Outline

1. Introduction
2. Time value of money
3. Comparison methods – Part 1
4. Comparison methods – Part 2
5. Depreciation
6. Taxes
7. Retirement and replacement
8. Inflation & Sensitivity
9. Cost estimation
10. Analysis of Project cash flows

2. Time value of money

Interest and interest rate

Equivalent values of a single cash flow

Equivalent values of multiple cash flows

Equivalent values of a uniform series of
cash flows

Equivalent values of a gradient series

Effective and nominal interest rate

Loans

Working Capital

What do you prefer $100 or $200 ?

Timing is not mentioned

$100 today vs. $200 ten years from now?

If you choose to get $100 now and invest it

in a saving account at 8% per yr. We will
have $216 ten yr. from now.
That means $100 received today is
equivalent to $216 ten yr. from now.

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Interest and interest rate
Cash flow refers to receipt or payment of an
amount of money.
Interest is the rent charged for the use of
borrowed money (monetary unit).
Interest rate is the ratio of the interest charged
during the interest period to the amount owed at
the start of the period.

i=
( A1 − A0 ) =  A1  − 1
A0 A 
 0

Interest and interest rate (cont.)

Compound and simple Interest is the rent

charged for the use of borrowed money
(monetary unit).
e.g. Consider an investment of $1,000 to be
repaid at the end of 5 periods at 10%
period amount owed Interest amount owed
at beginning during at end of the
of the period period period
1 $1,000 $100 $1,100
2 1,100 110 1,210
3 1,210 121 1,331
4 1,331 133.10 1,464.10
5 1,464 146.41 1,610.51

Interest and interest rate (cont.)

 Compound interest is the interest for each

period that is based on the amount owed at the
beginning plus the accumulated interest of all
previous periods.
 Simple interest is the interest that is calculated
using the amount owed at the beginning only.
Compound interest is always bigger than simple
interest since the earlier one calculates
“interest on interest”.

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Equivalent values of a single cash flow
Let P = amount of the original investment (Present value).
F = equivalent future amount at the end of N period
(Future value).
N = number of periods.
i = compound interest rate per period.
P
compounding

0 1 2 3 4 N
P=?
F=?

0 1 2 3 4 N
Discounting F

Equivalent values of a single cash flow (cont.)

Cash Flow Diagram is a chart used to illustrate the

magnitude and timing of cash flows as they
occurs over varios points of times.
Horizontal line (X) represents time (period).
Vertical arrows represent positive cash flows or
receipts (upward arrow) or negative cash flows or
disbursements (downward arrow).

Equivalent values of a single cash flow (cont.)

Period Amount Interest Amount
owed at during owed at end
beginning of period of period
period
1 P iP (1 + i )P
2 (1 + i )P i (1 + i )P (1 + i )2 P
3
(1+ i )2 P i (1 + i ) P
2
(1 + i )3 P
N (1 + i )N −1 P i (1 + i )N −1 P (1 + i ) N
P=F
P
compounding

0 1 2 3 4 N
F = (1+i)N P

3
 Equivalent values of a single cash flow (cont.)
For compounding process under compound
interest, we have
F = (1 + i ) P
N

which is not the same as that under simple interest

F = P + NiP = P(1+iN)

For discounting process under compound

interest, we have
F
= F (1 + i )
−N
P=
(1 + i )N

Equivalent values of a single cash flow (cont.)

Ex 2-1: Finding future value
What is the equivalent future value 5 yr. From now of $100
invested at 10% per yr.

Ex 2-2: Finding number of period
At compound interest of 10% per yr., how long will it take to
double an amount of money?

Ex 2-3: Finding present value
At compound interest of 6% per period, what is the
equivalent present value of $1,000 at the end of 20
periods?

Ex 2-4: Finding interest rate
What is the compound interest rate that a current
investment of $100 promises to yield $150 after 5 yr?

Equivalent values of a single cash flow (cont.)

From the equations listed previously, compound

interest tables, where each table represents a
specific interest rate, can be contracted

F = (1 + i ) P P = F (1 + i )
N −N

“Compound amount factor” or (F/P, i, N)

“Present worth factor”

or “ Discount factor” or (P/F, i, N)

(X/Y, i, N) = to find the equivalent amount X given

amount Y, the interest i, and the number of
compounding/discompounding periods N.

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Equivalent values of multiple cash flows
When a number of cash flows occur at different
periods, total equivalent present and future
values of the cash flow diagram are the
summation of equivalent present and future
values of every periods throughout the planning
horizon, respectively.

