Topic 1: Financial Management

Financial Mathematics

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 Note!
• We will assume no inflation!
– In the discussion that follows
– (And for the next several weeks)

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 Notation
• i = interest rate (per time period)
• n = # of time periods
• P = money at present
• F = money in future
– After n time periods
– Equivalent to P now, at interest rate i
• A = payment at end of each time period
– E.g., annual

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 Assumptions
• Assume all cash flow occurs at the end of each
time period
– For example, all year 1 payments are due on
December 31 of year 1
• The present is the end of period 0

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 Overview
• Converting from P to F, and from F to P
• Converting from A to P, and from P to A
• Converting from F to A, and from A to F
• (No gradient methods!)
• Sensitivity analysis (Section 2.9)

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 Present to Future,
and Future to Present

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 Converting from Present to
Future

• To find F given P:
Fn

………….
n

Compound forward in time

P0

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 Derive by Recursion
• Invest an amount P at rate i:
– Amount at time 1 = P (1+i)
– Amount at time 2 = P (1+i)2
– Amount at time n = P (1+i)n
• So we know that F = P(1+i)n
– (F/P, i%, n) = (1+i)n
– Single payment compound amount factor
Fn = P (1+i)n
Fn = P (F/P, i%, n)

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Example—Present to Future
• Invest P=$1,000, n=3, i=10%
• What is the future value, F?
F = ??

0 1 2 3
P = $1,000
i = 10%/year

F3 = $1,000 (F/P, 10%, 3) = $1,000 (1.10)3

= $1,000 (1.3310) = $1,331.00

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 Converting from Future to
Present
• To find P given F:
– Discount back from the future Fn

………….
n
Bring a single sum in future
back to the “present”
P

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Illustration of Discounting

100
0
Present Value

80
0.01
60 0.05
40 0.1
0.2
20
0.3
0
0

8
10

12

14

16

18

20
Time

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 Converting from Future to
Present
• Amount F at time n:
– Amount at time n-1 = F/(1+i)
– Amount at time n-2 = F/(1+i)2
– Amount at time 0 = F/(1+i)n
• So we know that P = F/(1+i)n
– (P/F, i%, n) = 1/(1+i)n
– Single payment present worth factor

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Example—Future to Present
• Assume we want F = $100,000 in 9 years.
• How much do we need to invest now, if the interest
rate i = 15%? F9 = $100,000

i = 15%/yr

0 1 2 3 ………… 8 9

P= ??
P = $100,000 (P/F, 15%, 9) = $100,000 [1/(1.15)9]
= $100,000 (0.1111) = $11,110 at time t = 0

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 Annual to Present,
and Present to Annual

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 Converting from Annual to
Present
• Fixed annuity—constant cash flow
P = ??

1 2 3
…………..
.. .. n-1 n
0

$A per period

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 Converting from Annual to
Present
• We want an expression for the present
worth P of a stream of equal, end-of-
period cash flows A
P = ??

0 1 2 3 n-1 n

A is given

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Converting from Annual to Present

Write a present-worth expression for each

year individually, and add them

 1 1 1 1 
P  A   ..  n 1
 n 
 (1  i) (1  i) (1  i) (1  i) 
1 2

The term inside the brackets is a geometric progression.

This sum has a closed-form expression!
Converting from Annual to Present

Write a present-worth expression for

each year individually, and add them
 1 1 1 1 
P  A   ..  n 1
 n 
 (1  i) (1  i) (1  i) (1  i) 
1 2

 (1  i)n  1 
P  A n 
for i  0
 i(1  i) 
(Derivation given in Section 2.2)
Converting from Annual to Present

This expression will convert an annual cash

flow to an equivalent present worth amount:
 (One period before the first annual cash flow)

 (1  i)n  1 
P  A n 
for i  0
 i(1  i) 
 The term in the brackets is (P/A, i%, n)
 Uniform series present worth factor
Converting from Present to Annual

Given the P/A relationship:

 (1  i)n  1 
P  A n 
for i  0
 i(1  i) 

We can just solve for A in terms of P, yielding:

 i (1  i )n  Remember: The present is

A P  always one period before
 (1  i ) n
 1  the first annual amount!

 The term in the brackets is (A/P, i%, n)

 Capital recovery factor
 Converting from Present to
Annual
• This is how mortgages and car loans work:
– The bank gives you an amount P today
– You pay equal amounts A until you have paid the loan
plus interest
– In the first year, you pay mainly interest, and little of
the principal
– In the last year, you pay mainly the principal, and little
interest (since little of your original loan amount P is
still owed)

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 Converting from Present to
Annual
• How is it possible to calculate a constant amount to
repay, and have the total be exactly equivalent to P?
– It is sort of like magic!
• The calculations would be easier if you paid an equal
fraction of the principal P every year, plus whatever
interest is owed on the unpaid portion of the principal:
– But in that case almost nobody could afford to get a mortgage,
because the payments would be very high in the first few years!

