SELECTED NOTES ON ENGINEERING ECONOMICS

by

A. M. Clausing Department of Mechanical and Industrial Engineering University of Illinois at Urbana-Champaign Urbana, IL 61801

Copyright © 2002 by A. M. Clausing All Rights Reserved Printed March 14, 2007

NOMENCLATURE a BAL BV c D
EUAC EUAB

a uniform amount per interest period, an annuity the balloon; the remaining balance at end of a series of payments book value base amount in a geometric progression depreciation equivalent uniform annual cost equivalent uniform annual benefit future worth at end of the n-th interest period first cost gradient: the periodic increase at end of each period in an arithmetic progression interest or discount rate per period expressed as a decimal interest rate with continuous compounding; units: (time)-1 effective annual interest rate nominal interest rate internal rate of return number of interest compounding periods per year number of interest periods or life of asset

SV t w

Salvage Value time defined by Eq. (29)

Subscripts j j-th time (interest) period

Interest Factors f/p p/f f/a a/f p/a a/p p/g a/g p/c single-payment compound amount factor (CAF) single-payment present worth factor (PWF) uniform series compound amount factor (SCAF) sinking fund factor (SFF) uniform series present worth factor (SPWF) capital recovery factor (CRF) gradient present worth factor (GPWF) gradient uniform series exponential present worth factor (EPWF)

f FC g

i ic ie in IRR m n

NPW net present worth p r RR present worth rate of change per period expressed as a decimal rate of return

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INTRODUCTION The basis of many engineering decisions is an economic one, and engineering economics

provides the tools necessary to economically evaluate alternatives. For example, a proposed scheme for the utilization of solar energy must not only be technically feasible, but it must also be economically viable in order to be embraced. The question is how does one determine the economic viability of proposed engineering systems? Systems like highly automatic manufacturing plants and nuclear power generation plants are capital intensive. Therefore, such plants generally would not be competitive if systems were selected on the basis of initial costs. However, making decisions based solely on initial costs is an approach used only in the simplest financial transactions. In general, the time value of money, the difference in annual operating costs, the escalating costs of conventional fuels, and other factors must be taken into account in order to make a rational economic comparison of alternatives. Life-cycle costing rather than initial-investment costing is a more appropriate way to determine if a given project is an economically viable one. The economic analysis associated with proposed engineering and business ventures is complicated by unknowns like future product demand, future global competition, escalating energy costs due to fossil fuel depletion, future inflation rates, future environmental impacts, etc. Today's decisions should be strongly influenced by projections of these quantities. Unfortunately, such projections are very difficult to make with any degree of confidence. Although engineering economics is concerned with the influences of economic factors, one should not lose sight of the importance of non-monetary attributes. Environmental, social, political, and aesthetic factors all play significant roles. Even national security should be considered. High sulfur coal is an inexpensive fuel for the production of power, yet US legislation resulting from environmental concerns severely restricts the use of this fuel. Likewise, few nuclear power plants are being built today in the United States due to social and safety concerns. These notes are only concerned with making economic comparisons and decisions based solely on economic factors. It is assumed that the relevant discount rates, inflation rates, etc. are given, and the many variables that influence these economic factors are not of concern. The basic terminology, fundamental concepts, and mathematical tools required to perform economic comparisons will be presented. Examples are provided to illustrate the use of these tools and concepts.

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FUNDAMENTAL CONCEPTS and DEFINITIONS Engineering economics utilizes a collection of simple mathematical techniques to make

rational economic comparisons of various engineering alternatives. These mathematical techniques enable one to account for the time value of money in making comparisons. As a simple example, consider a $1,000 loan. If one borrows $1,000 today and uses this money for ten years, one clearly would be required to repay more than $1,000 at the end of ten years. Similarly, if the loan were repaid in ten equal annual payments, one would expect to pay more than $100 each year. Although the sum of the ten $100 payments is numerically equal to the original $1,000 loan, these ten payments are equivalent in economic value only if the time value of money is ignored. The time value of money means that a monetary amount on one date is not directly comparable with the same monetary amount on another date, even if inflationary influences are negligible. Interest charges (or payments) are a direct consequence of the time value of money. Consider again the $1,000, ten-year loan with some positive rate of interest, i. The ability to determine the future worth, f, at the end of ten years of a present worth, p (the original $1,000 loan), is essential in economic analyses. Alternatively, if the loan is to be repaid with ten equal annual payments, a, the series of ten equal annual payments that is equal in economic value to the present worth, p, would be required. The concept of equivalence, the fact that different amounts of money at different times can be equal in economic value, is fundamental to engineering economy. Other examples of equivalence are: (i) the present worth of a series of anticipated maintenance costs paid annually over the nyear life of a proposed piece of equipment,

(ii) the present worth of the anticipated fuel costs for heating a proposed factory over its n-year life with a fuel escalation rate of r percent per year, and (iii) the present worth of the salvage value of a delivery truck at the end of its useful life. The dependence of the economic value of a loan or investment on time is a consequence of interest. Interest may be thought of as money paid for the use of borrowed money or the return obtained by the productive investment of capital. Interest is defined as interest = total amount accumulated - original amount The interest rate, i, is by definition
i= interest accrued during unit time period original amount

(1)

(2)