P=? F=?
A2
A1 AN
A0 A3
0 1 2 3 4 N
A4

Equivalent values of multiple cash flows (cont.)

P = ? discounting
N Aj N A2
P=∑ A j (1 + i )
(1 + i ) j ∑
−j AN
= A1
j =0 j =0 A0 A3
0 1 2 3 4 N
A4

compounding F=?
A2 N
F = ∑ (1 + i ) A j
j
A1 AN
A3 j =0
0 1 2 3 4 N
A4

Equivalent values of a uniform series of cash

flows
Uniform series of cash flows is the amount of
money that is identically distributed at the end of
each period throughout the cash flow diagrams.
A1 = A2 = A3 = A4 = . . . = AN A1 = A2 = A3 = A4 = . . . = AN

0 1 2 3 4 N 0 1 2 3 4 N
P=? F=?
 (1 + i )N − 1  (1 + i )N − 1
P = A N 
= A( P / A, i, N ) F = A  = A( F / A, i, N )
 i(1 + i )   i 

“Series present worth factor” “Series compound

amount factor”

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 Equivalent values of a uniform series of cash flows
(cont.)
Uniform series (Annuity) from a present
amount or a future sum
A1 = A2 = A3 = A4 = . . . = AN = ?

 i(1 + i )N 
A = P  = P ( A / P, i , N )
 (1 + i ) − 1
N
0 1 2 3 4 N

P “Capital recovery factor”

or “annuity factor”
A1 = A2 = A3 = A4 = . . . = AN = ?

 i 
A = F  = F ( A / F , i, N )
 (1 + i ) − 1
N
0 1 2 3 4 N
F
A
“Sinking fun factor”

Equivalent values of a uniform series of cash flows

(cont.)

Ex 2-6: How much can we afford to spend now on a certain
labor-saving device if the acquisition of this device is
expected to result in savings of $2,000 per month for 30
months? Assume that all saving occur at end-of-month and
our opportunity cost, the discount rate, is 2% per month.

Ex 2-7: A sum of $100, 000 is to be spent on a certain
cost-reduction program, the effects of which will be
experienced over a 10-year period. If the firm’s interest rate
is 15% per year, determine the minimum saving per year
such that this investment would be warranted? Assume
that all savings occurs end-of-year.

Ex 2-8: A sum of $10,000 is deposited into a fund earning
3% per quarter (3 mo.). If $500 is withdraw from the fund at
the end of each quarter, how long will it take to exhaust the
fund?

Equivalent values of a uniform series of cash flows

(cont.)

Ex 2-9: A sum of $800 is deposited into a fund at the
beginning of each year for 6 yr. IF the fund earns interest at
rate 0f 10% per yr., what will be the value of the fund at
then end of the sixth yr?

Ex 2-10: A consulting engineering wants to buy certain
computer equipment that will cost $4,000. How much
should he deposit into a fund at then end of each moth for
24 months if the fund is expected to earn 1% per month?.

6
 Equivalent values of a uniform series of cash flows
(cont.)
Annuity with beginning-of-period cash flows –
a inform series of cash flows occur at the
beginning, rather than the end of each period.

A A

0 1 2 N-1 N

P
P = A[1 + ( P / A, i , N − 1)]

Equivalent values of a uniform series of cash flows

(cont.)
Present value of a deferred annuity is a uniform
series that begins at the end of period n and
continues until the end of period N, 1≤ n ≤ N.
A
.........
Absolute
0 1 2 ... n-1 n N

P 0 1 ……. N–n+1 Relative

P = A(P / A, i, N − n + 1)(P / F , i, n − 1)
or
or = A[(P / A, i, N ) − (P / A, i, n − 1)]

Equivalent values of a uniform series of cash flows

(cont.)

Ex 2-11: If a funding generate interests at a rate of 12%
per yr., how much must be invested now in order to provide
withdrawals of $10,000 per yr. At the ends of years 5
through 10? Here, n = 5 and N = 10.

Ex 2-12: What is the equivalent present value of insurance
payment of $750 each, occurring at the start of every 6-
month period over 5 yr., assuming a discount rate of 14%
(nominal, per yr.) compounded semiannually?

