Centre for Management of

Technology and Entrepreneurship

University of Toronto

Cash Flow Analysis Part A

Copyright: Joseph C. Paradi

1996-2003

Centre for Management of Technology and Entrepreneurship Course: CHE349

File: CHE349/CashFlowA4
Categories of Cash Flows
Some of these may be broken down further
First cost - expense to build or to buy and install
Operations and maintenance (O&M) - annual
expense, can include ; electricity, labour, repairs, etc.
Salvage value(s) - receipt at project termination for
disposal of the equipment (can be a salvage cost)
Revenues - annual receipts due to sale of products or
services
Overhauls - major capital expenditure that occurs part
way through the life of the asset
Prepaid expenses - annual expenses, such as leases
and insurance payments, that must be paid in advance

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Economic Equivalence
How do we measure and compare economic worth of
various cash flow profiles? We need to know:
Magnitude of cash flows
Their direction (receipt or disbursement)
Timing (when does transaction occur)
Applicable interest rate(s) during time period under consideration
We should be economically indifferent to choosing
between two alternatives that are economically
equivalent and could therefore be traded for one another
in the financial marketplace
Any cash flow can be converted to an equivalent cash
flow at any point in time
Can be applied to compare project alternatives find
equivalent value of each at any common point in time
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An Example of Equivalence
Suppose you are offered the alternative of receiving
either $3,000 at the end of 5 yrs (guaranteed) or P
dollars today. You would deposit the P dollars into an
account that pays 8% interest. What value of P would
make you indifferent to your choice between P dollars
today and the $3,000 at the end of 5 yrs?
Determine the present amount that is economically
equivalent to $3,000 in 5 yrs given the investment
potential of 8% per year.

F = $3,000, N = 5 years, i = 8% per year

Find P
P = F/(1+i)N = $2042
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Economic Equivalence:
General Principles
Equivalence calculations to compare alternatives
require a common time basis
Equivalence depends on the interest rate
May require conversion of multiple payment cash flow
to a single cash flow
Equivalence is maintained regardless of point of view
(borrower or lender)

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Equivalence - A Factor
Approach
Now we can look at organizing the approach to
Engineering Economy by defining its language and
notations.
Engineering Economy Factors apply compound interest
to calculate equivalent cash flow values. The tabulated
values at the end of the book (or you can use the
functions in spreadsheets) convert from one cash flow
quantity (P, F, A, or G) to another.
Assumptions:
1. Interest is compounded once per period
2. Cash flow occurs at the end of the period
3. Time 0 is period 0 or the start of period 1
4. All periods are the same length
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Definitions
The following are the definitions for the variables used:

i interest rate per period, expressed as a decimal

N Number of periods (also called the study horizon)
P Present cash flow, or value equivalent to a cash flow
series
F Future cash flow at the end of period N, or future worth
at the end of period N equivalent to a cash flow series
A Uniform periodic cash flow (annuity) at the end of every
period from 1 to N. Also a uniform constant amount
equivalent to a cash flow series.
G Gradient or constant period-by-period change in cash
flows from period 1 to N (arithmetic series)
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Factor Notation
These have their roots in the pre-computer age when
prepared tables were used by engineers for many
design needs. However, they still serve to state the
problem and can be used to solve it too.
The format of engineering economy factors is:
(X/Y, i%, N) where X and Y are chosen from the cash
flow symbols P,F,A and G.
So, if you have Y multiplied by a factor, you get the
equivalent value of X: P = A(P/A, i ,N) e.g. convert from
a cash flow (F) in year 10 to an equivalent present
value (P), the factor is:
(P/F, i N) - see text pages after 559 for the tables

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Names of the EE Factors -
see pp 83 in text
So now we know how all this works together, but these
factors have names as follows:
(P/F,i,N) Present worth factor
(F/P,i,N) Compound amount factor
(P/A,i,N) Series present worth factor
(A/P,i,N) Capital recovery factor, how much an investment
has to return to recover its cost - no salvage value
(A/F,i,N) Sinking fund factor - where a savings account is
used to accumulate funds for future investment
(F/A,i,N) Series compound amount factor
Note that the first letter is the variable you are seeking
and the second the one you have P/A want First Cost
(investment), have annuity payment

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Compound Interest Factors
for Discrete Compounding
The four discrete cash flow patterns are:
a single disbursement or receipt
a set of equal amounts in/out over a sequence of periods -
annuity
a set of equal amounts in/out that change by a constant
amount from one period to the next in a sequence of periods -
arithmetic gradient series
a set of equal amounts in/out that change by a constant
proportion from one period to the next in a sequence of periods
- geometric gradient series
The following assumptions apply:
compounding periods are equal
cash flows at the end of the period (consider payment at 0 to
be at period -1
annuities and gradients occur at period ends
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The Basic Single Payment
Factors
P and F are the basic single payment quantities and
they are related as follows:
F = P(1 + i)N it can be developed as:
Fn= P(1+ in) - where: i is the annual interest rate -
simple interest - but this is not very useful, so we
develop the compound interest model:
Fn = Fn-1 (1+ i)
So we can see this in the EE notation as:
(F/P,i,N) = (1 + i)N and for the reverse
(P/F,i,N) = (1 + i)-N
The limits of P and F are:
1 when i and N approach 0
P approaches 0; F infinity when i and N approach infinity.
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The Relationship between P
and F
F If you had $2000
F occurs N periods after P now and invested
it at 10%, how
much would it be
0 1 2 N-1 N worth in 8 years?

