CASH FLOW ANALYSIS

Uniform Annuities, Continuous

Compounding and Excel Functions

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 Administrative Items
Online Quiz 1:
o Starts, Friday May 19 at 11:00 PM
o Ends, Friday May 26 at 11:59 PM
o Chapters 1, 2 and up to annuities in Chapter 3 (not including mortgages, bonds
and non-uniform annuities).
o Chapters 1, 2 & 3 including general concept of EE, decision making, time
value of money, interest rate calculations, cash flow diagram, and annuities.

Online Quiz 2:
o Starts, Friday May 26 at 11:00 PM
o Ends, Friday June 2 at 11:59 PM
o Chapters 3
o Chapter 3 including non-uniform annuities, bonds and mortgages; there
will also be a small number of 'review-type' questions from Chapter 2.

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 Learning Objectives
Compound interest factors recap
Relationships between compound interest factors recap
Uniform annuities:
o White board problems
o Annuity due
o Capital recovery formula
o Mortgages and loans
o Linear interpolation
o Bonds
Non standard annuities
Continuous compounding with uniform annuities
Spreadsheet functions

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Compound Interest Factors Recap

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 Relationships between Compound
Interest Factors
Single Payment
o Compound amount factor = 1/Present Worth Factor
o (F/P, i, n) = 1/(P/F, i, n)

Uniform Series (Annuities)

o Capital recovery factor = 1/Present Worth Factor
o (A/P, i, n) = 1/(P/A, i, n)

o Compound amount factor = 1/Sinking Fund Factor

o (F/A, i, n) = 1/(A/F, i, n)

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Relationships between Compound
Interest Factors

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 Uniform Annuities
Problem 1
A Ford Mustang costs $17 000. It can be financed at
5.9% for 48 months, with monthly compounding.
How much will the monthly payments be?

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Uniform Annuities
Problem 2

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 Uniform Annuities: Annuity Due
Problem 3
What is the present worth of a series of 15 annual payments of $1000
each, when the first payment is now and the interest rate is 5%,
compounded yearly?
This is an example of an annuity due the payments of an annuity
are made at the start of each period rather than at the end.

Method1: Count the first payment as a present worth and the next
14 payments as a regular annuity:

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 Uniform Annuities: Annuity Due
Problem 3
What is the present worth of a series of 15 annual payments of $1000
each, when the first payment is now and the interest rate is 5%,
compounded yearly?
This is an example of an annuity due the payments of an annuity
are made at the start of each period rather than at the end.

Method 2: Determine the

present worth of a standard P1 A(P / A, i , N ) = 1000(P/A,5%,15)
annuity at time 1 and then = 1000(10.380)
find its worth at time 0
= 10 380
(now). The worth at time 1
is:

Then the present worth now P0 P1(F/P, i , N )

(time 0) is: 10 380(F/P,5%,1) 10 380 (1.05)
10 899

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Uniform Annuities: Capital Recovery Formula

Industrial equipment and other assets are often

purchased at a cost of P on the basis that they will
incur a savings of A per cash flow period for the firm.

At the end of the their useful life, the asset will be sold
for some salvage value S.

With some algebra, the formula to determine A for a

given P and S can be derived that combines the
capital recovery factor with the sinking fund factor as
follows: A = (P - S)(A/P,i,N) + Si

A is often called the Capital Recovery Cost 11

Uniform Annuities: Capital Recovery Formula
Problem 4
A supplier of laboratory equipment is looking at a mobile demonstration unit
which will cost $71 000. It will have a useful life of 5 years and the salvage
value at that time is estimated at $8 000.
a) If the cost of capital is 15% per year, what are the equivalent annual costs
(i.e., the annual capital recovery costs) of purchasing the equipment?
b) If the mobile demonstration unit is estimated to produce extra profits of
$23 000 per year, is it economically justified?

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Uniform Annuities: Mortgages in Canada

The legal document:

o Long-term amortized loan that is used for buying property
o If payments are not made, the lender can seize the property
and sell it to recover the debt
o Legal document outlines the terms and conditions for
repayment of the loan (amortization period, interest rate,
penalties, etc.)
Amortization:
o Length of time it takes to pay off loan assuming:
Payments are made on time with no additional payments
Interest rate doesnt change

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Uniform Annuities: Mortgages in Canada

Mortgage calculations require a defined amortization period

and term.

Amortization period is the duration over which

the original loan is calculated to be repaid.

