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Accounting & Financial

management
Session 5

Interest Factors for Discrete


Compounding, Discrete Cash Flow
Single Payment compound amount
(F/P, i%, N) = (1+i)n
Single payment present worth (Discount)
(P/F, i%, N) = 1/(1+i)n
Sinking fund
(A/F, i%, N) = i / [(1+i)n 1]
Uniform series compounded amount
(F/A, i%, N) = [(1+i)n 1] / i

Interest Factors for Discrete


Compounding, Discrete Cash Flow
Annuity factor
(P/A, i%, N) = [(1+i)n-1] / [i(1+i)n]
Capital recovery factor
(A/P, i%, N) = [i(1+i)n] / [(1+i)n -1]
Uniform gradient P.W factor
(P/G,i%, N) = (1/i) [ {(1+i)n -1/i(1+i)n} {n/(1+i)n}]
Uniform gradient annual series
(A/G, i%, N) = (1/i)- [n / (1+i)n 1]

Criteria of Financial Analysis


1. Net Present Value
2. Internal Rate of Return
3. Benefit Cost Ratio

Example - 1
A person buys a small piece of land for
$5000 down and annual payment of $500
for next 6 years from now. What is the
present worth of the investment if the
interest rate is 8% per year?

Example - 2
A person buys a small piece of land for
$5000 down and deferred annual
payments of $500 for 6 years starting 3
years from now. What is the present worth
of the investment if the interest rate is 8%
per year?

Solution
PW = 5000 + 500 (P/A, 8%, 6) (P/F, 8%,2)
= $6981.6

Exercise
Mixer machines are manufactured in a factory, if no
improvements are made in the factory, the
manufacturing cost of machine is $ 2000 from 1 to 10
months, $ 1600 in moth 11th and $1800 in 12th
month. If some improvements could be made in the
factory to make it more suited for larger production,
these improvements would reduce the manufacturing
cost of mixer machine to $1500 for first 10 months,
1400 in 11th month and $1650 in 12th month. The
improvement cost is expected to be $ 2500 in year
zero.
Calculate NPV of the project in year zero, if market
rate of interest is 2% per month

Exercise
A plant superintendent is trying to decide between two
excavating machines with the estimates presented below.
(a)Determine which machine should be selected on the basis of
PWC analysis, using an interest rate of 15% per annum.
(b)Use EUAC analysis

Description

Machine- A

Machine -B

First cost $

11000

18000

Annual O&M cost $

3500

3100

Salvage value $

1000

2000

Life, years

Exercise
An investment company is considering building a 25 units
apartment complex in a growing town. Because of the long term
growth potential of the town, it is felt that the company could
average 90% of full occupancy for the complex each year. If the
following items are reasonably accurate estimates, what is the
minimum monthly rent that should be charged if a 12% MARR/
year is desired? Use the annual worth method.
Land investment
$ 50,000
Building investment cost
$ 225,000
Study period
25years
Upkeep expense per month
$ 35
Property tax and insurance
10% of total
initial investment

% Gradient
Amount increase or decrease by constant %.
Amount {(1+ r / 1+ i)n - 1} / ( r i)}
Where
r = % change in amount
i = rate of interest
n = Total period of change

Example
Calculate equivalent present worth of
$35000 now and annual series of $7000
per year for 5 years beginning 1 year from
now, which starts to increase annually at
12% thereafter for the next 8 years. Use
interest rate 15% per year.