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and the number of interest compounding periods per year is denoted by m.5% per month on the unpaid balance compounded monthly may be stated as 18% per annum. Compound interest is based on the total amount at the end of the previous period. To be correct. the nominal rate of x% in loan transactions is often specified simply as x% or as x% per year. interest is to be added. however. on the sum of the original amount (or principal) and the total interest accumulated during previous periods. This rate is called the effective annual interest rate. in. Simple interest ignores the time value of the interest accrued in preceding interest periods. an interest rate. the type of interest. Unfortunately. compounded. m. The unit time period or interest period is typically one year. must be considered. i. it would be better if nominal interest rates were never used. of 1. When the value of accrued interest is taken into account. but shorter interest periods such as one month are also used. when the word interest is used. hence. the fraction i as defined by Eq. at the end of each interest period. is defined as the interest rate times the number of compounding periods per year. Specifically. Thus. one arrives at the actual annual interest rate being charged.The interest rate is usually expressed as a percent. therefore. either simple or compound.5% per month compounded monthly has an effective annual rate of 5 March 14. 100% times i. The total number of interest periods is denoted by n. ie. 2007 . Worse yet. it is almost never used in engineering economy. the nominal interest rate. that is. an interest rate of 1. If interest is compounded over a period less than one year. This type of interest accounts for the time value of money and is the quantity used exclusively in these notes. hence. compound interest is implied. If more than one interest period is involved. simple interest = p • n • i (3) where p is the original amount or principal. For example. in = m • i (4) Nominal interest rates ignore the time value of accrued interest. the rate should be described as a nominal 18% per annum compounded monthly. this is not the case. (2) is the quantity to be used in all formulas that are presented. that is. and is given by ie = (1 + i )m ! 1 (5) Hence. that is.

The minimum attractive rate of return. the effective-state-federal income tax rate is March 14.000 18. from the disposal of the property when it is retired from service.ie = (1 + 0. or another safe investment.734 12.810 19. before an investor would make a capital commitment.000 12.683 12. is the net amount received.750 in = 18% i [%] 18 9 9/2 3/2 9/26 0 ie [%] 18. would generally be larger on an investment involving risk than that expected from a bank. The salvage value. MARR. Three main types of taxes are of importance: property taxes. SV. Table 1 The Influence of Compounding Frequency on the Effective Annual Interest Rate in Percent in = 6% i [%] 6 3 3/2 1/2 3/26 0 ie [%] 6.56% not 18%.000 6.184 in = 12% i [%] 12 6 3 1 3/13 0 ie [%] 12. state income taxes.015)1 2 ! 1 = 0. Since state income taxes are presently deductible on federal tax returns.360 12.1956 or 19.180 6.252 19. Taxes and depreciation must also be considered in engineering economy. RR.722 Compounding Frequency. The property tax is usually a fixed percentage of the first cost of the property. The influence of compounding frequency is greater.168 6.551 12.562 19. and federal income taxes. The life of a piece of equipment or property is the number of years the prudent user retains the property for its stated purpose. 2007 6 . after disposal expenses are deducted.136 6. and the asymptotic value—the value with continuous compounding—is approached more slowly at higher rates of interest. The salvage value may be a positive or negative amount.685 19. m 1 2 4 (Annual) (Semiannual) (Quarterly) 12 (Monthly) 52 (Weekly) ∞ (Continuously) The interest rate or rate of return. This is partly a consequence of the risk and partly a consequence of the limited amount of available investment capital or credit. expected on an investment would normally include a reasonable profit. The influence of the compounding frequency on the effective annual rate is shown in Table 1.090 6.

In this figure. several repayment plans of a $1. B. Income taxes are paid on net income less depreciation. hence. and C is. maintenance. The cash flow is defined as the net receipt that results from the receipts and disbursements in the same interest period: cash flow = receipts . it is dependent on the taxable income. a net receipt (a benefit). the economic value of all repayment plans has the same present worth: the original $1. Cash flow diagrams are often used in the analysis of the equivalent present worth or future worth of a series of receipts (income) and/or disbursements (costs). a.state) + state rate (6) The federal income rate for any but the smallest corporations is approximately 50 percent of the net profit. The total amount repaid in Plans A. however. For individuals. The book value is the original cost minus the total amount of depreciation charged to date. March 14.49.effective rate = federal rate (1 .00.000 loan over a four-year period with an interest rate of 8 percent compounded annually are presented. respectively.360. A downward arrow represents a negative cash flow: a net disbursement (a cost).68.000 loan. The major effect of depreciation in engineering economics is a reduction in income tax. Representative cash flow diagrams are given in Fig.disbursements (7) The cash flow diagram is a graphic description of the cash flows.320. $1. The market value is the amount of money that can be obtained for the object on the open market.207. 1. the reduction in income tax allows the company to retain some of its income for replacement. The horizontal line is the time axis. The arrows are generally not drawn to scale. and obsolescence. $1. or in the calculation of the equivalent uniform annual amount. The time interval on the horizontal scale is one year. that is. The market value and the book value normally are not equal. Depreciation is the decrease in value of property due to wear. and $1. and investment. deterioration. 2007 7 . State rates are dependent on the particular state as well as taxable income and tax status. An upward arrow represents a positive cash flow.

