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Equivalence Calculations

This document discusses equivalence calculations involving cash flows. It provides examples of equivalent cash flows that have the same value when discounted to the present using the same interest rate over the same time period. Equivalence can be established at any point in time by discounting both cash flows to that point. Equivalence also applies when cash flows have different interest rates applied each period, where the interest rate that sets equivalent receipts equal to equivalent disbursements is the actual rate earned on the investment. Breaking a cash flow into portions and performing equivalence on each portion will produce the same results.

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14 views

Equivalence Calculations

This document discusses equivalence calculations involving cash flows. It provides examples of equivalent cash flows that have the same value when discounted to the present using the same interest rate over the same time period. Equivalence can be established at any point in time by discounting both cash flows to that point. Equivalence also applies when cash flows have different interest rates applied each period, where the interest rate that sets equivalent receipts equal to equivalent disbursements is the actual rate earned on the investment. Breaking a cash flow into portions and performing equivalence on each portion will produce the same results.

Uploaded by

miang.gabriel0928
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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EQUIVALENCE CALCULATIONS INVOLVING CASH FLOW

Two cash flows need to be presented along the same time period using a similar
format to facilitate comparison.

When interest is earned, monetary amounts can be directly added only if they occur at
the same point in time.

EQUIVALENCE BETWEEN CASH FLOWS

Equivalent cash flows are those that have the same value.

Example : Two equivalent cash flows.


Cash Flow 1 Cash Flow 2
=====================================================
P = $1000.00 P = $0.00
i = 12% i = 12%
n = 4 years n = 4 years
F = $0.00 F = $$1000*[1+0.12]^4 = $1,573.50

The equivalence can be established at any point in time. Arbitrarily setting n = 8


years, for example, gives:
For cash flow 1 : F = $1000.0 * [1 + 0.12]^8 = $2475.96
For cash flow 2 : F = $1573.5 * [1 + 0.12]^4 = $2475.96

Note : Two or more distinct cash flows are equivalent if they are equivalent to the
same cash flow.

EQUIVALENCE FOR DIFFERENT INTEREST RATES

Example 1 : Given the following cash flow:


===================================================
Interest rate applicable
from previous year (t-1)
Year End Amount to current year end (t)
===================================================
0 $0.00 NA
1 $200.00 12% compounded quarterly
2 $0.00 12% compounded quarterly
3 $100.00 7% compounded annually
4 $100.00 10% compounded annually
5 $100.00 10% compounded annually

The above cash flow can be converted to its present value as follows:
Assuming the following cash flow:
===================================================
Time (Year End) Receipts Disbursements
===================================================
0 $0.00 -$1000.00
1 $0.00 -$500.00
2 $482.00 $0.00
3 $482.00 $0.00
4 $482.00 $0.00
5 $0.00 -$250.00
6 $482.00 $0.00
7 $482.00 $0.00

In this case, equivalence states that the actual interest rate earned on an investment is
the one that sets the equivalent receipts to the equivalent disbursements.

For the above table, the following equality can be set:


$1000 + $500.00 (P/F,i,1) + $250(P/F,i,5) =
$482(P/A,i,3)(P/F,I,1) + $482.00 (P/A,i,2)(P/F,i,5)

By trial and error i = 10% will make the above equation valid. The equivalence can be
made at any point of reference in time, it does not need to be the origin (time = zero)
to produce the same answer.

If the receipts and disbursement of cash flow are equivalent for some inter= est rate,
the cash flows of any equivalent portion of the investment are eq= ual at that interest
rate to the negative (-) of the equivalent amount of t= he cash flows that constitute the
remaining portion on the investment.

For example, break-up the above cash flow between year 4 and 5. Perform th= e
equivalence at the 4th year produces the following:
-1000(F/P,10,4)-500(F/P10,3)+482(F/A,10,3) = -(-250(P/F,10,1)+482(P/A,10,2)
(P/F,10,1))

-1000(1.464)-500(1.331)+482(3.310) = -$(-250(0.9091)+482(1.7355)(0.9091))
-$534 = -$534

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