Bicol University

COLLEGE OF ENGINEERING
Legazpi City

MODULE

The Concept of
4
Equivalence
Overview
This module covers the concepts of economic equivalence.

Lesson Objectives
At the end of this lesson, the student should be able to:
1. Understand economic equivalence; and
2. Understand equivalence calculations.

Lesson Outline
1. Introduction
1.1. Mathematical Equivalence
1.2. Decisional Equivalence
1.3. Market Equivalence
2. Equivalence Calculations – Equations of Value

4.1. Introduction

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 The Concept of Equivalence [BES 12] Engineering Economics

Alternatives should be compared when they produce similar results, serve the same
purpose, or accomplish the same function. The central factor in deciding among alternatives
involves a comparison of economic worth. We should consider the comparison of alternative
options, or proposals, by reducing them to an equivalent basis that is dependent on (1) the
interest rate, (2) the amounts of money involved, and (3) the timing of the monetary receipts
or expenses.
Equivalence simply means “the state of being equal in value”. It is a condition that exists
when the value of a cost at one time is equivalent to the value of the related benefit received
at a different time. We shall distinguish three concepts of equivalence that may underlie
comparisons of costs and benefits at different times – mathematical equivalence, decisional
equivalence and market equivalence.

MATHEMATICAL EQUIVALENCE
Mathematical equivalence is simply a mathematical relationship between time and
money. It says that two cash flows*, at time and at time + , are equivalent with
respect to the interest rate, , if
= (1 + ) .
Notice that if (where is a second number of periods) is mathematically
equivalent to , then
= (1 + )

= (1 + ) (1 + )

= (1 + )

so that and are also equivalent to each other. The fact that mathematical
equivalence has this property permits complex comparisons to be made among many cash
flows that occur over time.

DECISIONAL EQUIVALENCE
For any individual, two cash flows, at time and at time + , are equivalent
if the individual is indifferent between the two. Here, the implied interest rate relating
and can be calculated from the decision that the cash flows are equivalent, as opposed

* An in-depth discussion on cash flows, cash flow diagrams and cash flow analysis will be dealt in the next module.

2 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | [email protected] Instructor | [email protected]
[BES 12] Engineering Economics 4.1 Introduction

to mathematical equivalence, in which the interest rate determines whether the cash flows
are equivalent.

MARKET EQUIVALENCE
Market equivalence is based on the idea that there is a market for money that permits
cash flows in the future to be exchanged for cash flows in the present, and vice versa.
Converting a future cash flow, F, to a present cash flow, P, is called borrowing money, while
converting P to F is called lending or investing money. The market equivalence of two cash
flows P and F means that they can be exchanged, one for the other, at zero cost.
The interest rate associated with an individual’s borrowing money is usually a lot
higher than the interest rate applied when that individual lends money. For example, the
interest rate a bank pays on deposits is lower than what it charges to lend money to clients.
The difference between these interest rates provides the bank with income. This means
that, for an individual, market equivalence does not exist. An individual can exchange a
present worth for a future worth by investing money, but if he or she were to try to borrow
against that future worth to obtain money now, the resulting present worth would be less
than the original amount invested. Moreover, every time either borrowing or lending
occurred, transaction costs (the fees charged or cost incurred) would further diminish the
capital.
Large companies with good records have opportunities that differ from those of
individuals. Large companies borrow and invest money in so many ways, both internally
and externally, that the interest rates for borrowing and for lending are very close to being
the same, and the transaction costs are negligible. They can shift funds from the future to
the present by raising new money or by avoiding investment in a marginal project that
would earn only the rate that they pay on new money. They can shift funds from the present
to the future by undertaking an additional project or investing externally.
But how large is a “large company”? Established businesses of almost any size, and
even individuals with some wealth and good credit, can acquire cash and invest at about
the same interest rate, provided that the amounts are small relative to their total assets.
For these companies and individuals, market equivalence is a reasonable model, assuming
that market equivalence makes calculations easier and still generally results in good
decisions.

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 3

Instructor | [email protected] Instructor | [email protected]
 Bicol University
COLLEGE OF ENGINEERING
Legazpi City

4.2. Equivalence Calculations – Equations of Value

Equivalence calculations can be viewed as an application of compound-interest
relationships. An equation of value is obtained by setting the sum of the values on a certain
comparison or focal date of one set of obligations equal to the sum of the values on the same
date of another set of obligations.
In doing calculations, we must first convert cash flows to a common basis in order to
compare their values. One aspect of this basis is the choice of a single point in time at which to
make our calculations.

EXAMPLE 1 Equivalence Calculations

Engr. Natan owes his creditor (a) Php 100,000 due without interest at the end of 10
years, and (b) Php 30,000 at the end of 5 years with accumulated interest from today at
4% compounded annually. He will discharge his obligations by two equal payments at
the ends of the 3rd and 7th years. If the creditor states that money is worth 6%
compounded semiannually, find the new payments.
SOLUTION
First let’s analyze his original obligations:
 Php 100,000 at 0% interest due after 10 years
= Php 100,000 at year 10
 Php 30,000 at 4% compounded annually due after 5 years
= Php 30,000 (1.04)5 at year 5

Now, let’s consider his payments. Let be the value of the two equal payments.
Therefore, we have payments of at year 3 and at year 7.

Next, let’s determine our comparison point and make a diagram. Choose year 0*.

* For equivalence calculations, setting the comparison point to year 0 is most commonly used. However, we can use any point in
time as our comparison point.

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[BES 12] Engineering Economics 4.2 Equivalence Calculations – Equations of Value

Setting up the equation, we have

( ) ( )
0.06 0.06
100,000 1 + + 30,000(1.04) 1+
2 2
( ) ( )
0.06 0.06
= 1+ + 1+
2 2

Solving for the value of , we obtain the payments of

= , .

Let’s check the result at a different comparison point, say year 5.

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 5

Instructor | [email protected] Instructor | [email protected]
The Concept of Equivalence [BES 12] Engineering Economics

Setting up the equation, we have

( ) ( ) ( )
0.06 0.06 0.06
100,000 1 + + 30,000(1.04) = 1+ + 1+
2 2 2

Solving for the value of , we obtain the payments of

= , .

As we see, whatever comparison point we choose, the result will be the same.

EXAMPLE 2 Equivalence Calculations

Dr. Murillo bought a lot worth Php 1 million if paid in cash. On installment basis, he
paid a down payment of Php 200,000; Php 300,000 at the end of one year; Php 400,000
at the end of three years; and a final payment at the end of 5 years. What was the final
payment if money is worth 10% compounded annually?
SOLUTION
Let’s set our comparison point to year 0, and let be the final amount.

6 KIM ARVIN P. LEOCAD IO, REE OLIV ER M. PADUA, CE

Instructor | [email protected] Instructor | [email protected]
[BES 12] Engineering Economics 4.2 Equivalence Calculations – Equations of Value

Setting up the equation, we have

200,000 + 300,000(1 + 0.10) + 400,000(1 + 0.10) + (1 + 0.10)

= 1,000,000

Solving for the value of , we obtain the payments of

= , .

To better understand equivalence calculations, we will discuss cash flows, cash flow
diagrams and cash flow analysis in the next module.

KIM ARVIN P. L EOCAD IO, R EE OLIV ER M. PADUA, CE 7

Instructor | [email protected] Instructor | [email protected]