and other financial institutions are generally required by law or business practice to be precise to the nearest penny.000 Loan with an 8% Interest Rate Compounded Annually Note that if simple interest were charged in repayment Plan B. annual compounding results in an interest payment of $360.49 Plan C Payment of interest charges each year with principal repayment after four year period (Amount repaid: $1320) $1000 1 2 i=8% 3 4 $80 $80 $80 $1080 Figure 1 Cash Flow Diagrams for Several Repayment Plans of a $1. whereas.207.Plan A Equal annual payments (Amount repaid: $1.68) $1000 i=8% 1 2 3 4 $301.92 $301. This may March 14.08) = $320.92 Plan B Repayment of loan with accrued interest at the end of the four year period $1000 i=8% 1 2 3 4 $1360. the interest payment would be p•n•i = ($1000)(4)(.92 $301.49 Monetary computations in banks. 2007 8 .92 $301. insurance companies.

are derived and presented in this section. the present. a present value p. The output of an analysis can be no more accurate than the input. 2007 n (8) 9 . 3. the interest and the total amount will grow with time as shown in Table 2. will have grown to the future value f that is given by: f = p (1+ i ) or March 14. Examples are given to illustrate the use of the conversion formulas.require ten or more places of accuracy. (f . p/f If an amount p is allowed to accumulate for n time periods with an interest rate i. 10 years in the future. Table 2 The Influence of the Number of Time Periods on the Interest and the Accumulated Amount—the Future Value. after n time periods. for example. INTEREST FORMULAS The mathematical formulas that permit the conversion of an amount at one period of time.p) pi Accumulated Amount. Since illustrative points may be lost if quantities are rounded. for example. many estimates are incorporated in economic analyses in engineering and such accuracy is usually neither justifiable nor necessary. The conversion of an arbitrary series of n annual cash flows to a present worth. and Present-Worth Factor (PWF). or a uniform annual series will also be addressed. 3.1 Compound-Amount Factor (CAF). to an equivalent amount at some other period of time. These formulas enable one to account for the time value of money. On the other hand. f Period 1 2 • • • n Interest. numerical values that follow are given either to the nearest dollar or nearest penny. f/p. f p (1+ i ) p (1+ i ) • • • n!1 2 p (1+ i ) i • • • p (1+ i ) i p (1+ i ) n Hence. a future worth.

f = p if i = 0. This notation will be used throughout these notes. Equation (8) also gives p 1 = = (PWF) f (1 + i) n (10) The factor p/f is called the single payment Present-Worth Factor (PWF). i%.f ( )n ( ) p = 1 + i = CAF (9) The factor f/p is referred to in engineering economy as the single-payment Compound-Amount Factor (CAF). 2007 10 . The influence of n and i on the single-payment compound amount factor (CAF). n). March 14. f/p. Note that the limit of f/p as i approaches zero is one. that is. 2. is shown graphically in Fig. The most common notation used to denote these factors and simultaneously to specify the interest rate and the number of periods is (f/p. an intuitively obvious result.

(8) could be solved for i or n which gives. 2007 11 . the so-called 72 Rule. On the other hand.i = 30% 10 f/p 24 18 15 12 10 9 8 7 6 5 4 3 2 i = 1% 1 0 5 10 15 20 25 30 Number of Periods Figure 2 The Influence of i and n on the Compound Amount Factor (CAF). Eq. respectively: March 14. Fig. for quickly estimating the number of years required for an investment to double. it would take only four years for the money to lose half of its economic value. f/p If an investment earns 7% compounded annually. and n or i are given and i or n is to be determined. money sitting in one's shoe box would lose approximately half of its value in 14 years if the effective average rate of inflation were 5% per year. Clearly. nd. a fixed income at high rates of inflation is not attractive. Specifically: nd ! 72 i (%) If p. At an 18% inflation rate. f. A rule exists. 2 shows that it will approximately double every 10-year period—a good number to remember.

what is the present worth of your winnings? March 14. i%. 2 or eqs. is obtained by multiplying the present value p. that is.5%.000 will accumulate to what value after ten years if the interest is left in the account and the account pays 6% interest compounded quarterly? Solution: The future value f. (5). (10). Section 2). 000 (1. follows from Eq. (1+ ie )1 = (1+ i )m or ie = (1+ i )m "1 Since the present worth of a receipt or disbursement is always less than its future value (assuming that i > 0).2: You have won a million dollars in the Poor Man's Lottery.1 ! f$n i = # p &1 " % and ! f$ ln # p " % n= ln(1+ i) (11) (12) Hence. given any three of four quantities p. Thus: "f % f = p $ . At 9 percent interest compounded annually.8140) #p & or f = $7. (11). f. (9). 2007 12 .1. or (12) can be used to obtain the fourth quantity. (9).256. that is: {discount } = { f " p} = p )% . i. the word discount is used in financial circles for the difference between the future worth and the present worth. 40 = $4. Fig. ' - (# f *$ p + Example 3. the accumulated value of the saving account at the end of the tenyear period. and n. The effective interest rate (see Eq. $4000. by f/p. n& "1.07 Example 3. You later read in the fine print that all winnings are paid 25 years after the date on which the winning ticket is drawn.1: A savings deposit of $4.

