90 CHAPTER 3 I

nterest Rate and Economic Equivalence

7
: ' Afil!Hl,U Compound ln! erest _ _ ·'.'.:ll
Suppose you deposit $1,000 in a bank savings account that pays intereS t at a rate f
lh0% compounded annually. Assume that you don't withdraw the interest earned o
. (one year), but let it accumulate. How much would you havat
tat ethend of eac h penod
e end of year 3? e
SOLUTION
Given: P == $1,000, N == 3 years, and i = 10% per year.
Find: F.

Applying Eq. (3.3) to our three-year, 10% case, we obtain

• Simple interest:

F == $1,000[1 + 0.10(3)] = $l, 300

• Compound interest:

F == $1,000(1 + 0.10) 3 = $1,331

The total interest earned is $331, which is $31 more than was accumulated under the
simple-interest
cisely method. We can keep track of the interest accrual process more pre-
as follows.

Amount at Beginning

--
Period
of Interest Period
Interest Earne,t Ainount at Enil
Perfod
~ 1!:_1 ):------._ .!1:!oo_
for Period of lnte ...,,t
2
-1. . __ __ ·-
, - ---
$ 1,000 $
.

1,100 1,21 0
1 210 1,210(0.J Q) l 3 -
3 ' ------ , 31

COMMENTS: At the end of the first year, you would have $l

terest, or a total of $1,100. In effect, at the beginning of th ,OOQ, Plus$ .

interest earned would be 0. 10( $1,100) = $ 11 o, and t

be depositing $1,100, rather than $1,000. Thus, at the en~ second Yea, Joo in in-
the seco' .Y0 0 Wou]d
$1,100 + $110 = $1,210. This is the amount you wouJd e halanc nd .Year, the
ginning of the third year, and the interest earned for : dePositi~ "'0 uld be
[Link] ( $1,2 IO) = $ 12 I. With a beginning principal amount ~ ; 1 Periodg at lhe be-
in terest, the total balance would be $1,331 at the enct of y0 1,210 Pl Would b
the compounding process 1s . 1llustrate
. dm . p·1gure 3.5. lls th e $ 1 e
ear 3· '"l"1•he se
21
qllence of
 3.1 Interest The Cost of Money 91

•.:.
$1 ,100

:
0
:

•.:
$1 ,210
1

..:
;-~ $T
$1,000

:
f
$1 ,100
...: 3

f
$1 ,210

Figure 3.5 The process of computing the balance when $1 ,000

at 10% is deposited for three years (Example 3.1).
: R 3 Interest Rate and Economic Equivalence

Comparing Simple with Compound Interest

-~--
In 1626, Peter Minuit of the Dutch West India Company paid $24 to purchase
Manhattan Island in New York from the Indians. In retrospect, if Minuit had invest-
ed 2010?
in the $24 in a savings account that earned 8% interest, how much would it be worth

SOLUTION
Given: P = $24, i = 8% per year, and N = 384 years.
Find: F, based on (a) 8% simple interest and (b) 8% compound i Ere:-est.
(a) With 8% simple interest,

F = $24[1 + (0.08)(384)] = $761.28

(b) With 8% compound interest,

F = $24(1 + 0.08)384 == $164 033 801

' , ,073,200
COMMENTS: The significance of compound interest · b .
. 1
of us can hardly comprehend the magnitude of $ so v1ous int
trill' · h.1s example. Many
164
ulation in the United States was estimated to be around ' 00 - In ~~10, the total pop-
were distributed equally _among the population, each ~08. ~!hon. If the money
$532,577. Certainly, there is no way of knowing exactly ho;d1v1dua1 would receive
is worth today, but most real-estate experts would agre h much Manhattan Island
. nowhere near $164 trillion. . (Note
1s . ) that the U.S. natioe at the Value of the island
natl debt
9
was estimated to be $IO.s tn 11100
· as of March I, 2009
~PTER 3 Interest Rate and Economic Equivalence

IIUIU~
Suppose you are offered the alternative of receiving either $~,000 at ~e ~nd of five Years
:
or P dollars today. There is no question that the $3,000 will be p~1d m full (no risk)
Because you have no current need for the money, you would deposit the P dollars in ·
account that pays 8% interest. What value of P would make you indifferent to yo:
choice between P dollars today and the promise of $3,000 at the end of five years?
STRATEGY: Our job is to determine the present amount that is economically equiva.
lent to $3,000 in five years, given the investment potential _of 8% per_ year. Note that
the statement of the problem assumes that you would exercise the option of using the
earning power of your money by depositing it. The "indifference" ascribed to you
refers to economic indifference; that is, in a marketplace where 8% is the applicable
interest rate, you could trade either cash flow for the other.
SOLUTION
Given: F = $3,000, N = 5 years, and i = 8% per year.
Find: P.
Equation: Eq. (3.3), F = P(I + i)N.
Rearranging terms to solve for P gives
p = F
(1 + i)N
Substituting yields
$3,000
P = -- - = $2042
(1 + 0.08) 5 '
We summarize the problem graphically in Figure 3.6.

