Factors: How time and interest affect money

Single payment factors

I Recall that P dollars now are equivalent to F dollars after

n time periods at a (compound) interest rate of i per time
period, where:
I F = P (1 + i)n
I Rewrite this as: F = P (F/P, i, n)
I where (F/P, i, n) = (1 + i)n is the ‘F/P’ factor.
I In addition, this implies that:
F
I P = = F (P/F, i, n)
(1 + i)n
1
I where (P/F, i, n) = is the ‘P/F’ factor.
(1 + i)n
Single payment factors
I The two factors derived are for single payments.
I i.e., they are used to find the present or future amount
when only one payment is involved.
I F/P means find F given P .
I Example: (F/P, 6%, 20) represents the factor that is used
to calculate the future amount F accumulated in 20
periods if the interest rate is 6% per period. P is given.
Simple vs. compound interest revisited

I Consider an initial deposit P in an account that pays

simple interest at a fixed rate per time unit.
I The value of the account at t = 2 is:
I P × (1 + 2i).
I Consider instead that the investor withdraws their money
from the account at t = 1 and immediately redeposits it.
I At t = 2, they have:
I P (1 + i) × (1 + i) = P (1 + 2i + i2 )
I The two strategies lead to an inconsistency in the value of
the same initial deposit at t = 2.
I Simple interest does not encourage long-term investment
and is inconvenient in practice.
Simple vs. compound interest revisited
I Consider an initial deposit of P in an account that pays
compound interest at a fixed rate i per time unit.
I The value of the account at t = 2 is:
I P × (1 + i)2
I Consider instead that the investor withdraws their money
from the account at t = 1 and immediately redeposits it.
I At t = 2, they have:
I P (1 + i) × (1 + i) = P × (1 + i)2
I The two strategies do not lead to an inconsistency in the
value of the same initial deposit at t = 2.
I Compound interest does encourage long-term investment
and is convenient in practice.
I Here and elsewhere, when the type of interest is not
specified, assume it is compound interest.
Tables and spreadsheets

I The P/F and F/P factors, as well as other factors, are

tabulated at the end of your textbook.
I You may use these tables or the formulas that we derive.
I Spreadsheets (i.e., Excel) has built-in functions for factors
(or you can easily build your own functions for calculating
the factors).
I Excel is very suited for practical interest calculations.
Example

I Sandy, a manufacturing engineer, just received a year-end

bonus of $10,000 that will be invested immediately. With
the expectation of earning at the rate of 8% per year,
Sandy hopes to take the entire amount out in exactly 20
years to pay for a family vacation when the oldest daughter
is due to graduate from college.
I Find the amount of funds that will be available in 20 years.
Example

I P = $10,000
I i = 8% per year
I n = 20 years
I F =?
I F = P (1 + i)n
I F = $10,000(1 + 0.08)20
I F = $10,000(4.6610) = $46,610
I Alternatively,
I F = P (F/P, i = 8%, n = 20)
| {z }
table lookup
I F = $10,000(4.6610) = $46,610
Example

I The Houston American Cement factory will require an

investment of $200 million to construct. Delays beyond the
anticipated implementation year of 2012 will require
additional money to construct the factory. Assuming that
the cost of money is 10% per year, compound interest,
determine the following for the board of directors of the
Brazilian company that plans to develop the plant.
I (a) The equivalent investment needed if the plant is built
in 2015.
I (b) The equivalent investment needed had the plant been
constructed in the year 2008.
Example

I (a) P = $200M
I i = 10% per year
I Using $1 million units:
I F3 = P (F/P, i, n) = 200(F/P, 10%, 3)
I F = 200(1.3310) = $266.2 (i.e. $266,200,000)
Example

I (b) P−4 = F (P/F, i, n) = 200(P/F, 10%, 4)

I P−4 = $200(0.6830) = $136.6 (i.e. $136,600,000)
Uniform series factors

I Suppose one will pay A dollars every time period for n

periods starting with the end of period 1.
I What is the future worth equivalence of this uniform series?
Uniform series factors

I Moving backwards, this series of cash flows is equivalent to:

I F = A + A(1 + i) + A(1 + i)2 + ... + A(1 + i)n−1 (g. series)
1 − (1 + i)n (1 + i)n − 1
I F =A =A
1 − (1 + i) i
I F = A(F/A, i, n)
(1 + i)n − 1
I (F/A, i, n) = is the ‘F/A factor’.
i
Uniform series factors