Solution
PW = 35000 + 7000 (P/A,15%, 4) +
[7000(1.12/1.15)9 1/ (0.12 - 0.15)](P/F,15%,4)
PW = $83232

Example
Calculate the present worth of the following
series of incomes and expenses if the interest
rate is 8% per year compounded annually.
Year

Income, $

Expenses, $

12000

1000

1-6

800

100

7 - 11

900

200

Exercise
A businessman purchased a building and
insulated the ceiling with 6 inches of foam.
This cut the heating bill by $25/ month and
the air conditioning cost by $20/ month.
Assuming that the winter season is the first 6
months of the year and the summer season
is the next 6 months, what was the
equivalent amount of his savings after the
first 3 years at an interest rate of 1% per
month

Exercise
A company purchased a machine for $18000.
Its annual maintenance and operation cost was
$ 2700. After 4 years from the initial purchase,
the company decided to purchase an additional
unit for the machine which would make it fully
automatic. The additional unit had a first cost of
$9100. The cost for operating the machine in
fully automatic condition was $1200/ yr. If the
company used the machine for 13 years with
no salvage value, what was its EUAC at
interest rate of 9% per year.

PW of alternative evaluation
Make a present worth comparison of the equal service
machines for which the costs are shown in table
below, if i = 10% per year.
Description

Type A

Type B

First cost ($)

2500

3500

Annual operating cost ($)

900

700

Salvage value

200

350

Life years

Capitalized Cost Calculation


1.
2.
3.
4.
5.

Cash-flow diagram
Find PW of nonrecurring amounts
Find EUAW of all recurring amounts
EUAW / i% to get the capitalized cost
Add value obtained in step 2 to the value
obtained in step 4

Example
Calculate the capitalized cost of a project
that has an initial cost of $150,000 and an
additional investment of $50,000 after 10
years. The annual operating cost will be
$5000 for the first four years and $8000
thereafter. In addition there is expected to
be a recurring major rework cost of
$15000 every 13 years. Assume that
i=15% per year.

Rate of Return
ROR is the rate of interest paid on the
unpaid balance of borrowed money or the
rate of interest earned on the un
recovered balance of investment, so that
the final payment or receipt brings the
balance to exactly zero with interest
consideration

Trial & Error Method for ROR


ROR = A% + [a / (a-b)] (B% - A%)
where
A% : low interest rate
B% : High interest rate
a : Positive NPV
b : Negative NPV

Example
If $5000 is invested now in common stock
that is expected to yield $100 per year for
10 years and $7000 at the end of10 years
what is the rate of return.

Solution

Assume i= 5%
NPV at 5% rate of interest = $69.46
Assume i= 6%
NPV at 6% rate of interest = -$355.19

ROR = 5% + [ 69.46/ (69.46 +355.19)](6% - 5%)


ROR = 5.16%

Amortized Loan
If a loan is to be repaid in equal periodic
amounts, it is said to be an amortized
loan.

Example
A firm borrows $10000, from a bank at 6%
per year rate of interest on balance
amount that is outstanding at the
beginning of each year. The loan is to be
repaid in three equal payment at the end
of each year. Determine the amount of
installment and develop loan amortization
table.

Solution
Installment Amount: 10000 (A/ P, 6%, 3) = $ 3741.1
Amortization Table
Year Beginning Inst.
Interest Paid
Balance
Amount
Amount Amount Principal Amount
1

$10000

$3741.1 $600

$3141.1

$6850.9

6850.9

3741.1

411.5

3329.6

3529.3

3529.3

3741.1

211.8

3529.3

0.00

Exercise
Set up an amortizing schedule for a $25000
loan to be repaid in equal installments at the
end of each of the next five years, assume
interest rate is 10% per year.

Benefit Cost Ratio


It is the ratio of equivalent worth of benefit
to equivalent worth of cost.
B/C = AWB / AWC > 1 Desirable
Modified Approach:
B/C = [AB ADB O&M] / CR

Example
A small flood control dam is expected to
have an initial cost of $2.8 million and an
annual upkeep cost of $20000. In addition
minor reconstruction will be required every
five years at a cost of 100,000. As a result
of the dam flood damage will be reduced
by an average of $120,000 per year Using
an interest rate 7% to determine B/C of
the dam. Assume the dam is expected to
last 25 years.
(b) Assume the dam will be permanent.