Lecture 03

Cash flow analysis

This lecture further develops the formulas for cash

flows that are uniform or are changing by an
arithmetic or a geometric series. This lecture is the
basis of the whole course, and you are expected to
fully understand the materials.

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1. Cash flow conversions

 The focus of this lecture is to learn a series of interest formulas.
• Cash flows are converted into different point of time, with the concept of
equivalence.

F
A A A A A i

0 1 2 3 4 5 … n

P
 We have learned single payment cash flows in the last lecture.
• Compounding factor: (F/P, i, n)
• Discounting factor: (P/F, i, n)
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 1.1. Cash flow types: Uniform series
 We will now consider cash flows with annuity (A).
• Annuity is a series of cash flows for n periods.
• It is not necessarily annual; It can be monthly, quarterly, annual, etc.
• Annuity can be uniform or changing in each period.
 Uniform annuity (A) during n periods
• Annuity and future worth (F vs. A)
o Uniform series compound amount factor: (F/A, i, n)
o Uniform series sinking fund factor: (A/F, i, n)
• Annuity and present worth (P vs. A)
o Uniform series present worth factor: (P/A, i, n)
o Uniform series capital recovery factor: (A/P, i, n)
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1.2. Non-uniform annuity series

 In some cases, the annuity series is non-uniform.
• Arithmetic gradient series changes by a constant amount per period (e.g.,
Increasing operating cost; salary package).
• Geometric gradient series changes by a constant percentage per period (e.g.,
Inflation, productivity growth, college tuition).
A+(n-1)G
A(1+g)n-1
A+3G
A+2G
A+G A(1+g)3
A(1+g)2
A A(1+g)
A

0 1 2 3 4 n 0 1 2 3 4 n

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 2. Uniform series: F and A
 Uniform series compound amount factor: (F/A, i, n)
• If I save $A every year for n years, how much do I have at the end of n years?
 (1  i )n  1 
F  A   A(F / A, i , n)
 i 
 Uniform series sinking fund factor: (A/F, i, n)
• If I want to have $F at the end of n years, how much do I save $A each year?
 i 
AF   F ( A / F , i , n)
 (1  i )  1 
n

• Be careful on the timing at n!

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Ex 2-1. F and A
 If you deposit $5,000 in a bank each year with an interest rate of 6%,
how much will you have at the end of 10 years?
F 5000 FA 6 10 5000 13.1811 65905

 You want to save $A each month to buy a notebook of $2,000 at the

end of the year. If bank pays 6% interest, compounded monthly, how
much do you have to save each month?

A 2000 A F 0.54 127 2000 0.0811

62
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 Ex 2-2. F and A

gjj
 A student is borrowing $100 per year for 3 years, starting from year 1.
The loan will be repaid 2 years later at a 10% interest rate. How much

jw
should he pay 5 years from now? Flp

100 FIP 101 2 400

t toyear3
concert
F 100 IF A loll 3 x FIP 101 2 40072
ye
recommended
approach
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3. Uniform series: P and A

 Uniform series present worth factor, (P/A, i, n)
• How much must be saved over n periods to recover an investment of $P made
today?

it
 (1  i )n  1 
P  A n 
 A(P / A, i , n)
 i (1  i ) 
 Uniform series capital recovery factor, (A/P, i, n)
hiii
• How large does the annual return A have to be to recover the capital investment
of P?
 i (1  i )n 
AP   P ( A / P , i , n)
 (1  i )  1 
n

• Be careful on the timing at 0! 1 periodbefore

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 payment
Éan
compounded
Ex 3-1. P and A
 To buy a car, Helen borrows $30,000 from a bank for 5 years at 3%
interest. What is the amount of the monthly payment?
A 30000 A P O 251 607 3000010.0187 8 40

 When you retire, you want to receive $3,000 at the end of each month
for 20 years from the retirement fund. If the monthly rate of return is
0.5%, what is the present worth of the fund at the time of retirement?