I Additionally,
i
I A=F = F (A/F, i, n)
(1 + i)n − 1
i
I (A/F, i, n) = is the ‘A/F factor’.
(1 + i)n − 1
I Note: the last A value and F occur at the same time.
Uniform series factors

I Finally, to find the present amount, P , equivalent to the

uniform series of cash:
I F = P (1 + i)n
F (1 + i)n − 1
I P = , where F = A
(1 + i)n i
n
 
(1 + i) − 1
I P =A = A(P/A, i, n)
i(1 + i)n
(1 + i)n − 1
 
I (P/A, i, n) = is the ‘P/A factor’.
i(1 + i)n
Uniform series factors

i(1 + i)n
 
I A=P = P (A/P, i, n)
(1 + i)n − 1
i(1 + i)n
 
I (A/P, i, n) = is the ‘A/P factor’.
(1 + i)n − 1
I Note: uniform end-of-period series of A values begin at the
end of period 1 and extend for n periods.
I That is, the present worth P must always be located one
period prior to the first A.
Amortization

I Amortization is the process of substituting a current

payment P for periodic payments of A per period (e.g. car
or home loan).
I e.g. consider a loan of $1,000 issued on Jan 1, 2006, to be
paid back in equal monthly payments over 5 years at an
interest rate of 1% per month.
I What will be the monthly payment?
Amortization

I P = $1000
I n = 5 × 12 = 60 months
I The monthly payment is:
I A = P (A/P, i, n) = 1000(A/P, 1%, 60)
(0.01)(1 + 0.01)60
 
I A = $1000 = $22.24
(1 + 0.01)60 − 1
Example

I How much money should you be willing to pay now for a

guaranteed $600 per year for 9 years starting next year, at
a rate of return of 16% per year?
Example

I A = $600
I n = 9 years
I i = 16% per year
I P =?
I P = A(P/A, 16%, 9) = $600(4.6065) = $2763.9
Example

I The Houston American Cement plant may generate a

revenue base of $50 million per year. The president of the
Brazilian parent company Votorantim Cimentos may have
reason to be quite pleased with this projection for the
simple reason that over the 5-year planning horizon, the
expected revenue would total $250 million, which is $50
million more than the initial investment.
I With money worth 10% per year, address the following
question from the president: Will the initial investment be
recovered over the 5-year horizon with the time value of
money considered?
I If so, by how much extra in present worth funds? If not,
what is the equivalent annual revenue base required for the
recovery plus the 10% return on money.
Example

I Initial investment = 250 − 50 = $200 M.

I A = $50 M per year
I n = 5 years
I i = 10% per year
I P =?
I In $1 million units:
I P = A(P/A, i, n)
I P = 50(P/A, 10%, 5) = 50(3.7908) = $189.54 < 200.
I The present worth value is less than the investment plus a
10% per year return, so the president should not be
satisfied with the projected annual revenue.
I Minimum A required:
I A = 200(A/P, 10%, 5) = 200(0.2638) = $52.76 per year
Example

I The president of Ford Motor Company wants to know the

equivalent future worth of a $1 million capital investment
each year for 8 years, starting 1 year from now. Ford
capital earns at a rate of 14% per year.
Example

I A = $1 M
I n = 8 years
I i = 14% per year
I F =?
I In $1000 units:
I F = A(F/A, 14%, 8) = $1000(13.2328) = $13,232.8
Example
I Once again, consider the HAC case, in which a projected
$200 million investment can generate $50 million per year
in revenue for 5 years starting 1 year after start-up. A 10%
per year time value of money has been used previously to
determine P , F , and A values.
I Now the president would like the answers to a couple of
new questions about the estimated annual revenues.
I (a) What is the equivalent future worth of the estimated
revenues after 5 years at 10% per year?
I (b) Assume that, due to the economic downturn, the
president predicts that the corporation will earn only 4.5%
per year on its money, not the previously anticipated 10%
per year. What is the required amount of the annual
revenue series over the 5-year period to be economically
equivalent to the amount calculated in (a)?
Example

I (a) In $1 million units:

I Future worth: F = 50(F/A, 10%, 5)
I F = 50(6.1051) = 305.255 (i.e. $305,255,000)

I (b) A = 305.255(A/F, 4.5%, 5)

I Since the factor tables do not include 4.5%, use the formula
for A/F :
 
0.045
I A = 305.255
(1.045)5 − 1
I A = 305.255(0.18279) = $55.798 (i.e. $55,798,000)
Factor values for untabulated i or n values

