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CHAPTER 2
5. 6. 7. 8.
Derivation by Recursion: F/P factor F = P(1+i) F = F (1+i)..but: F = P(1+i)(1+i) = P(1+i)2 F =F (1+i) =P(1+i) 2 (1+i)
1 2 2 3 1 2
= P(1+i) 3 In general:
Fn = P(1+i)n Fn = P(F/P,i%,n)
Present Worth Factor from F/P Since Fn = P(1+i)n We solve for P in terms of FN P = F{ 1/ (1+i)n} = F(1+i)n
Desire an expression for the present worth P of a stream of equal, end of period cash flows A
Uniform Series Present Worth and Capital Recovery Factors Write a Present worth expression
Uniform Series Present Worth and Capital Recovery Factors The second equation
Uniform Series Present Worth and Capital Recovery Factors Setting up the subtraction
Uniform Series Present Worth and Capital Recovery Factors Simplifying Eq. [3] further
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.
Sinking Fund and Series Compound amount factors (A/F and F/A)
A/F Factor
Example: Formosa Plastics has major fabrication plants in Riyadh and in Jaddh. 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. Sol. Example:
A = $1,000,000/yr; n = 8 yrs, i = 14%/yr F8 = ??
Solution of Example 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
Example:
How much money must Carol deposit every year starting, l year from now at 5.5% per year in
Solution of Example The cash How diagram from Carol's perspective fits the A/F factor. A= $6000 (A/F,5.5%,7) =6000(0.12096) = $725.76 per year The A/F factor Value 0f 0.12096 was computed using the A/F factor formula
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
An Example
Assume you need the value of the A/P factor for i = 7.3% and n = 10 years. 7.3% is most likely not a tabulated value in most interest tables So, one must work with i = 7% and i = 8% for n fixed at 10 Proceed as follows
Using a previously programmed spreadsheet model the exact value for 7.3% is:
The base annuity component The objective is to find a closed form expression for the Present Worth of an arithmetic gradient Linear Gradient Example
G=$50
2 periods to the left of the 1G point or, 1 period to the left of the very first cash flow in the gradient series. DO NOT FORGET THIS!
Present Worth Point
Gradient Component
Present Worth Point PW of the Base Annuity is at t=0 PWBASE Annuity=$100(P/A,i %,7)
Present Worth: Linear Gradient The present worth of a linear gradient is the present worth of the two components: 1. The Present Worth of the Gradient Component and, 2. The Present Worth of the Base Annuity flow Requires 2 separate calculations! Present Worth: Gradient Component The PW of the Base Annuity is simply the Base Annuity A{P/A, i%, n} factor
What is needed is a present worth expression for the gradient component cash flow. We need to derive a closed form expression for the gradient component. Present Worth: Gradient Component General CF Diagram Gradient Part Only
Next Step: Factor out G and re-write as .. Factoring G out. P/G factor
We have 2 equations [1] and [2]. Next, subtract [1] from [2] and work with the resultant equation. Subtracting [1] from [2] ..
Extension The A/G factor Some authors also include the derivation of the A/G factor. A/G converts a linear gradient to an equivalent annuity cash flow. Remember, at this point one is only working with gradient component There still remains the annuity component that you must also handle separately! The A/G Factor
Convert G to an equivalent A
Gradient Example
PW(10%) of the base annuity = $100(P/A,10%,5) PWBase = $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 Set Up
Example Summarized
Geometric Gradient
Geometric Gradients
An arithmetic (linear) gradient changes by a fixed dollar amount each time period. A GEOMETRIC gradient changes by a fixed percentage each time period. We define a UNIFORM RATE OF CHANGE (%) for each time period Define g as the constant rate of change in decimal form by which amounts increase or decrease from one period to the next
First Major Point to Remember: A1 does NOT define a Base Annuity; There is no BASE ANNUITY for a Geometric Gradient! The objective is to determine the Present Worth one period to the left of the A1 cash flow point in time Remember: The PW point in time is one period to the left of the first cash flow A1!
Geometric Gradients: Derivation For a Geometric Gradient the following parameters are required: The interest rate per period i The constant rate of change g
Geometric Gradients
Geometric Gradients
There exist an infinite number of combinations for i, n, and g: Hence one will not find tabulated tables for the (P/A,g,i,n) factor.
You have to calculated either from the closed form for each problem or apply a pre-programmed spreadsheet model to find the needed factor value No spreadsheet built-in function for this factor!
Assume maintenance costs for a particular activity will be $1700 one year from now. Assume an annual increase of 11% per year over a 6-year time period.
If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0. First, draw a cash flow diagram to represent the model.
Solution
P= $1700(P/A,11%,8%,7) Need to calculate the P/A factor from the closed-form expression for a geometric gradient. From a spreadsheet we see:
Geometric Gradient ( -g )
Consider the following problem with a negative growth rate g.
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 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?
Example: i unknown
The Cash Flow Diagram is
Example: i unknown
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.
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!
X = 0.6931/0.0488 = 14.2057 yrs With discrete compounding it will take 15 years to a mass $2,000 (have a little more that $2,000)
Chapter Summary
This chapter presents the fundamental time value of money relationships common to most engineering economic analysis calculations Derivations have been presented for: Present and Future WorthP/F and F/P Annuity Cash flows P/A, A/P, F/A and A/F Gradients P/G, A,G and P/A,g,i,n One must master these basic time value of money
relationships in order to proceed with more meaningful analysis that can impact decision making. These relationships are important to you professionally and in your personal lives. Master these concepts!!!