Feedback and Warm-Up Review

• Feedback of your requests

• Cash Flow
• Cash Flow Diagrams
• Economic Equivalence

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 Cash Flows
• The expenses and receipts due to
engineering projects.

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 Cash Flow Diagrams
• The costs and benefits of engineering
projects over time are summarized on a
cash flow diagram.
• Cash flow diagram illustrates the size,
sign, and timing of individual cash
flows

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 Cash Flow Diagrams
$15,000

Positive net Cash flow $2000

(receipts) $13,000 is net positive cash flow

1 2 3 4 5 Time (# of interest periods)

0

Negative net Cash Flow

(payments)

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 Economic Equivalence

•We need to compare the economic worth of $.

•Economic equivalence exists between cash

flows if they have the same economic effect.

Convert cash flows into an

equivalent cash flow at
any point in time and compare.

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 Topics Today

• Single Sum Compounding

• Annuities
• Conversion for Arithmetic Gradient Series
• Conversion for Geometric Gradient Series

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 Simple Interest
• The interest payment each year is found by multiplying the
interest rate times the principal, I = Pi. After any n time
periods, the accumulated value of money owed under simple
interest, Fn, would be:
Fn = P(1 + i*n)

• For example, $100 invested now at 9% simple interest for 8

years would yield

F8 = $100[1+0.09(8)] = $172
• Nobody uses simple interest.
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 Compound Interest
• The interest payment each year, or each period, is found
by multiplying the interest rate by the accumulated value
of money, both principal and interest.
Accumulated EOP
End of Period Value or Amount Interest for Amount Owed or Value Accumulated
(EOP) Owed (1) Period (2) Next Period (3) = (1) + (2)
0 P Pi P + Pi = P ( 1 + i )
1 P ( 1 + i )1 [P ( 1 + i )1]i P ( 1 + i ) + P ( 1 + i )i = P ( 1 + i )2
2 P ( 1 + i )2 [P ( 1 + i )2]i P ( 1 + i )2 + P ( 1 + i )2i = P ( 1 + i )3
3 P ( 1 + i )3 [P ( 1 + i )3]i P ( 1 + i )3 + P ( 1 + i )3i = P ( 1 + i )4
¼ ¼ ¼ ¼
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 Compound Interest
• Consequently, the value for an amount P invested for n
periods at i rate of interest using compound interest
calculations would be:

Fn = P( 1 + i )n
• For example, $100 invested now at 9% compound
interest for 8 years would yield:

F8 = $100( 1 + 0.09 )8 = $199

• Compound interest is the basis for practically all
monetary transactions.

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 Future/Present Value

• FV = PV(1 + i)n.

• PV = FV / (1+i)n.

• Discounting is the process of

translating a future value or a set of
future cash flows into a present
value.
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Calculating Present Value
If promised $500,000 in 40
years, assuming 6%
interest, what is the value
today? (Discounting)

FVn= PV(1 + i)n

PV = FV/(1 + i)n
PV = $500,000 (.097)
PV = $48,500

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 The Rule of 72
• Estimates how many years an investment
will take to double in value
• Number of years to double =
72 / annual compound interest rate
• Example -- 72 / 8 = 9 therefore, it will
take 9 years for an investment to double
in value if it earns 8% annually
• Challenge: Prove it!!!!!!!!!!!!!!!!!!!!!

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Example: Double Your Money!!!

Quick! How long does it take to double $5,000 at

a compound rate of 12% per year?

Key “Rule-of-72”.

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Example: Double Your Money!!!

Quick! How long does it take to double $5,000 at

a compound rate of 12% per year?

