Chapter 2 – Time value of money

– Interest: the cost of

money
– Economic equivalence
– Interest formulas –
single cash flows
– Equal-payment series
– Dealing with gradient
series
– Composite cash flows. Power-Ball Lottery

1
 Decision dilemma – take a lump sum
or annual installments
A suburban Chicago couple
won the Power-ball.
They had to choose
between a single lump
sum $104 million, or $198
million paid out over 25
years (or $7.92 million
per year).
The winning couple opted
for the lump sum.
Did they make the right
choice? What basis do
we make such an
economic comparison?
2
 Option A Option B
(lump sum) (installment plan)

0 $104 M
1 $7.92 M
2 $7.92 M
3 $7.92 M

25 $7.92 M
3
 What do we need to know?

• To make such comparisons (the lottery decision

problem), we must be able to compare the value
of money at different point in time.
• To do this, we need to develop a method for
reducing a sequence of benefits and costs to a
single point in time. Then, we will make our
comparisons on that basis.

4
End-of-period convention

0
1

Beginning of End of interest

Interest period period

0 1
5
 Methods of calculating interest

– Simple interest: rarely used; but the point is that

there are different types of interest

– Compound interest: what people generally mean

when they say “interest”

6
 Investment variables

P → present value
F → future value
I → total interest
i → interest rate
N → number of interest periods
n → identifier of an interest period
Bn → balance at the end of interest period n

7
 Compounding process

$1,080

0 $1,166.40
$1,259.71
1

$1,000
2
3
$1,080
$1,166.40 8
 $1,259.71

0 1 2

F = $1, 000(1+ 0.08)3

$1,000
= $1, 259.71

9
 Compound interest formula
n = 0:P
n = 1: F1 = P(1+ i)
n = 2 : F2 = F1 (1+ i) = P(1+ i) 2

⁝
n = N : F = P(1+ i) N

The fundamental law of engineering economy

(1 + i)N → compound amount factor 10
 Practice problem: Warren Buffett’s
Berkshire Hathaway
– Went public in 1965: $18
per share
– Worth today (August 22,
2003): $76,200
– Annual compound growth:
24.58%
– Current market value:
$100.36 Billion
– If he lives till 100 (current
age: 73 years as of 2003),
his company’s total
market value will be ?

11
 Market value

Assume that the company’s stock will continue to

appreciate at an annual rate of 24.58% for the next
27 years.

F = P(1 + i)N = $100.36(1 + 0.2458)27 = $37,902

$37.902 trillion

12
 Practice problem

• If you deposit $100 now (n = 0) and $200 two years

from now (n = 2) in an account that pays 10%
interest, how much would you have at the end of year
10?

13
 Solution

0 1 2 3 4 5 6 7 8 9 10

$100(1+0.10)10 = $100(2.59) = $259

$100
$200 $200(1+0.10)8 = $200(2.149) = $429
F = $259 + $429 = $688
14
 Practice problem
Consider the following sequence of deposits &
withdrawals over a period of 4 years. If you earn
10% interest, what would be the balance at the
end of 4 years?

0 1
$1,210

4
?
2 3

$1,000 $1,000 $1,500 15

 $1,210 ?
0 1 3
2 4

$1,000 $1,000
$1,500
$1,100
$1,000
$1,210 $2,981
$2,100 $2,310
-$1,210 + $1,500

$1,100 $2,710

16
 Solution
End of Beginning Deposit Withdraw Ending
Period balance made balance

n=0 0 $1,000 0 $1,000

n=1 $1,000(1 + 0.10) $1,000 0 $2,100

=$1,100

n=2 $2,100(1 + 0.10) 0 $1,210 $1,100

=$2,310

n=3 $1,100(1 + 0.10) $1,500 0 $2,710

=$1,210

n=4 $2,710(1 + 0.10) 0 0 $2,981

=$2,981

17
 Economic equivalence

What do we mean by “economic equivalence?”

Why do we need to establish an economic
equivalence?
How do we establish an economic equivalence?

