Economics- for Breadth and Various Depth Exams Robert B.

Case, PE, PTOE, F ASCE Spring 2013

Rates, Present Value, and Future Value Rate (i) ---change in value of money over one time period, equal to the ratio of the change divided by the original amount (often expressed in %) ---known by various names ("interest ____", "inflation ____", "____ of return", "effective ____", discount ____) depending on the situation Note: Discount Rate: The interest rate at which an agent discounts future events (re economics.about.com) Present Value (P) --- the equivalent value today of a future payment or series of payments Future Value (F) --- the number of dollars that will exist in the future after some amount of money is invested today or some series of payments is invested over time The relationship between F and P is demonstrated by the following example: --- putting one payment of $100 in the bank and watching it grow at 5% interest
5% start: 1 2 3 4 5 6 7 8 9 10 after x years $100 $105 $110 $116 $122 $128 $134 $141 $148 $155 $163 interest earned $5.00 $5.25 $5.51 $5.79 $6.08 $6.38 $6.70 $7.04 $7.39 $7.76

With 5% interest rate, $100 turns into $105 dollars after one year, $163 after 10 years. The "present value" is $______; the "future value" is $______. Note that after the first year, one earns more than $5 (i.e. more than 5% of the original investment) because the interest is reinvested.

Conversion Factors By simple math: What we want = what we know * conversion factor If we want F and know P, then conversion factor is F/P: If we want P and know F, then conversion factor is P/F: These conversion factors F/P and P/F can be found using: 1) compound amount factor, or 2) factor tables (back of Lindeburg) 1) Using "Compound Amount Factors"
i: starting principal $100 $105 $110 $116 $122 $128 5% interest earned $5.00 $5.25 $5.51 $5.79 $6.08 $6.38 ending principal $105 $110 $116 $122 $128 $134 (F) starting ending principal principal P P(1+i) P(1+i) P(1+i)(1+i) P(1+i)(1+i) P(1+i)(1+i)(1+i) and so on until: P(1+i)^n

F = P * (F/P) P = F * (P/F)

year 1 (P) 2 3 4 5 6

So, F = P*(1+i)^n. Therefore (from at top): and since P/F is the inverse of F/P:

(1+i)^n is the (F/P) factor (P/F) = 1/ (1+i)^n, i.e. dividing by (1+i)^n

Therefore this compound amount factor (1+i)^n can be used when moving between F and P, via either multiplication or division as appropriate. To calculate F from P in the above example: F = P * (F/P) = $100 * (1+0.05)^6 = $100 * _______ = $134 to calculate P from F in the example on page 1: P = F * (P/F) = $163 / (1+ 0.05)^10 = $163 / _______ = $100 2) Using "Factor Tables" The ratios P/F and F/P can also be found in factor tables (e.g. back of Lindeburg). In the above example, if trying to calculate F from P: F = P * (F/P) = $100 * 1.3401 = ______ For the example on p. 1, if trying to calculate P from F: P = F * (P/F) = $163 * 0.6139 = ______

Example problems: present vs. future value Lindeburg Practice Problems 11th Ed. p. 86-1 #'s 1 thru 3 (answers: 1: $1790.80; 2: $1584.20; 3: $623.60)

Uniform Series Cash Flow of Amount A A is the number of dollars which changes hands per pay period (in a scenario with a series of equal payments). Because of the complexity of the math involving a series of payments, calculations concerning A are best done using factor tables.

Demonstration problem: constant payments A contractor uses 100k cy of sand each year. Hes found a quarry with 1m cy of sand. Hes debating whether to buy it. Not counting the cost to buy the quarry, it will cost him $4/cy to mine sand from the quarry. But he can buy sand for $5/cy. If he can invest money elsewhere and earn 10% annually, what is the most he would offer for the quarry (assume $0 land value when sand gone)?

What we want = what we know * conversion factor What we want: max. amount to pay for quarry, or present worth (P) of savings What we know: annual savings: 100,000 * $1 = $100,000 (A) Therefore, use: P = A * (P/A)

i=10%

n=10

P = $100,000 * 6.1446 = $_____________, the maximum he should pay for the quarry. A spreadsheet depreciating each year's savings shows the correctness of the above answer:
10% years 1 2 3 4 5 6 7 8 9 10 savings earned $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 $100,000 present value $90,909 $82,645 $75,131 $68,301 $62,092 $56,447 $51,316 $46,651 $42,410 $38,554 $614,457

Example problem: series of payments Lindeburg Practice Problems 11th Ed. p. 86-1, Problem #7 (answer: $354.80)

Timelines Hint: Use a timeline to help in working time-money problems.

Example problem: usage of timeline Lindeburg Practice Problems 11th Ed. p. 86-1 #8 (answer: $480.31)

Taking the Xth Root To solve an equation with one side raised to the X power, take the Xth root of both sides. Example problem: taking the Xth root Lindeburg Practice Problems 11th Ed. p. 86-1 #10 (answer: 6%) Solution: This problem can be solved using math and a calculator, or by thumbing through the factor tables.