4 mm) needs no name.Solution: In this example.. economic values would be indistinguishable if only the monetary unit were supplied. the present worth.000.256. 25' #p & Note: the discount is $884. with which we are all familiar. ! The conversion of the economic value of a present amount. and the economic factors f/p. are vastly different. Analogously. (ii) March 14.968 "f % 8.92 payments. Hence.25 feet are equivalent lengths. etc. p. The units associated with engineering data provide critical information that is used in converting from one quantity to another. (f/p. to its equivalent economic value in the future. 9%. the conversions are no different than the conversion of 15 inches to 1. etc. the conversion factor (1 in)/(25. p/f is called the single-payment Present Worth Factor (PWF). all monetary amounts must be appropriately qualified: the present value..4536 kg)/(lbm). in Example 3. For example. There are. Likewise. This task is compounded by the fact that the reciprocals of all economic factors are also named.000. the present value is obtained from the future value by dividing by f/p or multiplying by p/f. the notations f/p. that are being presented. Once the appropriate factor is calculated. i. In contrast.6231 $ . f. and the name: single-payment Compound-Amount Factor (CAF) are introduced. n). Specifically: (i) While the numerical values of the three lengths.1.000 has an equivalent future economic value of $7. etc. p.3048 m.49 are vastly different. (0. the present value of $4. 1 ft. Hence: p= f $1. f/a. however. the three monetary amounts: the present value of $1.032! Clearly. an examination of their units readily shows that the three lengths are equivalent.000. The factors used to convert economic values are all dimensionless quantities. the four annual $301. f = $1.25 feet by multiplying 15 inches by the conversion factor: (1 ft)/(12 inches). 12 inches. some fundamental differences between engineering data and economic data.000 = = $115.360. you will have to wait a while before you can call yourself a millionaire. In the example presented earlier in this section. yet they are economically equivalent quantities. and between the conversion factors like (12 inches)/(ft). f. the future value. typically all have the same monetary unit (the US$ in the United States). of the future value. and future value of $1.000 is determined by dividing f by f/p. Hence.07 for the conditions stated in that example. they also must be given names in order to identify them. Learning these names is not a trivial task. Fifteen inches and 1. Thus. is effected simply by multiplying by f/p or dividing by p/f. p. therefore. on the other hand. and 0. The data being analyzed in engineering economy. 2007 13 .

6. The notation used for this quantity is (p/c. f/p is dependent on i and n. etc. amazingly. 3. f. n)r. will later be introduced that is also dependent on an escalation rate. a fund for purchasing a home. r. hence. The resulting progression is: Period 1 2 3 • • • n Hence. and Sinking Fund Factor. Tabulations of the compound-amount factor f/p and. The future sum accrued at the end of the n periods is desired. For example. could be built up by depositing a dollars at the end of each time period for n periods in an account earning interest at a rate i per period. and succeeding payments are made at the end of succeeding time periods including the n-th period. its reciprocal p/f. 2007 14 . i. such tabulations are no longer of sufficient value to warrant their inclusion in these notes.. The cash flow diagram is f 1 2 n-1 n a a a a It should be emphasized that the first payment is made at the end of the first time period.2 Uniform Series Compound-Amount Factor. n).(iii) The economic conversion factors are not constants. f/a. the notation (f/p. A factor. a building fund. the future value. a/f A retirement fund. Some tips for programming interest formulas are given in Section 3. is a{1+ (1 + i) + (1 + i) + K + (1+ i) 2 n!1 Accrued Amount at End of Respective Period a a{1+ (1 + i)} 2 a{1+ (1 + i) + (1 + i) } } March 14. i. With the advent of inexpensive programmable calculators and personal computers. p/c. are given in typical engineering economics books.

For example. The sum of ! the geometric series can be easily obtained by multiplying both sides of Eq. that is. 4. 0. Its reciprocal is called the Sinking Fund Factor (SFF).76. March 14. is shown in Fig. 2007 15 . 8. !20) = 4. This figure is a loglog plot of f/a as a function of n for i equal to 1. a. a i = = (SFF) f (1 + i)n ! 1 (15) The uniform-series compound-amount factor. 12. an intuitively obvious result. Note also that the limit of f/a as i approaches zero is n.08. that ! f = n•a if i = 0. 20) = 45. 24.08. f/a.n"1 f = a{1+ (1+ i) + (1+ i) 2 + K + (1+ i) n"1} = a# (1+ i) j= 0 j (13) The terms are seen to form a geometric progression with the common ratio (1+ i) . 3. This gives f [1 ! (1 + i)] = a[1 ! (1+ i)n ] or f (1 + i)n ! 1 = (SCAF) a = i (14) The factor f/a is called the Uniform Series Compound-Amount Factor (SCAF). 0. (f/p.661 whereas (f/a. (13) by (1+ i) and subtracting the resulting expression from Eq. It is seen that f/a grows much more rapidly than f/p due to the uniform annual payment. and 48 percent. (13). is.