P 3000 PIA O 5 2407 418741

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3.1. Compounding and payment periods

 Helen makes monthly payments for the loan with 3% interest rate.
What is the compounding period?
• If nothing is mentioned, the compounding period is the same as the payment
period.
• In the above example, the monthly rate of 0.25% is compounded every month.
 What if Helen makes payment every other years? What is the
compounding period?
• Should it be the compounding of every two years?
• No. The maximum compounding period is one year in practice.
 To use the interest factor formula, the compounding period and the
payment period should be matched.
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 Ex 3-2. Deferred annuity
 Jake’s father promised to give him $10,000 per year for 5 years starting
11th year from now. With i = 5%, what is the present worth of that
applies
promise? A = 10,000 5 t intent
atallyear
x

I
0 1 2 10 11 12 13 14 15
11th
new
P=?
ya wanttend present withat

P 10000 PA JY 5 x PIF 5 10 26579

P 10000 FIA P F 51,15

54,5 x Another approach

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Ex 3-3. Sporadic payment (1)

 On January 1, Wendy deposited $5,000 in a credit union that pays 8%
interest, compounded quarterly. She wishes to withdraw the money in
five equal yearly sums beginning December 31 of the first year. How
much should she withdraw each year?

• The compounding period is different from the payment period.

• You should change either the compounding period or the payment period.
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 Ex 3-3. Sporadic payment (2)
 Method 1: Change the compounding period to the 4-quarter period.
Compute an effective i for the 4-quarter period.
use
or on the exam rate
be 8.241
I t 0.0274 I the interest
he
W 5000 A P 8.24 5 1260 thots
 Method 2: Change the payment period to a quarter.
A 5000 A IP 2 20 3064quaptghay

W 306 F A 2 1 4 1260 convert

into
future worth

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3.2. Value of a “Jackpot”

 Have you dreamed of winning a Jackpot?
 If you win a $20 million jackpot, are you richer by $20 million?
• In Canada, you would be richer by $20 million!
• You are paid $20 million immediately, with no income tax.
 However, the situation is different in the United States.
• In the United States, you are usually paid an equal annuity over 10 – 40 years,
with income taxes.
• With a 20-year payment rule, for example, you receive $1 million per year.
• Alternatively, you can opt for an immediate lump sum payment, which is much
less than $20 million due to discounting.
• Why do they have this system? Marketing!
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 Ex 3-4. Value of a “Jackpot”
 Suppose you won a $20 million jackpot in the United States, which pays
an equal amount for 20 years from the next year. If you choose an
immediate lump-sum payment, how much do you get today, with i =
6%? Assume there is no income tax.

4 A p
$1 million
p p
0 1 2 3 19 20

P IM PIA 61,207 11.47M

 If the prize is paid from today, what is the present worth of the jackpot?

P IM IM PIA 6 19 8112.16M

Iffy 15
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qq.g.gg
i Ex 3-4. Jackpot payment

QEI  When you win a jackpot, the lottery company would deposit $11.47
million to a bank which gives 6% interest every year.
• You are paid $1 million every year from the deposit which runs out 20 years later.
14000000

12000000

10000000

8000000

6000000

4000000

2000000

0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

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 Case 3.1. Powerball in 2022
 In the Unite States, Mega Millions and Powerball are two main lotteries.
• In 2022, Americans spent $100 billion on lotteries. (Canadians $12 billion.)
• The historical prize of Powerball was $2.04 billion on Nov. 7, 2022.
• The prize is paid over 30 years, so a lump-sum payment is $997 million.
• After deducting federal tax ($370 million) and state tax ($110 million if living in
New York), the net payment could be “only” $517 million!

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Ex 3-5. Changing interest rates

 A 15-year savings fund pays $1,000 at the end of each month. If the
interest rate is 12% for the first 10 years and 6% thereafter, what is the
present worth of the fund?
y seat

P
I t p p
1000 PIA 1,120
i
qt if
Pends

1000 PIA 0.54.160 x PIF 11,1207 85374

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 Ex 3-6. Finding the number of periods
 After a memorable vacation in Europe, Olivia is stuck with a $8,000
credit card debt. Her current credit card charges 18%, and a new card
12%, both compounded monthly. If she pays $200 each month, how
much faster (in months) could she pay off with the new card?
OLD 181 1.51 mo
8000 200 PIA 1.51 n PIA 1.5 n 40 6024270
NEW 12 it no

ooo 200 PIA I't n PIA 11 n 40

504451g pay
talk all yur
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Ex 3-7. Finding an interest rate

 You want to borrow $100,000 from a bank to buy a new recreational
vehicle (RV). You can afford to make monthly payments of $2,000 for 5
years.
• What is the highest monthly rate you can afford on this loan?
• What are the APR and the effective annual interest rate?

