Theme 3 Equivalence Calculations
3.1. Equivalence Calculations Involving Cash Flows
Equivalent cash flows are those that have the same value and the
calculated expression of equivalence can be used as a basis for choice.
i = 15%
R300
R798
Equivalence can be established at any point in time, since it is known that
for one cash flow to be equivalent to another, their equivalent values must
be equal at any point.
i = 15%
Two or more distinct cash flows are equivalent if they are equivalent to the
same cash flow.
If cash flow A is equivalent to cash flow C and cash flow B is equivalent to
C then cash flows A and B would be equivalent to each other.
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As cash flows are converted to their equivalences from one time period to
the next, the interest rate associated with each time period must be
reflected in the calculation.
P(Y3) = 100(P/A,10,2) + 100 =100(1.7355) + 100 = 273.55
P(Y2) = P(Y3)(P/F,7,1) = 273.55(0.9436) = 258.12
P(Y1) = P(Y2)(P/F,3,4)+200 = 258.12(0.8885) + 200 = 429.34
P(0) = P(Y1)(P/F,3,4) = 429 34(0.8885) = 381.469
Individual exercise:
Calculate the value of F at year 5 (R623)
Calculate the equal-payment-series cash flow A that runs from t = 1 to t = 5
that is equivalent to the four receipts in the previous example.
380 = A1(P/F,3,4) + A2(P/F,3,8) + A3(P/F,7,1)(P/F,3,8)
+ A4(P/F,10,1)(P/F,7,1)(P/F,3,8)
+ A5(P/F,10,2)(P/F,7,1)(P/F,3,8)
= A1(0.8885) + A2(0.7894) + A3(0.9346)(0.7894)
+ A4(0.9091)(0.9346)(0.7894)
+ A5(0.8265)(0.9346)(0.7894)
A = R103 per year
A general principle of equivalence states that the actual interest rate
earned on an investment is the one that sets the equivalent receipts equal
to the equivalent disbursements.
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PV Disbursements: PV Receipts:
1000+500(P/F,i,1)+250(P/F,i,5) = 482(P/A,i,3)(P/F,i,1)+482(P/A,i,2)(P/F,i,5)
By trial and error 10% is found to be the value for i that sets the receipts
identified as positive values equal to the disbursements designated by
negative values at t = 0.
Equivalent cash flows will exhibit their equivalence regardless of the
point in time used as a basis for the equivalence calculation.
Arbitrarily take n = 5 :
1000(F/P,10,5)+500(F/P,10,4)+250 = 482(F/A,10,3)(F/P,10,1)+482(P/A,10,2)
1000(1.611)+500(1.464)+250 = 482(3.310)(1.100)+482(1.7355)
2593 = 2593
If the receipts and disbursements of a cash flow are equivalent for some
interest rate, the cash flows of any equivalent portion of the investment are
equal at that interest rate to the negative (-) of the equivalent amount of the
cash flows that constitute the remaining portion of the investment.
At n = 4:
Cash flow 1:
-1000(F/P,10,4) – 500(F/P,10,3) + 482(F/A,10,3)
= -1000(1.464) – 500(1.331) + 482(3.310)
= -534
Cash flow 2:
- [-250(P/F,10,1) + 482(P/A,10,2)(P/F,10,1)]
= - [-250(0.9091) + 482(1.7355)(0.9091)]
= -534
3.2 Equivalence Calculations Involving Bonds and
Loans
A Bond is a financial instrument and consists of a pledge by a borrower of
funds to pay a stated amount or percent of interest on the par or face value
at a stated time.
The yield to maturity is defined as the rate of return experienced from the
bond investment from the current date until the bond matures.
The current yield of a bond is the interest earned each year as a
percentage of the current price, often called the coupon rate.
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An individual can purchase (for R900) a R1000 municipal bond that pays
6% tax-free interest semi-annually. If the bond will mature to its face value
in 7 years, what will the rate to maturity be (The equivalent rate of return)?
Interest calculation: 1000(0.06/2) = R30 per semi-annual period
PV of Investment = PV of Income Alternatively the NPV = 0
900 = 30(P/A, i ,14) + 1000(P/F, i ,14)
At 3% P = 30(11.2961) + 1000(0.6611) = 1000
At 4% P = 30(10.5613) + 1000(0.5775) = 894
By interpolation: i = 3.94% semi-annually
The nominal annual interest rate is:
r = (3.94%semi-annually)(two semi-annual periods/year)
= 7.88%
An individual can purchase a R1000 municipal bond that pays 6% tax-free
interest semi-annually. The bond will mature to its face value in 7 years.
The investor requires a yield of 10% on any investment he makes. What
price would he be prepared to pay for this bond?
Interest calculation: 1000(0.06/2) = R30 per semi-annual period
PV of Investment = PV of Income
P = 30(P/A, 5 ,14) + 1000(P/F, 5 ,14)
P = 30(9.8987) + 1000(0.5051)
= 802.06
The investor would therefore not be prepared to pay more than R802.06 for
the bond.