18
 Economic equivalence

– Economic equivalence exists between cash

flows that have the same economic effect and
could therefore be traded for one another.
– Even though the amounts and timing of the cash
flows may differ, the appropriate interest rate
makes them equal.

19
 Equivalence in personal finance
If you deposit P dollars today for N
periods at i, you will have F F
dollars at the end of period N.

F =P(1+i)N
0
N

P  F P
20
 Alternate way of defining equivalence
P

F dollars at the end of period

N is equal to a single sum P
dollars now, if your earning 0 N
power is measured in terms
of interest rate i. F

P = F(1+i)−N

(1 + i)-N → present worth factor

0 21 N
 Practice problem
At 8% interest, what is the equivalent worth
of $2,042 now, 5 years from now?

$2,042 If you deposit $2,042 today in an account

that pays 8% interest annually how much
would you have at the end of 5 years?

0 1 2 3 4 5

22

0 1 2 3 4 5
 Solution

F = $2,042(1 + 0.08)5 = $3,000

Using interest tables: (F/P,8%,5) = 1.4693

$2,042 X 1.4693 = $3,000

23
 At what interest rate
would these two amounts be equivalent?

$2,042
i=? $3,000

0 5

24
 Equivalence between two cash flows

Step 1: Determine the base

period, say, year 5. $2,042 $3,000
Step 2: Identify the interest
rate to use.
Step 3: Calculate
equivalence value.
0 5
i = 6% , F = $2,042(1 + 0.06) 5 = $2,733
i = 8% , F = $2,042(1 + 0.08) 5 = $3,000
i = 10% , F = $2,042(1 + 0.10 ) 5 = $3,289
 Example - equivalence
Various dollar amounts that will be economically
equivalent to $3,000 in 5 years, given an interest rate
of 8%.
$3,000
P= 5
= $2,042
(1+ 0.08)

P F
$2,042 $2,205 $2,382 $2,572 $2,778 $3,000
0 1 2 3 4 5 26
 Example

$200 V
$150
$120
$100 $100
$80

0 1 2 3 4 5 0 1 2 3 4 5

Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.

27
 Approach
V

$200

$150
$120
$100 $100
$80

0 1 2 3 4 5

28
 V3 = $511.90 + 264.46 = $776.36
V

$200(1 + 0.10)-1 + $100(1 + 0.10)-2

$200 = $264.46

$150
$120
$100 $100
$80

0 1 2 3 4 5

$100(1 + 0.10)3 + $80(1 + 0.10)2 + $120(1 + 0.10) + $150

= $511.90
29
 Practice problem
How many years would it 2P
take an investment to
double at 10% annual
interest?
0

F = 2P = P(1+ 0.10) N N=?

2 = 1.1N P

log 2 = N log1.1
log 2
N=
log1.1
30

= 7.27 years
 Rule of 72

Approximately how
72
long it will take for N
a sum of money to interest rate (%)
double
72
=
10
= 7.2 years
31
 Practice problem
You just purchased 100 shares of stock at $60
per share. You will sell when the market price
has doubled. If you expect the stock price to
increase 20% per year, how long do you expect
to wait until selling?

32
 Practice problem
$1,000
$500
Given: i = 10%,
A

Find: C that makes the 0 1 2 3

two cash flow streams
to be indifferent C C

0 1 2 3
33
 Approach
$1,000
Step 1: Select the base
period to use, say n = 2. $500
Step 2: Find the equivalent A
lump sum value at n = 2
0 1 2 3
for both A and B.
Step 3: Equate both
equivalent values and C C
solve for unknown C.
B

0 1 2 3
34
 Solution

A $1,000
V2 = $500(1 + 0.10)2 + $1,000(1+0.10)-1 $500
=
$1,514.09 A
0 1 2 3
B V2 = C(1 + 0.10) + C = 2.1C

C C

To find C: B
2.1C = $1,514.09
C = $721 0 1 2 3
35
 Practice problem
$1,000
$500
At what interest rate
would you be A

indifferent between the 0 1 2 3

two cash flows?
$502 $502 $502
B

0 1 2 3
36
 Approach
Step 1: Select the base period
to compute the equivalent $1,000
value (say, n = 3)
Step 2: Find the net worth of $500
each at n = 3. A
0 1 2 3