$J,oooo -f.
o.o8J ,s

$2,042

0 0
$2,205
I
0 0
$2,381 $2,572 $2,778 $3,000
I
0 1 2 3 4 5
Years

Figure 3 6 y ·
. . anous dollar amounts that w1·n b .
$3,000 m five years oiven an · t e econorrucally equivalent to
' o m erest rate of 8% (Example 3 _3).

COMMENTS: In this example, it is clear th . . .

fer the promise of $3,000 in five years t at;f: is anything l~ss than $2,042, you would pre·
would prefe~ P. Ac:, you may have alreado ollars today; if p is greater than $2,042, you
er to be equivalent to the future amo t yFguessed, at a lower interest rate, p must be high-
. un . or example, ati = 4%, p = $2,466.
 J Equivalent Cash Flows Are Equivalent at Any
Common Point in Time
In Example 3.3, we determined that, given an interest rate of 8% per year, receiving
$2,042 today is equivalent to receiving $3,000 in five years. Are these cash flows
also equivalent at the end of year 3?
STRATEGY: This problem is summarized in Figure 3.7. The solution consists of solv-
ing two equivalence problems.
(a) What is the future value of $2,042 after three years at 8% interest?
(b) Given the sum of $3,000 after five years and an interest rate of 8%, what is the
equivalent sum after three years?
SOLUTION
Given:
(a) P = $2,042; i = 8% per year; N = 3 years.
(b) F = $3,000; i = 8% per year; N = 5 - 3 = 2 years.
Find:
~a) V3;
(b) V3. Are these two values equal?
•
TER 3 Interest Rate and Economic Equivalence

Vi
$2,042(1 + 0.08) 3

$2,042 --- .....

I
I
$2,572

t
0 1 2
Years
I
I
3 4 5

(a)

$2,572
17 '
I
$3,000

I
I

4 5
0 1 2
Years
(b)
Base period

figure J. 7 Selection of a base period for an equivalence

calculation (Example 3.4).

Equation:
(a) F = P(l + i)N.
(b) P = F(l + i)-N_
Notation: The usual terminology of F and P is confusing in tbis example, since
the cash flow at n = 3 is considered a future sum in part (a) of the solution and a past
cash flow in part (b) of the solution. To simplify matters, we are free to arbitrarily
designate a reference point n = 3 and understand that it need not to be the present.
Therefore, we assign the equivalent cash flow at n = 3 to a single variable, V3.
(a) The equivalent worth of $2,042 after three years is
V3 = 2,042(1 + 0.08) 3
= $2,572
(b) The equivalent worth of the sum $3,000 two years earlier is
V3 = F(l + i)-N
= $3,000(1 + 0.08)-2
= $2,572
(Note that N = 2 beca th .
ing is calculated in duse at !s the number of periods during which discount·
() . . or er to amve back at year 3.)
c While our solut10n doesn't strict! .,
ti me, they will b · Ypr?ve th at the two cash flows are equivalent at :Ul)
e equ1vc1 Ient at any time I
r
• ct.
as ong as we use an interest rate ot S r.
 Changing the Interest Rate Oestri
Equivalence
In Example 3.3, we determined that, given an interest rate of 8% per year, receiving
$2,042 today is equivalent to receiving $3,000 in five years. Are these cash flows
also equivalent at an interest rate of 10%?

SOLUTION
Given: P = $2,042, i = 10% per year, and N = 5 years.
Find: F and is it equal to $3,000?
We first determine the base period under which an equivalence value is computed.
Since we can select any period as the base period,)et's select N = 5. Then we need
to calculate the equivalent value of $2,042 today five years from now.
F = $2,042(1 + 0 .10) 5 = $3,289.
Since this amount is greater than $3,000, the chang.. in interest rate breaks the equiv-
alence between the two cash flows.