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3.3. Equivalence Calculations Involving Loans
3.3.1 Effective Interest on a Loan
The effective interest rate that sets the receipts equal to the disbursements
on an equivalent basis is the rate that properly reflects the true interest
cost of the loan.
3.3.2. Repayment Schedule of the Loan
A = P(A/P, i , n)
3.3.3. Remaining Balance of a Loan
F = P(F/P, i , k) P = A(P/A, i , n-k)
F=A(F/A, i ,k)
Remaining balance:
PF/P,i,k) - A(F/A,i,k) = A(P/A,i,n-k)
R10 000 is borrowed with the undertaking that it will be repaid in equal
quarterly payments over 5 years at an interest rate of 16% per year
compounded quarterly. Immediately after the 13 the payment , the
borrower wishes to pay the balance.
Calculation of the quarterly payment:
A = 10000(A/P,4,20)
= 10000(0.0736)
= 736 per quarter
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Calculation of balance after the 13th payment:
(Equivalence of P at t = 13)- (Equivalent amount repaid)
U13 = 10000(F/P,4,13) – 736(F/A,4,13)
= 10000(1.665) – 736(16.627)
= 4413
Alternatively:
U13 = A(P/A, i , n-k)
= 736(P/A,4,7)
= 736(6.0021)
= 4418
For loans in which the interest rate changes over time , the above
approach can be applied with recognition of the changing interest rate.
3.3.4. Principal (capital) and Interest Payments of a Loan
The amount upon which the interest for the period is charged, is the
remaining balance at the beginning of the period.
It = portion of payment A at time t that is interest.
Bt = portion of payment A at time t that is used to reduce remaining
balance.
A = It + Bt
Interest formula:
It = A(P/A, i , n-t+1)(i)
Show me how: Interest component of a loan payment
Calculation of the interest component of a loan payment
A(P/A, i , n-[t-1]) = balance remaining at the end of period t-1
Principal (Capital) formula:
Bt = A(P/F, i , n-t+1)
The interest charged for period t , for any loan where interest is charged on
the remaining balance , is computed by multiplying the remaining balance
at the beginning of period t ( end of period t-1) by the interest rate.
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P = 1000 n = 4 i = 15%
A = 1000(A/P,15,4) = 1000(0.3503) = 350.30
End of Loan Payment Payment on principal Interest
Year t payment
1 350.30 350.30(P/F,15.4) 150.00
= 350.30(0.5718)
= 200.30
2 350.30 350.30(P/F,15.3) 119.98
= 350.30(0.6575)
= 230.32
3 350.30 350.30(P/F,15.2) 85.40
= 350.30(0.7562)
= 264.90
4 350.30 350.30(P/F,15.1) 45.68
= 350.30(0.8696)
= 304.62
Total 1401.20 1000.14 401.06
[Link] Loans with Variable Interest Rates
A1 =100000(A/P,8,10) =100000(0.14903) = 14903
U1 =14903(P/A,8,9) =14903(6.2469) = 93097.55
A2 = 93097.5(A/P,9,9) = 93097.5(0.16680) = 15528.67
U2 = 15528.67(P/A,9,8) = 15528.67(5.5348) = 85948.08
A3 = 85948.08(A/P,10,8) = 85948.08(0.18744) =16110
U3 = 16110(P/A,10,7) = 16110(4.8684) = 78430.41
A4 =78430(A/P,12,7) = 78430(0.21912) = 17185.67
[Link] Loan vs. Paying Cash
Loan option:
Purchase a vehicle at the normal price of R200 000. A loan is considered
for the total amount at 12%(APR) and 36 equal monthly payments.
Cash option:
Purchase the vehicle for cash at the discount price of R190 000. The funds
to buy the vehicle is presently earning 6% APR.
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Loan option:
A = 200000(A/P, 1%,36)
= 200000(0.0332)
= 6640
i = 6%/12 = 0.5%
PV = 6640(P/A,0.5,36) = 6640(32.87) = 218263.44
Cash option:
PV =190 000
There would be R28263.44 savings in present value with the cash option.
[Link] Buy vs. Lease
Buy option Lease option
Price of vehicle R200 000 R200 000
Down payment R20 000 0
APR 12%
Monthly payments R6 640 R2 656
Admin. Costs R 344
Market value end of month 36 R120 000 R120 000
Buy option: 120 000
PV = -20000 –6640(P/A,1,36) + 120000(P/F,1,36)
= - 136 045.8
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Lease option:
PV = -3000 – 2656(P/A,1,35)
= -3000 –2656(29.4086)
= - 81109.2
The lease option is the most economical one.
Lease payments are made at the beginning of each payment
period with the first payment at t=0 and the last payment at t=35.
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