Term is the duration over which the loan

agreement is valid otherwise called the maturity.

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Uniform Annuities: Mortgages in Canada

Amortization periods are typically between 5 years and

35 years
o The norm is 20 or 25 years
Terms
o A mortgage is often made up of smaller periods called terms
and a term is the period in which the interest rate term is
fixed.
o At the end of the term, the mortgage can be renewed for a
another term at the current interest rate.

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Uniform Annuities: Mortgages in Canada

Conventional:
o For 75% or less of the appraised value
High-ratio mortgages:
o Higher than 75% and usually require an outside agency such
as the CMHC (Central Mortgage and Housing Corporation) to
insure the mortgage.
Some Others:
o variable and fixed rate options

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Uniform Annuities: Mortgages in Canada

Equity
o The value remaining in a property after all mortgage and
loans registered against the title are subtracted from its value.
Interest Rate
o Interest rate is expressed as:
% compounded semi-annually
o Nominal rate mortgage at 6% is actually 3% semi-annually
o To determine actual effective monthly rate for this example
o (1+i)6 = 1.03
o In this case: i = 0.49%/month

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Uniform Annuities: Mortgages in Canada
Problem 5
A rental property was recently purchased for $350,000. The down payment amount
was $50,000 and the remaining amount was obtained from a mortgage. The
mortgage has a nominal interest rate of 6%, compounded monthly with a 30-year
amortization period. The term of the mortgage is 5 years. What are the couples
current monthly payments? How much will they owe in 5 years?

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 Uniform Annuities: Linear Interpolation

Linear interpolation is the process of approximating a

complicated function by a straight line to estimate a
value for the independent variable based on two
sample pairs of independent and dependent variables
and an instance of the dependent variable.

Linear interpolation is used in EE for approximating

the interest rate based on a set of conditions as
described by the mathematical model developed from
a cash flow analysis.

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Uniform Annuities: Linear Interpolation

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 Uniform Annuities: Linear Interpolation
Problem 6
A new machine costing $8000 will reduce annual production costs by
$2100. The machine will operate for 5 years, at which time it will have no
resale value. What rate of return is being earned on this investment?
Restated: For what interest rate will a cash flow of $2100 per year for 5
years be equivalent to a present amount of $8000?

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 Uniform Annuities: Bonds
Bonds are investments that provide an annuity and a
future value in return for a cost today. There is a par
or face value at time of maturity.

They also have a coupon rate in form of an annuity that is

calculated as a percentage of the face value.

Bonds can be sold at more or less than the face value at

anytime before the maturity date, depending on how
buyers perceive them as investments.

To calculate the present worth of a bond, sum together

the present worth of the face value (a future amount) and
the coupons (an annuity) at an appropriate interest rate.
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 Uniform Annuities: Bonds

When Bonds are purchased, the fixed items:

o Face Value (e.g., $1000)
Amount paid out when the bond matures
o A nominal interest rate (e.g., 8% semi-annually)
Sometimes called coupon rate
The amount of interest paid out to the bond holder per compounding
period
The purchase price can vary depending on the current
market interest rate as the present worth of a bond is
determined from the fixed values above (the interest
paid out per compounding period and the final face
value paid out in the future).

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 Uniform Annuities: Bonds
Problem 7
What is the present worth of a bond available today
if money can earn 12% compounded semiannually,
the bond maturing in 15 years with a face value of
$5,000 and a 7% coupon rate?

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 Non Standard Annuities

When compounding interest periods and payment

periods differ, an adjustment is required in order to
utilize the formulas.
This is usually done by:
1. Computing the equivalent payment amounts for each
compounding period and applying the interest rate

2. Computing an effective interest rate for the payment periods

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Non Standard Annuities: Problem 8

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 Continuous Compounding at
Nominal Rate r per period
Continuous Compounding Sinking Fund
1
, , =
1
Continuous Compounding Capital Recovery
( 1)
[, , ] =
1
Continuous Compounding Series Compound Amount
1
[ , , ] =
1
Continuous Compounding Series Present Worth
1
[, , ] =
( 1)
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 Spreadsheet Annuity Functions

To find the equivalent P:

o PV(i, n, A, F, Type)
To find the equivalent A:
o PMT(i, n, P, F, Type)
To find the equivalent F
o FV(i, n, A, P, Type)
To find n:
o NPER(i, A, P, F, Type)
To find i:
o RATE(n, A, P, F, Type, guess)
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Questions Period

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