000 is obtained by dividing this future value by f/a based on the effective annual interest rate of 0. If the deposits earn 8% interest compounded quarterly. the annual deposit.08243. that must be made to accumulate the future amount. what is the required annual deposit? Solution: Since the compounding period and the payment period are different.000 1 2 9 10 a a a a Hence. It is (1 + 0. The cash flow diagram is $40.02)4 . a. f = $40. the effective annual interest rate must be utilized.000.08243. f/a Example 3.1000 i = 48% 24 12 8 4 1 100 f/a 10 1 1 10 Number of Periods Figure 3 The Influence of i and n on the Uniform-Series Compound-Amount Factor (SCAF). 2007 16 .3: Equal annual deposits are to be made at the end of each year for the next ten years to build up a fund to purchase a home that will cost $40.1 = 0. Thus: March 14.

March 14. was derived in Section 3. the future value of the original loan p(1i + i) n must be equal to the future value of the periodic payments. p could represent the amount of a mortgage and a the periodic fixed payment that will fully amortize the debt at the end of n time periods with an interest charge on the unpaid balance of i percent per time period. p. In transactions involving the recovery of invested capital. a/p An expression for determining the future worth. 10) 14.234%. Hence.3 Uniform Series Present Worth. 2007 17 .a= $40. The progression for this case is Period 1 2 3 • • • n p (1+ i ) ! a {1+ (1+ i) + K + (1 + i) n n !1 Value at End of Respective Period p (1+ i ) ! a p (1+ i ) ! a {1+ (1+ i)} p (1+ i ) ! a {1 + (1 + i) + (1+ i)2 } 3 2 } If the loan is to be fully amortized. and Capital Recovery Factor. f. 000 = ( f /a.65496 or a = $2729. 8.45 3. The relevant cash flow diagram is p 1 2 n-1 n a a a a For example. p/a. for example. loans and mortgages. is desired. a. the uniform series of amounts a that is equivalent to the present worth.000 $40.2. of a uniform series of amounts.

4. a.08. 12. and 48 percent. (16) reveals a more direct way of deriving an expression for p/a assuming expressions for f/a and f/p are known. p/a. This figure is a log-log plot of p/a as a function of n for i equal to 1. 4. the present value and the future value of a series of payments is simply the total value of all of the payments: a•n. 8. (f/a. 3). 24. March 14. 2007 18 . 0. is being discounted. is shown in Fig. 20) = 9. For a finite positive value of i. p/a is less than n. both p/a and f/a approach n.818. For example. without interest. Since a is being discounted. p/a decreases with increasing i. 20) = 45. The factor p/a is called the uniform Series Present Worth Factor (SPWF) or simply the Series Present Worth p (1 + i)n ! 1 = = (SPWF) a i (1 + i) n (17a) Its reciprocal is called the Capital Recovery Factor. That is. As i approaches zero. 0.08. a i (1 + i) n = = (CRF) p (1 + i)n ! 1 (17b) The uniform-series present worth factor.p = a # (1+ i) j=0 n"1 j (1+ i) n f (1+ i)n " 1 a = = f i (1+ i) n p The expression on the right-hand side of Eq. whereas f/a increases with increasing i (see Fig. It is seen that p/a grows more slowly than f/a since each annual payment. and f/a is greater than n.76 whereas (p/a.

p = a•(p/a) = a/i. Likewise. if an endowment p that supports. that is earned each year. the principal. the present worth. p. in working with endowments or with systems like roads that are to be maintained forever. This limit is of interest. i. is called the Capitalized Cost. If one only spends the interest. If the uniform annual cost associated with maintaining such a system is a. remains to earn the same amount in succeeding years. and this endowment is earning the interest rate. this result is intuitively obvious. of these costs. p. for example. (16) as well as Fig. Again. p/a It can be seen from Eq.i = 1% 10 p/a 4 8 12 24 i = 48% 1 1 10 Number of Periods Figure 4 The Influence of i and n on Uniform-Series Present Worth Factor. 2007 19 . for example. scholarships is to be maintained in perpetuity. the institution may award the amount given by: ! a$ a = p# = p •i " p% each year without diminishing the value of the endowment. March 14. 4 that the asymptotic value of p/a as n approaches infinity is 1/i. p•i.

if each a is multiplied by (1+ i) .000 "p .Example 3. A sum can be shifted one time period to the right by multiplying it by (1+ i) .2819 The value placed on capital is clearly evident by the difference between the amount borrowed. whereas payments are commonly made at the beginning of the time periods (annuity due) in leases. follows as: a= $60. 2007 a(1+i) 20 a(1+i) a(1+i) . a a a 1 2 n-1 n a(1+i) March 14.75%.797. hence.000 1 i = 9/12 = 0.000.4: Determine the monthly payment required to fully amortize a 30-year. there are 360 months in the 30-year period. Solution: The cash flow diagram is: p = $60.75 % 2 359 360 a a a a Note that the monthly interest rate is 0. Payments are usually made at the end of the time periods (ordinary annuity) in direct reduction loans and mortgages. 1 2 n-1 n a to the ordinary annuity mode. that is. $60. a. $173. and n is equal to 360. $60.000 mortgage on a home with a 9 percent rate of interest compounded monthly. 360$ #a % = $60. The monthly payment.77 124. the cash flow diagram is shifted from the annuity due mode. and the amount paid back. 0.000 = $482.75%.

