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Technology and

Entrepreneurship

University of Toronto

1996-2004

Centre for Management of Technology and

Entrepreneurship

Course: CHE349

File: CHE349/CashFlowA4

First cost - expense to build or to buy and install

Operations and maintenance (O&M) - annual

expense, can include ; electricity, labour, repairs, etc.

Salvage value(s) - receipt at project termination for

disposal of the equipment (can be a salvage cost)

Revenues - annual receipts due to sale of products or

services

Overhauls - major capital expenditure that occurs part

way through the life of the asset

Prepaid expenses - annual expenses, such as leases

and insurance payments, that must be paid in advance

Centre for Management of Technology and

Course:

Economic Equivalence

How do we measure and compare economic worth of

various cash flow profiles? We need to know:

Magnitude of cash flows

Their direction (receipt or disbursement)

Timing (when does transaction occur)

Applicable interest rate(s) during time period under consideration

between two alternatives that are economically

equivalent and could therefore be traded for one another

in the financial marketplace.

Any cash flow can be converted to an equivalent cash

flow at any point in time.

Centre for Management of Technology and

Course:

An Example of Equivalence

Suppose you are offered the alternative of receiving

either $3,000 at the end of 5 yrs (guaranteed) or P

dollars today. You would deposit the P dollars into an

account that pays 8% interest. What value of P would

make you indifferent to your choice between P dollars

today and the $3,000 at the end of 5 yrs?

Determine the present amount that is economically

equivalent to $3,000 in 5 yrs given the investment

potential of 8% per year.

F = $3,000, N = 5 years, i = 8% per year

Find P

P = F/(1+i)N = $2,042

Centre for Management of Technology and

Course:

Economic Equivalence:

General Principles

Equivalence calculations to compare alternatives

require a common time basis

Equivalence depends on the interest rate

May require conversion of multiple payment cash flow

to a single cash flow

Equivalence is maintained regardless of the individual's

point of view (borrower or lender)

Course:

Equivalence - A Factor

Approach

Now we can look at organizing the approach to

Engineering Economy by defining its language and

notations.

Engineering Economy Factors apply compound interest

to calculate equivalent cash flow values. The tabulated

values at the end of the book (or you can use the

functions in spreadsheets) convert from one cash flow

quantity (P, F, A, or G) to another.

Assumptions:

1. Interest is compounded once per period

2. Cash flow occurs at the end of the period

3. Time 0 is period 0 or the start of period 1

4. All periods are the same length

Centre for Management of Technology and

Course:

Definitions

The following are the definitions for the variables used:

i interest rate per period, expressed as a decimal

N Number of periods (also called the study horizon)

P Present cash flow, or value equivalent to a cash flow

series

F Future cash flow at the end of period N, or future worth

at the end of period N equivalent to a cash flow series

A Uniform periodic cash flow (annuity) at the end of every

period from 1 to N. Also a uniform constant amount

equivalent to a cash flow series.

G Gradient or constant period-by-period change in cash

flows from period 1 to N (arithmetic series)

Centre for Management of Technology and

Course:

Factor Notation

These have their roots in the pre-computer age when

prepared tables were used by engineers for many

design needs. However, they still serve to state the

problem and can be used to solve it too.

The format of engineering economy factors is:

(X/Y, i%, N) where X and Y are chosen from the cash

flow symbols P,F,A and G.

So, if you have Y multiplied by a factor, you get the

equivalent value of X: P = A(P/A, i ,N) e.g. convert from

a cash flow (F) in year 10 to an equivalent present

value (P), the factor is:

(P/F, i N) - see text pages after 559 for the tables

Centre for Management of Technology and

Course:

So now we know how all this works together, but these factors

have names as follows:

(P/F,i,N) Present worth factor

(F/P,i,N) Compound amount factor

(P/A,i,N) Series present worth factor

(A/P,i,N) Capital recovery factor, how much an investment has to

return to recover its cost - no salvage value

(A/F,i,N) Sinking fund factor - where a savings account is used to

accumulate funds for future investment

(F/A,i,N) Series compound amount factor

Note that the first letter is the variable you are seeking and the

second the one you have P/A want First Cost (investment), have

annuity payment

Course:

for Discrete Compounding

The four discrete cash flow patterns are:

a single disbursement or receipt

a set of equal amounts in/out over a sequence of periods annuity

a set of equal amounts in/out that change by a constant

amount from one period to the next in a sequence of periods arithmetic gradient series

a set of equal amounts in/out that change by a constant

proportion from one period to the next in a sequence of periods

- geometric gradient series

compounding periods are equal

cash flows at the end of the period (consider payment at 0 to

be at period -1

annuities and gradients occur at period ends

Centre for Management of Technology and

Course:

10

Factors

P and F are the basic single payment quantities and

they are related as follows:

F = P(1 + i)N can be developed as:

Fn= P(1+ in) - where: i is the annual interest rate simple interest - but this is not very useful, so we

develop the compound interest model:

Fn = Fn-1 (1+ i)

So we can see this in the EE notation as:

(F/P,i,N) = (1 + i)N and for the reverse

(P/F,i,N) = (1 + i)-N

The limits of P/F and F/P factors are:

1 when i and N approach 0

P/F approaches 0; F/P infinity when i and N approach infinity.