Principle 3: Equivalence Calculations May Require the Conversion

of Multiple Payment Cash Flows to a Single Cash Flow
In all the examples presented thus far, we have limited ourselves to the simplest case
of converting a single payment at one time to an equivalent single payment at anothe1
time. Part of the task of comparing alternative cash flow series involves moving each
individual cash flow in the series to the same single point in time and summing these
values to yield a single equivalent cash flow. We perform such a calculation in
Example 3.6.

[~:[Link];ru m Equivalence Calculation~ •

Payments
Suppose that you borrow $1,000 from a bank for three years at 10% annual interest.
The bank offers two options: (1) repaying the interest charges for each year at the
end of that year and repaying the principal at the end of year 3, or (2) repaying the
loan all at once (including both interest and principal) at the end of year 3. The re-
payment schedules for the two options are as follows .
 ~=t2~S"-=~~-~~~:---
d Economic Equivalence
Race an
ga CHAPTER 3 /nceres_c_ _ _ ____________

[ Opdon•
. 1 · End-o f-year repayment of interest, and
Opt•~" . ment at end of loan $100 $100
principal repay $1 ,100
Option 2: One end-of-loan repayment of both
principal and interest () () -----
1,331

Determine whether these options are equivalent, assuming that the appropriate inter.
est rate for the comparison is 10%.
STRATEGY: Since we pay the principa] after three years in either plan, the repayment
of principal can be removed from our analysis. This is an important point: We can ig.
nore the common elements of alternatives being compared so that we can focus en.
tirely on comparing the interest payments. Notice that under option 1, we will pay a
total of $300 interest, where1:, s nnder option 2, we will pay a total of $331. Before con-
cluding that we prefer opUo::., L , rc.::member that a comparison of the two cash flows is
based on a combination rJJ" pafnent amounts and the timing of those payments. To
make our comparison, we must compare the equivalent value of each option at a sin-
gle point in time. Since option 2 is already a single payment at n = 3 years, it is sim-
plest to convert the cash flow pattern of option 1 to a single value at n = 3. To do this,
we must convert the three disbursements of option 1 to their respective equivalent val-
ues at n = 3. At that point, since they share a time in ccrnr,1on. vve can simply sum
them in order to compare them with the $331 sum in opdcn 2 ,'. Figure 3.8).
SOLUTION
Given: Interest payment series; i = 10% per year.
Find: A single future value F of the flows in option I.

Equation: F P(l + i)N, applied to each disbursement in the cash flow diagram.
Nin Eq. (3.3) 1s the number of periods during which interest is in effect and n is the
period number (i.e., for year 1, n = 1). We determine the value of F b~ finding the
interest period for e~ch payment. Thus, for each payment in the series, N can be cal-
3 ~y subtractJng n from the total number of years of the loan (3). That is,
cul"_ted
N - n. Once the value of each payment has been found, we sum the payments.

Option I
0 I Option 2
1-- 2 3 ? 0

l l 1
1 2 3

$100 $100 $100

Figure ) 8 I . . $33 1
. nterest earn,noc f~ ..•
 F3 for $100 at n = 1: $100(1 + 0.10) 3 - 1 = $121
F3 for $100 at n = 2: $100(1 + 0.10) 3 - 2 = $110
F3 for $100 at n = 3: $100(1 + 0.10) 3 - 3 = $100
Total = $331
By converting the cash flow in option 1 to a single future payment at year 3, we can
compare options 1 and 2. We see that the two repayment schedules are equivalent. Thus,
the bank would be economically indifferent to a choice between the two plans. Note that
the final interest payment in option 1 does not accrue any compound interest.
Interest Rate and Economic Equivalence

[[Link],ru Slngle_;:~- ·Dfve,r: i, N, and p

If you had $2,000 now and invested it at 10%, how much would it be worth in eight Yeats?

SOLUTION
Given: P = $2,000, i = 10% per year, and N = 8 years (Figure 3.11).
Find: F.
We can solve this problem in any of three ways.

i = 10%
•
I
I
I
I
0 I

!
I I I I I I I I
1 2 3 4 5 6 7 8
Years
$2,000

Figure 3.11 A cash flow diagram from the investor's

point of view (Example 3.7).

