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Cash Flow Diagrams (CFD)
• Used to model the positive and negative cash flows.
• At each time at which cash flow will occur, a vertical
arrow is added, point down for costs and up for
revenues.
• Cash flow are drawn to relative scale
• Rent and insurance are beginning-of-period cash
flows; i.e. just put an arrow in where it occurs.
• O&M, salvages, and revenues are assumed to be end-
of-period cash flows.
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Example 3-1
Purchase a new $30,000 mixing machine. The machine
may be paid for in one of two ways
– A. Pay the full price now minus a 3% discount
– B. Pay $5000 now, $8000 at the end of 1st yr, and $6000 at
end of each following year
List the alternatives in the form of a table of cash flows
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Continue … Example 3-1
End of year
0 (now)
1
2
3
4
5
Pay in Full Now Pay over 5 Yrs
-$29,100 -$5000
0 -$8000
0 -$6000
0 -$6000
0 -$6000
0 -$6000
Cash flow table:
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Example 3-2
A man borrowed $1000 from a bank at 8% interest.
– At the end of 1st yr: Pay half of the $1000 principal amount
plus the interest.
– At the end of 2nd yr: Pay the remaining half of the principal
amount plus the interest for the second year.
Compute the borrower’s cash flow
End of Year Cash Flows
0 (Now) +$1000
1 -580
2 -540
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Time Value of Money
• If monetary consequences occur in a short period of
time → Simply add the various sums of money
• What if time span is greater?
• $100 cash today vs. $100 cash a year from now?
• Money is rented. The rent is called the interest
• If you put $100 in the bank today, and interest rate is
9% → $109 a year from now
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Simple Interest
• Interest that is computed only on the original sum and
not on accrued interest.
– e.g. if you loaned someone the amount of P at a simple
interest rate of i for a period of n years:
• Total interest earned = P × i × n = P i n
• The amount of money due after n years:
F = P + P i n
Or F = P(1+ i n)
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Example 3-3You loaned a friend $5000 for 5 years at a simple
interest rate of 8% per year.
How much interest you receive from the loan?
How much will your friend pay you at the end of 5 yrs.
Total interest earned = P i n = (5000)(0.08)(5) = $2000
Amount due at the end of loan = P + P i n = 5000 + 2000
= $7000
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Compound Interest
• This is the interest normally used in real life
• Interest on top of interest
• Next year’s interest is calculated based on the unpaid
balance due, which includes the unpaid interest from
the preceding period.
… Compound InterestCompound interest is interest that is charged on the original sum and
un-paid interest.
You put $500 in a bank for 3 years at 6% compound interest per year. At the end of year 1 you have (1.06) 500 = $530. At the end of year 2 you have (1.06) 530 = $561.80. At the end of year 3 you have (1.06) $561.80 = $595.51.
Note: $595.51 = (1.06) 561.80
= (1.06) (1.06) 530 = (1.06) (1.06) (1.06) 500 = 500 (1.06)3
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Single Payment Compound Amount Formula
If you put P in the bank now at an interest rate of i% for n years,
the future amount you will have after n years is given by
F = P (1+ i )n
i = interest rate per interest period (stated as decimal)
n = number of interest periods
P = a present sum of money
F = A future sum of money
The term (1+i)n is called the single payment compound factor.
F = P (1+i)n = P (F/P,i,n)
Also P = F (1+i)-n = F (P/F,i,n)
The factor (F/P,i,n) is used to compute F, given P, and given i and n.
The factor (P/F,i,n) is used to compute P, given F, and given i and n.
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Present ValueExample 3-6If you want to have $800 in savings at the end of four years, and 5% interest is paid annually, how much do you need to put into the savings account today?We solve F = P (1+i)n for P with i = 0.05, n = 4, F = $800.
P = F/(1+i)n = F(1+i)-n
P = 800/(1.05)4 = 800 (1.05)-4 = 800 (0.8227) = $658.16.
Alternate Solution
Single Payment Present Worth Formula
P = F/(1+i)n = F(1+i)-n
P = F (P/F,i,n) , i = 5% and n = 4 periods
From tables in Appendix B, (P/F,i,n) = 0.8227
P = 800 x 0.8227 = $658.16
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F = 800
P = ?
Present ValueExample: You borrowed $5,000 from a bank at 8%
interest rate and you have to pay it back in 5 years. The debt can be repaid in many ways.
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Plan A: At end of each year pay $1,000 principal
plus interest due.
Plan B: Pay interest due at end of each year and
principal at end of five years.
Plan C: Pay in five end-of-year payments.
Plan D: Pay principal and interest in one payment
at end of five years.
…Example (cont’d)You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years.
Plan A: At end of each year pay $1,000 principal plus interest due.
a b c d e f
Year Amnt.