Centre for Management of Technology and

Course:

11

and F

F If you had $2,000

F occurs N periods after P

1

N-1

it at 10%, how

much would it be

worth in 8 years?

P

P = $2,000, i = 10% per year, N = 8 years

F = P(1+i)N =$2,000(1+0.10)8= $4,287.18

F = P (F/P,10%, 8)=$2,000*2.1436 =$4,287.20

Course:

12

F

F occurs N periods after P

1

N-1

P

If $1,000 is to be received in 5 years. At an annual

interest rate of 12%, what is the P of this amount?

F=$1000, i = 12%, N = 5 years

P = F/(1+i)N= $1000/(1+.12)5 = $567.40

P = F(P/F, 12%,5) = $1000(0.5674) = $567.40

Centre for Management of Technology and

Course:

13

Discrete Compounding,

Discrete Cash Flows P. 571

Course:

14

Combining Factors

We can combine these factors in various ways to create

a model for the real problem at hand:

delayed income stream because of startup time

another need may be prepaid expenses - also a way to deal

with startup delays or construction delays.

proposition - in fact deriving one formulas factor from

an others

Also, many times the problem has to be defined in

more than one part

Then, there are many approaches to a specific problem

- one may be longer but the answer must be the same

Centre for Management of Technology and

Course:

15

A Simple Example

We invest $120,000 [P=-120,000]

We pay for 5 years $30,000/year [P=30,000(P/A,12%,5)]

Then pay $35,000 at year 3 [P=-35,000(P/F,12%,3)]

Receive $40,000 at year 4 [P=40,000(P/F,12%,4)]

$40,000

$30,000

$30,000

$35,000

$120,000

Centre for Management of Technology and

Course:

16

for Annuities: Uniform Series

All cash flows in series are equal (annuity)

N-2 N-1

Before 1st A, F would occur

At same time as last A.

=

K1

A(1 + i)-K

(1 i) N 1

P = A

n

i(1 i)

Series Present Worth Factor

Centre for Management of Technology and

P = A(P/A i, N)

p.62 Text

Course:

17

for Annuities: Uniform Series

From before, P = A [(1+i)N-1]/[i(1+i)N]

Then to get (F/A, i, N) we can convert this to a future

single payment by multiplying both sides by (1+i)N

(1+i)N * P = A[(1+i)N-1]/i resulting in

F = A[(1+i)N-1]/i

p.60 text

Course:

18

Bonds

Financial instrument used by large firms and

government to raise funds to finance projects, debt

obligations,

A special form of loan, usually with a long term

The creditor (firm or government) promises to pay a

stated amount of interest at specified intervals for a

defined period and then to repay the principal at a

specific date (maturity date)

Canada savings bonds usually represent the lowest

interest because they are the safest (set tone for

interest rates), then are provincial bonds, next are

Blue-Chip corporates (banks, large firms)

Junk bonds are very high interest and risk

Centre for Management of Technology and

Course:

19

Bond Terminology

P = Purchase price of a bond

F = Sales price (or redemption value) of a bond

V = Par (face) value the stated value on the bond

r = annual interest shown (or coupon rate)

n = compounding period (quarterly, six months, etc.)

i = the yield rate per annum (usually the market rate)

N = number of remaining years to maturity

Redemption when the issuer pays for it in cash

Maturity Date date on which the par value is to be

repaid (date bond expires)

Market Value the price one has to pay to buy a bond

A = V(r/n) = the value of a single interest payment (a

coupon)

P = V(r/n) (P/A, i/n, nN) + F (P/F, i, N)

Centre for Management of Technology and

Course:

20

Bond Valuation

Yield to maturity (return on investment) = actual

interest earned from a bond over the holding period

(equivalent to IRR calculations)

When considering buying or selling bonds, the yield is

the fundamental consideration and this depends on a

number of issues:

Inflation rate (usually included in the yield by market forces)

Your tax position

Foreign exchange risk if you invest in other currencies

unlikely to the face value, except at redemption.

Centre for Management of Technology and

Course:

21

Canadian Bonds

Course:

22

Course:

23

Example of Arithmetic

Gradients

We have two propositions for investment:

New Multi Processor Computer

Natural Gas Pipeline

End of Year

Computer

0

-$50,000

1

+$20,000

2

+$15,000

3

+$10,000

4

+$5,000

Natural Gas

-$50,000

+$5,000

+$10,000

+$15,000

+$20,000

have revenues of $37,000 over the time period.