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Equivalent values of a gradient series
Arithmetic gradient is the condition in which
cash flows increase by uniform amount from
period to period, leading to arithmetic
progression.
(N-1)G
G = amount of cash
3G flows increasing
2G uniformly from one
G
period to the next.
G G G
0 G G G

0 1 2 3 4 N

Equivalent values of a gradient series/

arithmetic gradient (cont.)
1  (1 + i )N − 1 N 
Future value: F = G  − 
 i  i  i 
 (1 + i )N − iN − 1
Present value: P = G  = G ( P / G, i, N )
 i (1 + i )
2 N


“Gradient present worth factor”

Uniform series (Annuity) value:

 (1 + i )N − iN − 1
A = G  = G ( A / G, i, N )
 i (1 + i ) − 1 
N

“Gradient uniform series factor”

Equivalent values of a gradient series/

arithmetic gradient (cont.)

Arithmetic gradient can be either positive or negative.

0 1 2 3 4 N 0 1 2 3 4 N

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 Equivalent values of a gradient series/
arithmetic gradient (cont.)

Ex 2-13: positive arithmetic gradient
Consider a series of cash flows shown in picture (a) below,
determine the equivalent present value, if an interest rate is
10% per period.

Ex 2-14: negative arithmetic gradient
Consider a series of cash flows shown in picture (b) below,
determine the equivalent uniform series, if an interest rate
is 10% per period.
i = 10% i = 10%
0 1 2 3 4 5 0 1 2 3 4 5

$100
$300
$110
$400
$120 $500
(a) $130
$140
$600 (b)
$700

Equivalent values of a gradient series (cont.)

Geometric gradient is the condition in which

cash flows increase at a constant rate, g, from
period to period, such that for a given value of
given value of A1.
A j +1 = A j (1 + g ) for j = 1,2,.., N-1
AN

A3
A2
A1

0 1 2 3 N

Equivalent values of a gradient series/

geometric gradient (cont.)
1 − (1 + g ) (1 + i )N −N

Present value: P = A1   for i ≠ g
 i−g 

P = A1 N (1 + i ) −1 for i = g

“Geometric series
present worth factor”
(P/A1,i,g,N)
(P/A1,i,g,N) can also be written as the functions of other factors
as:.
(P / A1 , i, g , N ) = 1 − (F / P, g , N )(P / F , i, N )
 i−g 

9
 Equivalent values of a gradient series/
arithmetic gradient (cont.)

Ex 2-15:
Manufacturing costs are expected to be $100,000 in the
first year, increasing by 5% each year over 7-year period.
Find the equivalent present value of these cash flows
assuming a 10% discount rate and end-of-year cash flow.

Effective and nominal interest rate

Mostly the interest rate is quoted on the annual
basis (per year).
But it is not always, especially when the interest
period is less than one year (interest is
compounded more than once per period) or
when cash flows occurs within periods (instead
of at then end of the periods).
Then, we need to understand the relationship
between period and sub-period.
Interest of 12% per year vs. 1% per month.

Effective and nominal interest rate (cont.)

1. Periods and subperiods:

F = ? We need to know
P = $1 what kind of
period basis used
to describe the
0 1 2 3 M interest rate.
j
M equal subperiods

1 period

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 Effective and nominal interest rate (cont.)

Effective interest rate (i) (per period)

P = $1 F = $1(1+iM)M

0 1 2 3 M
j
1 period
Let i = (effective) interest rate per period.
M = number of subperiods of equal length.
iM = effective interest rate per subperiod
(compounded at the end of each subperiod).

i = (1 + iM ) − 1 iM = (1 + i )
M 1
or M −1

Effective and nominal interest rate (cont.)

nominal interest rate (r) (per period)

is effective interest rate per subperiod times the
number of subperiods.
e.g., interest rate of 6% per interest period of six
months means the interest rate is 12% compounded
semiannually or the nominal interest rate is 12%, but
the actually (or effective) on the principle is not 12%,
but something bigger, since compounding occurs twice
during the year.
Let r = nominal interest rate per period.
r
r = MiM or iM =
M
Remember: always, i > r, except when M =1

Effective and nominal interest rate (cont.)

Banks often publish two rates paid on

deposited funds:

Rate corresponds to the nominal rate per

yr. (r) which also known as “APR – Annual
percentage rate”.
Yield corresponds to the effective rate per
yr. (i)

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 Effective and nominal interest rate (cont.)

Ex 2-16:
A credit card company charges the interest compounded
monthly at rate 1.5% on the unpaid balanced. What is the
effective annual rate?

Ex 2-17:
Labor costs for a certain operation are $8,000 per week,
occurring at the end of each week over 3-year period. If the
effective discount rate is 15% per year, calculate the
equivalent present value of those costs.

Effective and nominal interest rate (cont.)