Owed
Int. Owed Total OwedPrincip.
Payment
Total
Paymentint*b b+c
1 5,000 400 5,400 1,000 1,400
2 4,000 320 4,320 1,000 1,320
3 3,000 240 3,240 1,000 1,240
4 2,000 160 2,160 1,000 1,160
5 1,000 80 1,080 1,000 1,080
SUM 1,200 5,000 6,200
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…Example (cont'd)You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years.
Plan B: Pay interest due at end of each year and principal at end of five years.
a b c d e f
Year Amnt.
Owed
Int. Owed Total OwedPrincip.
Payment
Total
Paymentint*b b+c
1 5,000 400 5,400 0 400
2 5,000 400 5,400 0 400
3 5,000 400 5,400 0 400
4 5,000 400 5,400 0 400
5 5,000 400 5,400 5,000 5,400
SUM 2,000 5,000 7,000
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… Example (cont'd)You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years.
Plan C: Pay in five end-of-year payments.
a b c d e f
Year Amnt.
Owed
Int. Owed Total OwedPrincip.
Payment
Total
Paymentint*b b+c
1 5,000 400 5,400 852 1,252
2 4,148 332 4,480 920 1,252
3 3,227 258 3,485 994 1,252
4 2,233 179 2,412 1,074 1,252
5 1,160 93 1,252 1,160 1,252
SUM 1,261 5,000 6,261
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… Example (cont'd)You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years.
Plan D: Pay principal and interest in one payment at end of five years.
a b c d e f
Year Amnt.
Owed
Int. Owed Total OwedPrincip.
Payment
Total
Paymentint*b b+c
1 5,000 400 5,400 0 0
2 5,400 432 5,832 0 0
3 5,832 467 6,299 0 0
4 6,299 504 6,802 0 0
5 6,802 544 7,347 5,000 7,347
SUM 2,347 5,000 7,347
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The four plans were
Year Plan 1 Plan 2 Plan 3 Plan 4
1 $1400 $400 $1252 0
2 1320 400 1252 0
3 1240 400 1252 0
4 1160 400 1252 0
5 1080 5400 1252 7347
Total $6200 $7000 $6260 $7347
How do we know whether these plans are equivalent or not?
→We won’t be able to know by simply looking at the cash flows,
therefore some effort should be made.
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Equivalence
• In the previous example, four payment plans were
described.
• The four plans were used to accomplish the task of
repaying a debt of $5000 with interest at 8%.
• All four plans are equivalent to $5000 now.
• i.e. all four plans are said to be equivalent to each
other and to $5000 now.
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Present ValueExample 3-8If you want to have $800 in savings at the end of four years, and 5% interest is paid annually, how much do you need to put into the savings account today?We solve F = P (1+i)n for P with i = 0.05, n = 4, F = $800.
P = F/(1+i)n = F(1+i)-n
P = 800/(1.05)4 = 800 (1.05)-4 = 800 (0.8227) = $658.16.
Alternate Solution
Single Payment Present Worth Formula
P = F/(1+i)n = F(1+i)-n
P = F (P/F,i,n) , i = 5% and n = 4 periods
From tables in Appendix B, (P/F,i,n) = 0.8227
P = 800 x 0.8227 = $658.16
F = 800
P = ?
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In 3 years, you need $400 to pay a debt. In two more years, you need $600 more to pay a second debt. How much should you put in the bank today to meet these two needs if the bank pays 12% per year?
Interest is compounded yearly
P = 400(P/F,12%,3) + 600(P/F,12%,5)= 400 (0.7118) + 600 (0.5674) = 284.72 + 340.44 = $625.16
Example 3-8
$400
0 1 2 3 4 5
$600
Alternate Solution
P = F(1+i)-n
P = 400(1+0.12)-3
+ 600(1+0.12)-5
P = $625.17
P
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In 3 years, you need $400 to pay a debt. In two more years, you need $600 more to pay a second debt. How much should you put in the bank today to meet these two needs if the bank pays 12% compounded monthly?
Interest is compounded yearly
P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16
Example 3-8 (Interest Compounded monthly)
$400
0 1 2 3 4 5
$600
Interest is compounded monthly
P = 400(P/F,12%/12,3*12) + 600(P/F,12%/12,5*12)
= 400(P/F,1%,36) + 600(P/F,1%,60)
= 400 (0.6989) + 600 (0.5504)
= 279.56 + 330.24 = $609.80
P
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Borrower point of view:You borrow money from the bank to start a business.
Investors point of view:You invest your money in a bank and buy a bond.
Points of view
Year Cash flow
0 - P 1 0 2 0 3 +400 4 0 5 +600
Year Cash flow
0 + P 1 0 2 0 3 -400 4 0 5 -600