the same formulas are applicable if the periodic payment a is replaced by a(1+ i) . What should they specify for the monthly payment in order to realize the desired yield? Solution: The cash flow diagram for this 120 month period is: ! i=1% a a a a $30. They wish to achieve a yield of 1 percent per month.000 #f % . i.000 each and leasing them to their customers for a ten-year period. and they expect to be able to sell the trucks at the end of the lease for $30. 2007 21 . and the remaining ordinary annuity whose present value is a(p/a. a. This avoids introducing a new factor or the confusion that might otherwise arise in shifting the quantity. Example 3. 120& $p ' due ( p* ) a + annuity March 14. 1%.000 " a= $30. Alternatively: "p $ # a % annuity "f $ # a % annuity = due " p$ (i + i) # a% "f$ (i + i) #a% (18) = due (19) The present worth of an annuity due is easily calculated by dividing it into two parts: the first payment whose present worth is a. n-1).Hence.000 The monthly payment follows as: 2 119 120 $80.000.000 1 $80. to the next time period.5: A rental agency is considering purchasing a fleet of large trucks priced at $80.

01) .300387 = a= = $1007. result in a rapidly decreasing series.16 3.or $30. 2007 22 . However. Two types of progressions. per period.000 received for the fleet at the end of 10 years is only $9.910. such as the sum-of-the-year's digits method. The growth for this case is linear.089. enable the treatment of relatively complex problems. and the progression is arithmetic. and leases. or uniform annual amount. used in combination with the previously derived factors. arithmetic progressions and geometric progressions. A series of increasing or decreasing amounts is also a common occurrence in engineering economy. The results.000 is discounted by $20. 1%. with loans. Most actual series of receipts or disbursements from items such as net profit or maintenance costs would be sufficiently complex that each year would have to be considered separately in order to determine the equivalent present worth. for example. Fuel costs and capital costs are often assumed to increase exponentially with time.28 #p % (1+ 0. For example. that is. annuities. a series of end-of-period disbursements increasing by a constant amount.70052)(1. are considered in these notes. g. The cash flow diagram is: 1 2 g 3 4 n-1 n 2g 3g (n-2)g (n-1)g March 14.000 $70.4 Arithmetic and Geometric Progressions A series of equal amounts is common in dealing.000 " Note that the present value of the $30. 3.910. sufficiently accurate approximations for engineering purposes can often be generated by simplified progressions. hence. future worth. maintenance costs are expected to increase with the age of the property. the salvage value of $30. Consider first the constant gradient series. Depreciation schedules.01) (69. 120 $a & $80.

for example. ! p# * p 1 '! p # = (" $ % n & + g i) a " f $. Specifically. a. (24) The uniform series worth. (20) from the resulting equation. (20) by (1+ i) and subtracting Eq. of a gradient series would be used.Note that the first disbursement is made at the end of the second period. a/g follows by multiplying Eq. one obtains " 1 1 1 n % p {(1+ i ) ! 1} = g # + & 2 + K+ n ! (1 + i) (1+ i )n ' $(1 + i ) (1+ i ) or p 1 "(1 + i )n ! 1 n % = # & n ! g i $ i (1 + i ) (1+ i )n ' (21) p/g is called the Gradient Present Worth Factor (GPWF). (23). (23) by a/f which gives: " a %* a 1' = (1 ! n $ + g i) # f &. is " 1 2 3 n !1 % p = g# & 2 + 3 + 4 +K + (1 + i) (1 + i ) (1+ i )n ' $(1 + i ) (20) Multiplying both sides of Eq. (22) is multiplied by f/p. and (24) can be used to determine the present worth. Or. one obtains f 1 &! f # ) = '" $ % n* g i( a + (22) (23) Likewise. in investment analysis if all costs were being translated to a uniform stream of annual payments over the system lifetime. The present worth of this series. 2007 23 . and the disbursement made at the end of the n-th period is (n "1) g . Equations (22). future March 14. if Eq. the sum of the individual present values. The gradient present worth factor also can be written in terms p/a and p/f.

that are equivalent to the uniform gradient series. The gradient series.04. a log-log plot of p/g as a function of n for i equal to 1. Since the disbursements are being discounted. (p/g.6: The annual maintenance cost of a small office building is $1. 4. 8.04. 4 and 5 shows that p/g grows more rapidly than p/a because the end-of-period disbursements are increasing by a constant amount. is shown in Fig.worth. 2007 24 . p/g. and the payments can be assumed to be made at the end of the time periods. The life of the building is assumed to be 25 years. 20) = 111. each period in the gradient series. 0. What is the present worth of the maintenance costs? Solution: The cash flow diagram is: March 14. 5. For example.59. p/g decreases with increasing i as is clearly seen in Fig. 0. 5. g.56 whereas (p/a. and 48 percent. respectively. and uniform annual amount. 12. i = 1% 100 4 8 12 p/g 10 i = 48% 24 1 1 10 Number of Periods Figure 5 The Influence of i and n on the Gradient Present Worth Factor. 20) = 13. A comparison of figs. p/g Example 3. the interest rate is 9 percent compounded annually. This is especially true at small values of i when these future payments are not discounted very much. 24.200 for the first year and increases by $100 each year thereafter.

