EMGT 6225

Economic Decision Making

Module 2: Analyzing Cash Flows

and Series of Cash Flows

Manish Ranjit, Ph.D.

Northeastern University
 Objectives
• Analyze cash flows with arithmetic gradients and
geometric gradient series, finding present, annual
and future values of these cash flows
• Calculate the interest rate per cash flow period and
apply it to time value of money calculations
• Practice analyzing cash flows - using all types of
transactions so far
• Analyze problems with multiple compounding and
changing interest rates applied

2
Reading Assignments:
Chapter 2.4 to end

3
Lesson 1: Analyzing Cash Flow Series
 Check Your Knowledge
Question 1

Ideally, how frequently should you add money

to a retirement savings account if your goal is
to have about one million dollars in fifty
years?

• Once (i.e., one ‘lump sum’ payment)

• Weekly
• Monthly
• Yearly
5
 Question 2
Quinn wants to have one million dollars
saved toward her retirement in fifty years
from now and she is considering two
different long-term savings options. Option
1 accrues interest at the rate of 2%
annually, and Option 2 accrues it at 20%
annually. For each option, approximately
how much money would Quinn need to
save annually over the next fifty years to
end up as a millionaire?

6
 Question 2 Contd.
• Option 1 (2% APR) = $1,000/year,
Option 2 (20% APR) = $200/year

• Option 1 (2% APR) = $22/year,

Option 2 (20% APR) = $11,000/year

• Option 1 (2% APR) = $11,000/year,

Option 2 (20% APR) = $22/year

7
 Gradient Series
• In this series, more money is saved each
period instead of "uniform“ savings.
• Very common series and is used in industry all
the time.
• Manufacturing companies budget this way;
they realize that maintenance costs go up
each year as their equipment ages.

8
 Gradient Series Contd.
Formula
Formula 2 CF Diagram
1
At = (t-1)G
t = 1,...,n

Note that the gradient is not measured

until the second period because it is
the increase between the initial
deposit and the next deposit.
9
 Gradients in the 'Real World'
• Maintenance costs associated with the care of
your automobile.
• There is a uniform series of maintenance costs
(for example, changing the oil and replacing
tires), plus
• A gradient series which is equal to the amount
you would need to put away for other types of
repairs that will increase over time as the car
ages.
10
Example: Find PW of a Gradient Series
A couple plan to start saving money by
depositing $500 into their savings account 1
year from now. They estimate that the deposits
will increase by $100 each year for 9 years
thereafter. What would be the present worth of
the investments if the interest rate is 5% per
year?

11
Example Gradient Series Cont.

12
 Example Gradient Series Cont.
P = PU + PG
= -500 (P|A 5%, 10) - 100 (P|G 5%, 10)
= -500 (7.7217) - 100 (31.652)
= -7026.05

13
 Ways to Convert Gradient Series
Converting Gradient Converting Gradient Converting Gradient
Series to Present Series to Future Series to Annual
Worth Worth Worth

Not in tables
P = G(P|G i%, n) F = G(F|G i%, n) A = G(A|G i%, n)
14
 Check Your Knowledge
In word problems that have gradient series
(G), you can easily find A or P using factors
in your table. But what can you do in
instances where your tables do not have
factors for F given G and you need to find F?
• Convert it to something that you already
know.
• Nothing. The equation cannot be solved.
• You would need to look it up online or in
a different book

15
 Review: Converting Gradient Series
The most common scenario is to have P given G
(P|G) or A given G (A|G). Some problems will
have F given G (F|G), but if you do not have F|G,
you need to know how to convert it to either an
A or a P.