$502 $502 $502

B

0 1 2 37 3
 Establish equivalence at n = 3

Option A : F 3 = $500(1+ i)3 + $1, 000

Option B : F3 = $502(1+ i) 2 + $502(1+ i) + $502

– Find the solution by trial and error, say i = 8%

O ption A : F 3 = $500(1.08) 3 + $1, 000

= $1, 630
O ption B : F3 = $502(1.08) 2 + $502(1.08) + $502
= $1, 630
38
 Interest formulas
– Single payments
◦ present worth factor (F/P,i,N)
◦ capital recovery factor (P/F,i,N)
– Unequal payment series
– Equal payment series
◦ compound amount factor (F/A,i,N)
◦ sinking fund factor (A/F,i,N)
◦ present worth factor (P/A,i,N)
◦ capital recovery factor (A/P,i,N)
39
 Retirement planning
A 21-year old inherits $100,000 from a distant
relative who has deceased. She decides to
spend some and invest the rest immediately in
order to retire at 65 with a $1,000,000 savings
account. At 8% interest compounded annually,
how much must be invested?

40
 Solution

$1,000,000 = P (1+0.08)44
P = $1,000,000/29.56 = $33,834
$100,000 - $33,834 = $66,166

41
 Multiple payments

How much do you need

to deposit today (P) to
$25,000
withdraw $25,000 at n
$3,000 $5,000 =1, $3,000 at n = 2,
0

1 2 3 4
and $5,000 at n =4, if
your account earns
10% annual interest?
P

Set up spreadsheet solution 42

 Uneven payment series
$25,000

$3,000 $5,000
0

1 2 3 4

$25,000

$3,000 $5,000
0 0
0

1 2 3 4
+ 1 2 3 4
+ 1 2 3 4
P2
P4
P1
P1 = $25,000(P / F ,10%,1) P2 = $3,000(P / F,10%, 2) P4 = $5,000(P / F,10%, 4)
= $22,727 = $2, 479 = $3, 415
43

P = P1 + P2 + P3 = $28,622
 Check
Beginning Interest Payment Ending
balance earned balance
n=0 0 0 +28,622 28,622

n=1 28,622 2,862 -25,000 6,484

n=2 6,484 649 -3,000 4,133

n=3 4,133 413 0 4,546

n=4 4,546 455 -5,000 1

44
Rounding error
It should be “0.”
 College fund
Suppose you make an annual contribution of $100
each year to a college education fund for a
niece. She is 4 years old now, and you will start
next year and make the last deposit when she is
18. The fund is a money market account
earning 6.5%/year. What will it be worth
immediately after the last deposit?

Set up spreadsheet solution 45

 beginning ending
Age n balance deposit interest balance
4 0 0.00 0 0.00 0.00
5 1 0.00 100 0.00 100.00
6 2 100.00 100 6.50 206.50
7 3 206.50 100 13.42 319.92
8 4 319.92 100 20.79 440.72
9 5 440.72 100 28.65 569.36
10 6 569.36 100 37.01 706.37
11 7 706.37 100 45.91 852.29
12 8 852.29 100 55.40 1007.69
13 9 1007.69 100 65.50 1173.19
14 10 1173.19 100 76.26 1349.44
15 11 1349.44 100 87.71 1537.16
16 12 1537.16 100 99.92 1737.07
17 13 1737.07 100 112.91 1949.98
18 14 1949.98 100 126.75 2176.73
 Equal payment series
F

0 1 2 N
A A A

P
0 1 2 N

0 N

47
Equal payment series – compound amount factor
F

0 1 2 N
A A A

F
0 1 2 N

0 1 2
N

A A A
 Compound amount factor
F

A(1+i)N-2
A A A

A(1+i)N-1

0 1 2 N 0 1 2 N

F = A(1 + i)N-1 + A(1 + i)N-2 +  + A 49

 Compound amount factor
F = A(1 + i)N-1 + A(1 + i)N-2 +  + A

multiply by (1 + i):

