1. Econ. Lecture 3 Economic Equivalence and Interest Formula’s Read 45-70
Problems 2.6, 2.8, 2.11, 2.14, 2.15

2. First an example from last lecture
Single Payment To Find Given Functional Notation
Compound Amount Factor F P (F/P, i, n)
Present Worth Factor P F (P/F, i, n)
This notation refers to interest tables in the back of your text, Appendix C.
The table works out multiplication factors for a given interest rate over a given number of years.

3. Example:
To raise money for a business, a person asks for a loan from you. They offer to pay you $3000 at the end of four years. How much should you give him if you want 12%/year on your money?
P = unknown
n = 4 years
i = 12%
F = $3000
P = F/(1+i)n = 3000/ (1+0.12)4 = $

4. With the Interest Tables
P = F(P/F,i,n) = 3000(P/F,12%,4) = 3000 (0.6355) = $
Slight difference in the answer that you get is minimal.

5. Back to Equivalence
Economic equivalence – exists between cash flows that have to same economic effect
Economic indifference – if two cash flows are equal to each other, we don’t care which is chosen

6. There are four simple principles of Equivalence:
1)               Alternatives require a common time basis – A point in time will be used that best fits the analysis of our alternatives, given P,F
2)                Dependent on interest rate
3)                May require conversion of multiple payments to a single payment
4)                Equivalence is maintained regardless frame of reference

7. Example of Principle One:
Deposit $4000 today and 10%. In 15 years you have $16, How much do you have after 10 years?

8. From both time directions find V10?
F = $4000(F/P,10%,10)= $4000 (2.5937) = $
P = $16,708.80(P/F, 10%,5) = $16, (0.6209) = 10,374.49
Equal in time!

9. Five types of cash flows
1)      Single Cash Flow – one P or F
2)      Uniform Series – equal payment series, equal series of payments for n years
3) Linear Gradient – changing payment by a constant amount G, in each cash flow

10. 4) Geometric Gradient – changing. payment by a constant
4)      Geometric Gradient – changing payment by a constant percentage, g, in each cash flow
5)      Irregular Series – no overall regular pattern in payment scheme

12. Uneven Cash Flow
When presented with an uneven payment series, the F or P can be calculated by summing the individual payments.

13. Example: For the given cash flow, determine F at 30 years, 4%.
Example: For the given cash flow, determine F at 30 years, 4%. F? 7 10 13 25 30
800
400
3000
3800

14. F = 3000(F/P,4%,23) + 800(F/P,4%,20) + 3800(F/P,4%,17) + 400(F/P,4%,5)
= 3000*(2.4647) + 800*(2.1911) *(1.9479) + 400*(1.1699)
= = $17,016.96

15. Uniform Payment Series

16. Consider the following situation:

17. F = A + A(1+i) + A(1+i)2 (1)
In this case, n = 3, equation (1) can be written as:
F = A + A(1+i) + A(1+i)n-1 (2)

18. Multiplied by (1+i):
(1+i)F = A(1+i) +A(1+i)n-1 +A(1+i)n (3)
Subtract (2) F = A + A(1+i) + A(1+i)n-1
Equals iF = -A + A(1+i)n

19. Equal Payment Series compound amount Factor or
Uniform Series Compound Amount (F/A,i,n)