2. If a period is divided into a large number of
sub-periods:
It is the case that the interest is not
compounded once (or twice or three times) a
period, but a large number of times (M→∞)
each period.
Thus, the relationship between the nominal
interest rate (r) and effective interest rate (i) is:

i = er − 1
or

r = ln (1 + i )

Effective and nominal interest rate (cont.)

Ex 2-18:
If interest is compounded continuously, what effective rate
per period (i) corresponds to a nominal rate (r) of 10%?

Ex 2-19:
A bank advertises that it will pay interest on a $10,000
certificate of deposit at a rate of 7.2% with interest
compounded “continuously”. What is the corresponding
yield?

12

Cash flows within periods
For simplicity, cash flows are assumed to occur
at the end of the periods.
However, in the real world it is not always the
case since cash flows normally occur
within/during the periods.
There are four alternative approaches to
treat the cash flow occurs within the periods.
1. No interest compounding within a
subperiod
2. Period and subperiod (End of period )
3. Continuous compounding
4. Mid-period convention

cash flows within periods (cont.)

1. No interest compounding within a subperiod
We can accumulate the subperiod cash flows to
compute a singles value for the period. M
A j = ∑ Ai, j
Approx.
i=1 Mx

A1,j$ A
x 2,j
per subperiod
A3,j AM,j

subperiod
0 1 2 3 M 0 1 2 3 M

1 period 1 period

e.g. (Ex.2-17) Wages of $8,000/wk would be roughly

equivalent to (52*$8,000) = $416,000/yr.

Using this approach, the compounding effects within

subperiod is ignored.

cash flows within periods (cont.)

2. Period and subperiod (End of period )
Cash flows occurring within each period are
compounded toward the end of the period using iM to
find the equivalent end-of-period cash flow for each
period – “discrete” cash flow. M
A j = ∑ A j (1 + iM )
j

j = M − jApprox. Mx

A1,j $Ax2,jperAsubperiod
3,j AM,j

subperiod
0 1 2 3 M 0 1 2 3 M

1 period 1 period
e.g. (2-17) Wages of $8,000/wk would be roughly
equivalent to $8,000*(F/A,iM,52) = $445,858/yr.

Using this approach, the compounding effects within

subperiod is taken into account.

13
 cash flows within periods (cont.)
3. Continuous compounding
In many cases, the subperiod cash flows occurs very
often (very large number of subperiods or M ∞) with
almost similar amount of cash flows for every
subperiod.

e.g., within a period, cash flows such as wages,

material costs occurs as often as weekly or even daily.

Then, they can be treated as “continuous cash

flows”.

cash flows within periods (cont.)

The future worth of discrete cash flow under
continuous compounding

From F = P(1 + i ) N

and i = e −1r

for continuous compounding, then

F = Pe rN

Effective and nominal interest rate (cont.)

Ex 2-20:
A sum of $10,000 is invested in an account earning interest
at the nominal rate of 7.2% per year. Determine the value
of this account at the end of 2 years if interest is
compounded (a) semiannually, (b) quarterly, (c) monthly
and (d) continuously.

14
 cash flows within periods (cont.)
The uniform series of cash flows within
periods under continuous compounding

Here, we try to find the equivalent value of the

uniform series of cash flows at the end of each
period with continuous compounding, i.e.,

subperiod
0 1 2 3 M 0 1 2 3 M

1 period 1 period

with F = A( F / A, iM , M )

cash flows within periods (cont.)

Assume that the number of subperiods (M) is very
large (M ∞) and let
Ā = “total” amount of money distributed uniformly within
the period.
Ā/M = cash flow occurring at the end of each subperiod.

Ā/M per subperiod Aj = (Ā/M)(F/A,iM,M)

subperiod
0 1 2 3 M 0 1 2 3 M

1 period 1 period

A  (1 + iM ) − 1   er − 1  i 
M
A=   A = A = A
M→∞ 
M iM   r   ln(1 + i ) 
where iM = effective interest
rate per subperiod (= r/M) “fund flow conversion factor”

cash flows within periods (cont.)

Ex 2-21:
It is expected that a total of $12,000 will be spent out of the
firm party cash fund over the course of a year. Actually,
expenditures occurs daily and are approximately the same
from day to day? The continuous cash flow assumption
would be appear to warranted here. If the firm’s discount
rate is 20% per year, determine the equivalent value at the
end of the year.