16
 Converting Gradient Series
P=G gradient series, present
worth factor
= G(P|G i%,n)

A=G gradient-to-uniform series

conversion factor
= G(A|G i%,n)

F=G gradient series, future

worth factor
= G(F|G i%,n)

17
 Example
If you borrow $10,000 at 8% compound annual interest and
repay the loan with 5 annual payments, what will be the
size of the 3rd payment if each payment is $100 greater
than the previous payment?
$10,000(A|P 8%,5) = A + $100(A|G 8%,5)
A = $10,000(0.25046) - $100(1.84647) = $2,319.95
Third payment = $2,319.95 + 2($100) = $2,519.95
PW of a Negative (Decreasing) Gradient
Example:

19
Example Negative Gradient Cont.

A=1000

20
 Example Negative Gradient Cont.
P = A (P/A, i, n) – G (P/G, i, n)
= 1000 (P/A, 2%, 5) – 100 (P/G, 2%, 5)
= 1000 (4.713) – 100 (9.240)
= $3789.00

21
 Geometric Series
• We are not putting the same amount of money in
each year as we saw in the gradient series.
• The amount goes up by a percentage of the
previous amount.
• It is based on the same principle as a raise in your
salary. If you get a 5% raise this year, then when
you get a 5% raise next year, it is based on that
increased salary from the previous year.

22
 Geometric Series Contd.

Formula 1 Formula 2 CF Diagram

At = A (1+j) t =
t-1 At = A1(1+j)t-1 t =
2,...,n 1,...,n

23
 Geometric Series
• Not as common as the gradient series
• Once you have the cash flow, the problem is easy to
solve.
• The gradient and geometric series are more
complicated than the uniform series, but are used in
many investment and saving plans.
• Note: when i = j, the denominator of these formulas
calculates to 0. Since it is mathematically impossible to
divide by 0, there are special cases for this particular
instance in the table.
24
 Converting Geometric Series to
Present Worth

P = nA1/(1+i) i=j

P = A1(P|A1 i%, j%, n)

25
Converting Geometric Series to
Future Worth

F = nA1/(1+i) i=j

F = A1(F|A1 i%, j%, n)

26
 Geometric Series Contd.
• Example 2.30
A company is considering purchasing a new machine tool. In
addition to the initial purchase and installation costs,
management is concerned about the machine’s maintenance
costs, which are expected to be $1000 at the end of the first
year of the machine’s life and increase 8%/year thereafter.
The machine tool’s expected life is 15 years. Company
management would like to know the present worth
equivalent for expected costs. If the firm’s time value of
money is 10%/year compounded annually, what is the
present worth equivalent?

27
 Example 2.30
A firm is considering purchasing a new machine. It will have
maintenance costs that increase 8% per year. An initial
maintenance cost of $1,000 is expected. Using a 10%
interest rate, what present worth cost is equivalent to the
cash flows for maintenance of the machine over its 15-year
expected life?
A1 = $1,000, i = 10%, j = 8%, n = 15, P = ?
P = $1,000(P|A110%,8%,15) = $1,000(12.03040) = $12,030.40
Time Value of Money Factors
i
10.00% 10.00%
P =1000*NPV(10%,1,1.08,1.08^2,1.08^3,1.08^4,1.08^5,
Geometric Series - Present Worth
j 4% 5% 6% 10% 15%
To Find P To Find P To Find P To Find P To Find P
n Given A 1 Given A 1 Given A 1 Given A 1 Given A 1

1.08^6,1.08^7,1.08^8,1.08^9,1.08^10,1.08^11,1.08^12,
(P|A 1,i%,j%,n) (P|A1,i%,j%,n) (P|A1,i%,j%,n) (P|A 1,i%,j%,n) (P|A 1,i%,j%,n)
1 0.90909 0.90909 0.90909 0.90909 0.90909
2 1.76860 1.77686 1.78512 1.81818 1.85950
3 2.58122 2.60518 2.62930 2.72727 2.85312
4 3.34951 3.39586 3.44278 3.63636 3.89190

