Scribd
Upload
62 views22 pages

Chapter 4 Economic Equivalent

The interest rate that makes the two cash flow streams indifferent is 8%.

Uploaded by

ORK BUNSOKRAKMUNY
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
62 views22 pages

Chapter 4 Economic Equivalent

The interest rate that makes the two cash flow streams indifferent is 8%.

Uploaded by

ORK BUNSOKRAKMUNY
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 22

Economic Equivalence

Sean Piseth
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?
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.
Equivalence from Personal Financing
Point of View
F

 If you deposit P dollars


today for N periods at F  P(1  i) N
i, you will have F
0
dollars at the end of N
period N.

PF P
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
N
P  F (1  i )

0 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 a savings


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

0 1 2 33 4 5
F

=
0 5
Solution

F  $2,042(1  0.08) 5

 $3,000
Example 2.2
At what interest rate
would these two amounts be equivalent?

$2,042
i=? $3,000

0 5
Equivalence Between Two Cash Flows

 Step 1: Determine the


$2,042 $3,000
base period, say, year 5.
 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  $2, 042
(1  0.08) 5

P F
$2,042 $2,205 $2,382 $2,572 $2,778 $3,000
0 1 2 3 4 5
Example 2.3

$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.


Approach
V

$200

$150
$120
$100 $100
$80

0 1 2 3 4 5
V3  $511.90  $264.46 V
 $776.36

$200
$200(1  0.10)1  $100(1  0.10) 2
$150  $264.46
$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
Practice Problem
2P
 How many years would
it take an investment to
double at 10% annual
0
interest?
N=?

P
Solution

2P
F  2 P  P (1  0.10) N
2  1.1N

log 2  N log1.1
0
log 2
N=? N
P
log1.1
 7.27 years
Rule of 72

 Approximating 72
how long it will N
take for a sum of interest rate (%)
money to double 72

10
 7.2 years
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
Approach
$1,000
 Step 1: Select the base
period to use, say n = $500
2. A
 Step 2: Find the 0 1 2 3
equivalent lump sum
value at n = 2 for both
A and B. C C
 Step 3: Equate both B
equivalent values and
solve for unknown C. 0 1 2 3
Solution
 For A: $1,000

1
$500
V2  $500(1  0.10)  $1,000(1  0.10)
2

 $1,514.09 A
0 1 2 3
 For B:
V2  C (1  0.10)  C
C C
 2.1C
 To Find C: B
2.1C  $1, 514.09
0 1 2 3
C  $721
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

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

$502 $502 $502

0 1 2 3
Establish Equivalence at n = 3

Option A : F3  $500(1  i)  $1, 000


3

Option B : F3  $502(1  i) 2  $502(1  i)  $502

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

Option A : F3  $500(1.08) 3  $1, 000


 $1, 630
Option B : F3  $502(1.08) 2  $502(1.08)  $502
 $1, 630

You might also like