Gradient series

– Linear gradient
– Geometric gradient
 Linear gradient series

(1 + i)N –iN - 1
P=G
i2(1 + i)N

= G(P/G,N.i)

Gradient series present worth factor

Gradient series as a composite series
 Example – supper lottery

$3.44 million

Cash option

0 1 2 3 4 5 6 7 25 26

Annual payment option

$357,000
G = $7,000
$196,000
$189,000
$175,000

0 1 2 3 4 5 6 7 25 26
Equivalent present value of annual payment
option at 4.5%

P = [$175,000 + $189,000(P/A, 4.5%, 25) +

$7,000(P/G, 4.5%, 25)](P/F, 4.5%, 1) =
$3,818,363
 Excel
solution
Example – present value calculation for a gradient series

$2,000
$1,750
$1,500
$1,250
$1,000

0
1 2 3 4 5

How much do you have to deposit

now in a savings account that
P =? earns a 12% annual interest, if you
want to withdraw the annual series
as shown in the figure?
 Method 1:
$2,000
$1,750
$1,500
$1,250
$1,000

0
1 2 3 4 5

$1,000(P/F, 12%, 1) = $892.86

$1,250(P/F, 12%, 2) = $996.49
P =? $1,500(P/F, 12%, 3) = $1,067.67
$1,750(P/F, 12%, 4) = $1,112.16
$2,000(P/F, 12%, 5) = $1,134.85
$5,204.03
 Method 2:

P1 = $1,000(P / A,12%,5)
= $3,60480
.

P2 = $250(P / G,12%,5)
= $1,599.20

P = $3,604.08 + $1,59920
.
= $5,204
 Example – linear gradient

You are trying to decide between 2 job offers. Allied Signal

has offered to pay you $50,000/year, with guaranteed
pay increases of $2,000/year. Raytheon has offered to
start you at $54,000/year, with no pay increases over
the next 5 years. What is the present worth of the each
cash flow over the next 5 years, using the end of year
convention and assuming an 8% interest rate is
available?
 Linear gradient series

$50k $52k $54k $56k $58k

Allied Signal

0 1 2 3 4 5

$54k $54k $54k $54k $54k

Raytheon

0 1 2 3 4 5
 Composite cash flow
$0 $2k $4k $6k $8k

0 1 2 3 4 5
$50k $52k $54k $56k $58k strict linear gradient series

= +
equal payment series
0 1 2 3 4 5 $50k $50k $50k $50k $50k

0 1 2 3 4 5
 Gradient to equal-payment conversion

$0 $G $2G $3G $4G $A $A $A $A $A

⇔
0 1 2 3 4 5 0 1 2 3 4 5
strict linear gradient series equal payment series

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

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

⎡ (1 + i ) N − iN − 1 ⎤ ⎡ i (1 + i ) N ⎤ ⎡ (1 + i ) N − iN − 1 ⎤
A=G⎢ ⎥ ⎢ ⎥ =G⎢ ⎥ = G ( A / G , i, N )
⎣ i (1 + i ) ⎦ ⎣ (1 + i ) − 1 ⎦ ⎢⎣ i ⎡⎣(1 + i ) − 1⎤⎦ ⎥⎦
2 N N N
 Future worth of a gradient series

$0 $G $2G $3G $4G $A $A $A $A $A

⇔
0 1 2 3 4 5 0 1 2 3 4 5
strict linear gradient series equal payment series

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

⎡ (1 + i ) N − iN − 1 ⎤ ⎡ (1 + i ) N − 1 ⎤ G ⎡ (1 + i ) N − 1 ⎤
F =G⎢ ⎥⎢ ⎥ = ⎢ − N ⎥ = G ( F / G , i, N )
⎢⎣ i ⎡⎣(1 + i ) − 1⎤⎦ ⎥⎦ ⎣
N
i ⎦ i ⎣ i ⎦
 Linear vs. geometric gradient

A8
A
Cash flows on a linear gradient A5 A 6
7

increase by a constant amount A A 4

3
each interest period. A1 A2
An = A1 + (n − 1)G, n = 1, 2,..., n

Cash flows on a geometric gradient A8

increase by a constant percentage A7
each interest period. The A6
A5
percentage is call the growth rate, A
A1 A2 A3 4
g.
An = A1 (1 + g ) n −1 , n = 1, 2,..., n
 Geometric gradient application

Suppose you bought $P worth of an

income stock, which pays a steady
dividend of g% each year, and you
reinvest the dividends (to buy more
stock). Draw the dividend income
cash flow for 8 years. ($Pg = $A1)

A8
An = A1 (1 + g ) n −1 , n = 1, 2,..., n A7
A6
A5
A
A1 A2 A3 4
 Present worth factor

1 – (1 – g)N (1 + i)-N
P = A1 i≠g
i-g

N
P = A1 i=g
1+i A8
A7
A6
A5
A
A1 A2 A3 4
 Example – problem 2.43

What is the amount of 10 equal annual deposits that can

provide five annual withdrawals, when a first withdrawal
of $1000 is made at the end of year 11, and subsequent
withdrawals increase at the rate of 6% per year over the
previous year’s, if…
(a) … the interest rate is 8%, compounded annually.
(b) … the interest rate is 6%, compounded annually.
 Example 2.17: find P, given A1,g,i,N

– given:
g = 5%
i = 7%
N = 25 years
A1 = $50,000
– find: P

⎡1 − (1 + 0.05) 25 (1 + 0.07) −25 ⎤

P = $50, 000 ⎢ ⎥
⎣ 0.07 − 0.05 ⎦
= $940, 696
 Required additional savings

P= $50, 000( P / A , 7% , 25)

= $582, 679
∆P = $940, 696 − $582, 679
= $358, 017
 Problem 2.32 Cash Flow

– Equal payment series, A = $?, i = (a) 8% or (b) 6%, N = 10.

– Geometric gradient series, A1 = $1000, paid at end of interest period
11, g = 6%, N = 5, i = (a) 8% or (b) 6%

g = 6%
$1000

0 1…
11 … 15
$A
Composite $200

cash flows $150 $150 $150 $150

$100 $100 $100

$50

0
1 2 3 4 5 6 7 8 9

PGroup 1 = $50( P / F ,15%,1)

= $43.48

PGroup 2 = $100( P / A,15%, 3)( P / F ,15%,1)

= $198.54
PGroup 3 = $150( P / A,15%, 4)( P / F ,15%, 4)
= $244.85
PGroup 4 = $200( P / F ,15%, 9)
= $56.85
P = $43.48 + $198.54 + $244.85 + $56.85
= $543.72

Figure 2-32
 Unconventional equivalence calculations

Situation 1: If you make 4

annual deposits of $100
in your savings account
which earns 10% annual
interest, what equal
annual amount can be
withdrawn over 4
subsequent years?
 Unconventional equivalence calculations

Situation 2: What value

of A would make the
two cash flow
transactions
equivalent if i = 10%?
 Example – problem 2.53

Find the value of X so that the following 2 cash

flows are equivalent for an interest rate of 10%
compounded annually: (i) $400 withdrawn in
each of years 1-3 and $200 withdrawn in each
of years 4-5, and (ii) $X withdrawn in each of
years 1-2, 5 and $300 deposited in each of
years 3-4. See 2.53 in text for figure.