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EDA Lec 3

The document outlines a course on Economic Decision Analysis in Construction, detailing topics covered each week, including cost concepts, financial analysis, and cash flow analysis. It emphasizes the importance of understanding the time value of money, interest calculations, and economic equivalence in making informed financial decisions. Various examples illustrate the application of these concepts in real-world scenarios, such as investment evaluations and loan repayment plans.

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Waqar Hussain
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0% found this document useful (0 votes)
9 views46 pages

EDA Lec 3

The document outlines a course on Economic Decision Analysis in Construction, detailing topics covered each week, including cost concepts, financial analysis, and cash flow analysis. It emphasizes the importance of understanding the time value of money, interest calculations, and economic equivalence in making informed financial decisions. Various examples illustrate the application of these concepts in real-world scenarios, such as investment evaluations and loan repayment plans.

Uploaded by

Waqar Hussain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
You are on page 1/ 46

ECONOMIC DECISION

ANALYSIS IN
CONSTRUCTION

Dr Zahoor

Lecture 3
Course topics and schedule
Project
Week Topic Reading (Assignment Journal
)
Introduction, Study Skills , Engineering
1 Chapter 1
Economics, Decision Making Process
2 Cost Concept, Chapter 2
Accounting systems, Balance Sheet, Chapter 18,
3
Income sheet Handouts
4 Time value of Money Chapter 3
5 Interest and Equivalence Chapter 2 Submit Weeks 1-4
7 Rate of Return Chapter 7 Phase 1 Due
8 Deprecation Chapter 11
9 Profit Centre Analysis Hand outs
10 Financial Analysis Chapter 8,9 Submit Weeks 1-9
11 Cash Flow Analysis Chapter 12
12 Benefit Cost Analysis Chapter 9 Phase 2 Due
13 Income Tax Chapter 15
14 Financing Chapter 16
15 Financial Decision Making Chapter 17 Submit Weeks 1-14
16 Project Presentations Phase 3 Due
17 Final Exam
Interest and Equivalence

Cash Flow Simple and


Diagram Compound
Interest
 Time Value of Present Value
Money

3
Notation & Cash Flow Diagram &
Tables
 Conventions
 The horizontal line is a time scale, with
progression of time moving from left to
right
 the end of Period 2 is coincident with the
beginning of Period 3.
 Arrows signify cash flows and are placed
at the end of the period
 If a distinction needs to be made,
 downward arrows represent expenses
(negative cash flows or cash outflows)
 upward arrows represent receipts
(positive cash flows or cash inflows)
4
Notation & Cash Flow Diagram &
Tables

5
EXAMPLE

 Before evaluating the economic merits of a proposed


investment, the XYZ Corporation insists that its
engineers develop a cash flow diagram of the proposal.
An investment of $10,000 can be made that will
produce uniform annual revenue of $ 5310 for 5 years
and then have a positive salvage value of $2000 at the
end of year 5. Annual expenses will be $ 3000 at the
end of each year for operating and maintaining the
project. Draw a cash flow diagram for the 5 year life of
project.

6
SOLUTION EXAMPLE

2000

5310 5310 5310 5310 5310

1 2 3 4 5

3000 3000 3000 3000 3000

$10,000

7
Time Value of Money
Question: Would you prefer $100 today or
$100 after 1 year?
There is a time value of money. Money is a
valuable asset, and people would pay to have
money available for use. The charge for its use is
called interest rate.
Question: Why is the interest rate positive?
Argument 1: Money is a valuable resource, which
can be “rented,” similar to an apartment. Interest
is a compensation for using money.
Argument 2: Interest is compensation for
uncertainties related to the future value of the
money.

8
We know that receiving $1 today is worth
more than $1 in the future. This is due
to OPPORTUNITY COSTS.
Opportunity cost is the benefit that is
foregone by engaging a business resource in
a chosen activity…..
The opportunity cost of receiving $1 in
the future is the interest we could have
Today
earned if we had received the $1 Future
sooner.
If we can MEASURE this
opportunity cost, we can:

 Translate $1 today into its equivalent in


the future (COMPOUNDING).

