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Chapter 4 Part II The Time Value of Money - Part II

Instructor: Joonyup Eun

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Contents

A Uniform Series (Annuity) to Its Present and Future Equivalent Values Deferred Annuities (Uniform Series) Equivalence Calculations Involving Multiple Interest Formulas

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A Uniform Series (Annuity) to Its Present and Future Equivalent Values


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Definition of Annuity

An annuity is a series of equal (uniform) cash flows occurring at fixed time intervals.

The first cash flow occurs at the end of the first period. The last cash flow occurs at the end of the last period

N-1

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Preliminary Geometric Series

Lets define

1 = , 2 = , 3 = 2 , , = 1 , = =1

Calculate = + + 2 + + 1 = + 2 + + 1 + = 1 = 1 1 = 1

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Finding F when Given A

Find the future equivalent at the end of th period of an annuity, a series of .


=
=1

1 = 1

N-1

N 1 + 1 + 1 + 1 +

3 2 1
1

= + 1 + + 1 + 2 + + 1 + 2 + 1 + 1 1 + 1 + 1 = = 1 1 +
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Finding F when Given A

Let , %,

1+ 1 = . Then 1 + 1

= , %,

Example:

Interest at 8% per year Receiving $502 each year for the next 3 years.
$502 $502 $502

=?

0 =
7
1+

2 = 502
1+0.08 0.08

3 1

3 =1629.693

= 8%

= , %, = 502 , 8%, 3 = 502 3.2464 = 1629.693


Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding P when Given A

Find the present equivalent of an annuity, a series of .

=
=1

1 = 1

0 1 1 + 1 1 + 2 1 + 3 1 + (1) 1 + = 1 + = 1 +
8
1 1

N-1

+ 1 +
2

+ 1 +

+ + 1 +

+ 1 +

1 1 + 1 1 +

1 + 1 = 1 +

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding P when Given A

Let , %, = Example:

1+ 1 1+

. Then

= , %,

Interest at 8% per year Receiving $502 each year for the next 3 years.
=? $502 $502 $502 = 8%

2 = 502

1+ 1 1+

1+0.08 3 1 =1293.703 0.08 1.08 3

= , %, = 502 , 8%, 3 = 502 2.5771= 1293.704


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Relationship between and


= 1629.693

= 1293.703 $502
$502 $502

= 8%

= , %, 1293.703 = 1629.693 , 8%, 3 = 1629.693 0.7938 = 1293.703 = , %, = , %, , %, = , %, , %, , %, = , %, , %,


1+ 1 1+
10

1+ 1

1 1+

1+ 1 1+

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Finding A when Given F


1+ 1

1+ 1

Let , %, =

1+ 1

, Then

= , %, Example: You need $1,000,000 ten years later. You will make 10 yearly deposits in a saving account at the end of each year. The interest rate is 5% per year. How much money you need to pay every year?

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Finding A when Given F

Example:You need $1,000,000 ten years later.You will make 10 yearly deposits in a saving account at the end of each year. The interest rate is 5% per year. How much money you need to pay every year? = 1,000,000

10

= 5%

= , %, = 1,000,000 , 5%, 10 = 1,000,000 0.0795 = 79,500

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Finding A when Given P

1+ 1 1+

=
1+ 1+ 1

1+ 1+ 1

Let , %, =

, then

= , %, Example:You plan to borrow a loan of $100,000 which you will repay with equal annual payments for the next 5 years. Suppose the interest rate you are charged is 8% per year and you will make the first payment one year after receiving the loan. How much is your annual payment?

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Finding A when Given P

Example:You plan to borrow a loan of $100,000 which you will repay with equal annual payments for the next 5 years. Suppose the interest rate you are charged is 8% per year and you will make the first payment one year after receiving the loan. How much is your annual payment?

$100,000 = 8% 0 1 2 3 4 5

= , %, = 100,000 , 8%, 5 = 100,000 0.2505


= 25,050
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Other consideration

For the problems that

Finding the number of cash flows in an Annuity Given A,P and I Example

= 1,000,000

1 = 1,000

N-1

N?

= 5%

1,000,000 = 1,000 , 5%, = 1,000


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1+0.05 1 0.05 1+0.05

N?

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Other consideration

For the problems that

Finding the interest rate I, Given A, F and N = 1,000,000 Example

49

50

=?

= 1,000
1+ 50 1

1,000,000 = 1,000 , %, 50 = 1,000

=?

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Other consideration

For the problems that

Finding the interest rate I, Given A, F and N Finding the number of cash flows in an Annuity Given A,P and I

No closed form (analytical) solution is known. We can solve these problems numerically. Please refer to Excel help session.

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Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV= FV= Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV= FV= Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV= FV=
Plan 1
0 = 1000 , 10%, 3 10,000 , 10%, 3 = 10,000 1 $1,000 2 $1,000 3 $1,000

= 10%

=?
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$10,000
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Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV= Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV= FV= Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV= FV=
Plan 1
0 = 1000 , 10%, 3 10,000 = 13,310 1 $1,000 2 $1,000 3 $1,000

= 10%

$10,000
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=?

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Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV=13,310 Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV= FV= Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV= FV=
Plan 2
0 = 13,310 , 10%, 3 = 10,000 1 2 3 = 10%

=?
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$13,310
Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV=13,310 Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV=10,000 FV= Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV= FV=
Plan 2
0 = 13,310 1 2 3 = 10%

$13,310
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=?

