Chapter 4 - 2 - Time Value of Money Part II

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

3 Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics
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
Preliminary Geometric Series
Lets define
1 = , 2 = , 3 = 2 , , = 1 , = =1
Calculate = + + 2 + + 1 = + 2 + + 1 + = 1 = 1 1 = 1
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 +
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

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 +
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

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+
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?
11
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
12
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?
13
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
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

15
1+0.05 1 0.05 1+0.05
N?
Other consideration
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
=?
16
Other consideration
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.
17
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%
=?
18
$10,000
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
19
=?
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%
=?
20
$13,310
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
21
=?
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 =?
22
$4,021
$4,021
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 =?
23
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.
24
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
25
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
26
= 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 PV?
= 50,000 +3,000 , 10%, 4 +7,500 , 10%, 5 = 35,833.49
27
Example
= 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
= 10%
Example
= 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
= 10%
Example
= 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
= 10%
Deferred Annuities (Uniform Series)

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
Present Value of Deferred Annuities

0
N-1
J+1 J+2
= , %,
0 = , %,
0 = , %, , %,
33
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

Future Value of Deferred Annuities

= , %,
=? 0 1 2 3 4 5 6 J
N-1
J+1 J+2
35
Deferred Future Value of Annuities

0 1 2 J-1 J J+1 N-1 =?
= , %,
= , %, = , %, , %,
36
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
40 =?
Equivalence Calculations Involving Multiple Interest Formulas

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
39
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
40
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
41
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
42

Chapter 4 - 2 - Time Value of Money Part II

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Chapter 4 - 2 - Time Value of Money Part II

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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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Preliminary Geometric Series

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

Finding F when Given A

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

Finding F when Given A

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

Finding P when Given A

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding P when Given A

1+0.08 3 1 =1293.703 0.08 1.08 3

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

Relationship between and

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding A when Given F

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding A when Given F

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding A when Given P

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Finding A when Given P

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

For the problems that

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

1+0.05 1 0.05 1+0.05

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

For the problems that

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

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

For the problems that

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

All three plans are economically equivalent.

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Deferred Annuities (Uniform Series)

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

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Present Value of Deferred Annuities

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

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

Future Value of Deferred Annuities

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Deferred Future Value of Annuities

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Equivalence Calculations Involving Multiple Interest Formulas

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example (Present equivalent expenditure 0 )

Purdue School of Industrial Engineering Fall 2013, IE343 Engineering Economics

Example (Future equivalent expenditure 8 )