Today Future

?
If we can MEASURE this
opportunity cost, we can:
 Translate $1 in the future into its
equivalent today (DISCOUNTING).

Today Future

?
Simple Interest
Simple interest is interest that is computed on the original
sum.

If you loan an amount P for n years at a rate of i % a year,


then after n years you will have:
F = P + n  (i P) = P + n  i  P = P (1 + i n).

Note: Interest is usually compound interest, not simple


interest.

12
Simple Interest Example
You loan your friend $5000 for five years at a
simple interest rate of 8% per year.
At the end of each year your friend pays you
0.08  5000 = $400 in interest. (this money
is not paid until the end of the fifth year)
At the end of five years your friend also
repays the $5000.
After five years your friend has paid you:

5000 + 5  400 = 5000 + 5  [ 0.08  5000].


13 Note: The borrower has used the $400 for 4
Simple Interest Example

 Example:
 P = $1,000
 i = 8% End of Beginning Interest Ending
 N = 3 years Year Balance earned Balance
0 $1,000

1 $1,000 $80 $1,080

2 $1,080 $80 $1,160

3 $1,160 $80 $1,240

14
Compound Interest Formula

n 0 : P
n 1: F1 P(1  i )
2
n 2 : F2 F1 (1  i ) P(1  i )

N
n  N : F P (1  i )

15
Compound Interest
Compounded interest is interest that is charged on the
original sum and un-paid interest.
You put $500 in a bank for 3 years at 6% compound
interest per year.
 At the end of year 1 you have (1.06)  500 = $530
 At the end of year 2 you have (1.06)  530 = $561.80
 At the end of year 3 you have (1.06)  $561.80 =
$595.51
Note:
$595.51 = (1.06)  561.80 = (1.06) (1.06) 530
= (1.06) (1.06) (1.06) 500 = 500 (1.06)3
16
Single Payment Compound
Formula
If you put P in the bank now at an interest rate of i% for n
years,
the future amount you will have after n years is given by
F = P (1+i)n
The term (1+i)n is called the single payment compound
factor.
The factor is used to compute F, given P, and given i and
n.
Handy Notation.
(F/P,i,n) = (1+i)n
F = P (1+i)n

17
Compound Interest Example

 P = Principal amount
 i = Interest rate End of Beginning Interest Ending
Year Balance earned Balance
 N = Number of
interest periods
0 $1,000
 Example:
 P = $1,000 1 $1,000 $80 $1,080
 i = 8% 2 $1,080 $86.40 $1,166.40
 N = 3 years
3 $1,166.40 $93.31 $1,259.71

18
Compound Interest Example
$1,259.71
F = P (1+i)n

0 1 2

F $1, 000(1  0.08)3


$1,000
$1, 259.71

19
Compound Interest Example

20
Present Value Example

If you want to have $800 in savings at the


end of four years, and 5% interest is paid
annually, how much do you need to put into
the savings account today?

We solve P (1+i)n = F for P with i = 0.05, n = 4, F


= $800.
P = F/(1+i)n = F(1+i)-n ( P = F (P/F,i,n) )
= 800/(1.05)4 = 800 (1.05)-4 = 800 (0.8227) =
$658.16.

Single Payment Present Worth Formula


P = F/(1+i)n = F(1+i)-n
21
Factors in the Book

22
Economic Equivalence

23
Economic Equivalence

Which one would you prefer?

•$ 20,000 today
•$ 50,000 ten years from now
•$ 8,000 each year for the next ten years
We need to compare their economic worth!

Economic equivalence exists between cash flows


if they have the same economic effect.

