Economic Equivalence Lecture No.3 Chapter 2 Fundamentals of Engineering Economics Copyright © 2008

At Issue – How Do You Compare Two Different Money Transactions? Consider the following two cash receipts. Which option would you prefer? Option 1Option 2 $1,000 $1,200

Which Option Would You Prefer?

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

Definition - 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, an appropriate interest rate (discount rate) makes them equal.

Using Compound Interest to Establish Economic Equivalence

$2,042 5 F 0 At 8% interest, what is the equivalent worth of $2,042 now 5 years from now? 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? = Practice Problem

Solution

Example 2.2 Equivalence $2,007$1, At what interest rate would these two payments be equivalent? i = ?

Steps to Establish an Economic Equivalence

Example 2.3 Equivalence Calculation $100 $80 $120 $150 $200 $ V = Compute the equivalent lump-sum amount at n = 3 at 10% annual interest.

Equivalent Worth Calculation at n = 3.

At What Interest Rate Are These Two Transactions Equivalent? Option 1Option 2 $1,000 $1,200

Select the base period at n = Option 1Option 2 $1,000 $1,200 $1, 000(1+i) 2  Base period

Lottery Problem – What interest rate are the two payoff options equivalent? $10.57M $167M 0

Solution – about 4.5%