100000 2000 PIA i 607 PIA I 607 50

CERATE 60,2000 1000007 0.621 0.51 2220.751

APR 0.6211 12 7.441
Nominal interest is APR
e it 0.621 7.71
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 4. Non-uniform annuity: Arithmetic gradient
 Arithmetic gradient: The annuity changes by a constant amount per
period.
• Examples: Increasing operating cost; salary package
• Cash flows can be divided into two components. Geo
I't
year

t
• The first component is simply a uniform series.
• The second component increases by a fixed increment G per period.
• The second gradient series starts with zero at year 1.
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4.1. Arithmetic gradient factors

 Present worth: P = A(P/A, i, n) + G(P/G, i, n)
Increase by G
 Annual worth: A = A +I G(A/G, i, n) uniformannuity
• A is the uniform annuity converted from the gradient series. y
 Arithmetic gradient present worth factor
(1 + i )n  in  1
(P / G, i, n) =
i 2 (1 + i )n

1
 Arithmetic gradient uniform series factor Rector
at
1 n table
(A / G, i, n) = 
i (1 + i )  1
n

• Do you want to use these formulas? Use the factor tables or Excel!

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 Ex 4-1. Arithmetic gradient PW
 A man wants to set aside enough money for the maintenance of his car
for the next five years. If he needs $120 in the first year with an annual
increase of $30, how much should he deposit now, with i = 5%?

P 120 PIA 51 5 30 PIG 5 5 766

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Ex 4-2. Arithmetic gradient AW

 A textile mill requires maintenance cost, which starts at $24,000 in the
first year, reducing by $6,000 each year for 4 years. What is the annual
maintenance cost if the interest rate is 10%?

A 24000 6000 A1 6,101,42

4 4
157
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 Ex 4-3. Arithmetic gradient PW
 Compute the value of D in the diagram for i = 10%. 400

1200 130

485 D F A 10 4 FIP 101,1 100 PIA101 3 t 100 PIG107,3

method
Yr4 D FIA 101,4 100 pig101,4 more efficient

D 95
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Ex 4-4. Early retirement

 John plans to retire at age 45 with $5 million in his account. After
graduating a university, he starts to save $5,000 from his 26th birthday
with an increase of $G every year until his 45th birthday. If his annual rate
of return is 4%, what gradient step G is required to achieve his goal?
5,000 + 19G
5,000 + G
5,000

0 1 2 … 20

P PA 4 1,207 G PIG 41,207 5 mill x

5000 PIF4

26
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Because
needs

toequal at
thesavethe
period 13
 4.1. Case: RIM’s patent dispute
 RIM (currently “Blackberry”) patent dispute
• In 1998, RIM introduced BlackBerry 950, the first wireless email device.
• In 2001, a US firm, NTP, filed a lawsuit against RIM on patent infringements.
• In March 2006, RIM agreed to pay NTP $612 million for settlement.
 How did RIM come up with the amount of $612 million?
• During 2003 – 2006, some of NTP patents were ruled invalid.
• The disputed patents might eventually be ruled invalid, but RIM would suffer
during the several years of decision.
• A newspaper reported that “In March 2006, RIM revised its quarterly revenue
forecast from $590 million to $550 million.”
• This showed an expected loss of $40 million per quarter at the time of settlement.
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Ex 4-5. RIM’s patent settlement

 What would be the present worth of RIM’s loss in sales, if RIM loses $40
million per quarter and the dispute lasts for 3 more years, given an
interest rate of 6%?

P 40 PIA 1.51 127 432 mill

 More realistically, suppose the $40 million quarterly loss would increase
by $4 million every quarter. What would be the present worth of the
loss for 3 years, given i = 6%?