P = $2000, i = 10% per year, N = 8 years

P F = P(1+i)N =$2000(1+0.10)8= $4287.18
F = P (F/P,10%, 8)=$2000*2.1436 =$4287.20

$1000 is to be received in 5 years. At an annual interest

rate of 12%, what is the present worth of this amount?
F=$1000, i = 12%, N = 5 years
P = F(1+i)-N= $1000(1+.12)-5 = $567.40
P = F(P/F, 12%,5) = $1000(0.5674) = $567.40
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Combining Factors
Obviously, we can combine these factors in various
ways to create a model for the real problem at hand:
delayed income stream because of startup time
another need may be prepaid expenses - also a way to deal
with startup delays or construction delays.
In this same class of issues come the opportunity to
construct solutions from cash flow diagrams
Thus we can link formulas together to model the actual
proposition - in fact deriving one formulas factor from
an others
Also, many times the problem has to be defined in
more than one part
Then, there are many approaches to a specific problem
- one may be longer but the answer must be the same
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A Simple Example
At start we have P = -120,000
The 5 year @ $30,000/year is P=-30,000(P/A,12%,5)
Then, the $35,000 is P=-35,000(P/F,12%,3)
Finally, the $40,000 is P=40,000(P/F,12%,5)
$40,000

$30,000 $30,000

$35,000
$120,000

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Discrete Compounding,
Discrete Cash Flows P. 571

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Compound Interest Factors
for Annuities: Uniform Series
All cash flows in series are equal (annuity)
A A A A A

1 2 N-2 N-1 N

P
P = A(1 + i)-1 + A(1 + i)-2 + . + A(1 + i)-(N-1) + A(1 + i)-N
n
= A(1 + i)-K
K1
(1 i) N 1
P = A n
i(1 i)
Series Present Worth Factor P = A(P/A i, N) p.62 Text

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Compound Interest Factors
for Annuities: Uniform Series
From before, P = A [(1+I)N-1]/[I(1+I)N]

Then to get (F/A, i, N) we can convert this to a future

single payment by multiplying both sides by (1+i)N

(1+i)N * P = A[(1+i)N-1]/i resulting in

F = A[(1+i)N-1]/i p.60 text

Thus, we get the (P/A,i,N) and the (F/A,i,N) factors

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Bonds
Financial instrument used by large firms and
government to raise funds to finance projects, debt
obligations,
A special form of loan, usually with a long term
The creditor (firm or government) promises to pay a
stated amount of interest at specified intervals for a
defined period and then to repay the principal at a
specific date (maturity date)
Canada savings bonds usually represent the lowest
interest because they are the safest (set tone for
interest rates), then are provincial bonds, next are
Blue-Chip corporates (banks, large firms)
Junk bonds are very high interest and risk
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Bond Terminology
P = Purchase price of a bond
F = Sales price (or redemption value) of a bond
V = Par (face) value the stated value on the bond
r = bond rate per interest period (or coupon rate)
i = the yield rate per interest period
N = number of interest payments received by the
bondholder
Redemption when the issuer pays for it in cash
Maturity Date date on which the par value is to be
repaid (date bond expires)
Market Value the price one has to pay to purchase a
bond
A = Vr = a single interest payment
P = Vr (P/A, i, N) + F (P/F, i, N)
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Bond Valuation
Yield to maturity (return on investment) = actual
interest earned from a bond over the holding period
(equivalent to IRR calculations)
When considering buying or selling bonds, the yield is
the fundamental consideration and this depends on a
number of issues:
Current yields for that type of security (economy dependent)
Inflation rate (usually included in the yield by market forces)
Your tax position
Foreign exchange risk if you invest in other currencies
The actual price of a bond, even at issue, is very
unlikely to the face value, except at redemption.
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Canadian Bonds

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Example of Arithmetic
Gradients
We have two propositions for investment:
New Hand Held Computer
Natural Gas Pipeline
Cash Flow Profiles
End of Year Computer Natural Gas
0 -$50,000 -$50,000
1 +$20,000 +$2000
2 +$10,000 +$5000
3 +$5000 +$10,000
4 +$2000 +$20,000