15
 cash flows within periods (cont.)
The continuous cash flow can occur in a single
period, multiple periods or even every period through
N periods.
P=?
F  i  1  N 
P = F    
 ln (1 + i )  1 + i  
period
0 1 2 N-1 N (
= F P / F , i, N )
P=?
A  i
P = A 
  (1 + i ) N − 1 
 N 
 ln(1 + i )   i (1 + i )  
period
= A( P / A, i, N )
0 1 2 N-1 N

cash flows within periods (cont.)

Ex 2-22:
A major overhaul is expected to cost $40,000 in the 30th
month of ownership. If the discount rate is 2% per month,
and assuming that these costs occur continuously and
uniformly during the 30th month, calculate the equivalent
present value.

Ex 2-23:
Repeat Ex 2-17 using the continuous cash flow, continuous
compounding approximation, calculate the equivalent
present value.

cash flows within periods (cont.)

4. Mid-period convention:
It is based on the assumption that all cash flows within
the period are aggregated and concentrated at the
midpoint of the period.

Thus, this means we assume that the period is divided

into 2 subperiods (M = 2) with effective rate is per
subperiod.

16
 cash flows within periods (cont.)
Aj2
AjM
Aj1 Ajk

subperiod
(actual)
0 1 2 .... M/2 .......k ....... M

i = (1 + iS ) − 1
2
period j
M

∑A
k =1
jk or

iS = (1 + i ) − 1
subperiod 0.5
(assumed)
0 1 2

period j

M 
Aj A j =  ∑ A jk  1 + i
subperiod  k =1 
(assumed)
0 1 2

period j

cash flows within periods (cont.)

Ex 2-24:
Cash flow of $1,000 per month are expected to occur at the
end of each month throughout year j. If the interest rate is
20% per year, determine the equivalent end-of-year cash
flow using the mid-period convention.

Ex 2-25:
Repeat Ex 2-17 using the mid-period convention.

cash flows within periods (cont.)

End-of-period vs. continuous vs. mid-period cash
flow assumptions
P
The most
End-of-period
week iM accurate
0 1 ...52 ....... 1 ...52
approach
year i
0 1 2 3
P
Continuous
cash flow
year i
0 1 2 3
P
Mid-period
year i
0 1 2 3

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Loans
Loans are the borrowing and lending of money.
Principle (P) of the loans is the total amount of
money advanced by the lender to the borrower.
All loans involves
 The amount of timing of cash flows between the
lender and borrower.
 The effective interest rate per period.
The interest accumulated in period j:
I j = iPj −1
where Pj-1 = amount of principle remaining at the end
of period j-1 (or the start of period j), for j =1,2,3,…,N.

Loans (cont.)
Two common types of repayment plan
1. Single repayment:
Principle of loan (P)

i
0 1 2 .... N
F = P0 ( F / P, i, N ) = P0 (1 + i )
N

Repayment (F)

Not occur in the real world

Loans (cont.)
2. Uniform periodic repayment:
Principle of loan (Po)
-Repay the loan P0 with N
equal payments.
-e.g. home mortgages, car
0 1 2 j …. N or student loans.
I1 I2 Ij IN
∆Pj = A-Ij A = P0 ( A / P, i, N )
Equal payment (A)

- Amount of interest paid in that period (j) is

I j = iPj −1

18
 Loans (cont.)

- Each repayment includes the portion of principal (not

including the interest) and the interest in that period.

- Amount of principle paid in that period (j) is

∆Pj = A − I j

- Principle remaining at the end of period j (after jth

payment)

Pj = A( P / A, i, N − j )

or Pj = Pj −1 − (A − I j )

Loans (cont.)

Ex 2-26:
For single repayment, how much do we repay at the end of
24 months for the original loan of $1,000 with the interest
compound monthly at the rate of 1% per month.

Ex 2-27:
You loan $1,000 from a bank and agree to repay the bank
in uniform periodic repayment. How much do we repay
over 5 periods with interest rate of 10% per period. Also,
calculate the interest accumulated, principal portion and
principal remaining in each period.

Extra examples

Ex 2-28:
Assuming an effective interest rate of 10% per annum:
a) How much must be invested today in order to provide an
annuity of $20,000 per year for 4 years, with the first
payment occurring exactly 10 years from now?
b) How much must be invested today in order to provide an
annuity of $10,000 every 6 months for 4 years (8
payments) with the first payment occurring exactly 10 years
from now?
c) A sum of $2,000 will be deposited into a savings account at
the beginning of each year for 10 years. If the fund accrues
interest at the rate of 10% per year, how much will be in the
find after 10 years.

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