1.08^13,1.08^14) = $12,030.40
5 4.07590 4.15059 4.22668 4.54545 4.97789
6 4.76267 4.87102 4.98207 5.45455 6.11325
7 5.41198 5.55870 5.71000 6.36364 7.30022
8 6.02587 6.21512 6.41145 7.27273 8.54113
9 6.60628 6.84171 7.08740 8.18182 9.83846
10 7.15503 7.43981 7.73877 9.09091 11.19475
11 7.67385 8.01073 8.36645 10.00000 12.61270
12 8.16436 8.55570 8.97130 10.90909 14.09509
13 8.62813 9.07589 9.55417 11.81818 15.64487
14 9.06659 9.57244 10.11583 12.72727 17.26509
15 9.48114 10.04642 10.65708 13.63636 18.95896
Example 2.30
 Geometric Series Contd.
• Example 2.32
An investment of $100,000 is made in a limited partnership in a
natural-gas drilling project. The first year of the investment
produced net revenue of $25,000. Over a 20-year period, the
net revenue received from the investment decreased by 10
percent each year. Based on a TVOM of 12 percent, what is
the present worth for the investment?

30
 Geometric Series Contd.
• Example 2.32
An investment of $100,000 is made in a limited partnership in a natural-
gas drilling project. The first year of the investment produced net
revenue of $25,000. Over a 20-year period, the net revenue received
from the investment decreased by 10 percent each year. Based on a
TVOM of 12 percent, what is the present worth for the investment?
A1 = $25,000, i = 12%, j = -10%, n = 20, P = ?
P = -$100,000 + $25,000(P|A1 12%,-10%,20)
P = -$100,000 + $25,000(4.48817) = 12,204.15

P = -$100,000 + $25,000[1 – (0.90)20(1.12)-20]/(0.12 + 0.10)

P = $12,204.15

31
Example 2.32
 Geometric Series Contd.
• Example 2.31
Mattie Bookhout receives an annual bonus and deposits it in a
saving account that pays 8 percent compounded annually.
The amount increases by 10 percent each year, her initial
deposit is $500. Determine how much will be in the fund
immediately after her tenth deposit?

F = $500 (F/A1 8%, 10%, 10) = $500 (21.74087) = $10,870.44

33
Example 2.31
 Example
Suppose you invest $100,000 and receive $25,000 one year after
making the investment. Further, suppose each year you receive 10%
more than the previous year. If your time value of money equals
10%, how long will it take for you to fully recover your investment?
P = $100,000, A1 = $25,000, i = 10%, j = 10%, n = ?

$100,000 = $25,000(P|A1 10%,10%,n)

(P|A1 10%,10%,n) = $100,000/$25,000 = 4.0
From p. 853, 4 < n < 5
Interpolating, n = 4 + (4.00000 – 3.63636)/(4.54545 – 3.63636) = 4.4
Since i = j = 10%, P = n A1/(1 + i), or $100,000 = $25,000n/1.10.
Therefore, n = $100,000(1.10)/$25,000 = 4.4 years
 Revised Example
Suppose you invest $100,000 and receive $25,000 one year after
making the investment. Further, suppose each year you receive 10%
less than the previous year. If your time value of money equals 10%,
how long will it take for you to fully recover your investment?
P = $100,000, A1 = $25,000, i = 10%, j = -10%, n = ?
$100,000 = $25,000(P|A1 10%,-10%,n)

$100,000 = $25,000 = $25,000

  1  0.10  n 
1   
 n

  1  0. 10   = 0.20 1  ( 0 . 81818)
(0.81818) = 1 – 0.20($100,000)/$25,000
n
 
 0.10  ( 0.10)   years 0 . 20 
n = log(0.20)/log(0.81818)
 = log(0.20)/log(0.9/1.1)
 = 8.02
 
 Example
If you borrow $10,000 at 8% compound annual interest and
repay the loan with 5 annual payments, what will be the
size of the 3rd payment if each payment is 10% greater than
the previous payment?
$10,000 = A1(P|A1 8%,10%,5)
A1 = $10,000(0.08 – 0.10)/[1 – (1.1/1.08)5] = $2,081.47
A3 = A1(1.10)2 = $2,081.47(1.10)2 = $2,518.58
Lesson 2: Multiple Compounding
Periods in a Year
 Introduction
• Thus far, when referring to an interest rate, we said
that it was x% compounded annually or x% annual
compound interest.