1. Using a calculator. You can simply use a calculator to evaluate the ( I + it fac-
tor (financial calculators are pre-programmed to solve most future-value problems):
F = $2,000(1 + 0.10) 8
= $4,287.18
2. Using compound-interest tables. The interest tables can be used to locate the
compound-amount factor for i = 10% and N = 8. The number you get can be
substituted into the equation. Compound-'interest tables are included as Appendix
B of this book. From the tables, we obtain
F = $2,000(F / P, 10%, 8) = $2,000(2.1436) = $4,287.20
This is essentially identical to the value obtained by the direct evaluation of the
single-cash-flow compound-amount factor. The slight difference is due to round-
ing errors in the table.
3. Using Excel. Many financial software programs for solving compound-inter~SI
problems are available for use with personal computers. Excel provides financial
funcLions to evaluate various interest formulas where the future-worth calcula·
tion looks like Figure 3.12. '

A B
1 p $ 2,000
2 N 8
3 i 10%
4
5 F $4,287 .18 =FV(10%,8,0,-2000)

Figure 3. 12 Excel: FV function.

•
I •• 11 i3 ''1tfi_;_ t ;~.~'(ei
f ¢ - $) I . :fl¥)0p \• '1, /.
, ·,;.ou»,":,~,: ts:
''a '#,~ . ' ,.,
-Fi·n·d,:,7P.~:G
-f,. ·l -"
iv~n·· 1.· i -~-nd.'· N
+ . ("·.~-~J S J, c !I ~•-· ·. • ,.. n',if • , ,

Suppose that $1,000 is to be received in five years. At an annual interest rate of 12%,
what is the present worth of this amount?

SOLUTION
Given: F = $1,000, i = 12% per year, and N = 5 years.
Find: P.
P = $1,000(1 + 0.12)-5 = $1,000(0.56743) = $567.43.
Using a calculator may be the best way to 1nake-this s1tnpte calculation. To have $1,000
in your savings account at the end of five year:,'., rnust deposit $567 .43 now. yr,u.
We can also use the interest tables to find that
(0.56743 )

P = $1,000(P / F, 12%, 5) = $567.43.

Again, you could use a financial calculator or a computer to find the present worth.
With Excel, the present-value calculation looks like Figure 3.13.

A B
1 F $ 1,000
2 i 12%
3 N 5
4
5 p $567.43~ =PV(12%,5,0,-1000)

Figure 3.13 Excel: PV function.

 l~~~;f;~ C,.Ctl' Solving for i
• -
' ":'4',:""' ·..,
. .'·•·- ---~-· - . .,,,..•.. •·:,i .. ·,. . . '
2311.:-
:

Suppose you buy a share of stock for $20 and sell it for $40. Then your profit is $
If that happens within a year, your rate of return is an impressive l OOo/,. 20
( $20 /$20 = I). If it takes five years, what would be the average annual rate of re~
turn on your investment? (See Figure 3.14.)

$20

i= ?
0
1 2 3 4 5
Years

$10

Figure 3.14 Cash flow diagram ([Link] 3.9).

SOLUTION
Given: P = $20, F = $40, and N = 5.
Find: i.
Here, we know P, F, and N, but we do not know i, the interest rate you will earn
on your investment. This type of rate of return is easy to calculate, because you make
only a one-time lump-sum investment. Problems such as this are solved as follows.
F = P(l + i)N
$40 = $20( 1 + i) 5; solve for i
i = 21!5 - 1
= 14.87%
• Using compound-interest tables. You can solve the problem by using th~ in-
terest tables in Appendix B. Look across the N = 5 row in the (F/P, z, 5)
columns until you locate a value near 2:
$40 = $20( 1 + i) 5
2 = (1 + i) 5 = (F/P,i,5)

In the 15% interest table, (F / P, 15%, 5) = 2.0114, so the interest rate at

which $20 grows to $40 over five years is very close to 15%. This procedure
 will be very tedious for fractional interest rates or when N is not a whole num-
ber, because you may have to approximate the solution by linear interpolation.
• Using Excel. The most practical approach is to use either a financial calcula-
tor or an electronic spreadsheet, such as Excel. A financial function such as
RATE (N, 0, P, F) allows us to calculate an unknown interest rate. The pre-
cise command statement would be as shown in Figure 3.15.
Note that, in Excel format, we enter the present value (P) as a negative
number, indicating a cash outflow.

A B
1 F $ 40.00
2 p $ 20.00
3 N 5
4 , =RATE(5,0, -20,40)
5 ; 14.87%

Figure 3.15 Excel: RATE function

' "f,,. and, i

You have just purchased 100 shares of Citigroup stock at $60 per share. You will sell the
stock when its market price has doubled. If expect the stock price to increase 20%
per year, how long do you anticipate waiting bsfon?. se!Ung the stock (Figure 3.16)?

$12,000

!
0 i = 20%

I I - - - N =?
I I

$6,000

Figure 3.16 Cash flow diagram.