Centre for Management of Technology and

Course:

24

Natural Gas Options

$20,000

$15,000

(+)

$10,000

(+)

$5,000

0

(-)

Computer

Option

$50,000

$20,000

$15,000

$10,000

$5,000

0

(-)

Natural Gas

Option

$50,000

Course:

25

Arithmetic Gradients

An easy definition of an arithmetic gradient is: revenue

grows by $10,000 (G) each year.

(N-1)G

But the rate is not always constant

3G

2G

Each successive cash flow increases

by a fixed amount equal to G

0

1. A>0 and G>0 - means positive and increasing

2. A>0 and G<0 - means positive but decreasing

3. A<0 and G>0 - means negative but becoming less so

4. A<0 and G<0 - means negative and becoming more so

Centre for Management of Technology and

Course:

26

Arithmetic Gradients

cont'd...

A series of receipts or disbursements that start at 0 at

the end of the 1st period and then increase by a

constant amount from period to period.

e.g. increasing operating costs for an aging machine

series is a common pattern.

The gradient formulas can be derived just as the

annuity formulas were. See Text pages 68-70.

To convert gradient to uniform series:

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

Then can convert A to P or F

Centre for Management of Technology and

Course:

27

A>0

A+(N-1)G

A+3G

A+2G

A+G

A

Course:

28

Very useful to model inflation, change in productivity,

shrinkage of market size

Each successive cash flow increases (or decreases) by

a constant % each period.

The base value of the series is A. The growth rate

(rate of increase or decrease) is referred to as g.

If g is positive, the terms are increasing in value.

If g is negative, terms are decreasing in value.

Centre for Management of Technology and

Course:

29

A>0 and G>0 = Geometric

Series

Note: There is a cash flow

at end of period 1

A(1+g)

A(1+g)N-1

A(1+g)3

A(1+g)2

N-1

N-2

Course:

30

Geometric Gradients

We can define a growth adjusted interest rate i0:

i0

1 i

1

1 g

So that

1

1 g

0

1 i

1 i

i>g>0

g>i>0

g=i>0

Growth is + and greater than interest rate i0 is

Growth is + and = to interest rate

A

i0 0 P N

1 g

g<0

Course:

31

Geometric Gradients

Formulas

(P / A, i, N)

(P / A, g, i, N)

or

(1 g)

(1 i) N 1 1

(P / A, g, i, N)

N

i(1 i) 1 g

Course:

32

Deferred Annuity

If the cash flow does not begin until some later date,

the annuity is known as deferred annuity.

Annuity is deferred for J periods.

P0 = A (P/A, i%, N-J) ( P/F, i%, J)

A

0 1

J+2

J+1

J+3

N-1

P=?

Centre for Management of Technology and

Course:

33

Gradients

Treat each cash flow individually

Convert the non-standard annuity or gradient to

standard form by changing the compounding period

Convert the non-standard annuity to standard by

finding an equal standard annuity for the compounding

period

How much is accumulated over 20 years in a fund that

pays 4% interest, compounded yearly, if $1,000 isF = ?

deposited at the end of every

$1000fourth year?

12

16

20

Course:

34

Different Solutions

Method 1: consider each cash flows separately

F = 1000 (F/P,4%,16) + 1000 (F/P,4%,12) + 1000

(F/P,4%,8) + 1000 (F/P,4%,4) + 1000 = $7013

Method 2: convert the compounding period from annual

to every four years

ie = (1+0.04)4-1 = 16.99%

F = 1000 (F/A, 16.99%, 5) = $7013

Method 3: convert the annuity to an equivalent yearly

annuity

A = 1000(A/F,4%,4) = $235.49

F = 235.49 (F/A,4%,20) = $7012

Centre for Management of Technology and

Course:

35

PW Computations when N

scholarships, endowments, etc.

There are many engineering projects where the life of

the project is so long as to be considered forever.

Usually 50 years as a rule of thumb, but assume cash

flows continue indefinitely.

There are other projects where a sum of money is

provided at the beginning of the project and it is then

invested to yield the amount used for the project

(annuities for 50 years)

For both, the PW of the infinitely long uniform series of

cash flows becomes the Capitalized Value

Centre for Management of Technology and

Course:

36

PW when N

Until now, we assumed that the horizon N is a fixed

number of years.

The present worth of a very long and uniform series of

cash flows is calculated as:

P lim A(P / A,i ,N )

N

(1 i )N 1

P A lim

N

N

i

(1

i

)

1

1

(1 i )N

P A lim

N

i

A

P

i

Centre for Management of Technology and

Course:

37

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