the present worth of the maintenance costs is: p = $1. a constant rate of change per period. r.479. recall that the gradient series.200(9. is denoted by c. In contrast.8226) + $100(76. If the base amount. 2007 25 . and the progression is geometric. The present worth of each term in the geometric progression is " 1 (1+ r) (1+ r)2 (1+ r)n! 2 (1 + r)n!1 % p = c# + +K + + & 2 + (1+ i )3 (1 + i )n!1 (1+ i )n ' $(1+ i ) (1 + i) (25) March 14. fuel costs with a fuel escalation rate.74 Consider next costs that grow at a constant rate. the cash flow diagram is c c (1+r) c (1+r) 2 c (1+r) 3 c (1+r) n-2 c (1+r) n-1 1 2 3 4 n-1 n The depicted growth. is an exponential growth. 9%.9265) = $19. r. hence. the amount at the end of the first year.i = 9% 1 $1200 2 3 24 25 $1300 $1400 $3500 $3600 The given series is equivalent to the superposition of a uniform annual series with a = $1. 25 #a % #g % p = $1. an arithmetic progression. for example. 9%. 25$ + $100 & .200 and a gradient series with g = $100.200 or "p "p $ . is appropriate for a constant amount of change per period.

the sum is seen to be &!1 + r#n * (" 1 + i $ % 1( c p= ' + 1 + i 1+ r % 1 ( 1+i ( ) . 4. of 10 percent. 8. Hence. i = 1% 100 r = 10 % p/c 4 8 12 10 24 i = 48% 1 1 10 Number of Periods Figure 6 The Influence of n and i on the Exponential Present Worth Factor. p/c. is shown in Fig. p/c. for an Escalation Rate. and 48 percent. the slope increases with increasing n for i < r and decreases with increasing n if i > r. r. of 10 Percent March 14. Figure 6 is a log-log plot of p/c as a function of n for i equal to 1. 24.If (1+ i)"1 is factored out of Eq. (25). 12. p/c. On this log-log plot. 2007 26 . r. 6 for an escalation rate. the Exponential Present Worth Factor (EPWF) is: (26) ! 1+ r # %1 p " 1+ i $ = c r %i n (27) The exponential present worth factor.

2007 . "f . w is positive only if r > i and w' is positive only if r < i. especially in the light of the simplicity of Eqs. n ) . Once the geometric series is converted to its equivalent present worth. where c 1+ r w'= 1+ i &1 1+ r (30) ! "p $ Also. w. n ) . # c % shift ( r & i * -( 1+ i * 0 Returning to Eq. respectively. and Eq. However. n $ % p #a = . all relations presented are valid for both positive and negative values of i. i. (29) and (30) are valid for all values of r and i including those that result in negative values of w and w'. which gives: p c = r= i n n = 1+ i 1+ r (28) The factor p/c can also be written in terms of f/a or p/a. p/c becomes n . respectively. Specifically. Eq. Since the limit of both f/a and p/a obviously must approach n as i approaches zero. ' 1+ r ) +' 1+ r ) "p $ = & 1/ . its tabulation is illogical.Alternatively. i. it should be noted that is simply ( p a. i. w'. (30) for r < i. specifically. p/c would be determined from Eq.w'. this expression is undefined if (r = i) . At the same time. if conventional tables of f/a and p/a ! are to be used. i. (26). The notation to be used for p/c is ( p c. into Eq. Eqs. (29) for r > i. and n. n) and (a p. Since p/c is a function of three variables. the amount at the end of the first year is sometimes denoted as (1+ r) c . 27 r March 14. Hence. (29) and (30). r. (28) for r = i. n ) . The validity of Eqs. n $ % p #a = . (27). the limit as (r " i) can be found by applying L' Hospital's rule. (29) and (30) is # c % shift easily established by substituting (1 + w) and (1 + w'). where c 1+ i and w= 1+ r &1 1+ i (29) "p . In this case. its future worth and the equivalent uniform annual amount can be obtained by multiplying by (f p.

800.800 (1.1 $ &1 # 1.88 = $3. 9%.12855 March 14.800 . (a) What is the annual fuel cost for the 20th year (the estimated useful life of the facility)? (b) What is the present value of the total fuel costs for this 20-year period? (c) What is the equivalent uniform annual amount? Solution: The cash flow diagram is: 1 2 19 20 $1800 $1800 (1.070.1) $1800 (1. 9%.01 (c) The equivalent uniform annual amount is: a= p "p .64 19 n= 2 0 (b) The present value of the total fuel costs for this 20-year period is: "p p = $1.Example 3.88 0. 20$ #c % 20 1 0% " 1.800 (20.09 % p = $1.951. 20$ #a % = $36.800 = $1.1) = $11.008.1) 18 $1800 (1.1) 19 (a) The annual fuel cost for the 20th year is cash flow = $1.44 9.070.03938) = $36.7: The fuel cost for the next 12-month period for a small office building is projected to be $1. 2007 28 . If the fuel escalation rate is 10 percent per year and the interest rate is 9 percent compounded annually.

