Question

1. What do we mean by “Economic Equivalence?” Support your view with a simple example if applicable.
2. Why do we need to establish an economic equivalence?
3. How do we establish an economic equivalence?

Answer 1

Economic equivalence exists between cash flows that have the same economic effect and could therefore be traded for one another. 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.

Even though the amounts and timing of the cash flows may differ, the appropriate interest rate makes them equal.

You borrowed $5,000 from a bank and you have to pay it back in 5 years. There are many ways the debt can be repaid, given interest rate is 8%

Plan 1: At end of each year pay $1,000 principal plus interest due.

Plan 2: Pay interest due at end of each year and principal at end of five years.

Plan 3: Pay in five end-of-year payments ($1,252).

Plan 4: Pay principal and interest in one payment at end of five years. All these plans are equivalent in the sense that the sum of all outgoing cash flows at time 0 is $5,000.

Economic equivalence is used commonly in engineering to compare alternatives. In engineering economy, two things are said to be equivalent if they have the same effect. Unlike most individuals involved with personal finances, corporate and government decision makers using engineering economics might not be so much concerned with the timing of a project's cash flows as with the profitability of the project.