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV=13,310 Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV=10,000 FV=13,310 Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV= FV=
Plan 3
0 = 4,021 , 10%, 3 10,000 1 2 3 = 10%

$4,021 =?
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$4,021

$4,021

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV=13,310 Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV=10,000 FV=13,310 Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV=10,000 FV=
Plan 3
0 = 4,021 , 10%, 3 = 13,310 1 2 3 = 10%

$4,021

$4,021

$4,021 =?

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Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example

Annual interest rate is = 10%.You have 3 plans to pay the balance back. Plan 1: Pay interest, $1,000, due at end of each year and principal, $10,000, at end of third year. PV=10,000 FV=13,310 Plan 2: Pay principal and interest, $13,310, in one payment at the end of third year PV=10,000 FV=13,310 Plan 3: Pay off the debt in 3 equal end-of-year payments of $4,021 PV=10,000 FV=13,310

All three plans are economically equivalent.

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Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the PV?
= 50,000 +6,000 , 10%, 5 3,000 , 10%, 5 +4,500 , 10%, 5 = 35,833.49

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Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the FV?
= 50,000 , 10%, 5 +6,000 , 10%, 5 3,000 , 10%, 5 +4,500 = 57,710.20 $6,000 $6,000 $6,000 $6,000 $6,000
$4500

2
$3,000

3
$3,000

4
$3,000

5
$3,000

$3,000
$50,000
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= 10% =?
Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the PV?
= 50,000 +3,000 , 10%, 4 +7,500 , 10%, 5 = 35,833.49

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Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the FV?
= 50,000 , 10%, 5 +3,000 , 10%, 4 +7,500
$7,500 $3,000 $3,000 2 $3,000 3 $3,000 4 5

$50,000
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= 10%

Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the FV?
= 50,000 , 10%, 5 +3,000 , 10%, 4 , 10%, 1 +7,500 = 57,710.20
$7,500 $3,000 $3,000 2 $3,000 3 $3,000 4 5

$50,000
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= 10%

Example

You are analyzing a project with 5-year life. The project requires a capital investment of $50,000 now, and it will generate uniform annual revenue of $6,000 at the end of each year. Further, the project will have a salvage value of $4,500 at the end of the fifth year and it will require $3,000 each year for the operation. Appropriate interest rate is 10%. What is the FV?
= 50,000 , 10%, 5 +3,000 , 10%, 5 +4,500 = 57,710.20
$3,000 $3,000 2 $3,000 3 $3,000 4 $3,000$4500 5

$50,000
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= 10%

Deferred Annuities (Uniform Series)


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Deferred Annuities

Annuity series where the first of the uniform cash flows occurs at the end of period J+1 instead of at the end of period 1 and there are N-J such cash flows. Ordinary Annuities
0 1 2 3 4 5 6 N

N-5 N-4 N-3 N-2 N-1

Deferred Annuities
0
32

N-1

J+1 J+2

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Present Value of Deferred Annuities


0

N-1

J+1 J+2

= , %,

0 = , %,
0 = , %, , %,

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Example

A father, on the day his son is born, wishes to determine what lump amount would have to be paid into an account bearing interest of 12% per year to provide withdrawals of $2,000 on each of the sons 18th, 19th, 20th, and 21st birthdays.
0 17

2,000
1 2 3 4 5 6

2,000
21 = 12%

17 18 19 20

17 = 2000 , 12%, 4 = 6,074.60 0 = 17 , 12%, 17 = 6,074.60 0.1456 0 = 884.46


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Future Value of Deferred Annuities


= , %,

=? 0 1 2 3 4 5 6 J

N-1

J+1 J+2

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Deferred Future Value of Annuities


0 1 2 J-1 J J+1 N-1 =?

= , %,
= , %, = , %, , %,

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Example

When you take your first job, you decide to start saving right away for your retirement.You put $5,000 per year into the companys 401(k) plan, which averages 8% interest per year. Five years later, you move to another job and start a new 401(k) plan. You never get around to merging the funds in the two plans. If the first plan continued to earn interest at the rate of 8% per year for 35 years after you stopped making contributions, how much is the account worth?
0 1 2 3 4 5 6 17 18 19 39 40 = 8%

5,000

5,000

5 =?
5 = 5,000 , 8%, 5 = 5,000 5.8666 = $29,333.3 40 = 5 , 8%, 35 = 29,333.3 14.7853 = $433,697 $433,697 in the account
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40 =?

Equivalence Calculations Involving Multiple Interest Formulas


38 Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example
0 1 2 $200 $500 $400 $400 $400 $400 $400 3 4 5 6 7 8

= 20%

$100

The present equivalent expenditure 0 The future equivalent expenditure 8 The annual equivalent expenditure

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Example (Present equivalent expenditure 0 )


0 1 2 $200 $500 0 0 = 100 , 20%, 1 200 , 20%, 2 500 , 20%, 3 400 , 20%, 5 , 20%, 3 = 83.33 138.88 289.35 692.26 = 1,203.82 $400 $400 $400 $400 $400 3 4 5 6 7 8

= 20%

$100

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Example (Future equivalent expenditure 8 )


0 1 2 $200 $500 0 = 1,203.82 $400 $400 $400 $400 $400 3 4 5 6 7 8

= 20%

$100

8 = 100 , 20%, 7 200 , 20%, 6 500 , 20%, 5 400 , 20%, 5 = 0 , 20%, 8 = 1,203.82 4.2998 = 5,176.19

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Example (Annual equivalent expenditure )


0 1 2 $200 $500 0 = 1,203.82 ? = 0 , 20%, 8 = 1,203.82 0.2606 = 313.73 = 8 , 20%, 8 = 5,176.19 0.0606 = 313.73 $400 $400 $400 $400 $400 3 4 5 6 7 8

= 20%

$100

8 = 5,176.19

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