Approx. Years to Double = 72 / i%

72 / 12% = 6 Years
[Actual Time is 6.12 Years]
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 Single Sum Problems: Future Value

Given:
• Amount of deposit today (PV):$50,000
• Interest rate: 11%
• Frequency of compounding: Annual
• Number of periods (5 years): 5 periods
What is the future value of this single sum?
FVn = PV(1 + i)n
$50,000 x (1.68506) = $84,253

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Single Sum Problems: Present Value

Given:
• Amount of deposit end of 5 years: $84,253
• Interest rate (discount) rate: 11%
• Frequency of compounding: Annual
• Number of periods (5 years): 5 periods
What is the present value of this single sum?
• FVn = PV(1 + i)n

$84,253 x (0.59345) = $50,000

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 Annuities
• Definition -- a series of equal dollar
payments coming at the end of a
certain time period for a specified
number of time periods.
• Examples -- life insurance benefits,
lottery payments, retirement
payments.
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 Annuity Computations

An annuity requires that:

• the periodic payments or receipts
(rents) always be of the same
amount,
• the interval between such payments
or receipts be the same, and
• the interest be compounded once
each interval.
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 Example of Annuity
End of Year
0 1 2 3 4
7%
$1,000 $1,000 $1,000
$1,070
$1,145

If one saves $1,000 a year at the end $3,215 = FVA3

of every year for three years in an 2
account earning 7% interest, FVA3 = $1,000(1.07) +
compounded annually, how much $1,000(1.07)1 +
will one have at the end of the $1,000(1.07)0 = $3,215
third year?
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 Derivation of Equation
A A A A A A A A

1 2 3 4 n-2 n-1 n
?
Year Future Value of Annuity
n A
n-1 A(1+i)
n-2 A(1+i)2
. .
. .
1 A(1+i)n-1
Total Future Value (F) = A + A(1+i) + A(1+i)2 + ... + A(1+i)n-1
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 Derivation (cont.)
F = A + A(1+i) + A(1+i)2 + ... + A(1+i)n-1 :Eqn 1

Multiply both sides by (1+i) to get:

F(1+i) = A(1+i) + A(1+i)2 + ...+ A(1+i)n :Eqn 2

Subtract Eqn 2 from Eqn 1 to get:

F = A[(1+i)n - 1] / i
= A (F/A,i,n)
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 Annuities: Future Value
Given:
• Deposit made at the end of each period:
$5,000
• Compounding: Annual
• Number of periods: Five
• Interest rate: 12%
What is future value of these deposits?
F = A[(1+i)n - 1] / i
$5,000 x (6.35285) = $ 31,764.25 23
 Annuities: Present Value
Given:
• Rental receipts at the end of each period:
$6,000
• Compounding: Annual
• Number of periods (years): 5
• Interest rate: 12%

What is the present value of these receipts?

F = A[(1+i)n - 1] / i
$6,000 x (3.60478) = $ 21,628.68 24
 Annuities: Future Value
Given:
Deposit made at the beginning of each
period:
$ 800
• Compounding: Annual
• Number of periods: Eight
• Interest rate 12%

What is the future value of these deposits?

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 Annuities: Future Value
First Step:
Convert future value of ordinary annuity factor to
future value for an annuity due:
• Ordinary annuity factor: 8 periods, 12%: 12.29969
• Convert to annuity due factor: 12.29969 x 1.12:
13.77565
Second Step:
Multiply derived factor from first step by the
amount of the rent:

• Future value of annuity due: $800 x 13.77565 =

$11,020.52
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 Annuities: Present Value
Given:
• Payment made at the beginning of each
period: $ 4.8
• Compounding: Annual
• Number of periods: Four
• Interest rate 11%

What is the present value of these payments?

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 Annuities: Future Value
First Step:
Convert future value of ordinary annuity factor to
future value for an annuity due:
• Ordinary annuity factor: 4 periods, 11%: 3.10245
• Convert to annuity due factor: 3.10245 x 1.11
3.44372

Second Step:
Multiply derived factor from first step by the
amount of the rent:
• Present value of annuity due: $4.8M x 3.44372:
$16,529,856 28
Key of Annuity Calculation

Fv = Pv[(1+i) n - 1] / i

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 Summary
• Single Sum Compounding
• Annuities
• Key: Compound Interests Calculation

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