P 40 PIA 1.51 127 4 PIG 1.5 12 668 mill

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 4.2. Non-uniform Geometric gradient
 Geometric gradient series: The annuity changes by a constant
percentage per period.
• Examples: inflation, productivity growth, college tuition
• The geometric gradient series has only the present worth formula.
formula
 Two cases (g: constant growth rate) to havetouse
  1  g n 
(P / A, g, i , n)  1     / [i  g ] where i  g
1 geometric
A(1+g)n-1

  1  i   A(1+g)3
A(1+g)2
A(1+g)
n A
(P / A, g, i , n)  where i  g
1 i
0 1 2 3 4 n

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Ex 4-6. Geometric gradient series: i ≠ g

 The first-year maintenance cost of a new car is estimated to be $500,
and it increases at a rate of 10% per year. Using 8% interest rate,
calculate the annual worth of the maintenance cost for the first 5 years.

P 500 75ft 2401

A 2402 AIP 8 5 601

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 Ex 4-7. Geometric gradient series: i = g
 Emery is expected to receive dividends for the next 10 years, starting
$110,000 at the end of this year with a 10% increase each year. If all
dividends are invested at 10% interest, how much will Emery
accumulate in 10 years?

P 110000 need to
too Imit You
do this
y Chock
F Im TP 101,107 2,593,700 AIMEM

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Ex 4-8. RIM case revisited

 In the RIM case discussed above, suppose the $40 million quarterly loss
is increased by 6% every quarter. What would be the present worth of
the loss during the 3 year period, if the interest rate is 6%?

P 40 go
I 607Mt

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 5. Compounding period vs. payment period
 In practice, we often observe that the compounding period is different
from the payment period.
 Ann makes equal quarterly deposits of $1,000 into a savings account
that pays interest rate of 6% compounded monthly. How much will she
have at the end of 5 years? APR
1000
go Yo
bug Lo
ie 1 0.51 I 1.5071
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F 1000 FIA I 5071,20 237391

Ex 5-1. Less compounding period

 Suppose you make $500 monthly deposits to a registered retirement
savings plan (RRSP) that pays interest at a rate of 10% compounded
quarterly. How much will you have at the end of 10 years?

ftp.gimgdediae

F 1501 F A 251,40 4101103

1

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 Ex 5-2. Compounding period (1)
EGESTION
 Kathy deposited $2,000 per month from February 1, 2008 till January 1,
2010 (for 24 months). She then withdrew money semi-annually from
July 1, 2011 till January 1, 2021 (for 20 times). What is the amount of
each semi-annual cash flow, given the interest rate of 12% with
monthly compounding on all accounts?
A=?

JI
Jul/1/11 Jan/1/12 Jan/1/21
Santilli
Feb/1/08 Mar/1/08 Apr/1/08 Jan/1/10
1 1 76 1 6gg
M = 2,000
2000 FIA 11,24 FIP 1,12
• Monthly cash flow = Semi-annual cash flows, evaluated on Jan 1, 2011.
A PIA 6.151,20
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Ex 5-2. Compounding period (2)

 Value of monthly deposit

 Value of semi-annual withdrawal

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 Ex 5-3. Payment v. compounding period
 What is the monthly payment if $10,000 is borrowed at 8% interest rate,
compounded quarter, and the loan is repaid with 36 equal monthly
payments?

121 5945
11
10,2
Am 945 51315

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Excel commands in cash flows

 Find the equivalent of P
• (P/F) factor: PV(i, N, 0, -1)
• (P/A) factor: PV(i, N, -1)
 Find the equivalent of F
• (F/P) factor: FV(i, N, 0, -1)
• (F/A) factor: FV(i, N, -1)
 Find the equivalent of A
• (A/F) factor: PMT(i, N, 0, -1)
• (A/P) factor: PMT(i, N, -1)
 Find n: NPER(i, A, P, F); Find i: RATE(n, A, P, F)
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 Summary of lecture 03
 Uniform series formula
• F vs. A; P vs. A
 Changing series formula
• Arithmetic gradient vs. Geometric gradient
 Compounding period vs. payment period
 Check Excel commands for each factor series

 Selective end-of-chapter problems

• Newnan Ch4: 2, 4, 8, 13, 18, 20, 26, 30, 38, 46, 53, 57, 62, 71, 77, 87, 97, 133

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