24
Economic Equivalence

Comparison of alternative options, or


proposals, by reducing them to an
equivalent basis, depends on:
interest rate
amounts of money involved
timing of the affected monetary
receipts and/or expenditures
manner in which the interest, or profit
on invested capital is paid and the
initial capital is recovered
25
Equivalence Principles

Use a common time basis


 Equivalent cash flows are equivalent at any
common point in time
 Use the present time = present worth
 Use some future point in time = future worth

Equivalence depends on interest rate


 Changing the interest rate destroys
equivalence

Requires conversion of multiple payment cash


flows to a single cash flow
26
Present Value
Example: You borrowed $5,000 from a bank at 8% interest rate and
you have to pay it back in 5 years. There are many ways the debt
can be repaid.

Plan A: At end of each year pay $1,000 principal plus


interest due.

Plan B: Pay interest due at end of each year and


principal at end of five years.

Plan C: Pay in five end-of-year payments.

Plan D: Pay principal and interest in one payment at end


of five years.
27
Example
You borrowed $5,000 from a bank at 8% interest rate and you have to pay it
back in 5 years.
Plan A: At end of each year pay $1,000 principal plus interest due.

a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment

1 5,000 400 5,400 1,000 1,400


2 4,000 320 4,320 1,000 1,320
3 3,000 240 3,240 1,000 1,240
4 2,000 160 2,160 1,000 1,160
5 1,000 80 1,080 1,000 1,080
28
SUM 1,200 5,000 6,200
Example (cont'd)
You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back in 5
years.
Plan B: Pay interest due at end of each year and principal at end of five years.

a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
1 5,000 400 5,400 0 400
2 5,000 400 5,400 0 400
3 5,000 400 5,400 0 400
4 5,000 400 5,400 0 400
5 5,000 400 5,400 5,000 5,400
SUM 2,000 5,000 7,000
29
Example (cont'd)
You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back in 5 years.
Plan C: Pay 1,252 in five end-of-year payments.
[Uniform series capital recovery factor (page. 101, example 4.3)]

a b c d e f
Int. Owed Total Owed Total
Year Amnt. Princip. Payment
Owed int*b b+c Payment c+e

1 5,000 400 5,400 852 1,252


2 4,148 332 4,480 920 1,252
3 3,227 258 3,485 994 1,252
4 2,233 179 2,412 1,074 1,252
5 1,160 93 1,252 1,160 1,252
30
SUM 1,261 5,000 6,261
Example (cont'd)
You borrowed $5,000 from a bank at 8% interest rate and you have to pay it back
in 5 years.
Plan D: Pay principal and interest in one payment at end of five years.

a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
1 5,000 400 5,400 0 0
2 5,400 432 5,832 0 0
3 5,832 467 6,299 0 0
4 6,299 504 6,802 0 0
5 6,802 544 7,347 5,000 7,347
SUM 2,347 5,000 7,347
31 ?
COMPOUND INTEREST
Example (cont'd)
Plan 1: At end of each year pay $1,000 principal plus interest due
$ Owed
EOY
Year Pay. Owed
$6,000
1 $1,400 $5,000
2 $1,320 $4,000 $5,000
3 $1,240 $3,000 $4,000
4 $1,160 $2,000 $3,000 $ Owed
5 $1,080 $1,000 $2,000
$6,200 $15,000 $1,000
$0
1 2 3 4 5
Time (Years)

32
Example (cont'd)
Plan 2: Pay interest due at end of each year and principal at end of five
years.

EOY $ Owed
Year Pay. Owed
1 $400 $5,000 $6,000
2 $400 $5,000
3 $400 $5,000 $5,000
4 $400 $5,000 $4,000
5 $5,400 $5,000
$7,000 $25,000 $3,000 $ Owed
$2,000
$1,000
$0
1 2 3 4 5
Time (Years)

33
Example (cont'd)
Plan 3: Pay in five end-of-year payments

EOY
$ Owed
Year Pay. Owed
1 $1,252 $5,000 $6,000
2 $1,252 $4,148
$5,000
3 $1,252 $3,227
4 $1,252 $2,233 $4,000

5 $1,252 $1,159 $3,000 $ Owed


$6,261 $15,767 $2,000

$1,000

$0
1 2 3 4 5
Time (Years)