SOLUTION
Given: P = $6,000, F = $12,000, and i = 20% per year.
Find: N (years).
Using the single-payment compound-amount factor, we write
F = P(I + i)N = P(F/P,i,N)

$12,000 = $6,000(1 + 0.20)N = $6,000(F / P, 20%, N)

2 = (1.20)N = (F / P, 20%, N)
Again, we could use a calculator or a computer spreadsheet program to fi
Od J\r
1. Using a Calculator. Solving for N gives ·
log 2 = N log 1.20
or
log 2
N=--
log 1.20
= 3.80 4 years
2. Using Excel. Within Excel, the financial function NPER ( i, 0, P, F) corn
the number of compounding periods it will take an investment (P) to gro: u~
future value (F), earning a fixed interest rate (i) per compounding period. In to
example, the Excel command would look like Figure 3.17. ot

A B
1 F $ 12,000
2 p $ 6,000
3 ; 20%
4
5 N 3.80 - =NPER(20% ,0,-6000,12000)

Figure 3.17 Excel: NPER function

COMMENTS: A very handy rule of thumb, called the Ruk. of 72, estimates approximatr
ly how long it will take for a sum of money to double. '} 1:e rule states that, to find th
time it takes for a present sum of money to grow by a factor of two, we divide 72 byth
interest rate. In our example, the interest rate is 20%. Therefore, the Rule of72 indicalc:
72 /20 = 3.60, or roughly four years, for a sum to double. This is, in fact, relativtl)
close to our exact solution. Figure 3.18 illustrates the approximate number of years r,-
quired to double an investment at various interest rates using the Rule of 72.

18
years
Imagine! If you were to nvest
at a higher rate, you'd de uble
money that much faster!
12
years
9
years

6
years 5.14
years
4% 6% 8% 10% 12% 14%

Figure 3. 18 Number of years required to double an

initi al investment at various interest rates.
A
 3.3 Development of Formulas for Equivalen

3.3.3 Uneven Payment Series

A common cash flow transaction involves a series of disbursements or receipts. Familiar
examples of series payments are payment of installments on car loans and home mortgage
payments. Payments on car loans and home mortgages typically involve ide_ntical sums to
be paid at regular intervals. However, if there is no clear pattern over the senes, we call the
transaction an uneven cash flow series.
We can find the present worth of any uneven stream of payments by calculating the
present value of each individual payment and summing the results. Once the present
worth is found, we can make other equivalence calculations (e.g., future worth can be cal-
culated by using the interest factors developed in the previous section).

Pres

Wilson Technology, a growing machine shop, wishes to set aside money now to in-
vest over the next four years to use to automate its customer service department. The
company can earn 10% on a lump sum deposited now, and it wishes to withdraw the
money in the following increments.
Year 1: $25,000 to purchase a computer and database software designed for
customer service use.
Year 2: $3,000 to purchase additional haTdware to accommodate anticipated
growth in use of the system.
Year 3: No expenses .
Year 4: $5,000 to purchase software upgrades.
How much money must be deposited now to cover the anticipated payments over the
next four years? Assume each withdrawal and payment to occur at the end of each
year.

STRATEGY: This problem is equivalent to asking what value of P would make you in-
different in your choice between P dollars today and the future expense stream
($25,000, $3,000, $0, and $5,000). One way to deal with an uneven series of cash
flows is to calculate the equivalent present value of each single cash flow and to sum
the present values to find P. In other words, the cash flow is broken into three parts,
as shown in Figure 3 .19.

SOLUTION
Given: Uneven cash flow in Figure 3.19 with i = 10% per year.
Find: P.
P = $25,000(P /F, 10%, 1) + $3,000(P /F , 10%, 2)
+ $5,000(P / F, 10%, 4)
= $28,622
lAPTER 3 Interest Rate and Economic Equivalence

$25,000

$3,000 $5,000
0
I 1 2 3 4
I
I Years
=
I

0
$25,000 p

D
$3,000 $5,000

I 1 2 3 4
+
0
I I + I I +
0
I I I I
j
1 2

' n
3 4

n
I I 1 2 3 4
y
t
P1
P1 = $25,000(PIF, 10%, 1)
= $22,727
Pz
P4
n
Pz = $3,000(PIF, 10%, 2) P4 = $5,000(PIF, 10%, 4)
= $2,479 = $3,415
P= P1 + P2 + P4 = $28,622

Figure 3.19 Decomposition of uneven cash flow series (Example 3.11).

