# E02 CashFlow

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Centre for Management of Technology andEntrepreneurship

Centre for Management ofTechnology and

Entrepreneurship

University of Toronto

Copyright: Joseph C. Paradi199!"##$

Course: C%E&$9'ile: C%E&$9(Cash'lo)*$

Cash 'lo) *nalysis Part *

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2Course:Centre for Management of Technology and

Categories of Cash 'lo)s

First cost! e+pense to ,uild or to ,uy and install

Operations and maintenance O!M"! annuale+pense- can include electricity- la,our- repairs- etc.

#al$age $alues"! receipt at pro/ect termination fordisposal of the e0uipment can ,e a salvage cost2

%e$enues! annual receipts due to sale of products orservices

O$erhauls! ma/or capital e+penditure that occurs part)ay through the life of the asset

&repaid e'penses! annual e+penses- such as leasesand insurance payments- that must ,e paid in advance

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3Course:Centre for Management of Technology and

Economic E0uivalence

%o) do )e measure and compare economic )orth ofvarious cash 3o) pro4les5 6e need to 7no):

Magnitude of cash 3o)s

Their direction receipt or dis,ursement2

Timing )hen does transaction occur2

*pplica,le interest rates2 during time period under consideration

6e should ,e economically indi8erent to choosing,et)een t)o alternatives that are economically

e0uivalent and could therefore ,e traded for one anotherin the 4nancial mar7etplace.

*ny cash 3o) can ,e converted to an e0uivalent cash3o) at any point in time.

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*n E+ample of E0uivalence

uppose you are o8ered the alternative of receivingeither &-### at the end of ; yrs guaranteed2 or Pdollars today. interest. 6hat value of P )ould

ma7e you indi8erent to your choice ,et)een P dollarstoday and the &-### at the end of ; yrs5

?etermine the present amount that is economicallye0uivalent to &-### in ; yrs given the investment

potential of => per year.

' @ &-###- A @ ; years- i @ => per year'ind PP @ '(1Bi2A@ "-#$"

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(Course:Centre for Management of Technology and

Economic E0uivalence:eneral Principles E0uivalence calculations to compare alternatives

re0uire a common time ,asis

E0uivalence depends on the interest rate

May re0uire conversion of multiple payment cash 3o)to a single cash 3o)

E0uivalence is maintained regardless of the individualDspoint of vie) ,orro)er or lender2

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E0uivalence ! * 'actor*pproach Ao) )e can loo7 at organiing the approach to

Engineering Economy ,y de4ning its languageandnotations.

Engineering Economy 'actors apply compound interest

to calculate e0uivalent cash 3o) values. The ta,ulatedvalues at the end of the ,oo7 or you can use thefunctions in spreadsheets2 convert from one cash 3o)0uantity P- '- *- or 2 to another.

*ssumptions:1. Fnterest is compounded once per period". Cash 3o) occurs at the end of the period&. Time # is period # or the start of period 1$. *ll periods are the same length

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?e4nitions

The follo)ing are the de4nitions for the varia,les used:

i interest rate per period- e+pressed as a decimalN Aum,er of periods also called the study horion2

P Present cash 3o)- or value e0uivalent to a cash 3o)series

F 'uture cash 3o) at the end of period A- or future )orthat the end of period A e0uivalent to a cash 3o) series

A Uniform periodic cash 3o) annuity2 at the end of everyperiod from 1 to A. *lso a uniform constant amounte0uivalent to a cash 3o) series.

G radient or constant period!,y!period change in cash3o)s from period 1 to A arithmetic series2

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'actor Aotation

These have their roots in the pre!computer age )henprepared ta,les )ere used ,y engineers for manydesign needs. %o)ever- they still serve to state thepro,lem and can ,e used to solve it too.