• While it is true that practically all engineering

economic analyses incorporate annual compounding,
in personal financing, compounding typically occurs
more frequently than once a year.

39
 Introduction
• For example, credit cards charge interest of say 1.5% on
the unpaid balance of the account each month. As a
result, if you owe $1000 and do not pay it by the monthly
payment deadline, your balance owed increases to
$1015. If you do not make any payments, the interest
owed next month will be 1.5% of $1015.
• In this case of 1.5% per month, an alternate way of
expressing the interest rate is 18% per annum
compounded monthly, or 18% per year per month. When
expressed in this form, 18% is known as the nominal
annual interest rate (r).
40
 Introduction
• In the examples presented thus far, cash flows
occurred on an annual basis and money was
compounded annually. When cash flow frequency and
compounding frequency are not the same, one of two
approaches must be employed: the period interest
rate approach or the effective interest rate approach.

• When the interest period and the compounding period are the same (monthly), the
factors in Appendix A can be applied directly. Note, however, the number of interest
periods (n) must be adjusted to match the new frequency.

41
 Effective Interest Rate
Effective interest rate per year, ieff or ia, is the
annual interest rate taking into account the effect
of any compounding during the year.

Where:
r = nominal annual interest rate
m = number of compounding periods per year
ieff = EFFECT(r, m) - annual effective interest rate
42
 Effective Interest Rate
• If the interest rate is 12% per year compounded
quarterly, then r = 12%, and there are four interest
periods per year. Thus, the period interest rate is 3%
per quarter. Hence, $1 invested for 1 year at 3% per
quarter has a FW of F = 1(F/P 3%,4) = 1(1.12551) =
1.12551
• To obtain the same value in 1 year require an annual
compound interest rate of 12.551%. This value is
called the effective annual interest rate and is given
by (1.03)4 – 1 = 0.12251 = 12.551%
43
 Example 2.35
• Two thousand dollars is invested in an account that
pays 12 percent per year compounded monthly. What
is the account balance after 3 years?
• Here, r =12%, m = 12, period interest rate =r/m =
1%/month
• F = 2000 (F/P i%, n) = 2000 (F/P 1%, 36)
2000 (1.43077) = 2861.54
• ieff = (1+0.01)12 – 1 = 12.6825%
• F = 2000 (F/P i%, n) = 2000 (F/P 12.6825%, 3) = 2000
(1.43077) = 2861.54
44
 Example 2.35
• Two thousand dollars is invested in an account that
pays 12 percent per year compounded semiannually.
What is the account balance after 3 years?
• Here, r =12%, m = 2, period interest rate =r/m =
6%/month
• F = 2000 (F/P i%, n) = 2000 (F/P 6%, 6)
2000 (1.41852) = 2837.04
• ieff = (1+0.06)2 – 1 = 12.36%
• F = 2000 (F/P i%, n) = 2000 (F/P 12.36%, 3) = 2000
(1.41852) = 2837.04
45
 Example 2.37
What happens to the interest rate when we
change the compounding rate for an
investment?

46
Rate r m r/m ieff Formula ieff
12% per annum
compounded 12% 1 12% (F|P 12%,1) -1 12%
annually
12% per annum
compounded 12% 2 6% (F|P 6%, 2) -1 12.36%
semiannually
12% per annum
compounded 12% 4 3% (F|P 3%, 4) -1 12.55%
quarterly
12% per annum
compounded 12% 12 1% (F|P 1%, 12) -1 12.68%
monthly
12% per annum
compounded 12% 52 (1+.12/52)52 -1 12.73%
weekly
12% per annum
12% 365 (1+ .12/365)365-1 12.75%
compounded daily
12% per annum 47
(1+.12/8760)8760-
 Example 2.38
• Wenfeng Li borrowed $1000 and paid off the
loan with interest after 4.5 years. The amount
paid was $1500. What was the effective
annual interest rate for the transaction?
(Letting the interest period be 6 months).