COMMENTS: To see if $28,622 is indeed sufficient, let's calculate the balance at the
end of each year. If you deposit $28,622 now, it will grow to (1.10)($28,622), or
$31,484, at the end of year 1. From this balance, you pay out $25,000. The remain-
ing balance, $6,484, will again grow to (1.10)($6,484), or $7,132, at the end of year
2. Now you make the second payment ($3,000) out of this balance, which will leave
you with only $4,132 at the end of year 2. Since no payment occurs in year 3, the
balance will grow to (1.10)2($4,132) , or $5,000, at the end of year 4. The final

-
withdrawal in the amount of $5,000 will deplete the balance completely.

Future Value,s of in Uneven Series

with Varying Interest Rates
Suppose that you have a savings account with your federal credit union. By looking
at the history of the account, you learned the interest rate in each period during the
last five years was as shown in Figure 3.20.
Show how the credit union calculated your balance.
SOLUTION
Given: Deposit series shown in Figure 3.20 with varying interest rates; N = 5 years,
Find: Balance at the end of year 5 ( F ).
5
 0

1 2 3 4 5

$300
$400

$500

Figure 3.20 A future-value calculation with changing interest

rates.

• Contribution of $300 at n = 0 toward F 5 :

Balance at n = 1

$300(F /P, 5%, l)(F /P, 6%, 2)(F /P, 4%, 2) = $382.82
Balance at n = 3
Balance at n= 5

• Contribution of $500 at n = 2 toward F 5 :

Balance at n=3

Balance at n=5

• Contribution of $400 at n = 4 toward Fs:

$400(F / P,4%,1) = $416
• Total balance at n = 5:
Fs = $382.82 + $573.25 + $416.00 = $1,372.06

1:1~ CC Sabathia's New $161 Million Contract

Includes $9 Million Signing Bonus2
On December 18, 2008, CC Sabathia became one of the richest players in the
National Baseball League by agreeing to call New York (Yankees) home for the next
seven years. Sabathia, who finalized a seven-year, $161 million contract with the
Yankees, was paid $6 million of that bonus at the time of signing with the remaining
balance in the amount of $3 million to be paid in 2009. The starting salary for the
2009 season was $14 million, then Sabathia's contract increases to $23 million in
each of the final six seasons of the deal, the largest contract for a pitcher both in total
dollars and average salary.

2
Source: [Link] [Link]/news/locker-room/cc-sabathias-new- l 61-mi 11 ion-contract-includes-
9-mi Ili on-signing-bonus/
 With the salary and signing bonus paid at the end of each season, the net
al payment schedule looks like Table 3.3. annu.

TABLE 3.3 Sabathia's $161 Million Contract

End of Season Base Salary Pro-rated Signing Bonus

2008 $6,000,000
$14,000,000 $3,000,000 $17,000,000
2009
$23,000,000 $23,000,000
2010
$23,000,000 $23,000,000
2011
$23,000,000 $23,000,000
2012
2013 $23,000,000 $23,000,000

2014 $23,000,000 $23,000,000

2015 $23,000,000 $23,000,000

How much is Sabathia's contract actually worth at the time of signing? Assume
that Sabathia's interest rate is 6% per year and payments are made at the end of
each season.

SOLUTION
Given: Payment series given in Figure 3.21 , with i = 6% per year.
Find: P.

$23M $23M $23M $23M $23M $23M

J '~ ,~ '~
$17M " I'

$6M

2008 2009 2010 2011 2012 2013 2014 201 5

Figure 3.21 A cash flow diagram for Sabathia's contract with the
New York Yankees.

Actual worth of the contract at the time of signing:

Pcontract = $6,000,000 + $17,000,000(P / F , 6%, 1)
+ $23,000,000(P /F , 6%, 2) + ...
+ $23,000,000(P /F, 6%, 7)
= $128,734,396
Note that the actual worth of the contract is much less than the published figure of
$161 million.

COMMENTS: Unlike most players, Sabathia will have his salary paid in semimonthly
installments over all 12 months of the year, meaning he will have received six pay-
ments of $583,333 before opening day, April 6. In Chapter 4, we will consider equiv-
alence calculations with these more frequent payments.
 l:lniforrn Serie ;,
Suppose you make an annual contribution of $3,000 to your savings account at the
end of each year for 10 years. If the account earns 7% interest annually, how much
can be withdrawn at the end of 10 years (Figure 3.23)?
SOLUTION
Given : A = $3,000, N = IO years, and i = 7% per year.
Find: F .

