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
How much would you have to deposit
today to have $2000 in 4 years if you can
get a 12% interest rate compounded annually?
_{G}_{I}_{V}_{E}_{N}_{:}
DIAGRAM:
F _{4} = $2 000
i
FIND P:
=
12%
P = F _{4} (P/F,i,n) = 2 000(PF,12%,4) = 2 000(0.6355) = $1 271
•

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 ?
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
•
P is the present value of the flow at Time 0
•
i is the effective interest rate for each period
0
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 = A 1 (P/A,g,i,n)
Note: cash flow starts with A _{1} at Time 1, increases by constant g% per period
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?
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 – 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!)
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?
MAINT COST _{1}_{}_{8} PER DIAGRAM
GIVEN:
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} ?
1
2
3
n=8
P _{F} ?
$700
n=1
n=8
$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
MAINT COST _{1}_{}_{8} PER DIAGRAM
GIVEN:
FIND P: P = P _{A} + P _{G} (P _{P}_{G} ) = A(P/A,i,n) + G(P/G,i,n1)(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} ?
1
2
3
n=8
P PG ?
0
1
2
3
1
$100
$200
P G ?
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
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 ^{t}^{h} to the 17 ^{t}^{h} (inclusive), must be made to provide $7,000 on each birthday from the 18 ^{t}^{h} to the 21 ^{s}^{t} (inclusive)?
DIAGRAM:
$7 000
4
21 yrs
A ?
GIVEN:
WITHDRAWALS _{1}_{8}_{}_{2}_{1} = $7 000
i = 8%/YR, CPD YEARLY
FIND A _{4}_{}_{1}_{7} :
P _{1}_{7} = 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