• 1500 = 1000(F/P i%, 4.5) -> ln1.5 = 4.5 ln (1+i) -

> i = 9.4287%

48
 Example 2.38
• Wenfeng Li borrowed $1000 and paid off the
loan with interest after 4.5 years. The amount
paid was $1500. What was the effective annual
interest rate for the transaction? (Letting the
interest period be 6 months).

• 1500 = 1000(F/P i%, 9) -> ln1.5 = 9 ln (1+i) -> i =

4.60819
• ieff = (1+0.0460819)2 - 1=0.094287 = 9.4287%
49
 Example 2.36
• Rebecca Carlson purchases a car for $25,000 and
finances her purchase by borrowing the money at 8%
per year compounded monthly; she pays off the loan
with equal monthly payments for 5 years. What will
be the size of her monthly loan payment?
• r = 8%, m = 12, period interest rate = 8/12
=0.66667%per month
• A = 25000 (A/P 0.66667%,60) = 25000 (0.02028) =
507

50
 Example 2.39
• Greg Wilhelm borrowed $100,000 to purchase
a house. He agreed to repay the loan with
equal monthly payments over a 30-year
period at a nominal annual interest rate of 6%.
His monthly payment on the 30-year loan is?

• A = 100,000 (A/P 0.5%, 360) =

100,000(0.0059955) = $599.55

51
 When Compounding and Cash Flow
Frequencies Differ
• Previous examples – frequency of
compounding coincided with the frequency of
cash flows – monthly compounding and
monthly cash flows. What if they are not the
same?

52
 Mismatched CFs and Compounding
Frequencies
Two Cases:
1.CF more often or compounding less often than CF (monthly
cash flow and quarterly compounding)

2.CF less often or compounding is more frequent than CF

(quarterly cash flow and monthly compounding)

53
 Mismatched CFs and Compounding
Frequencies
1. CF more often or compounding less often than CF
(monthly cash flow and quarterly compounding)

Ann deposits $1000 at the end of each month into her bank savings
account. The bank paid 6% nominal interest, compounded and
paid quarterly. No interest was paid on money not in the account
for the full 3-month period (i.e. It is assumed that money
deposited during a compounding period earns no interest).
How much was in Ann’s account at the end of 3 years.

54
 Mismatched CFs and Compounding
Frequencies
1. CF more often or compounding less often than CF
(monthly cash flow and quarterly compounding)

Ann deposits $1000 at the end of each month into her bank savings
account. The bank paid 6% nominal interest, compounded
quarterly. It is assumed that money earns interest regardless
of when it is deposited. How much was in Ann’s account at the
end of 3 years.

imonthly = ((1+0.06/4)(4/12) ) – 1 = 0.004975 = 0.4975%

F = 1000 (F|A, 0.4975%, 36) = 1000 (39.31846) = 39,318.46

55
 Mismatched CFs and Compounding
Frequencies
Example 2.40
1.CF more often or compounding less often than CF (monthly cash flow and
quarterly compounding)

What size monthly payments should occur when $10,000 is borrowed at 8%

per year compounded quarterly and the loan is repaid with 36 equal monthly
payments? It is assumed that the money earns interest regardless of
when it is lend.

ieff = (1+imonthly)12 -1 = (1+iquarterly)4 -1

i = (1+0.08/4)4/12 – 1 = 0.006623 = 0.6623%
A = $10,000 (A/P 0.6623%, 36) =10000 (0.03131)
= $313.1
56
 Mismatched CFs and Compounding
Frequencies
2. CF less often or compounding is more frequent than CF
(quarterly cash flow and monthly compounding)

