You are on page 1of 12
Concepts from the example problems ( F / P, i, N) ( P / F, i,
Concepts from the example problems
Concepts from the
example problems

( F / P, i, N) ( P / F, i, N)

( F / A, i, N)

( A / F, i, N) ( P / A, i, N)

( A / P, i, N)

( P / G, i, N) ( A / G, i, N)

Problem 1 Problem 2 Problem 3 Problem 4 Problem 5 Problem 6 Problem 7 Problem 8

Example 1 How much would you have to deposit today to have $2000 in 4 years
Example 1
Example 1

How much would you have to deposit

today to have $2000 in 4 years if you can

get a 12% interest rate compounded annually?

GIVEN:

DIAGRAM:

$2 000 0 1 2 3 n=4 P?
$2 000
0
1
2
3
n=4
P?

F 4 = $2 000

i

FIND P:

=

12%

P = F 4 (P/F,i,n) = 2 000(P|F,12%,4) = 2 000(0.6355) = $1 271

Example 1 How much would you have to deposit today to have $2000 in 4 years
Example 1 How much would you have to deposit today to have $2000 in 4 years
• Different Ways of Looking at P/F From previous example, if you can earn 12% compounded

Different Ways of Looking at P/F
Different Ways
of Looking at P/F

From previous example, if you can earn 12%

compounded annually, you need to deposit

$1271 to have $2000 in 4 years.

You are indifferent between $1271 today and

$2000 in 4 years, assuming you can earn a

return on your money of 12%.

The present worth of $2000 in 4 years is $1271 (i = 12% cpd annually).

my abbreviation for compounded

If you could get 13% on your money, would you rather have the $1271 today, or $2000 in 4 years ?

Example 2 Tuition costs are expected to inflate at the rate of 8% per year. The
Example 2
Example 2

Tuition costs are expected to inflate at the

rate of 8% per year. The first year’s

tuition is due one year from now and will be $10,000. To cover tuition cost for 4

years, a fund is to be set up today in an

account that will earn interest at the rate of 5% per year, compounded annually. How much must be deposited into the

fund today in order to pay the 4 years of

tuition expenses?

Present Given Gradient (Geometric) • g is the geometric gradient over the time period  (time

Present Given Gradient (Geometric)

g is the geometric gradient over the time period

  • (time period: Time 0 to Time n, 1st flow at Time 1)

P is the present value of the flow at Time 0

  • (n periods in the past)

i is the effective interest rate for each period

0

n     ( 1  g )    1  
n
 (
1  g
) 
 1 
(
1 
i )
when
i
g
i
g
A g , ,
,
i n
)
 
n
when
i
g
(
1 
i )
P ? 1 2 3 n ( P / A 1 g = % P =
P ?
1
2
3
n
(
P
/
A 1
g = %
P = A 1 (P/A,g,i,n)

Note: cash flow starts with A 1 at Time 1, increases by constant g% per period

Example 2 Tuition costs are expected to inflate at the rate of 8% per year. The
Example 2
Example 2

Tuition costs are expected to inflate at the rate of 8% per

year. The first year’s tuition is due one year from now and

will be $10,000. To cover tuition cost for 4 years, a fund is

to be set up today in an account that will earn interest at the rate of 5% per year, compounded annually. How much must be deposited into the fund today in order to pay the 4

years of tuition expenses?

Example 2 - Concept If your rich Aunt Edna wanted to put a sum of money
Example 2 - Concept
Example 2 - Concept

If your rich Aunt Edna wanted to put a

sum of money in the bank today to pay

for your next four years of tuition, that sum would be $39,759 assuming 5%

return on investment and tuition that

begins at $10,000 increasing by 8% per year. This problem assumes tuition is due at the end of the year.

Complex Cash Flows Complex Cash Flows – Break apart (or separate) complex cash flows into component
Complex Cash Flows
Complex Cash Flows

Complex Cash Flows Break apart (or separate) complex cash flows into component cash flows in order to use the standard formulas.

Remember: You can only combine

cash flows if they occur at the same

point in time.

(This is like building with LEGOs!)

Problem 3 A construction firm is considering the purchase of an air compressor. The compressor has
Problem 3
Problem 3

A construction firm is considering the purchase of an air compressor.