I Given specific values of i and n, there are several ways to

obtain any factor value.
1. Use the formula for the factor
2. Use an Excel function with the corresponding P , F , or
A value set to 1.
3. Use linear interpolation in the interest tables.
I Interpolation introduces some level of inaccuracy,
depending upon the distance between the two boundary
values selected for i or n , as the formulas themselves are
nonlinear functions.
Linear interpolation
I Select two tabulated values (x1 and x2 ) of the parameter,
ensuring that the two values surround x closely.
I Find the corresponding tabulated factor values (f1 and f2 ).
I Solve for the unknown, linearly interpolated value f :
Example

I Determine the P/A factor value for i = 7.75% and n = 10

years.
Example
I (i) Apply the formula for P/A:
(1 + i)n − 1
I (P/A, 7.75%, 10) =
i(1 + i)n
(1.0775)10 − 1 1.10947
I (P/A, 7.75%, 10) = = = 6.78641.
0.0775(1.0775) 10 0.16348
I Or (ii) use interpolation after table lookup:
I The bounding interest rates are i1 = 7% and i2 = 8%.
I Corresponding P/A factor values
f1 = (P/A, 7%, 10) = 7.0236 and
f2 = (P/A, 8%, 10) = 6.7101
x 8 − 7.75
I f = f2 + x, where = (similar triangles)
(f1 − f2 ) 8−7
(7.0236 − 6.7101)(8 − 7.75)
I f = 6.7101 + = 6.7885
(8 − 7)
Arithmetic gradient factors

I In some cases, cash flows increase (or decrease) by a fixed

amount in each time period starting with period 2.
I Starting with a cash flow of A at the end of period 1, the
cash flows increase by the gradient, G, in each period.
I That is, the cash flows are A, A + G, A + 2G, ...,
A + (n − 1)G, in periods 1, 2, ..., n.
Arithmetic gradient factors

I Then, at time n (future worth), this series of cash flows is

equivalent to:
I F = FA + FG
I where FA is the equivalent at time n of the series with
uniform cash flows A per time period:
(1 + i)n − 1
 
I FA = A
i
Arithmetic gradient factors

I FG is the equivalent at time n of the arithmetic cash flow

series with gradient G, i.e., the series having G, 2G, ...,
(n − 1)G cash flows at the end of periods 2, 3, ..., n.
Arithmetic gradient factors

I Going backwards:
I FG = (n − 1)G + (n − 2)G(1 + i) + ... + G(1 + i)n−2
I This is an arithmetic-geometric series (solved the same way
as a geometric series):
I FG × (1 + i) = (n − 1)G(1 + i) + (n − 2)G(1 + i)2 +
(n − 3)G(1 + i)3 + ... + G(1 + i)n−1
Arithmetic gradient factors

I FG (1 + i) − FG = FG (i) = G(1 + i)(1) + G(1 + i)2 (1) + ... +

G(1 + i)n−2 (1) + G(1 + i)n−1 − (n − 1)G
1 − (1 + i)n−1
I FG × i = G(1 + i) × − (n − 1)G
1 − (1 + i)
(1 + i)n−1 − 1
I FG × i = G(1 + i) × − (n − 1)G
i
G [(1 + i)n − (1 + i)] (n − 1)Gi
I FG = −
i2 i2
n
G [(1 + i) − ni − 1]
I FG =
i2
[(1 + i)n − ni − 1]
I (F/G, i, n) = is the ‘F/G factor’.
i2
I What about (P/G, i, n)?
Arithmetic gradient factors

I F = P (1 + i)n
F
I P =
(1 + i)n
G [(1 + i)n − ni − 1]
I P =
i2 (1 + i)n
[(1 + i)n − ni − 1]
I (P/G, i, n) = is the ‘P/G factor’.
i2 (1 + i)n

I What about (A/G, i, n)?

Arithmetic gradient factors

I (A/G, i, n) = (A/F, i, n) × (F/G, i, n)

i [(1 + i)n − ni − 1]
I (A/G, i, n) = ×
n
(1 + i) − 1 i2
[(1 + i)n − ni − 1]
I (A/G, i, n) = is the ‘A/G factor’.
((1 + i)n − 1)i
Arithmetic gradient factors

I Note!
I The gradient G may be positive or negative in value.
I The base amount defines a uniform cash flow series of the
size A that occurs each time period.
I The conventional arithmetic gradient starts in year 2, and
P is located in year 0.
Example

I A local university has initiated a logo-licensing program

with the clothier Holister, Inc. Estimated fees (revenues)
are $80,000 for the first year with uniform increases to a
total of $200,000 by the end of year 9.
I Determine the gradient and construct a cash flow diagram
that identifies the base amount and the gradient series.
Example

