CASH FLOW ANALYSIS

Compounding for Discrete Payments

and Uniform Annuities

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 Administrative Items Recap
Course Content is Pre-Built, except for the Fri night lectures
o narrated slides, course readings, videos, online articles

Three Case Study Discussions on selected weeks (not graded)

o Weeks 4, 6 & 10
o No participation marks for online discussion

Weekly Online Lecture (live on Fri 6:30-9:30PM EST)

o For assistance using WebEx :
1. Go to https://mcmaster.webex.com/mcmaster/tc
2. On the left navigation bar, click "Support".

Weekly Self-Assessment
o There is an online self-assessment quiz available on Pearson's website for each chapter of Fraser's
textbook. The registration link for the Companion website for Fraser
is: http://pearsoned.ca/highered/Fraser_6e/. (You MUST purchase the book for access)

Five Quizzes on Weeks 3, 4, 6, 9 and 10

o Multiple choice
o Pre-built randomized quizzes for academic integrity

Mid-term Test:
o In Class (i.e. NOT online)
o Scheduled for Fri June 16th 7:00 9:00 PM, Location TBA

Final Exam:
o Scheduled last night of class on Fri Aug 4th 7:00 9:30 PM, Location TBA (tests cumulative knowledge) 2
 Administrative Items
Online Quiz 1:
o Starts, Friday May 19 at 11:00 PM
o Ends, Friday May 26 at 11:59 PM
o Chapters 1, 2 and up to annuities in Chapter 3 (not including mortgages, bonds
and non-uniform annuities).
o Chapters 1, 2 & 3 including general concept of EE, decision making, time
value of money, interest rate calculations, cash flow diagram, and annuities.

Online Quiz 2:
o Starts, Friday May 26 at 11:00 PM
o Ends, Friday June 2 at 11:59 PM
o Chapters 3
o Chapter 3 including non-uniform annuities, bonds and mortgages; there
will also be a small number of 'review-type' questions from Chapter 2.

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Nominal and Effective Interest Rate Recap

ie - effective interest rate/year Equivalent to base period from sub

compounding period interest rate

r - nominal interest rate /year Conventional annual interest rate

m - number of compounding periods in one year

The period used with compound interest method of computing interest

Equating the future worth after 1 year

F = P(1 + ie) = P(1 + r/m)m

Thus, effective interest rate/year is

ie = (1 + r/m)m - 1
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Nominal and Effective Interest Rate Recap
You have calculated the effective 6 month interest
rate as 4.2483%, based on a nominal interest rate
compounded monthly. What was the nominal
interest rate?
Solution
ie = (1 + r/m)m - 1
0.042483 = (1 + r/12)6 - 1
(1 + r/12)6 = 0.042483 + 1 = 1.042483
r/12 = (1.042483)-1/6 - 1 = 0.006958
Therefore, r = 12(0.006958) = 0.0835 = 8.35%
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 Effective Interest Rate and Cash Flow
Period
r - nominal interest rate
m - number of compounding periods in one year
k - number of compounding periods in one cash flow period

Cash Flow Period: Base unit of time over which

an effective interest rate is calculated, which may not be
one year

Thus, effective interest rate per cash

flow period is
ie = (1 + r/m)k - 1 6
 What Interest Rate to Use

Is the cash flow Yes

period the same as
the compounding i = r/m
period?

no

Is the cash flow

period less than the
compounding
period?

Move all cash flows

yes no
to the compounding
period and use i = ieff
i = r/m
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 Compounding period and payment
period are the same
What interest rate is applied for monthly payments
and 6% compounded monthly?
Solution

i = r/m
= 0.06/12
= 0.005
= 0.5%

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 Compounding is less frequent than
payments
What interest rate is applied for monthly payments
and 6% compounded semi annually?
Solution

i = r/m
= 0.06/2
= 0.03
= 3.0%

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 Compounding is more frequent than
payments
An investment earns a 6% nominal interest rate,
compounded daily. What is the effective interest
rate for a cash flow period of 1 month (30 days)?
Solution

ie = (1 + r/m)k - 1
= (1 + 0.06/365)30 - 1
= 0.004943 = 0.494%

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 Learning Objectives

Introduction to cash flows

Timing of cash flows and modeling
Compound interest factors
Single payment compound interest formulas
Uniform series compound formulas
Compound interest factors tables
White board problems
o uniform annuities

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 Introduction to cash Flows

Compound interest factors can be used to evaluate

different patterns of cash flows.
This chapter presents four common discrete cash flow
patterns:
1. Single Disbursement or Receipt
2. Annuity
3. Arithmetic Gradient Series
4. Geometric Gradient Series

We evaluate each to compare projects

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Timing of Cash Flows and Modeling

Timing of cash flows can be complicated / irregular

work with simplified models and assumptions
Assume that cash flows and compounding of cash
flows occur at the end of conventionally defined
periods (e.g. months / years).
Models that make this assumption are called
discrete models.