F(1 + i) = A(1 + i)N + A(1 + i)N-1 +  + A(1 + i)

subtract:

F(1 + i) – F = A(1 + i)N – A

(1 + i)N – 1
F=A
rearrange: i
Fi = A(1 + i)N – A
50
 Equal payment series compound amount factor
(future value of an annuity)
F
(1+ i) N − 1
0 1 2 3 F=A
N i
A
= A(F / A,i, N )
Example
• Given: A = $5,000, N = 5 years, and i = 6%
• Find: F
• Solution: F = $5,000(F/A,6%,5) = $28,185.46
51
 Validation

beginning ending
n balance deposit interest balance
0 0.00 0 0.00 0.00
1 0.00 5000 0.00 5000.00
2 5000.00 5000 300.00 10300.00
3 10300.00 5000 618.00 15918.00
4 15918.00 5000 955.08 21873.08
5 21873.08 5000 1312.38 28185.46

52
 Finding an annuity value
(sinking fund factor)
F
i
A= F
0 1 2 3 (1+i) N −1
N

A=? = F( A/ F,i, N)
P
Example:
• Given: F = $5,000, N = 5 years, and i = 7%
• Find: A
• Solution: A = $5,000(A/F,7%,5) = $869.50
53
 Equal payment series
(uniform series)
Find the future worth of the following cash flow,
assuming interest rate i.

0 1 2 3 4 N-3 N-2 N-1 N

$A $A $A $A $A $A $A $A

54
 Custodial account

Suppose you decide to open a custodial account

for your niece, who was born today. The
minimum deposit is $100 on opening the
account today, and you will put in $100 each
year up to and including her 18th birthday.
What is the account worth when it is turned
over to the child at age 18? You expect to
earn 10% interest per year.

55
 Custodial account cash flow

012…

18
$100 …

012…
 (1+ i) −1 
N
F = A 
 i  18
$100 …

 (1.10)19 −1 
F = $100   = $5115,9 See spreadsheet solution
 0.10 
56
 Sinking fund
You are saving up money to make a down
payment of $100,000 on a house when you
graduate in 4 years. You plan to invest $A at the
end of each summer in a money market account
earning 6.5%/year. Find A.

57
 Sinking fund
You are saving up money to make a down payment of
$100,000 on a house when you graduate in 4 years.
You plan to invest $A at the end of each summer in a
money market account earning 6.5%/year. Find A.

(1 + i)N – 1 (1 + 0.065)4 – 1
F=A =A = $100,000
i 0.065

4.41 A = $100,000
58
A = $100,000/4.41 = $22,690
 Annuity factor
(capital recovery factor)
You want to obtain a loan of $20,000 to buy a used car.
You will pay off the loan in yearly payments over the next
5 years. The salesman quotes a 6% annual interest rate
and yearly payments of $4,878. Is $4,878 an accurate
payment for this loan?

59
 Annuity factor
(equal series capital recovery factor)

(1 + i)N – 1
F=A
i

i i
A=F = P (1 + i)N (1 + i)N – 1
(1 + i)N – 1

i (1 + i)N
A=P
(1 + i)N – 1

60
A = P(A/P,i,N)
 Annuity factor
(capital recovery factor)
You want to obtain a loan of $20,000 to buy a used car.
You will pay off the loan in yearly payments over the next
5 years. The salesman quotes a 6% annual interest rate
and yearly payments of $4,878. Is $4,878 an accurate
payment for this loan?

i (1 + i)N 0.06 (1 + 0.06)5

A=P = $20,000
(1 + i)N – 1 (1 + 0.06)5 - 1

0.237 x $20,000 = $4,748

61
 Deferred payments

Suppose you get a student loan for $8,000, and your

payments are deferred until after you graduate, 2 years
from now (it means no interest applies for the next two
years). Then, you will make 15 yearly payments
(starting 2 years from now). What are your payments?
The interest rate is 8%/year.