I At year n, the cash flow is:

I A + 8G ≡ $200K
I 8G = $200K − $80K = $120K
I G = 120K/8 = $15,000
Example

I Neighboring parishes in Louisiana have agreed to pool road

tax resources already designated for bridge refurbishment.
At a recent meeting, the engineers estimated that a total of
$500,000 will be deposited at the end of next year into an
account for the repair of old and safety-questionable
bridges throughout the area. Further, they estimate that
the deposits will increase by $100,000 per year for only 9
years thereafter, then cease.
I Determine the equivalent (a) present worth and (b) annual
series amounts, if public funds earn at a rate of 5% per
year.
Example
Example

I Note: the cash flow in year n = 10 is:

I A + 9G, i.e. $500K + $900K.
I i = 5%
I (a)
I PT = A(P/A, 5%, 10) + G(P/G, 5%, 10)
I In $1000 units:
I PT = 500(P/A, 5%, 10) + 100(P/G, 5%, 10)
I PT = 500(7.7117) + 100(31.652) = $7026.05
Example

I (b)
I AT = PT (A/P, 5%, 10)
I In $1000 units:
I AT = $7026.05(0.1295) = $909.873
I Alternatively,
I AT = 500 + G(A/G, 5%, 10) = 500 + 100(4.0991) = $909.91
Example

I The announcement of the HAC cement factory states that

the $200 million (M) investment is planned for 2012. Most
large investment commitments are actually spread out over
several years as the plant is constructed and production is
initiated. Further investigation may determine, for
example, that the $200 M is a present worth in the year
2012 of anticipated investments during the next 4 years
(2013 through 2016). Assume the amount planned for 2013
is $100 M with constant decreases of $25 M each year
thereafter. As before, assume the time value of money for
investment capital is 10% per year to answer the following
questions.
I (a) In equivalent present worth values, does the planned
decreasing investment series equal the announced $200 M
in 2012?
Example

I (a) In $1 million units:

I P = A(P/A, 10%, 4) + G(P/G, 10%, 4)
I P = 100(P/A, 10%, 4) + (−25)(P/G, 10%, 4)
I P = 100(3.1699) − 25(4.3781)
I P = $207.537 > 200
I (b) Given the planned investment series, what is the
equivalent annual amount that will be invested from 2013
to 2016?
Example

I (b) In $1 million units:

I A = +100 + G(A/G, 10%, 4)
I A = +100 + (−25)(A/G, 10%, 4)
I A = +100 − 25(1.3812)
I A = $65.471 (i.e. $65,471,000)
I Alternatively,
I The planned investment series was shown equivalent to
P = $207.537 M (in part (a))
I Thus, A = P (A/P, 10%, 4) = 207.537(0.31547) = $65.471
I (c) What must be the amount of yearly constant decrease
through 2016 to have a present worth of exactly $200 M in
2012, provided $100 M is expended in 2013?
Example

I (c) G = ?
I In $1 million units:
I P ≡ 200 = 100(P/A, 10%, 4) + G(P/G, 10%, 4)
I 200 = 100(3.1699) + G(4.3781)
I G = $ − 26.721 (i.e. decreasing gradient)
Geometric gradient factors

I Suppose now that in a series of cash flows the amounts

increase (or decrease) by a fixed percentage or ratio (1 + g),
in each time period starting with period 2.
Geometric gradient factors

I At time n, this geometric gradient series is equivalent to:

I F = A1 (1 + g)n−1 + A1 (1 + g)n−2 (1 + i) + ...+
A1 (1 + g)(1 + i)n−2 + A1 (1 + i)n−1
Geometric gradient factors

I F = A1 (1 + g)n−1 + A1 (1 + g)n−2 (1 + i) + ...+

A1 (1 + g)(1 + i)n−2 + A1 (1 + i)n−1
1+i n
 
1−
1+g
I F = A1 (1 + g)n−1 × , i 6= g
1+i
1−
1+g
(1 + g) − (1 + i)n
n
 

1+g
I F = A1 ×   , i 6= g
g−i
1+g
(1 + g) − (1 + i)n
n
I F = A1 × , i 6= g
g−i
I If i = g, then F = A1 [(1 + i)n−1 n]
Geometric gradient factors
n n
A × (1 + g) − (1 + i) , if i 6= g

