2 Economic Equivalence What do we mean by “economic equivalence?” Why do we need to establish an economic equivalence?How do we establish an economic equivalence?
3 Economic EquivalenceEconomic equivalence exists between cash flows that have the same economic effect and could therefore be traded for one another.Even though the amounts and timing of the cash flows may differ, the appropriate interest rate makes them equal.
4 Equivalence from Personal Financing Point of View If you deposit P dollars today for N periods at i, you will have F dollars at the end of period N.
5 Alternate Way of Defining Equivalence PF dollars at the end of period N is equal to a single sum P dollars now, if your earning power is measured in terms of interest rate i.N=FN
6 = Practice Problem F At 8% interest, what is the equivalent worth of $2,042 now 5 years from now?$2,042If you deposit $2,042 today in a savingsaccount that pays 8% interest annually.how much would you have at the end of5 years?123453F=5
16 Rule of 72Approximating how long it will take for a sum of money to double
17 Practice Problem Given: i = 10%, $500$1,000ABCGiven: i = 10%,Find: C that makes the two cash flow streams to be indifferent
18 Approach Step 1: Select the base period to use, say n = 2. $500$1,000ABCStep 1: Select the base period to use, say n = 2.Step 2: Find the equivalent lump sum value at n = 2 for both A and B.Step 3: Equate both equivalent values and solve for unknown C.