CHAPTER II

Factors: How Time and Interest

Affect Money
 Content
1. Gradient Formulas (Geometric)
2. Shifted Cash Flows

2
2.3 Geometric Gradients
• An arithmetic (linear) gradient changes by a constant
amount each time period.
•A GEOMETRIC gradient changes by a fixed percentage
each time period.
•We define a UNIFORM RATE OF CHANGE (%) for each
time period
•Define “g” as the constant rate of change in decimal
form by which amounts increase or decrease from one
period to the next

3
2.3 Geometric Gradients:
Increasing
• Typical Geometric Gradient Profile
•Let A1 = the first cash flow in the series

0 1 2 3 4 …….. n-1 n

A1 A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1
4
2.3 Geometric Gradients:
Decreasing
• Typical Geometric Gradient Profile
•Let A1 = the first cash flow in the series

0 1 2 3 4 …….. n-1 n

A1(1-g)n-1
A1(1-g)3
A1(1-g)2

A1(1-g)

A1
5
2.3 Geometric Gradients:
Derivation
• First Major Point to Remember:

•A1 does NOT define a Base Annuity/

•There is not BASE ANNUITY for a Geometric
Gradient!
•The objective is to determine the Present Worth one
period to the left of the A1 cash flow point in time

•Remember: The PW point in time is one period to the

left of the first cash flow – A1!

6
2.3 Geometric Gradients:
Derivation
• For a Geometric Gradient the following parameters are
required:
•The interest rate per period – i
•The constant rate of change – g
•No. of time periods – n

•The starting cash flow – A1

7
2.3 Geometric Gradients:

•Pg = A1(P/A, g, i, n)
  1  g n 
1     nA1
Pg  A1  

1 i  
ig 
gi Pg 



 (1  i )
g not = to i Case: g = i

8
2.3 Geometric Gradient: Example
•Assume maintenance costs for a particular activity will
be $1700 one year from now.
•Assume an annual increase of 11% per year over a 6-
year time period.
•If the interest rate is 8% per year, determine the
present worth of the future expenses at time t = 0.
•First, draw a cash flow diagram to represent the model.

9
2.3 Geometric Gradient Example (+g)

•g = +11% per period; A1 = $1700; i = 8%/yr

0 1 2 3 4 5 6
7
$1700
$1700(1.11)1
$1700(1.11)2
$1700(1.11)3

PW(8%) = ??
$1700(1.11)5

10
2.3 Solution
• P = $1700(P/A,11%,8%,7)
•Need to calculate the P/A factor from the closed-form
expression for a geometric gradient.
•From a spreadsheet we see:
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = 11%
i= 8%   1  g n 
N= 7 1    
1 i  
7.04732 Pg  A1   gi
P/A,g,i,n factor is……
 ig 
 
First Amt= $ 1,700.00  
P. Value = $ 11,980.44
11
2.3 Geometric Gradient ( -g )
• Consider the following problem with a negative
growth rate – g. g = -10%/yr; i = 8%; n = 4
A1 = $1000
$900
$810
$729

0 1 2 3 4
P0=??

We simply apply a “g” value = -0.10

12
2.3 Geometric Gradient (-g value)
• Evaluate:   1  g n 
1    
For a negative g 1 i  
value = -0.10 Pg  A1   gi
 ig 
 
 
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = -10%
i= 8%
N= 4
P/A,g,i,n factor is…… 2.87637

First Amt= $ 1,000.00

P. Value = $ 2,876.37
13
2.4 Cash Flows that are
SHIFTED
• A shifted series is one whose present worth point in time is
NOT t = 0.
• Shifted either to the left of “0” or to the right of t = “0”.
• Dealing with a uniform series:
• The PW point is always located one period prior to the
first uniform-series amount when using the P/A factor
• The FW point is always located in the same period as
the last uniform-series amount when using F/A factor.

14
2.4 Shifted Series
Consider:
0 1 2 3 4 5 6 7
8

A = -$500/year
P2
P0
P of this series is at t = 2 (P2 or F2)
P2 = $500(P/A,i%,4) or, could refer to as F2
P0 = P2(P/F,i%,2) or, F2 (P/F,i%,2)

15
2.4 Shifted Series: P and F
Require F6
0 1 2 3 4 5 6 7
8
P0

A = -$500/year
P3 F6 = ??