F = $3,000(F / A, 7%, 10)

= $3,000(13.8164)
= $41,449.20
To obtain the future value of the annuity with the use of Excel, we may use the fol-
lowing financial command: =FV ( 7 %, 1 O, - 3 OOO} , as shown in Figure 3.24.
 F
!I
I

r
i= 7% Years I
0 1 2 3 4 5 6 7 8 9

l l l l l l l l l
A= $3,000

Figure 3.23 Cash flow diagram (Example 3.14).

1
2
3 $3,000.00 $5,515.38
4 $3 ,000 .00 $5,154.56
5 $3,000.00 $4,817.34
6 $3 ,000.00 $4,502.19
7 $3,000 .00 $4 ,207.66
8 $3,000.00 $3,932 .39
9 $3 ,000.00 $3,675.13
10 8 $3 ,000 .00 $3,434.70
9 $3,000.00 $3,210.00
10 $3,000.00 $3,000.00
=F\1(7% ,10, -3000)

Figure 3.24 Excel worksheet to find future worth (F).

VliP'Bi1i WI

l=Et]lliru ~0 Handling Time . . •

In Example 3.14, the first deposit of the 10-deposit series was made at the end of pe-
riod 1 and the remaining nine deposits were made at the end of each following peri-
od. Suppose that all deposits were made at the beginning of each period instead. How
would you compute the balance at the end of period 1O?

SOLUTION
Given: Cash flow as shown in Figure 3.25, and i = 7% per year.
Find: F 10 .

i=7% F
i
First deposit occurs at n = 0 I
Years I

(D
1 2 3 4 5 6 7 8 9 •10
I

+ + l l l A= $3,000
+ + l l
Figure 3.25 Cash flow diagram (Example 3.15).
 · Ienee
'TER 3 Interest Rate and Economic Equiva

.th . 3 23 Each payment has been shifted to

w
Compare Figure 3.25 wi Figu;; b~ c~mpounded for one extra year. Note ~ne Ye,
earlier; thus, each pay_ment wo~in balance (F) was $41,449.20. With the be _at llit
the end-of-year deposit, the en g lates by the end of period 9 Thi g1nnin~.
. h e balance accumu . sbl t
of-year deposit, t e sam .. 1 Therefore we can easily caJc 1 a"llt\
can earn interest for one add1tiona year. ' u ate the
suiting balance as re.
Fw = $41,449.20(1.07) = $44,350.64
The annuity due can be easily evaluated with the following financial command av~l
able on Excel:

=FV(7% ,10,-3000,0,1)

COMMENTS: Another way to determine the ending balance is to compare the 1'//
cash flow patterns. By adding the $3,000 deposit at period 0 to the original cash fl~
and subtracting the $3,000 deposit at the end of period 10, we obtain the second [Link]
flow. Therefore, the ending balance can be found by making the following adjll5!.
ment to the $41,449.20:

F10 = $41,449.20 + $3,000(F/P, 7%, 10) - $3,000 = $44,350.64.

Sinking-Fund Factor: Find A, Given F, i, and N

If we solve Eq. (3.10) for A, we obtain

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

(3.11
The term within the brackets is called the equal p t · · king"
. . - aymen series sm · '
ffactor,
d or smkmg-fund factor, and is referred to by the t t· ( A ''F. · N) A si 1 ·
· an m
un 1s · terest- beanng
· account into which a fi d no a. 10n d rv. •, z,d . h inte
period· it is commonl t bl' h ixe sum 1s epos1te eac ..
corporate
' b d on s. Yes a is ed for the purpose of replacing fixed assets or ren

I ~ ~l]!?J The_ Cost of Waiting in Buildin a

Retarement fund g
It is human nature to put things off d " . bel'
it comes to financial matters the '~ ;"Y,
I Will start saving next year." But w
_Procrastination can be staggering. Sup~;o
O
that you are making $5,00o ~nu:i°i
ontnbutions to your Roth IRA at the age of
and you earn a 7% return. Assuming that you plan to retire at age 65, you'll have
$1,428,747 saved at retirement.

F = $5,000(F / A, 7%, 45) = $1,428,747

Now if you want to save the same amount ($1,428,747) at retirement, what are the
required annual contributions as a function of starting age?

SOLUTION
Given: F = $1,428,747, N = 65 - n, and i = 7% per year.
Find: A.
The required annual contribution as a function of starting age n can be determined as

An= $1,428,747(A/F, 7%, 65 - n)

For example, if you wait even three years (or age 23), your annual contributions
would have to increase to nearly $6,195 to save that same amount by age 65. And if you
were to wait until age 40, you'd have to contribute nearly $22,589 a year! Figure 3.26
illustrates the general trend of required annual contributions and Table 3.4 illustrates the
cost of procrastination at each age.