57
 Mismatched CFs and Compounding
Frequencies
2. CF less often or compounding is more frequent than CF
(quarterly cash flow and monthly compounding)

Solution: Compute an effective interest rate for the time period

between individuals i = (1+r/m)m/k – 1
Where:
r = nominal annual interest rate
m = number of compounding periods per year
k = number of cash flows per year
I = interest rate per cash flow period
58
Note: The formula is derived as: (1+i)k – 1 = (1+r/m)m – 1
 Mismatched CFs and Compounding
Frequencies
2. CF less often or compounding is more frequent than CF
(quarterly cash flow and monthly compounding)

Solution : Compute an effective interest rate for the time period

between individuals
i = (1+r/m)m/k – 1

iyearly = (1+0.08/4)4/1 – 1 = 0.0824 = 8.24% per year

59
 Mismatched CFs and Compounding
Frequencies
2. CF less often or compounding is more frequent than CF
(quarterly cash flow and monthly compounding)

Solution : Compute an effective interest rate for the time period

between individuals

W = P(A/P, i , n) = 5000(A/P, 8.24% ,5) = 306(0.2520) = $1260

60
 Continuous Compounding
• In businesses and governments, transactions occur
every year, every month, every day, every hour,
every minute, and every second.
• In multi-national corporations, for example, money is
“put to work” immediately. Via electronic transfers,
money is invested around the world continuously.
• Explicit consideration of “around the clock” and
“around the world” money management motivates
the use of continuous compounding.

61
 Continuous Compounding Contd.
• Not only does compounding of money occur
“continuously,” but also expenditures occur
by the hour, minute, and second. Hence,
funds also flow continuously.
• ieff = er - 1
• F = Pern = P(F|P, r%, n)∞

62
 Continuous Compounding nm
 r 
F P1  i  P 1  
n
We have that
 m
nm
 r
If we consider that F P lim  1  
m 
 m
lim1  x  x 2.71828 e
1
Then
x 0

x r
m
 x rn
; nm  1


F P lim1  x 
x 0
1
x 
rn
Pe rn
 Examples
• Example 2.A.1 Summary of continuous
compounding interest factors for discrete flows

• Example 2.A.2 Summary of continuous

compounding interest factors for continuous
flows

• Example 2.A.3 Continuous Compounding with a

Geometric Series
64
 Example 2.A.1
If 2,000 is invested in a fund that pays interest at
a rate of 12% compounded continuously, after 5
years the cumulative amount in the fund will
be?

65
 Example 2.A.1
If 2,000 is invested in a fund that pays interest at
a rate of 12% compounded continuously, after 5
years the cumulative amount in the fund will
be?

F = P (F/P 12%, 5)∞ = 2000 (1.82212) = 3,644.24

F = 2000×e0.12×5 = 3,644.24

66
 Example 2.A.2
$1000 is deposited each year into an account
that pays interest at a rate of 12 percent
compounded continuously. Determine both the
amount in the account immediately after the
tenth deposit and the present worth equivalent
for 10 deposits?

67
Example 2.A.2

68
 Example 2.A.3
An individual receives an annual bonus and
deposits it in a savings account that pays 8%
compounded continuously. The amount
increases each year at a rate of 10%
compounded continuously; the initial deposit is
$500. Determine how much will be in the fund
immediately after the tenth deposit?

69
 Continuous Compounding

Substituting e-rn for (1+i)-n , er -1 for i, and ern for (1+i)n. 70

 Example 2.A.3
An individual receives an annual bonus and deposits it in
a savings account that pays 8% compounded
continuously. The amount increases each year at a rate
of 10% compounded continuously; the initial deposit is
$500. Determine how much will be in the fund
immediately after the tenth deposit?

F = A1 (F/A1 i%, j%, n)∞ = 500 (F/A1 8%, 10%, 10)∞ =

=500 [{exp(0.08*10)-exp(0.1*10)}/{exp(0.08)-exp(0.1)}]
= 500 (22.51619) = 11,258.09
71