•F for this series is at t = 6

•F6 = A(F/A,i%,4) where n = 4 time periods
forward.
16
2.4 Suggested Steps
• Draw and correctly label the cash flow diagram (+ & -) that
defines the problem.
• Locate the present and future worth points for each series on
CF diagram.
• Determine n by renumbering the CF diagram.
• Set up and solve the equations

17
2.4 Series with other single cash flows
• It is common to find cash flows that are combinations of
series and other single cash flows.
• Solve for the series present worth values then move to t =
0.
• Solve for the PW at t = 0 for the single cash flows.
• Add the equivalent PW’s at t = 0.

18
2.4 Series with Other cash flows
F4 = $300
• Consider:
A = $500

0 1 2 3 4 5 6 7
8
i = 10%

F5 = -$400

•Find the PW at t = 0 and FW at t = 8 for this

cash flow –watch the signs!
19
2.4 The PW Points are:
F4 = $300

A = $500

1 2 3
0 1 2 3 4 5 6 7
8
i = 10%

F5 = -$400

t = 1 is the PW point for the $500 annuity;

“n” = 3

20
2.4 The PW Points are:
Back 4 periods
F4 = $300

A = $500

1 2 3
0 1 2 3 4 5 6 7
8
i = 10%
Back 5 Periods
F5 = -$400

t = 1 is the PW point for the two other

single cash flows

21
2.4 Write the Equivalence
Statement
P = $500(P/A,10%,3)(P/F,10%,1)
+
$300(P/F,10%,4)
-
400(P/F,10%,5)

Substituting the factor values into the

equivalence expression and solving….

22
2.4 Substitute the Factors and
Solve
P = $500( 2.4869 )( 0.9090 ) $1,130.30
+
$300( 0.6830 )
$204.90
-
400( 0.6209 )
$248.36
=
$1583.56

23
2.4 The Linear Gradient –
Revisited
• The Present Worth of an arithmetic gradient (linear
gradient) is always located:
• One period to the left of the first cash flow in
the series ( “0” gradient cash flow) or,
• Two periods to the left of the “1G” cash flow

24
2.4 Shifted Gradient
• A Shifted Gradient is one whose present value point is
removed from time t = 0.
• A Conventional Gradient is one whose present worth point
is t = 0.

25
2.4 Example of a Conventional Gradient
• Consider:

Gradient Series

……..Base Annuity ……..

1 2 … n-1 n
0

•This Represents a Conventional Gradient.

•The present worth point is t = 0.

26
2.4 Example of a Shifted Gradient
• Consider:

Gradient Series

……..Base Annuity ……..

1 2 3 4 n-1 n
0

The Present Worth Point for the

Base Annuity and the Gradient
would be here!

This Represents a Shifted Gradient.

27
2.4 Shifted Gradient: Example
• Given:

G = +$100

Base Annuity = $100

0 1 2 3 4 ……….. ……….. 9 10

•Let Cash Flow (CF) start at t = 3:

•$100/ yr increasing by $100/year
through year 10; i = 10%; Find the PW
at t = 0.
28
2.4 Shifted Gradient: Example
• PW of the Base Annuity

P2 = $100(P/A,10%,8)

Base Annuity = $100

0 1 2 3 4 ……….. ……….. 9 10

nannuity = 8 time periods

P2 = $100( P/A,10%,8 ) = $100( 5.3349 ) = $533.49

P0 = $533.49( P/F,10%,2 ) = $533.49( 0.8264 )

= $440.88
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2.4 Gradient Present Worth
• For the gradient component
P2 = $100(P/G,10%,8)

G = +$100

0 1 2 3 4 ……….. ……….. 9 10

• PW of gradient is at t = 2:

•P2 = $100( P/G,10%,8 ) = $100( 16.0287 ) = $1,602.87

•P0 = $1,602.87( P/F,10%,2 ) = $1,602.87( 0.8264 )

• = $1,324.61
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2.4 Example: Final Solution
• For the Base Annuity
• P0 = $440.88
• For the Linear Gradient
• P0 = $1,324.61
• Total Present Worth:
• $440.88 + $1,324.61 = $1,765.49

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 2.4 Shifted Geometric
• Conventional Geometric Gradient
Gradient

P of G. Grad. Is at t = “0”

A1

0 1 2 3 … … … n

Present worth point is at t = 0 for a conventional

geometric gradient!