Which is preferable, the computer or natural gas? Both

have revenues of $37,000 over the time period.
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CF Diagrams for Computer &
Natural Gas Options
$20,000 $20,000

(+) $10,000 (+) $10,000

$5,000 $2,000 $2,000 $5,000

0 1 2 3 4 0 1 2 3 4

(-) (-)
Computer Natural Gas
Option Option

$50,000 $50,000

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Arithmetic Gradients
An easy definition of a gradient is: revenue grows by
(N-1)G
$10,000 (G) each year, or by 10%.
But the rate is not always constant 3G
2G
G
Note: No cash flow at end of period 1
Each successive cash flow increases
by a fixed amount equal to G 0 1 2 3 4 N
There are four possibilities besides G=0
1. A>0 and G>0 - means positive and increasing
2. A>0 and G<0 - means positive but decreasing
3. A<0 and G>0 - means negative but becoming less so
4. A<0 and G<0 - means negative and becoming more so
The gradient formulas can be derived just as the annuity
formulas were. See text pp 70.

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Arithmetic Gradients
cont'd...
A series of receipts or disbursements that start at 0 at
the end of the 1st period and then increase by a
constant amount from period to period.
e.g. increasing operating costs for an aging machine
The sum of an annuity plus an arithmetic gradient
series is a common pattern.
The gradient formulas can be derived just as the
annuity formulas were. See Text pages 68-70.
To convert gradient to uniform series:

A = G (A/G, i, N)

Then can convert A to P or F

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Arithmetic Gradient with
A>0

A+(N-1)G

A+3G
A+2G
A+G
A

0 1 2 3 4 N

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Geometric Gradient Series
Very useful to model inflation, change in productivity,
shrinkage of market size

Each successive cash flow increases (or decreases) by

a constant % each period.

The base value of the series is A. The growth rate

(rate of increase or decrease) is referred to as g.

If g is positive, the terms are increasing in value.

If g is negative, terms are decreasing in value.

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Arithmetic Gradient with
A>0 and G>0 = Geometric
Series
See Factor development in the text on pp 71.

Note: There is a cash flow A(1+G)N-1

at end of period 1

A(1+G)3
A(1+G)2
A(1+G)
A

0 1 2 3 4 N-1 N-2

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Geometric Gradients
We can define a growth adjusted interest rate i 0:
1 i 1 1 g
i
0
So that
1 g 1 i 0
1 i
There are 4 cases

i > g > 0 Growth is + but less than interest rate i0 is +

g > i > 0 Growth is + and greater than interest rate i0 is
g = i > 0 Growth is + and = to interest rate

A
i 0 \ PN
0

1
g
g<0 Growth is negative (series is decreasing i0 is +

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Deferred Annuity
If the cash flow does not begin until some later date,
the annuity is known as deferred annuity.
Annuity is deferred for J periods.
P0 = A (P/A, i%, N-J) ( P/F, i%, J)

0 1 2 J+1 J+3 N-1 N

J J+2

P=?

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Non-standard Annuities and
Gradients
Treat each cash flow individually
Convert the non-standard annuity or gradient to
standard form by changing the compounding period
Convert the non-standard annuity to standard by
finding an equal standard annuity for the compounding
period
How much is accumulated over 20 years in a fund that
pays 4% interest, compounded yearly, if $1000 isF = ?
deposited at the end of every
$1000fourth year?

0 4 8 12 16 20
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Different Solutions
Method 1: consider each cash flows separately
F = 1000 (F/P,4%,16) + 1000 (F/P,4%,12) + 1000
(F/P,4%,8) + 1000 (F/P,4%,4) + 1000 = $7013

Method 2: convert the compounding period from annual

to every four years
ie = (1+0.04)4-1 = 16.99%
F = 1000 (F/A, 16.99%, 5) = $7013

Method 3: convert the annuity to an equivalent yearly

annuity
A = 1000(A/F,4%,4) = $235.49
F = 235.49 (F/A,4%,20) = $7012
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PW Computations when N

These cases are also called "perpetuities" - e.g.

scholarships, endowments, etc.
There are many engineering projects where the life of
the project is so long as to be considered forever.
Usually 50 years as a rule of thumb, but assume cash
flows continue indefinitely.
There are other projects where a sum of money is
provided at the beginning of the project and it is then
invested to yield the amount used for the project
(annuities for 50 years)
For both, the PW of the infinitely long uniform series of
cash flows becomes the Capitalized Value

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PW when N
Until now, we assumed that the horizon N is a fixed
number of years.
The present worth of a very long and uniform series of
cash flows is calculated as:
P lim A(P / A,i ,N )
N

(1 i )N 1

P A lim N
N
i (1 i )
1
1
(1 i )N
P A lim
i
N


A
P
i
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