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Cash Flow Analysis

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Compound Interest Factors

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Compound Interest Factors

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 Single-Payment
Compound Interest Formulas
Notation:
o i = interest rate per period
o n = number of interest periods
o P = a present sum of money
o F = a future sum of money

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 Single-Payment
Compound Interest Formulas, contd
If the interest rates period is in years:
o After one year the future amount at the end of year one would
be:

= (1 + )

o After two years, the future amount at the end of year two
would be the additional interest on year ones total:

= 1 + + (1 + )

o Rearranging, we get:

= 1 + 1 + or (1 + )2
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 Single-Payment
Compound Interest Formulas, contd
Generalizing the previous slide:
= (1 + )

The above formula is the single payment compound

amount formula, which is written in functional notation
as:
= ( , , )

o The notation in brackets meaning future sum F, given present

sum P at interest rate i per interest period for n periods.
o Functional notation is written algebraically correct so that:

= so, =
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 Single-Payment Compound
Interest: Problem
$3000.00 deposited in a bank account at 7% per year
interest would be how much after four years?
Solution
F = P(F/P, 7%, 4)
F = 3000(1+0.07)4
F = $3932.39

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 Single-Payment
Compound Interest Formulas, contd
Suppose you want to find an equivalent value now for a
future value.
= (1 + )

o Rearranging:
1
= = (1 + )
(1 + )

o The notation becomes:

= ( , , )

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 Single-Payment Compound
Interest: Problem
If you want to have $3000.00 in the bank after four years
at 7% per year interest, what would you have to deposit
now?
Solution
P=F(P/F, 7%, 4)
P= 3000(1+0.07)-4
P = $2288.69

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 Uniform Series Compound Interest
Formulas
Uniform series (A) is defined as:
o An end-of-period cash receipt or disbursement in a uniform
series, continuing for n periods, the entire series equivalent to
P or F at an interest rate i

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 Uniform Series Formulas

In the general case:

F = A(1+i)n1 + . . . + A(1+i)2 +A(1+i) +A (1)

Multiplying by (1+i):

(1+i)F = A(1+i)n + . . . + A(1+i)3 + A(1+i)2 + A(1+i) (2)

Factoring out A and subtracting (1) from (2):

(1+i)F = A[(1+i)n+ . . . + (1+i)3 + (1+i)2 + (1+i)]

F = A[(1+i)n1+ . . . +(1+i)2 + (1+i) + 1]
iF = A[(1+i)n 1] 24
 Uniform Series Formulas, contd.
Rearranging the previous slide
o The uniform series compound amount factor is:

1+ 1
=

The notation is F = A(F/A, i%, n)

Solving for A:

=
(1 + ) 1

The notation is A = F(A/F, i%, n)

o uniform series sinking fund factor
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 Uniform Series Formulas, contd.
Taking the sinking fund formula and substituting the
single payment compound formula for F yields:

(1 + )
1+ 1

Therefore:
(1 + )
=
(1 + ) 1

Notation: A = P(A/P, i%, n)

o uniform series capital recovery factor
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 Uniform Series Formulas, contd.
Solving the capital recovery formula for P:

1+ 1
=
(1 + )

Notation: P = A(P/A, i%, n)

o uniform series present worth factor

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Compound Interest Factors Recap

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 Uniform Series Formulas
Problem 1
Joe wants to be able to purchase a dream car for about $19,000 on 1
January 2017, just after he graduates from college. Joe has had a
part time job and started making deposits of $275 each month into
an account that pays 9% compounded monthly beginning with the
first deposit on 1 February 2012. The last deposit is to be made on 1
January 2017. Determine how much money he would have saved to
buy the car. Will he be able to buy his dream car?
Solution

Monthly deposits, A = $275. n = 2/2012 to 1/2017 = 60

periods.

F = $275 (F/A, 0.75%, 60) = $275 (75.424) = $20,741.64

Joe will have $20,741.64 available for his purchase.

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 Uniform Series Formulas
Problem 2
You are repaying a debt of $10,000 with equal payments
made at the end of four equal periods. If the interest rate is
10% per period, how much of the original $10,000
principal will be paid in the second payment?
Solution
Principal = $10,000. Number of equal payments (n) = 4. i = 10%
per period.
A = P(A/P, i, n) = 10,000(A/P, 10%, 4) = 10,000 0.3155 = $3155
First payment interest on unpaid balance = 10,000 0.10 = $1000.
Principal repaid = A 1,000 = $2155.00
Second payment Principal due = 10,000 2155 = $7845
Interest on unpaid balance = 7,845 0.10 = $784.50.
Principal paid in the second payment = 3,155 784.50 = $2370.50.30
Compound Interest Factors Tables

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Compound Interest Factors Tables

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 Compound Interest Factors Tables
Problem 3
(With interest tables) What amount deposited today
into an account bearing 12% nominal interest will
yield $5000 at the end of two years? Interest is
compounded monthly.

Answer
From table: (P/F,1%,24) = 0.78757
P = F (P/F, 1%, 24)
= $5000(0.78757)
= $3937.85

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 Uniform Annuities
Problem 4

Solution
P = $5,000 Capital Recovery Factor:
n = 5 years A = P(A/P,i,n)
i = 10% A = P[i(1+i)n/((1+i)n-1)]
A=?

A = 5000(0.26380) = $1,318.99

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 Uniform Annuities
Problem 5

Solution
A = $565 Series Present Worth Factor:
n = 24 months P = A(P/A,i,n)
i = 0.12/12 = 1.0% P = A[((1+i)n-1)/i(1+i)n]
P=?

P = 565(21.243) = $12,002.30

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Questions Period

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