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 Future to Annual,
and Annual to Future

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 Converting from Future to
Annual $F

• Find the annual cash flow that is equivalent

to a future amount F

1 2 3
…………..
.. .. n-1 n
0

The future amount

$A per period?? $F is given!

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Converting from Future to Annual

Take advantage of what we know

Recall that:
 1  Substitute “P” and
PF n  simplify!
 (1  i ) 
and

 i (1  i )n 
A P 
 (1  i )  1 
n

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Converting from Future to Annual

First convert future to present:

 Then convert the resulting P to annual

 1  i(1  i) 
 n
A F n  
 (1  i )   (1  i )  1 
n

Simplifying, we get:

 i 
AF 
 (1  i )  1 
n

 The term in the brackets is (A/F, i%, n)

 Sinking fund factor (from the year 1724!) 26
Example 2.6 (from the book)

How much money must Carol save each year

(starting 1 year from now) at 5.5%/year:
 In order to have $6000 in 7 years?

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Example 2.6 (continued)

Solution:
 The cash flow diagram fits the A/F factor
(future amount given, annual amount??)
 A= $6000 (A/F, 5.5%, 7) = 6000 (0.12096)
= $725.76 per year
 The value 0.12096 can be computed (using
the A/F formula), or looked up in a table

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Converting from Annual to Future

 i 
Given A F 
 (1  i)  1 
n

Solve for F in terms of A:

 (1  i ) n  1 
F=A  
 i 
 The term in the brackets is (F/A, i%, n)
 Uniform series compound amount factor 29
 Converting from Annual to
Future $F

• Given an annual cash flow:

1 2 3
…………..
.. .. n-1 n
0

$A per period Find $F, given the $A

amounts

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More Numerical Examples

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 How Fast Does Our Money
Grow?
• Invest $1000 now for 64 years at 6%:
– F = P (1+i)n = $1000 (1.06)64 = $41,647
• Things get big over time!
• Invest $1000 each year for 64 years at 6%:
– F = A [(1+i)n - 1]/i
• = $1000 [(1.06)64 - 1]/.06 = $677,450
• This is really big!

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 Non-Equal, Non-Annual
Payments
• Same basic ideas still work
• Assume that you plan to invest:
– $2000 in year 0
– $1500 in year 2
– $1000 in year 4
• How much will you have in year 10?
– $2000 (1+i)10 + $1500 (1+i)8 + $1000 (1+i)6

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 A More Complicated Example
• How much to invest (at 5%) to get:
– $1200 in year 5
– $1200 in year 10
– $1200 in year 15
– $1200 in year 20
• Convert each future amount to present:
– According to P = F/(1+i)n
– Invest $1200/(1.05)5 + $1200/(1.05)10 + $1200/(1.05)15 +
$1200/(1.05)20 = $2706

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Sensitivity Analysis

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 Sensitivity Analysis
• So far, we have assumed that all of the numbers
and parameters are known with certainty:
• In reality, most of them will be estimates!
• We can use sensitivity analysis to assess the
impact of each input parameter on the output
variable of interest (present worth, internal rate
of return, etc.):
• Best performed using a spreadsheet!
• Vary the input parameters within ranges,
observe the change in the output variable

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 Sensitivity Analysis
• Perform “what-if” analysis on one or more input
parameters:
• Observe any changes in the output variable
• You can easily do this by hand in a spreadsheet
• Commercial Excel add-ins are also available:
• For example, Palisade Corporation’s TopRank

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 Sensitivity Analysis
• Varying one or more input parameters:
• Store the results of each change
• Plot the results as a function of input values
• If a small change in an input parameter leads to
a large change in the output:
• Then the output is “sensitive” to that input
• Either more effort should go into estimating that
parameter:
• Or you should choose a decision that is not
sensitive to that input!
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 Sensitivity Analysis
• If the output is not as sensitive to some input
parameters:
• Then not as much effort is required to
estimate those parameters!
• Because they do not have much impact on
the output variable of interest

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 Summary
The fundamental time-value-of-money
relationships common to most
engineering economic analysis
calculations
We learned how to convert:
 Present to future, and vice versa
 Annual to present, and vice versa
 Future to annual, and vice versa
We saw that costs get big over time
We learned about sensitivity analysis
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 Summary
You must master these basic relationships in
order to use them in economic analysis and
decision making:
 These relationships will be important to you,

both professionally and in your personal life!

 Make sure you have a good grasp of these
concepts, so you can use them correctly!

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