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WEEK 6
Agenda
Midterm # 1 Review Economic Decision Making Models
Interest Rate: The ratio of borrowed money to the fee charged for its use over a period. The ratio is usually expressed as a percentage
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present A = single amount in a series of n equal amounts at the end of each interest period F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
When interest is permitted to compound, the interest earned during each interest period is added to the principal amount at the beginning of the next interest period. We can show how this applied using the following table:
1 2
P P (1+i)
Pi P(1+i)i
3
4
P(1+i)2
P(1+i)n-1
P(1+i)2i
P(1+i)n-1i
Eqn 1
= (1 + )
Single Payment Compound-Amount Factor
Eqn 2
= ( , , )
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
EMP5100 - WEEK 5 - RIDHIMA SHARMA
Eqn 3
1 = (1 + )
Single Payment Present-Amount Factor
Eqn 4
= ( , , )
i = nominal annual interest rate n = number of interest periods, usually annual P = principal amount at a time assumed to be the Present F = amount, n interest period hence, equal to the compound amount of P, or the sum of the compound amounts of A, at the interest rate i
EMP5100 - WEEK 5 - RIDHIMA SHARMA
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Ordinary Annuity
In some situations, a series of receipts or payments occurring uniformly at the end of each period may be encountered. These are called ordinary annuities The sum of the compound amounts can be determined as follows:
1 + 1 =
For derivation: http://www.mathalino.com/reviewer/derivation-formulas/derivation-formula-future-amount-ordinary-annuity
EMP5100 - WEEK 5 - RIDHIMA SHARMA
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Ordinary Annuity
We can also express the relationship as:
F = A(F/A,i,n)
We can also express the relationship in terms of A as:
=
or A=F(A/F,i,n)
1 + 1
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Ordinary Annuity
We can also express the relationship in terms of the Present Value, P
= (1 + )
We can also express the relationship in terms of A as:
1+ 1 (1+) 1+ 1
= (1 +
or
A=P(A/P,i,n)
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Ordinary Annuity
Rearranging and solving for P, we get
1 + 1 = (1 + )
or P=P(P/A,i,n)
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Equivalence Calculations
Allows us to compare 2 or more situations In terms of money, two monetary amounts are equivalent when they have the same value in exchange. There are three factors involved in equivalence of sums of money: (1) the amount of the sums (2) the time of occurrence of the sums (3) the interest rate
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Equivalence Calculations
Example:
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Equivalence Calculations
F = P(F/P,i,n) = $1(F/P,10,8) = $2.144 Practically, this can mean that $1 today, is equivalent to $2.144 8 years from now given an interest rate of 10% compounded annually.
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Equivalence Calculations
Example:
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Equivalence Calculations
P = F(P/F,i,n) = $1(P/F,12,10) = $0.322 Practically, this can mean that $1 10 years from now, is equivalent to $0.322 today given an interest rate of 12% compounded annually. So if we dont want to exceed a total cost of $1, 10 years from now, we should not spend more than $0.32 today
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Equivalence Calculations
Example:
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Equivalence Calculations
F = A(F/A,i,n) = $1(F/A,8,20) = $45.762 Practically, this means that $1 spent each year for 20 years will result in a total cost of $45.76 20 years from now given an interest rate of 8%
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Equivalence Calculations
Example:
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Equivalence Calculations
A = F(A/F,i,n) = $1(A/F,12,6) = $0.1232 This means that $0.1232 must be received each year for 6 years to be equivalent to the receipt of $1, 6 years hence.
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Equivalence Calculations
Example:
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Equivalence Calculations
P = A(P/A,i,n) = $1(P/A,9,10) = $6.4177 This means that an investment of $6.4177 today must yield an annual benefit of $1 each year for 10 years if the interest rate is 9%.
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Equivalence Calculations
Example:
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Equivalence Calculations
A = P(A/P,i,n) = $1(A/P,14,7) = $0.233 This means that $1 can be spent today to capture an annual savings of $0.233 per year over 7 years if the interest rate is 14%
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28
1-1-2008
1-1-2009 1-1-2009
$9,500
$9,500 $8,000
29
$8,000
$9,500
$9,500
$9,500
$9,500 $9,500
$28,000
$25,000
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Because the PV is greater than $0, this is a desirable undertaking at an interest rate of 12%
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(1 + )
33
(1 +
(1+) 1+ 1
34
=
=0
(1 + )
(1 + ) 1 + 1
Annual Equiv= ($3,946)(A/P,12,4) Annual Equiv= $1,299 What this tells us is that if $28,000 is invested on Jan 1, 2005, a 12% return will be received plus an equivalent of $1,299 on Jan 1,2006, 2007, 2008, and 2009.
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=0
(1 + ) (1 + ) =
=0
(1 + )
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=
=0
(1 + )
Future Equiv= ($3,946)(F/P,12,4) Future Equiv= $6,211 What this tells us is that there will be a difference of $6,211 between future equivalent savings and future equivalent costs. Because this amount is great than zero, it is a desirable venture at 12%
EMP5100 - WEEK 5 - RIDHIMA SHARMA
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We know that:
cost of any asset = cost of depreciation + cost of interest on undepreciated balance
At the beginning of year 1: Cost of Depreciation = $800 Undepreciated Balance = $5000 Cost of Asset = $800 + $5,000(0.1) = $800 + $500 = $1,300
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(1
=0
+ )
(1 + ) 1 + 1
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Finding the number of units/year for which the cost of the two alternatives breaks would help in making the decision.
EMP5100 - WEEK 5 - RIDHIMA SHARMA
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Given: Fixed Costs: $0 (there are no fixed costs for the Buy option) Variable Costs: $8/unit
Let N be the number of units produced
50
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From the above, we can see that in excess of the break even quantity, the Make Option is better
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Lease-or-Buy Evaluation
Often, a company has to consider the decision to lease or buy a piece of equipment. In this case, the firm faces a lease-or-buy decision
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Lease-or-Buy Evaluation
Example:
Assume that a small electronic computer is needed for data processing in an engineering office. Suppose that the computer can be leased for $50/day, which includes the cost of maintenance. Alternatively, the computer can be purchased for $25,000. The computer is estimated to have a useful life of 15 years with a salvage value of $4,000 at the end of that time. It is estimated that the annual maintenance costs will be $2,800. If the interest rate is 9% and it costs $50/day to operate the computer, how many days of user per year are required for the two alternatives to break even?
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Given: Fixed Costs: $0 (no fixed costs) Variable Costs: $50/unit to lease computer $50/unit to operate computer
Let N be the number of computer units required
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Given: Initial Cost of Computer = $25,000 Salvage Value = $4,000 Useful life = 15 years Interest Rate = 9% Variable Costs: $50/day to operate Let N be the number of units produced
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= + +
= ( )( , , ) + () + +
= 5,766 + $50
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Given: Fabrication Cost: $140,000 Salvage Value: $20,000 Maintenance Cost: $12,000 $80/unit to operate machine
Let N be the number of operating hours
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Given: Fabrication Cost: $55,000 Salvage Value: $0 Maintenance Cost: $12,000 $80/unit to operate machine
Let N be the number of operating hours
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