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CHAPTER 2
Economic Equivalence
Equal-Payment Series
2.
3.
4.
5.
6.
Receipts
Payments
Plan 1
Year 0
$30,000.00
Plan 2
$300.00
$300.00
Year 1
$7,712.77
Year 2
$7,712.77
Year 3
$7,712.77
Year 4
$7,712.77
Year 5
$7,712.77
46,158.72
Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example
i (1 i ) N
( A / P, i , N ) A P
N
(1 i ) 1
0.09(1 0.09) 5
A P (30,000)
5
(1 0.09) 1
i
( A / F , i, N ) A F
N
(1 i ) 1
A $46,158.72
$7,712.77
=
0.09
5
(1 0.09) 1 $7,712.77
Figure 2-2 A cash flow diagram for plan 1 of the loan repayment example
9
n 0: P
n 1 : F1 P (1 i )
n 2 : F2 F1 (1 i ) P (1 i ) 2
M
n N : F P (1 i ) N
10
11
12
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Practice Problem
Problem Statement
If you deposit $100 now (n
now (n
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Solution
10
$100
$200
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Economic Equivalence
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Economic Equivalence
How do we know, whether we should prefer to have $20,000
today and
$50,000 ten years from now, or $8,000 each year for the next
ten years?
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19
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EXAMPLE 2.3
Equivalence Calculation
Step 1:
3) and i
10%.
$100(1+0.1)3+ $80(1+0.1)2+$120(1+0.1)1+$150
= $511.90
Step 2:
Step 3:
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23
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Given: P = $1,000,
i = 7 %, and N = 8 years;
Find: F
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Example 2.5
A zero coupon (installment) bond is a popular variation
on the bond theme for some investors. What should be
the price of an eight year (maturity) zero-coupon with a
face value (future value) of $1,000 if similar, nonzero
coupon bonds are yielding 6% annual interest?
Given: F = $1000,
Find: P
Example 2.6
Suppose you buy a share of stock for $10 and sell it for $20; your
profit is thus $10. it takes five years to gain this profit, what would
be the rate of return on your investment?
Given: P
$10, F
$20
$20 and
$10 (1+ i )5
1+ i =
= 1.14869
0.1487 = 14.87%
5 years,
$2 = (1+ i )5
Find: i
=
(F / P, i, 5)
1.14869 1
0.14869 or
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Example 2.7
You have just purchased 200 shares of GE stock at $15
per share. You will sell the stock when its market price
doubles. If you expect the stock price to increase 12%
per year, how long do you expect to wait before selling
the stock?
Given: P
$3,000,
$6,000 and
P (1+ i )N
(1.12) N
Log 2
i = 12%,
P (F/P, i, N) 6,000
=
Find: N
N log 1.12
solve for N
gives
N
0.301 / 0.049
Practice Problem
$1,000
$500
A
Given: i
10%,
B
0
30
Approach
Step 1:
$1,000
Step 2:
$500
A0
Step 3:
Equate both equivalent values
and solve for unknown C.
B
0
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Solution
For A:
$1,000
V2 $500(1 0.10) 2 $1, 000(1 0.10) 1
$1, 514.09
For
V B:
$500
C (1 0.10) C
2.1C
2.1C C:
$1, 514.09
To Find
C $721
B
0
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Practice Problem
$1,000
$500
would you be
indifferent between
the two cash flows?
$502
$502
$502
B
0
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Approach
Step 1:
$1,000
$502
$502
Step 2:
$502
2
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Establish Equivalence at n
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Practice Problem
interest
to
meet
future
Solution
$10,000
F = $10,000;
N = 6 years;
i = 7 %;
Find P
0
6
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