62
 Deferred payments

Suppose you get a student loan for $8,000, and your

payments are deferred until after you graduate, 2 years
from now (it means no interest applies for the next two
years). Then, you will make 15 yearly payments
(starting 2 years from now). What are your payments?
The interest rate is 8%/year.

i (1 + i)N 0.08 (1 + 0.08)15

A=P = $8,000
(1 + i)N – 1 (1 + 0.08)15 - 1

0.1168 x $8,000 = $934

63
Capital recovery factor (annuity factor)
 Present worth
Your father is about to get downsized out of his position. He has been
with the previous company through 3 previous mergers, and is
disgusted with that nature of the business. He is considering retiring
rather than seeking a new job. What would his retirement savings
have to be worth today in order to withdraw $50,000/year for the
next 15 years? He expects to invest conservatively, earning 5% per
year during his retirement years.

64
 Present worth
Your father is about to get downsized out of his position. He has been
with the previous company through 3 previous mergers, and is
disgusted with that nature of the business. He is considering retiring
rather than seeking a new job. What would his retirement savings
have to be worth today in order to withdraw $50,000/year for the
next 15 years? He expects to invest conservatively, earning 5% per
year during his retirement years.

(1 + i)N - 1 (1 + 0.05)15 - 1
P=A = $50,000
i (1 + i)N 0.05 (1 + 0.05)15

10.38 x $50,000 = $519,000

65
Present worth factor
Example: early savings plan – 8% interest
?

Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10

44

$2,000
?

Option 2: Deferred Savings Plan

0 1 2 3 4 5 6 7 8 9 10 11 12
44

66
$2,000
 Option 1 – early savings plan
(1 + i)N – 1 F10 = $2,000 (F/A,8%,10)
F=A ➔
i = $28,973

?
Then use:

F =P(1+i)N ➔ Option 1: Early Savings Plan

0 1 2 3 4 5 6 7 8 9 10
F44 = $28,973 (F/P,8%,34)
= $396,645 44

$2,000

Age 31 65
67
 Option 2: Deferred Savings Plan
(1 + i)N – 1
F=A
i

F44 = $2,000 (F/A,8%, 34)

= $317,233 ?

Option 2: Deferred Savings Plan

0 11 12
44

$2,000

68
 At what interest rate would these two
options be equivalent?
Option 1:
F44 = $2, 000(F / A,i,10)(F / P,i, 34)
Option 2:
F44 = $2, 000(F / A.i, 34)
Option 1 = Option 2
$2, 000(F / A,i,10)(F / P,i, 34) = $2, 000(F / A.i, 34)
Solve for i
69
 A B C D E F
1
2 Year Option 1 Option 2
3 0
4 1 $ (2,000)
5 2 $ (2,000) Interest rate 0.08
6 3 $ (2,000)
7 4 $ (2,000) FV of Option 1 $ 396,645.95
8 5 $ (2,000)
9 6 $ (2,000) FV of Option 2 $ 317,253.34
10 7 $ (2,000)
11 8 $ (2,000) Target cell $ 79,392.61
12 9 $ (2,000)
13 10 $ (2,000)
14 11 $ (2,000)
15 12 $ (2,000)
16 13 $ (2,000)
17 14 $ (2,000)
18 15 $ (2,000)
19 16 $ (2,000)
20 17 $ (2,000)
21 18 $ (2,000)
22 19 $ (2,000)
40 37 $ (2,000)
41 38 $ (2,000)
42 39 $ (2,000)
43 40 $ (2,000)
44 41 $ (2,000)
45 42 $ (2,000)
46 43 $ (2,000)
47 44 $ (2,000)
70
Using excel’s goal seek function

71
Result

72
73
 Gradient series
– Linear gradient
– Geometric gradient

74
Linear gradient series

Gradient series
present worth factor

75
Gradient series as a composite series

76
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
earns a 12% annual interest, if you
P =?
want to withdraw the annual series
as shown in the figure? 77
Method 1: $2,000
$1,750
$1,500
$1,250
$1,000

0
1 2 3 4 5
(P/F,i,N) : P = F(1+i)−N
$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: (1 + i)N - 1
P=A
i (1 + i)N

P1 = $1,000(P/ A,12%,5)
= $3,604.80

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

P=$3,604.08+$1,599.20
=$5,204

79
 Example – supper lottery
You won the lottery. Decide which option is better. 3.44 million$
paid right now or the distribution showed in the second figure below:
$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
F

0 1 2 3
N

A
P
81
 Equivalent present value of annual payment
option at 4.5%

P
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
Where:
(1 + i)N - 1
P=A
i (1 + i)N
P = F(1+i) −N 82
(P/F,i,N) :
 Excel
solution
 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?

