheets) convert from one cash flow
quantity (P, F, A, or G) to another.
Assumptions:
1. Interest is compounded once per period
2. Cash flow occurs at the end of the period
3. Time 0 is period 0 or the start of period 1
4. All periods are the same length
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Definitions
The following are the definitions for the variables used:
i interest rate per period, expressed as a decimal
N Number of periods (also called the study horizon)
P Present cash flow, or value equivalent to a cash flow
series
F Future cash flow at the end of period N, or future worth
at the end of period N equivalent to a cash flow series
A Uniform periodic cash flow (annuity) at the end of every
period from 1 to N. Also a uniform constant amount
equivalent to a cash flow series.
G Gradient or constant period-by-period change in cash
flows from period 1 to N (arithmetic series)
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Factor Notation
These have their roots in the pre-computer age when
prepared tables were used by engineers for many
design needs. However, they still serve to state the
problem and can be used to solve it too.
The format of engineering economy factors is:
(X/Y, i%, N) where X and Y are chosen from the cash
flow symbols P,F,A and G.
So, if you have Y multiplied by a factor, you get the
equivalent value of X: P = A(P/A, i ,N) e.g. convert from
a cash flow (F) in year 10 to an equivalent present
value (P), the factor is:
(P/F, i N) - see text pages after 559 for the tables
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N-1
P
P = $2,000, i = 10% per year, N = 8 years
F = P(1+i)N =$2,000(1+0.10)8= $4,287.18
F = P (F/P,10%, 8)=$2,000*2.1436 =$4,287.20
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N-1
P
If $1,000 is to be received in 5 years. At an annual
interest rate of 12%, what is the P of this amount?
F=$1000, i = 12%, N = 5 years
P = F/(1+i)N= $1000/(1+.12)5 = $567.40
P = F(P/F, 12%,5) = $1000(0.5674) = $567.40
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Discrete Compounding,
Discrete Cash Flows P. 571
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Combining Factors
We can combine these factors in various ways to create
a model for the real problem at hand:
delayed income stream because of startup time
another need may be prepaid expenses - also a way to deal
with startup delays or construction delays.
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A Simple Example
We invest $120,000 [P=-120,000]
We pay for 5 years $30,000/year [P=30,000(P/A,12%,5)]
Then pay $35,000 at year 3 [P=-35,000(P/F,12%,3)]
Receive $40,000 at year 4 [P=40,000(P/F,12%,4)]
$40,000
$30,000
$30,000
$35,000
$120,000
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N-2 N-1
K1
A(1 + i)-K
(1 i) N 1
P = A
n
i(1 i)
Series Present Worth Factor
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P = A(P/A i, N)
p.62 Text
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p.60 text
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Bonds
Financial instrument used by large firms and
government to raise funds to finance projects, debt
obligations,
A special form of loan, usually with a long term
The creditor (firm or government) promises to pay a
stated amount of interest at specified intervals for a
defined period and then to repay the principal at a
specific date (maturity date)
Canada savings bonds usually represent the lowest
interest because they are the safest (set tone for
interest rates), then are provincial bonds, next are
Blue-Chip corporates (banks, large firms)
Junk bonds are very high interest and risk
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Bond Terminology
P = Purchase price of a bond
F = Sales price (or redemption value) of a bond
V = Par (face) value the stated value on the bond
r = annual interest shown (or coupon rate)
n = compounding period (quarterly, six months, etc.)
i = the yield rate per annum (usually the market rate)
N = number of remaining years to maturity
Redemption when the issuer pays for it in cash
Maturity Date date on which the par value is to be
repaid (date bond expires)
Market Value the price one has to pay to buy a bond
A = V(r/n) = the value of a single interest payment (a
coupon)
P = V(r/n) (P/A, i/n, nN) + F (P/F, i, N)
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Bond Valuation
Yield to maturity (return on investment) = actual
interest earned from a bond over the holding period
(equivalent to IRR calculations)
When considering buying or selling bonds, the yield is
the fundamental consideration and this depends on a
number of issues:
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Canadian Bonds
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Example of Arithmetic
Gradients
We have two propositions for investment:
New Multi Processor Computer
Natural Gas Pipeline
Natural Gas
-$50,000
+$5,000
+$10,000
+$15,000
+$20,000
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(+)
$5,000
0
(-)
Computer
Option
$50,000
$20,000
$15,000
$10,000
$5,000
0
(-)
Natural Gas
Option
$50,000
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Arithmetic Gradients
An easy definition of an arithmetic gradient is: revenue
grows by $10,000 (G) each year.
(N-1)G
But the rate is not always constant
3G
2G
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Arithmetic Gradients
cont'd...
A series of receipts or disbursements that start at 0 at
the end of the 1st period and then increase by a
constant amount from period to period.
e.g. increasing operating costs for an aging machine
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A(1+g)
A(1+g)N-1
A(1+g)3
A(1+g)2
N-1
N-2
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Geometric Gradients
We can define a growth adjusted interest rate i0:
i0
1 i
1
1 g
So that
1
1 g
0
1 i
1 i
i>g>0
g>i>0
g=i>0
1 g
g<0
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Geometric Gradients
Formulas
(P / A, i, N)
(P / A, g, i, N)
or
(1 g)
(1 i) N 1 1
(P / A, g, i, N)
N
i(1 i) 1 g
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Deferred Annuity
If the cash flow does not begin until some later date,
the annuity is known as deferred annuity.
Annuity is deferred for J periods.
P0 = A (P/A, i%, N-J) ( P/F, i%, J)
A
0 1
J+2
J+1
J+3
N-1
P=?
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12
16
20
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Different Solutions
Method 1: consider each cash flows separately
F = 1000 (F/P,4%,16) + 1000 (F/P,4%,12) + 1000
(F/P,4%,8) + 1000 (F/P,4%,4) + 1000 = $7013
Method 2: convert the compounding period from annual
to every four years
ie = (1+0.04)4-1 = 16.99%
F = 1000 (F/A, 16.99%, 5) = $7013
Method 3: convert the annuity to an equivalent yearly
annuity
A = 1000(A/F,4%,4) = $235.49
F = 235.49 (F/A,4%,20) = $7012
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PW Computations when N
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PW when N
Until now, we assumed that the horizon N is a fixed
number of years.
The present worth of a very long and uniform series of
cash flows is calculated as:
P lim A(P / A,i ,N )
N
(1 i )N 1
P A lim
N
N
i
(1
i
)
1
1
(1 i )N
P A lim
N
i
A
P
i
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