Economic Equivalence

Economic equivalence is a fundamental concept upon which engineering economy computations are based. Before we delve into the economic aspects, think of the many types of equivalency we may utilize daily by transferring from one scale to another. Some example transfers between scales are as follows:

Often equivalency involves two or more scales. Consider the equivalency of a   speed  of 110 kilometers per hour (kph) into miles per minute using conversions between distance and time scales with three-decimal accuracy.

Four scales—time in minutes, time in hours, length in miles, and length in kilometers—are combined to develop these equivalent statements on speed. Note that throughout these statements, the fundamental relations of 1 mile = 1.609 kilometers and 1 hour = 60 minutes are applied. If a fundamental relation changes, the entire equivalency is in error.

Now  we  consider  economic  equivalency.         

Economic equivalence  is a combination of   interest rate and  time value of money  to determine the different amounts of money at different points in time that are equal in economic value. 

As an illustration, if the interest rate is 6% per year, $100 today (present time) is equivalent to $106 one year from today.

  Amount  accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

If someone offered you a gift of $100 today or $106 one year from today, it would make no difference which offer you accepted from an economic perspective. In either case you have $106 one year from today. However, the two sums of money are equivalent to each other   only  when the interest rate is 6% per year. At a higher or lower interest rate, $100 today is not equivalent to $106  one year from today.

In addition to future equivalence, we can apply the same logic to determine equivalence for previous years. A total of $100 now is equivalent to $100 1.06 = $94.34 one year ago at an interest rate of 6% per year. From these illustrations, we can state the following: $94.34 last year, $100 now, and $106 one year from now are equivalent at an interest rate of 6% per year. The fact that these sums are equivalent can be verifi ed by computing the two interest rates for 1-year interest periods.

The cash flow diagram in  Figure 1–10  indicates the amount of interest needed each year to make these three different amounts equivalent at 6% per year.

  Figure 1–10  Equivalence of money at 6% per year interest.

EXAMPLE 1.12

Manufacturers make backup batteries for computer systems available to Batteries + dealers through privately owned distributorships. In general, batteries are stored throughout the year,  and a 5% cost increase is added each year to cover the inventory carrying charge for the distributorship owner. Assume you own the City Center Batteries  + outlet. Make the calculations necessary to show which of the following statements are true and which are false about battery costs.

(a)    The amount of $98 now is equivalent to a cost of $105.60 one year from now.
(b)    A truck battery cost of $200 one year ago is equivalent to $205 now.
(c)    A $38 cost now is equivalent to $39.90 one year from now.
(d)    A $3000 cost now is equivalent to $2887.14 one year earlier.
(e)    The carrying charge accumulated in 1 year on an investment of $20,000 worth of  batteries is $1000.

Comparison of alternative cash flow series requires the use of equivalence to determine when the series are economically equal or if one is economically preferable to another. The keys to the analysis are the interest rate and the timing of the cash flows. Example 1.13 demonstrates how easy it is to be misled by the size and timing of cash flows.

EXAMPLE 1.13

Howard owns a small electronics repair shop. He wants to borrow $10,000 now and repay it over the next 1 or 2 years. He believes that new diagnostic test equipment will allow him to work on a wider variety of electronic items and increase his annual revenue. Howard received 2-year repayment options from banks A and B.

After reviewing these plans, Howard decided that he wants to repay the $10,000 after only 1 year based on the expected increased revenue. During a family conversation, Howard’s brother-in-law offered to lend him the $10,000 now and take $10,600 after exactly 1 year. Now Howard has three options and wonders which one to take. Which one is economically the best?

Solution

The repayment plans for both banks are economically equivalent at the interest rate of 5% per year. (This is determined by using computations that you will learn in Chapter 2.) Therefore,  Howard can choose either plan even though the bank B plan requires a slightly larger sum of  money over the 2 years.

The brother-in-law repayment plan requires a total of $600 in interest 1 year later plus the  principal of $10,000, which makes the interest rate 6% per year. Given the two 5% per year  options from the banks, this 6% plan should not be chosen as it is not economically better than  the other two. Even though the sum of money repaid is smaller, the timing of the cash flows  and the interest rate make it less desirable.   The point here is that cash flows themselves, or  their sums, cannot be relied upon as the primary basis for an economic decision. The interest  rate, timing, and economic equivalence must be considered.