84
 Linear gradient series
$50k $52k $54k $56k $58k

Allied Signal

0 1 2 3 4 5

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

Raytheon
85

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

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

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

0 1 2 3 4 5
 Gradient to equal-payment conversion
One way to answer this question is to transform your linear
gradient to a constant annual payment (annuity).
$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 = G( A / G,i, N )

A=G    =G
  (1+ i) −1  i [(1+ i)N −1]
2 N N
 i (1+ i) 87
 Future worth of a gradient series
You can also transform this gradient to an equivalent
future worth
$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) N −1   i  i  i 
 Linear vs. geometric gradient
A8
A7
Cash flows on a linear gradient A A 6
A4 5
increase by a constant amount A
A 3
each interest period. A1 2

An = A1 + (n −1)G, n = 1, 2,..., n

Cash flows on a geometric gradient

increase by a constant percentage A8
each interest period. The A7
A6
percentage is call the growth rate, g. A5
A
A1 A 2 A 3 4
A = A (1+ g) n−1 , n = 1, 2,..., n
n 1
 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
A7
A6
A5
A
A = A (1+ g) n−1 , n = 1, 2,..., n A1 A 2 A 3 4
n 1

90
 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
A A5
A
A 1 A2 3 4

91
 Example 2.19

Suppose that your retirement benefits during your first year of

retirement are $50,000. Assume that this amount is just enough
to meet your cost of living during the first year. However, your
cost of living is expected to increase at an annual rate of 5% due
to inflation. Suppose you do not expect to receive any cost-of-
living adjustment in your retirement pension. Then, some of
your future cost of living has to come from savings other than
retirement pension. If your savings account earns 7% interest a
year, how much should you set aside in order to meet this future
increase in the cost of living over 25 years?

92
 Example 2.19: find P, given A1, g, i, N

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

1 – (1 + g)N (1 + i)-N 1− (1+ 0.05) 25 (1+ 0.07) −25

P = A1 = $50, 000
i-g 0.07 − 0.05
= $940, 696 93
 Required additional savings
However, let’s find the present worth of the 50,000$ annual
payment:

P = $ 5 0 , 0 0 0 (P / A , 7 %, 2 5 ) = $ 5 8 2 , 6 7 9

This means that the extra amount that we need to have today is:

P = $ 9 4 0 , 6 9 6 − $ 5 8 2 , 6 7 9 = $ 3 5 8,0 1 7

94
 Example 2.20
You want to supplement your retirement income through IRA contributions.
You have 15 years left until retirement and you are going to make 15 equal
annual deposits into your IRA until you retire with the first deposit being
made at the end of year 1.
You need to save enough so that you can make 10 annual withdrawals that
will begin at the end of year 16. The first withdrawal will be $10,000, and
each subsequent withdrawal will increase at a rate of 4% over the previous
year's withdrawal in line with expected increase in cost-of-living. Your last
withdrawal will be at the end of year 25.
What is the amount of the equal annual deposit amount ( C) for the first 15
years? Assume the interest rate is 8% compounded annually before and after
you retire.

95
 Example 2.20 - solution
Methodology 1: Establish equivalence at n= 0.

96
 Example 2.20 - solution
Methodology 2: Establish equivalence at n=15.

97
 Example 2.20 - solution
Methodology 2: Establish equivalence at n=15.

98
 $200
Composite $150 $150 $150 $150

cash flows $50

$100 $100 $100

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 99
 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?

100
 Unconventional equivalence calculations

Situation 2:

What value of A would

make the two cash
flow transactions
equivalent if i = 10%?

101
102
103
105