32
 2.4 Shifted Geometric
• Shifted Geometric Gradient
Gradient

A1

0 1 2 3 … … … n

Present worth point is at t = 2 for this example

33
2.4 Geometric Gradient Example
i = 10%/year

0 1 2 3 4 5 6 7
8

A = $700/yr

A1 = $400 @ t = 5

12% Increase/yr

34
2.4 Geometric Gradient Example
i = 10%/year

0 1 2 3 4 5 6 7
8

A = $700/yr

PW point for the

annuity

12% Increase/yr

PW point for the

gradient

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2.4 The Gradient Amounts
t Base Amt
51 $400.00
62 $448.00
73 $501.76
84 $561.97

Present Worth of the Gradient at t = 4

3.73674
P4 = $400{ P/A1,12%,10%,4 } = $ 1,494.70

P0 = $1,494.70( P/F,10%,4) = $1,494.70( 0. 6830 )

P0 = $1,020,88
36
2.4 The Annuity Present Worth
• PW of the Annuity
i = 10%/year

0 1 2 3 4 5 6 7
8

A = $700/yr

P0 = $700(P/A,10%,4)

= $700( 3.1699 ) = $2,218.94

37
2.4 Total Present Worth
• Geometric Gradient @ t =0
• P0 = $1,020,88
• Annuity
• P0 = $2,218.94
• Total Present Worth”
• $1,020.88 + $2,218.94
• = $3,239.82

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2.4 Shifted Decreasing Linear Gradients

• Given the following shifted, decreasing gradient:

F3 = $1,000; G=-$100

i = 10%/year

0 1 2 3 4 5 6 7
8

Find the Present Worth @ t = 0

39
2.4 Shifted Decreasing Linear Gradients

• Given the following shifted, decreasing gradient:

F3 = $1,000; G=-$100
i = 10%/year

0 1 2 3 4 5 6 7
8
PW point @ t = 2

40
2.4 Shifted Decreasing Linear Gradients

F3 = $1,000; G=-$100
i = 10%/year

0 1 2 3 4 5 6 7
8
Use
(P/F,10%,2)

P0 here P2 or, F2: Then take back to t = 0

41
2.4 Shifted Decreasing Linear Gradients
F3 = $1,000; G=-$100
Base Annuity = $1,000
i = 10%/year

(P/F,10%,2)

0 1 2 3 4 5 6 7
8
P2 or, F2: Then take back to t = 0

P0 here

42
2.4 Time Periods Involved

F3 = $1,000; G=-$100
i = 10%/year

1 2 3 4 5

0 1 2 3 4 5 6 7
8

P2 or, F2: Take back to t = 0

P0 here Dealing with n = 5 periods.

43
2.4 Time Periods Involved
F = $1,000; G=-$100
3

$1,000 G = -$100/yr
i = 10%/year

1 2 3 4 5

0 1 2 3 4 5 6 7
8
P2 = $1,000( P/A,10%,5 ) – 100( P/G,10%.5 )
P2= $1,000( 3.7908 ) - $100( 6.8618 ) = $3,104.62

P0 = $3,104.62( P/F,10%,2 ) = $3104.62( 0 .8264 ) = $2,565.65

44
 2.4 Shifted Gradient Example: i = 10%

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

1. This is a “shifted” negative, decreasing

gradient.
2. The PW point in time is at t = 3 (not t = o)

45
2.5 Shifted Gradient Example
• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The PW @ t = 0 requires getting the PW @ t =3;

•Then using the P/F factor move PW3 back to t=0

46
2.5 Shifted Gradient Example
• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The base annuity is a $600 cash flow for 3 time

periods

47
2.5 Shifted Gradient Example: Base Annuity

• PW of the Base Annuity: 2 Steps

0 1 2 3 4 5 6 7

P3=-600(P/A,10%,4)
P0=P3(P/F,10%,3)
P3

P0 A = -$600
3.1699 0.7513
P0= [-600(P/A,10%,4)](P/F,10%,3)
P 0-base annuity = -$1428.93

48
 2.5 Shifted Gradient Example: Gradient

• PW of Gradient Component: G = -$50

0 1 2 3 4 5 6 7

P3-Grad = +50(P/G,10%,4)

P0=P3(P/F,10%,3)
P3

P0 0G 3G
1G 2G
4.3781 0.7513
=-$164.46
P0-grad = {+50(P/G,10%,4)}(P/F,10%,3)

49