Scribd
Upload
72 views22 pages

Understanding Economic Equivalence

Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

Uploaded by

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

Understanding Economic Equivalence

Economic equivalence exists when cash flows have the same economic effect even if the amounts and timing differ. Equivalence can be established by using the appropriate interest rate to calculate the equivalent present or future value of cash flows. Calculating equivalence allows alternatives to be evaluated on a common basis for comparison. Equivalence is useful for evaluating personal financial decisions as well as engineering economic assessments.

Uploaded by

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

Economic Equivalence

Lecture No.3
E-Eco: Engineering Economy
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
F
terms of interest rate i.
−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 3 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

$100
$120
$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 = 1.1
N

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

Common questions

Powered by AI

The time it takes for an investment to double is inversely related to the interest rate, meaning higher interest rates require less time. In this case, an investment doubles in approximately 7.27 years at 10% interest because of the compounding effect, as described by the formula P(1+i)^N = 2P, solved to determine N .

To find an unknown cash flow amount C that makes two cash flows indifferent, first select a base period, calculate the equivalent lump sum value for each cash flow at this period using the given interest rate, and equate these values to solve for the unknown C .

Economic equivalence allows us to compare different cash flows with varying amounts and timing by adjusting them to the same value at a specified future date using an interest rate. For example, using an 8% interest rate, cash flows at different times, like $2,042 now or $2,382 in 3 years, are calculated to be economically equivalent to $3,000 in 5 years by calculating their future worth in the base year .

Equivalence in personal finance enables the transformation of current and future amounts by using a specific interest rate to establish equal economic impact. This transformation involves calculating values such as equivalent lump-sum amounts or comparing alternatives like saving versus investing, factoring in interest accrual over time .

The key steps include determining the base period, identifying the appropriate interest rate, and calculating the equivalence value by adjusting the cash flows to this interest rate and period .

Selecting different base periods affects calculated equivalence by altering the reference point for determining future values of cash flows. Different periods involve varying compounding interests and time frames, which influence equivalence, requiring careful consideration to ensure accurate comparisons and value analysis .

Different interest rates significantly affect cash flows' equivalence over time by changing their future values. Calculating equivalence with different rates can result in varying equivalents, illustrating the sensitivity of cash flows to interest rate changes, as demonstrated when choosing base periods for calculations .

To determine the future value of a present cash flow, use the formula F = P(1+i)^N. For example, depositing $2,042 at an 8% interest rate will be $3,000 in 5 years. The calculation involves compounding the principal by adding interest over the number of periods specified .

Economic equivalence is established by ensuring that cash flows have the same economic effect and could be traded for one another through the use of an appropriate interest rate. This involves calculating equivalence by adjusting the amount and timing of cash flows so they become equivalent at a specified interest rate .

The Rule of 72 provides an approximation of how long it will take for a sum of money to double at a given interest rate by dividing 72 by the interest rate percentage. This method offers a quick estimation but lacks precision for exact calculations compared to more accurate compound interest formulas .

You might also like