1
I F = g−i

A1 [n(1 + i) n−1 ], if i = g
F
I P =
(1 + i)n
  n
1 + g

 1−
1+i


I P = A1 × i−g
, if i 6= g


A1 n
, if i = g

1+i
I Gradient g can be positive or negative (i.e. an increase or
decrease by a constant percentage each period).
I The initial cash flow A1 is not considered separately when
working with geometric gradients.
I A geometric gradient series has the amount A1 in period 1.
I Geometric gradient formulas are not tabulated.
Example

I A coal-fired power plant has upgraded an emission control

valve. The modification costs only $8000 and is expected to
last 6 years with a $200 salvage value. The maintenance
cost is expected to be high at $1700 the first year,
increasing by 11% per year thereafter.
I Determine the equivalent present worth of the modification
and maintenance cost at 8% per year.
Example

I i = 8% per year
I g = 0.11 6= i
I P =?
Example

  6 
1 + 0.11
 1 − 1 + 0.08 
I P = −8000 − 1700   + 200(P/F, 8%, 6)

 0.08 − 0.11



I P = −8000 − 1700(5.9559) + 126 = $−17,999

Example

I Assume that revenue may start at $50 million by the end of

the first year, but then decreases geometrically by 12% per
year through year 5. Determine the present worth and
future worth equivalents of all revenues during this 5-year
time frame assuming a rate of 10% per year.
Example

I g = −0.12 (decreasing gradient, opposing A1 )

I i = 10% 6= g
I n = 5 years
1+g n
 
1−
1+i
I P = A1 ×
i−g
I In $1 million units:
1 − 0.12 5
 
1−
1 + 0.1
I P = 50 ×
0.1 − (−0.12)
I P = 50(3.056) = $152.8
I F = P (F/P, 10%, 5) = $152.8(1.6105) = $246.08
Example

I Pyramid Energy requires that for each of its offshore wind

power generators $5000 per year be placed into a capital
reserve fund to cover unexpected major rework on field
equipment. In one case, $5000 was deposited for 15 years
and covered a rework costing $100,000 in year 15.
I What rate of return did this practice provide to the
company?
Example

I F = 100,000
I n = 15 years
I A = 5000 per year
I i=?
(1 + i)n − 1
 
I F =A
i
(1 + i)15 − 1
 
I 100,000/5000 = 20 = = (F/A, i, 15)
i
I i ≈ 3.98% by trial and error.
I Or: from the F/A interest tables for n = 15 years, the
value 20 lies between 3% and 4%.
I By interpolation, i = 3.98%
Example

I From the introductory comments about the HAC plant,

the annual revenue is planned to be $50 million. All
analysis thus far has taken place at 10% per year; however,
the parent company has made it clear that its other
international plants are able to show a 20% per year return
on the initial investment. Determine the number of years
required to generate 10%, 15%, and 20% per year returns
on the $200 million investment at the Georgia site.
Example

I In $1 million units:
I Suppose i = 10%
I P = 200 ≡ A(P/A, 10%, n)
(1 + i)n − 1
 
I P = 200 = 50
i(1 + i)n
(1 + i)n − 1
 
200
I = =4
i(1 + i)n 50
x−1
I Let x = (1 + i)n =⇒ =4
ix
1 1 1
I x= = =
1 − 4i 1 − 0.4 0.6
1
I (1 + 0.1)n = =⇒ n = 5.3596
0.6
I Thus n = 6 years (rounded up)
Summary
I (F/P, i, n) = (1 + i)n
1
I (P/F, i, n) =
(1 + i)n
(1 + i)n − 1
I (F/A, i, n) =
i
i
I (A/F, i, n) =
(1 + i)n − 1
(1 + i)n − 1
 
I (P/A, i, n) =
i(1 + i)n
i(1 + i)n
 
I (A/P, i, n) =
(1 + i)n − 1
[(1 + i)n − ni − 1]
I (F/G, i, n) =
i2
n
[(1 + i) − ni − 1]
I (P/G, i, n) =
i2 (1 + i)n
[(1 + i)n − ni − 1]
I (A/G, i, n) =
((1 + i)n − 1)i
Summary

n n
A × (1 + g) − (1 + i) , if i 6= g

1
I F = g−i

A1 [n(1 + i) n−1 ], if i = g
  n
1+g

 1−
1+i


I P = A1 × , if i 6= g
i−g

 n
A1 , if i = g


1+i
Summary of terminology

I F/P factor: Compound amount factor

I P/F factor: Present worth factor
I P/A factor: Uniform-series present worth factor
I A/P factor: Capital recovery factor
I A/F factor: Sinking fund factor
I F/A factor: Uniform-series compound amount factor
I P/G factor: Arithmetic gradient present worth factor
I A/G factor: Arithmetic gradient uniform-series factor