The format of engineering economy factors is: G(- A2 )here G and < are chosen from the cash

3o) sym,ols P-'-* and . o- if you have < multiplied ,y a factor- you get the

e0uivalent value of G: P @ *P(*- i -A2 e.g. convert froma cash 3o) '2 in year 1# to an e0uivalent presentvalue P2- the factor is:

P('- i A2 ! see te+t pages after ;;9 for the ta,les

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Aames of the EE 'actors !see pp =& in te+t o no) )e 7no) ho) all this )or7s together- ,ut these factors

have names as follo)s:P('-i-A2 Present )orth factor'(P-i-A2 Compound amount factorP(*-i-A2 eries present )orth factor

*(P-i-A2 Capital recovery factor- ho) much an investment has toreturn to recover its cost ! no salvage value*('-i-A2 in7ing fund factor ! )here a savings account is used toaccumulate funds for future investment'(*-i-A2 eries compound amount factor

Aote that the 4rst letter is the varia,le you are see7ing and thesecond the one you have P(* )ant 'irst Cost investment2- haveannuity payment

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Compound Fnterest 'actorsfor ?iscrete Compounding The four discrete cash 3o) patterns are:

a single dis,ursement or receipt a set of e0ual amounts in(out over a se0uence of periods !

annuity a set of e0ual amounts in(out that change ,y a constant

amountfrom one period to the ne+t in a se0uence of periods !arithmetic gradient series

a set of e0ual amounts in(out that change ,y a constantproportionfrom one period to the ne+t in a se0uence of periods! geometric gradient series

The follo)ing assumptions apply: compounding periods are e0ual cash 3o)s at the end of the period consider payment at # to

,e at period !1 annuities and gradients occur at period ends

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The Hasic ingle Payment'actors P and ' are the ,asic single payment 0uantities and

they are related as follo)s:' @ P1 B i2A can ,e developed as:'n@ P1B in2 ! )here: iis the annual interest rate !

simple interest ! ,ut this is not very useful- so )edevelop the compound interest model:'n@ 'n!11B i2

o )e can see this in the EE notation as:

'(P-i-A2 @ 1 B i2A

and for the reverseP('-i-A2 @ 1 B i2!A

The limits of P(' and '(P factors are: 1 )hen i and A approach # P(' approaches # '(P in4nity )hen i and A approach in4nity.

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The Ielationship ,et)een Pand '

P

'

# 1 " AA!1

' occurs A periods after P

Ff you had "-###no) and investedit at 1#>- ho)much )ould it ,e

)orth in = years5

P @ "-###- i @ 1#> per year- A @ = years' @ P1Bi2A@"-###1B#.1#2=@ $-"=.1=' @ P '(P-1#>- =2@"-###K".1$& @$-"=."#

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*nother P and ' E+ample

P

'

# 1 " AA!1

' occurs A periods after P

Ff 1-### is to ,e received in ; years. *t an annual

interest rate of 1">- )hat is the P of this amount5

'@1###- i @ 1">- A @ ; yearsP @ '(1Bi2A@ 1###(1B.1"2;@ ;.$#P @ 'P('- 1">-;2 @ 1####.;$2 @ ;.$#

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?iscrete Compounding-?iscrete Cash 'lo)s P. ;1

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Com,ining 'actors

6e can com,ine these factors in various )ays to createa model for the real pro,lem at hand: delayed income stream ,ecause of startup time

another need may ,e prepaid e+penses ! also a )ay to deal

)ith startup delays or construction delays. 6e can lin7 formulas together to model the actual

proposition ! in fact deriving one formulaLs factor froman otherLs

*lso- many times the pro,lem has to ,e de4ned inmore than one part

Then- there are many approaches to a speci4c pro,lem! one may ,e longer ,ut the ans)er must ,e the same

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* imple E+ample

6e invest 1"#-### P@!1"#-###N 6e pay for ; years -###(year P@!

-###P(*-1">-;2N Then pay &;-### at year & P@!&;-###P('-1">-&2N

Ieceive $#-### at year $ P@$#-###P('-1">-$2N

$#-###

1"#-###

-###

&;-###

-###

http://d/Engineering%20Economics/Library1/HiddenFiles.ppt#A%20Simple%20Examplehttp://d/Engineering%20Economics/Library1/HiddenFiles.ppt#A%20Simple%20Example7/25/2019 E02 CashFlow

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Compound Fnterest 'actorsfor *nnuities: Uniform eries *ll cash 3o)s in series are e0ual annuity2

, 2 ../2 ./,

0 0 0 0 0

&P 1*1 i2/1*1 i2/"O. *1 i2/A/12*1 i2/A

1 *1 i2/

P 1*

eries Present 6orth 'actor P 1*P(* i- A2 p." Te+t

K

1

n

+()i

+

n

N

)i1i

11(

Aote: P occurs 1 periodHefore 1st*- ' )ould occur

*t same time as last *.

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Compound F