Lecture No.

5
Chapter 3
Contemporary Engineering Economics
Copyright © 2010

Contemporary Engineering Economics, 5th edition © 2010

Economic Equivalence
„ What do we mean by “economic
equivalence?”
„ Why do we need to establish an economic
equivalence?
„ How do we measure and compare various
cash p
payments
y received at different p
points in
time?

Contemporary Engineering Economics, 5th edition, © 2010

What is “Economic Equivalence?”
y Economic equivalence exists between cash flows that
have the same economic effect and could therefore be
traded for one another
another.
y Even though the amounts and timing of the cash flows
may differ, the appropriate interest rate makes them
equal in economic sense.

Contemporary Engineering Economics, 5th edition, © 2010

Equivalence
Equivalence
E i l from
f Personal
P l Alternate
Alt t Way
W off Defining
D fi i
Financing Point of View Equivalence
y If you deposit P dollars today for y F dollars at the end of period N is
N periods at i,
i you will have F equal to a single sum P dollars
dollars at the end of period N. now, if your earning power is
measured in terms of interest
F
rate i.
i
P

F = P(1+i)N
0
0 N
N
F

P = F (1+ i)− N
P
0 N

Contemporary Engineering Economics, 5th edition, © 2010

 l 3.3
Example
Equivalence
‰ If you deposit $2,042 today in a y Various dollar amounts that will be
savings account that pays an 8%
interest annually, how much would
economically equivalent to $3,000 in five
you have at the end of 5 years? years, at an interest rate of 8%
‰ At an 8% interest, what is the
equivalent worth of $2,042
$2 042 now in 5
years?
F = $ 2 , 0 4 2 (1 + 0 . 0 8 ) 5
= $3,000

$2 042
$2,042

0 1 2 3 4 5
F

=
0 5

Contemporary Engineering Economics, 5th edition, © 2010

Example 3.4
i l
Equivalent h
Cash
Flows
‰$ ,
$2,042 todayy was
equivalent to receiving
$3,000 in five years, at an
interest rate of 8%. Are
these two cash flows are
also equivalent at the end of
year 3?
‰ Equivalent
q cash flows are
equivalent at any common
point in time, as long as we
use the same interest rate
(8% in
(8%, i our example).l )

Contemporary Engineering Economics, 5th edition, © 2010

Practice Problem 1
‰ Compute
p q
the equivalent value of the y Solution:
cash flow series at n = 3, using i = 10%. 
Compounding Process: $511.90

V3 = 100(1 + 0.10) + $80(1 + 0.10) + $120(1 + 0.10) + $150
3 2

+ $200(1
 + 0.10)−1 + $100(1 + 0.10)−2
Discounting Process: $264.46

$200 V = $511.90
$511 90 + $264.46
$264 46
$150
= $776.36

$100
$120
$100
= V3
$80

0 1 2 3 4 5 0 1 2 3 4 5 $200
$150
$120
$100 $100
$80

0 1 2 3 4 5
Contemporary Engineering Economics, 5th edition, © 2010
Practice Problem 2

‰ Find C that makes the two

cash flow transactions
y Approach:
equivalent at i = 10% y Step 1: Select a base period to use, say n = 2.
y Step 2: Find the equivalent lump sum value at n
$1 000
$1,000 = 2 for both A and B.
B
$500
y Step 3: Equate both equivalent values and solve
for unknown C.
A
$1,000
0 1 2 3 $500
For A: V2 =$500(1+0.10)2 +$1,000(1+0.10)−1 A
C C =$1,514.09 0 1 2 3
B: V2 =C(1+010)
ForB:
For 0.10)+C
B =2.1C
C C
2.1C =$1,514.09
0 1 2 3 C =$721 B

0 1 2 3

Contemporary Engineering Economics, 5th edition, © 2010

Practice Problem 3
‰ At what interest rate y Approach:
would you be indifferent
y Step 1: Select a base period to compute the equivalent
between the two cash value (say, n = 3)
flows?
y Step 2: Find the equivalent worth of each cash flow
$1,000 series at n = 3.
$500
$1,000
A A: F3 = $500(1+ i) +$1,000
OptionA:
Option 3
$ 00
$500
0 1 2 3 Option B: F3 = $502(1+ i) +$502(1+ i) +$502
2
A
0 1 2 3
i = 8%
$502 $502 $502 Option A : F3 = $500(1.08)3 + $1,000
$502 $502 $502
= $1,630
B
Option B : F3 = $502(1.08)2 + $502(1.08) + $502 B
= $1,630
0 1 2 3 0 1 2 3

Contemporary Engineering Economics, 5th edition, © 2010