$12,963

f v--===~·$8,911
Number of years delayed

u
0

• $6,195

23 28 33 38
Starting age of contribution

Figure 3.26 The cost of waiting in building a retirement fund .

 "b f s as a Function of Starting Age
E34 Required Annual Contn u .'on t f $1 428 747
TA BL • to Build Retirement Funds m the Amoun o ' '

C I D I E
B I
A
.... •.
.. ...
1 '
2 I I Annaul I Investm ent I Final
3 Start I End I Contribution I Return I Value
,. •~·i ;.ti/.-.: ,,,.:~J~,:-Y~ •. .· '· .,. '",•''
4
65 $4,339.73 7% $1,428,747
5 18
6 19 65 $4,657.66 7% $1,428 ,747
7 20 65 $5,000 .00 7% $1,428,747
8 21 65 $5,368.79 7% $1 ,428,747
9 22 65 $5,766 .27 7% $1,428,747
10 23 65 $6,194 .91 7% $1,428,747
11 24 65 $6,657 .42 7% $1,428 ,747
12 25 65 $7,156.79 7% $1,428 ,747
13 26 65 $7,696.32 7% $1,428,747
14 27 65 $8,279 .66 7% $1,428,747
15 28 65 $8,910 .88 7% $1,428,747
16 29 65 $9,594 .48 . 7% $1,428 ,747
17 30 65 $10,335.49 7% $1,428,747
18 31 65 $ 11,139.56 7% $1 ,428,747
19 32 65 $12,012.99 7% $1,428,747
20 33 65 $12,962.90 7% $1 ,428 ,747
21 34 65 $ 13,997.30 7% $1,428,747
-
22 35 65 $15,1 25.29 7% _______ $1,428 .747 _
23 36 65 $16,357.22 7% $ 1 ,42 ,2,. 74 7
24 37 65 $17,704 .92 1% --·--1- ______ _$ 1 A:?.f; ,7./4~ - I
25 38 65 $ 19,181 .97 7% l . i ,L!2S ,7•i7 ,
-·-·-·:=~--:
----- -
26 39 65 $20,804.02 7% i S 1·.~,28,7 47 _\
27
28
40 65 $22,589.22
J;~~.;:t,...-...,s,rJ'-': '§•::-· · """'
,,,~ ,. -..wi
u ,,
:'• 747,•'<t>i .if, d
.,,.,_;...,~A~-... ~•'

'· · rent lnvestmen

Consider three investment plans for an individual who just celebrated his 24th birth-
day at an annual interest rate of 8% (Figure 3.27):
Plan A. Invest $2,000 per year for the first 10 years of your career. At the end of 10
years, make no further investments, but reinvest the amount accumulated at
the end of 10 years for the next 31 years.
Plan B. Do nothing for the first 10 years. Then start investing $2,000 per year for
the next 31 years.
Plan C. Invest $2,000 per year for the entire 41 years.
Note that all investments are made at the birthday of each year; the first deposit will
be made on the 25th birthday ( n = l), and you want to calculate the balance on the
65th birthday (n = 41 ).
 Investor A

012345678910 4041
r
lllll!!lll
I I

I
$2,000

Investor B tF

llllllll[. . . lllllllllll
0 1 2 3 4 5 6 7 8 9 101112 4041

I I I I I I I I I I I

$2,

Investor C tF
0 1 2 3 4 5 6 7 8 9 10 4041

I ll ll ll ll lull ll lll L. . . ll ll ll ll l!l

$2,000
Figure 3.27 Cash flow diagrams for three investment options (Example 3.17).

SOLUTION
Given: Three different deposit scenarios with i = 8% aild 1V = 41 years.
Find: Balance at the end of 41 years (or on the 65th birthday ).
Plan A:
Balance at the end of IO years

F 65 = $2,000(F / A, 8%, 10) (F /P, 8%, 31)

$28,973.12

= $314,870.34
Plan B:
F65 = $2,000(F / A, 8%, 31)
$246,691.74
= $246,691.74
Plan C:
F6s = $2,000(F / A, 8%, 41)
$561,562.08

= $561,562.08
To illustrate your balance changes at the end of each year, you may want to construct
a tableau such as the one shown in Table 3.5. Note that, due to rounding errors, the
final balance figures can be slightly off from those calculated by interest fo rmulas.