Using Different Time Periods Note: The compound amount factor (1 + i)^n and the factor tables work for any time period (day, month, year). Notice that no time period is shown on the factor tables. When converting a rate from one time period (w/ RateI) to another period (w/ RateII): A. When converting to a longer period periodII = n * periodI 1. Using factor tables: (e.g. converting a monthly rate to a yearly rate)

(e.g. one year = 12 months) RateII = F/P 1 (where F/P is based on RateI and n)

or 2. Using compound amount factor:

RateII = (1 + RateI)^n 1

B. When converting to a shorter period (e.g. converting a yearly rate to a monthly rate) periodII = periodI / n 1. Using factor tables: (e.g. one month = year / 12) Thumb thru the factor tables (looking for 1+RateI on the nth row) or 2. Using compound amount factor: RateII = (1 + RateI)^(1/n) 1

For example, the equivalent yearly rate for a 5% monthly rate is: 1. using factor tables (w/ n=12): 2. using compound amount factor: 1.7959 1, or 0.7959, or 80% (1+0.05)^12 - 1 = 0.79586, or 80%

Example problem: using other time periods, converting from one period to another If you win the lottery and are offered either $34,761 lump sum or payments of $1,000 per month for 5 years, what is the effective annual discount rate of this offer? (answer: 26.82%)

What does this 27% mean concerning which payment method you will choose? If you chose the lump sum, could you spend $1,000 per month for 5 years?

Comparing the Cost of Several Alternatives When comparing the cost of two or more alternatives, compare "apples to apples", i.e. calculate all costs for the same timeframe: present value, future value, or annual value. Alternatives with Equal Life Lengths Any of the three timeframes can be used to compare values or costs. Alternatives with Differing Life Lengths Only annual value (or annual cost) can be used. For example, its not fair to compare the present cost of a 30-year bridge (e.g. initial cost plus discounted cost of 30 years of maintenance) to the present cost of a 10-year bridge (e.g. initial cost plus discounted cost of only 10 years of maintenance). Note: If you consider costs as positive numbers, consider revenues as negative, and vice versa. Hint: Use (+) signs and (-) signs to differentiate between costs and revenues.

Example problem: comparing the cost of alternatives Lindeburg Practice Problems 11th Ed. p. 86-1 #12 (answer: strengthen old bridge) Note: Lindeburg considered the present $13,000 salvage of the bridge as a cost in the strengthening the bridge alternative, instead of considering it as a revenue in the replace the bridge alternative. Because the present salvage would only occur under the replace the bridge alternative, I think that it should be placed there. Because of the two different life spans, the Lindeburg error slightly affects the difference in cost of the two alternatives, but doesnt affect the overall answer (i.e. strengthen old bridge).

Depreciation Depreciation refers to the fact that assets often lose value as they age. Sometimes the word is used to refer to a process, e.g. the practice of reducing the calculated value of an asset for tax purposes. Sometimes the word is used to refer to an amount, i.e. the amount of reduction in value over time. Straightline Depreciation One of the methods of calculating deprecation is the straightline method. In accordance with the method name, a chart plot of the value of an asset depreciated via the straightline method is a straight line. Therefore, the assets value goes down the same amount each year. Therefore, the annual depreciation (D) is equal to the total depreciation (known as depreciation basis) divided by the depreciation period (n, years) of the asset, where: D = (initial value final value) / n Based on simple math, the depreciated value of the asset at the end of any number of years (Y) is equal to: Depreciated Value = Initial Value D * Y

Example problem: straightline depreciation For a computer that cost $5,000 to buy, and which is considered to have a salvage value of $1,000 after a 5 year life span, what is its depreciated value after 3 years? (answer: $2,600)

Additional Problems If additional time remains, the following problems from NCEES Sample Questions & Solutions may be worked: Economics Const-504 (benefit-cost ratio); answer: B Trans-505 (present worth); answer: B
C504 Teaching: Compare "apples to apples": present benefits to present costs, or annual benefits to annual costs. When comparing an alternative to the status quo, changes in costs and benefits can be used to calc B/C. Sometimes the "Benefit" is a decrease in costs. Given: Parameter First Cost Salvage Annual Cost Life, yr's Present Plan $0 $0 $250,000 n.a. Alterantive Plan $10,000 $1,000 $248,000 5 Fill in (to help solve): Cost? Change Benefit? Benefit/Cost Ratio

P? F? A?

From table in back of Lindeburg:

(A/P) 10% 5 yr's: (A/F) 10% 5 yr's: (P/A) 10% 5 yr's: (P/F) 10% 5 yr's:

0.2638 0.1638 3.7908 0.6209

Solutions, Total Benefits and Costs: "Salvage" Considered As: Basis I. NCEES Annual Cost (C) II. RBC Present Cost (C) III. RBC Annual Benefit (B) IV. RBC Present Benefit (B)

Calculated Benefit $2,000 $7,582 $2,164 $8,203

Calculated Answer Cost (B/C Ratio) 0.808 $2,474 0.808 $9,379 0.820 $2,638 0.820 $10,000

Therefore it makes NO difference which timeframe you use (present vs. annual), and it makes only a little difference whether Salvage was considered C or B, not affecting the correct answer chosen.

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