The compressor has the following expected end of

year maintenance costs:

Year 1

$800

Year 2

$800

Year 3

$900

Year 4

$1000

Year 5

$1100

Year 6

$1200

Year 7

$1300

Year 8

$1400

What is the present equivalent maintenance cost if the interest rate is 12% per year compounded annually?

Problem 3 – Alt Soln 1 MAINT COST PER DIAGRAM GIVEN: i = 12%/YR, CPD ANNUALLY
Problem 3 – Alt Soln 1
Problem 3 – Alt Soln 1

MAINT COST 1-8 PER DIAGRAM

GIVEN:

  • i = 12%/YR, CPD ANNUALLY

FIND P: P = P A + P G + P F = A(P/A,i,n) + G(P/G,i,n) + F(P/F,i,n)

= $700(P/A,12%,8) + $100(P/G,12%,8) + $100(P/F,12%,1)

DIAGRAM:

= $700(4.9676) + $100(14.4715) + $100(0.8929) = $5014 P A ?

Problem 3 – Alt Soln 1 MAINT COST PER DIAGRAM GIVEN: i = 12%/YR, CPD ANNUALLY

1

2

3

4
4

n=8

P G ?
P G ?

P F ?

0
0

$700

n=1

1 2 3 4 $100 $200 $300
1
2
3
4
$100
$200
$300

n=8

$700

P ? 1 2 3 4 n=8 0 $700 $100 $100 $200 $300 $700
P ?
1
2
3
4
n=8
0
$700
$100
$100
$200
$300
$700

$100

NOTE: CAN BREAK INTO 3 CASH FLOWS:

ANNUAL, LINEAR GRADIENT, AND FUTURE

Problem 3 – Alt Soln 2 MAINT COST PER DIAGRAM GIVEN: i = 12%/YR, CPD ANNUALLY
Problem 3 – Alt Soln 2
Problem 3 – Alt Soln 2

MAINT COST 1-8 PER DIAGRAM

GIVEN:

  • i = 12%/YR, CPD ANNUALLY

FIND P: P = P A + P G (P PG ) = A(P/A,i,n) + G(P/G,i,n-1)(P/F,i,1)

= $800(P/A,12%,8) + $100(P/G,12%,7)(P/F,12%,1)

DIAGRAM:

= $800(4.9676) + $100(11.6443)(0.8929) = $5014 P A ?

Problem 3 – Alt Soln 2 MAINT COST PER DIAGRAM GIVEN: i = 12%/YR, CPD ANNUALLY

1

2

3

4
4

n=8

0 P G ?
0
P G ?
0
0
Problem 3 – Alt Soln 2 MAINT COST PER DIAGRAM GIVEN: i = 12%/YR, CPD ANNUALLY

P PG ?

0 1 2 3 1 $100 $200 P G ?
0
1
2
3
1
$100
$200
P G ?
P ? 1 2 3 4 n=8 0 $800 $100 $200 $600
P ?
1
2
3
4
n=8
0
$800
$100
$200
$600

$800

n=7

NOTE: P G MUST BE OFFSET ONE YEAR SO BRING THE OFFSET YEAR BACK TO TIME ZERO

$600

Problem 4 A young couple has decided to make advance plans for financing their 3 year
Problem 4
Problem 4

A young couple has decided to make advance plans for

financing their 3 year old daughter’s college education.

Money can be deposited at 8% per year, compounded

annually.

What annual deposit on each birthday, from the 4 th to the 17 th (inclusive), must be made to provide $7,000 on each birthday from the 18 th to the 21 st (inclusive)?

DIAGRAM:

17 18
17
18

$7 000

4

0
0

21 yrs

A ?

GIVEN:

WITHDRAWALS 18-21 = $7 000

i = 8%/YR, CPD YEARLY

FIND A 4-17 :

P 17 = A(F/A,i,n) = A(P/A,i,n) = A(F/A,8%,14) = 7 000(P/A,8%,4)

STRATEGY: CAN BREAK INTO 2 CASH FLOWS,

SO PICK A CONVENIENT POINT IN TIME AND SET

DEPOSITS EQUAL TO WITHDRAWALS…

= A(24.2149) = 7 000(3.3121) A = $957