34
Example (cont'd)
Plan 4: Pay principal and interest in one payment at end of 5 years.

EOY
Year Pay. Owed $ Owed
1 $0 $5,000
2 $0 $5,400 $8,000
3 $0 $5,832 $7,000
4 $0 $6,299 $6,000
5 $7,347 $6,802 $5,000
$7,347 $29,333 $4,000 $ Owed
$3,000
$2,000
$1,000
$0
1 2 3 4 5
Time (Years)

35
36
Example (cont'd)
Summary of Payment Plans
(a) (b) (c) (d)
Total
Plan Paid Tot. Int. Area under Ratio:
curve (b)/(c)
1 $6,200 $1,200 $15,000 0.08
2 $7,000 $2,000 $25,000 0.08
3 $6,261 $1,261 $15,767 0.08
4 $7,347 $2,347 $29,333 0.08

Question. What common property do all four plans have?


interest rate = (total int. paid)/(area under curve)

or

total int. paid = (interest rate) * (area under curve)

Since the areas under the curve vary for the 4 plans, but the interest
rate
37 does not, the total interest paid also varies.
Example (cont'd)

Ratio .08 is constant – all payment methods are


equivalent – equivalence is established between all
alternatives

Though each involve different EOY payment

38
Rates
Example. You put $500 in a bank for 3 years at
6% compound interest per year. Interest is
compounded quarterly.

39
Rates
Example. You put $500 in a bank for 3 years at 6%
compound interest per year. Interest is compounded
quarterly.

The bank pays you i = 6/4 = 1.5 % every 3 months;


1.5% for 12 periods (4 periods per year  3 years).
At the end of three years you have:
F = P (1+i)n = 500 (1.015)12 = 500 (1.19562)  $597.81
($598 in text due to
rounding)

Note. Usually the stated interest is for a 1-year period. If it


is compounded quarterly then an interest period is 3 months
long. If the interest is i per year, then for each quarter the
interest paid is i/4 because there are four 3-month periods a
year.
40
Example
Example. In 3 years, you need $400 to pay a debt. In two
more years, you need $600 more to pay a second debt.
How much should you put in the bank today to meet these
two needs if the bank pays 12% per year?

41
Example
Example. In 3 years, you need $400 to pay a debt. In two
more years, you need $600 more to pay a second debt.
How much should you put in the bank today to meet these
two needs if the bank pays 12% per year?

0 1 2 3 4 5

$400
$600

42
Example
Example. In 3 years, you need $400 to pay a debt. In two
more years, you need $600 more to pay a second debt.
How much should you put in the bank today to meet these
two needs if the bank pays 12% per year?

0 1 2 3 4 5

$400
$600

Interest is compounded yearly

P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16
43
Example
Example. In 3 years, you need $400 to pay a debt. In two
more years, you need $600 more to pay a second debt.
How much should you put in the bank today to meet these
two needs if the bank pays 12% per year?

0 1 2 3 4 5

$400
$600
Interest is compounded
monthly
Interest is compounded yearly
P = 400(P/F, 12%/12,
3*12) + 600(P/F, 12%/12,
P = 400(P/F,12%,3) + 600(P/F,12%,5)
5*12)
= 400 (0.7118) + 600 (0.5674) = 400(P/F, 1%, 36) +
= 284.72 + 340.44 = $625.16 600(P/F, 1%, 60)
44 = 400 (0.6989) + 600
Example: Points of view -
Borrower & Investor
Borrower point of view:You borrow money from
the bank to start a business.

Year Cash Year Cash


flow flow
0 -P 0 +P
1 0 1 0
2 0 2 0
3 +400 3 -400
4 0 4 0
5 +600 5 -600

Investors point of view:You invest your money


45 in a bank and buy a bond.
Concluding Remarks
The yellow Pages in the text book tabulate:

Compound Amount Factor


(F/P,i,n) = (1+i)n

Present Worth Factor


(P/F,i,n) = (1+i)-n

These terms are in columns 2 and 3,


identified as
Compound Amount Factor: “Find F Given P:
F/P”
Present Worth Factor: “Find P Given F: P/F”

46

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