approaches infinity. In order to determine the future value f to which the present value p has grown during the time t we need to separate variables and integrate.12.5735. 0. Equation (33) gives for this case: f = e (0 .01. m. as the number of compounding periods per year. and an interest rate of 0. The effective annual interest rate with continuous compounding is ie = e(ic )(1yr ) ! 1 (34) March 14.12/ yr )(4yr ) = e0. however. and shows why a time period must be associated with any interest quotation. the calculation of f/p for a time period of 4 years with continuous compounding at an interest rate ic equal to 0.6161 p In comparison.12 with annual compounding gives: (f/p. 0.48 = 1. i.12 with monthly compounding gives: (f/p. i = 0.6122. This gives: " or f p dp = p " t 0 c i dt (32) f = e ic t p (33) Consider. that discrete payments and discrete interest formulas are used almost exclusively in practice. the interest accumulated. Continuous compounding provides a useful and meaningful limit. the units of i would be (yr)-1.12/yr. 2007 29 . an interest rate of 0. (ii) It should be noted. 4) = 1. If time is measured in years. ie.3. The units of ic are [time]-1.5 (i) Continuous Compounding Continuous compounding is being introduced for two reasons: An understanding of continuous compounding clearly reveals the true nature of the interest rate. for example. The quantity ic is used in these notes to denote the continuous rate of interest.015 per month or in = 18% with monthly compounding. during the infinitesimal time interval dt is: dp = pic dt (31) Equation (31) clearly reveals that ic is a rate of interest. for example. The infinitesimal change in principal. This limit is the effective rate of interest. 48) = 1.

2007 30 . p/a for the 10 year period. is: (p/a. Only the time(s). assuming a series of 40 quarterly discrete payments. to its equivalent value in terms of any of the four remaining quantities. 3.12/ yr)( 0. For example. The monetary unit and economic value remain unchanged. The ratios f/p. a present value p could be converted to: (i) a future value f.0305.25yr) " 1= 0. f. ie for this quarter would be: ie = e (0. (ii) a uniform series a.12/yr. etc. and p/c can be used singly or in combination to convert any of the quantities. n. (iii) an arithmetic series g.9459. March 14. f/a. All of the basic ratios used in the conversion must be based on the given values of: i.Discrete interest formulas with discrete monthly.6 Discussion and Summary of Interest Formulas A summary of key interest factors and their limiting values is given in Table 3. r. 0. or (iv) a geometric series c. p/a. quarterly. p/g. with quarterly payments and continuous compounding at an interest rate of ic equal to 0. The names of all factors are listed in the NOMENCLATURE section. a. and possibly the number of amounts change. For example. p. the magnitudes of the amount(s). 40) = 22. and. yearly.0305 per quarter Thus. if c is involved. payments can be used with continuous compounding if i is replaced by the appropriate value of ie. g. and c.

Table 3 Interest Factors and Their Limiting Values n "# Factor (i > 0) ∞ i"0 (any n) 1 i "# (any n) ∞ f ( )n ( ) p = 1 + i = CAF f (1 + i)n ! 1 = (SCAF) a = i p (1 + i)n ! 1 = = (SPWF) a i (1 + i) n ∞ n ∞ 1 i n 0 p 1 "(1 + i )n ! 1 n % = # & n ! g i $ i (1 + i ) (1+ i )n ' or 1 2 i n2 " n 2 0 " p $+ p 1 (" p $ = ) & n ' . r. (10). r <i i#r "f . p 1 = f (1+ i) n Given the values of any four of the five quantities (p. n$ #a % 0 In previous decades. one can solve for the fifth ! quantity. Most spreadsheet programs have the main interest formulas available as built-in functions. a. r = i 1 . personal computers and programmable calculators now ! provide a much easier way to perform the calculations. Microsoft Excel offers the following functions to do this: PV FV March 14. However. 2007 returns the present value p returns the future value f 31 ! . which relates the present value p and future value f with a constant payment a over n periods with interest rate i. i). f. n. engineering economic calculations were often worked using printed tables of interest functions. = GPWF g i *# a % # f %"1+ r $ &1 p # 1+ i % = = EPWF c r&i n ". consider Eq. For example.

equal present values in no way imply equal or similar distributions of cash flows. p 1* p n * = ) " g i a #f& % * * $ p' . Since income taxes are paid on net income less depreciation.1 OTHER CONSIDERATIONS Depreciation Depreciation is the decrease in value of property due to wear. go to Help … Excel Help Contents. the following relationships between these factors are useful. an infinite number of possible cash flow distributions. an increase in depreciation produces a reduction in income tax. This tax credit is similar to March 14. Any cash flow distribution could be converted to its present value—a unique number that summarizes the cash flow distribution for a given i and n. p/g. 2007 32 . + (37) The quantities. p/a. and p/c are examples of factors that collapse special distributions of cash flows into a single number: the present value of the distribution. On the other hand. Financial functions. In Excel. If you want to program your own calculator. and obsolescence. "f% $ '1 f #p& = a i "f$ p #a% = a "f$ & #p% and (35) (36) ( . for given values of i and n. deterioration. Function Reference. there are. hence.PMT NPER RATE returns the payment a returns the number of periods n returns the interest rate i to see information on these and other financial The arguments for each function are the other four values. An investment tax credit has been given in some years by the federal government to stimulate economic growth. 4. 4.

depreciation effects a reduction in taxable income. n $ # % The sum-of-the-year's-digits method is an accelerated depreciation schedule. hence. 2007 33 . whereas. D.j + 1). BV. SYD. the depreciation for the j-th year is Dj = No. the present value of the deductions over the tax life of the asset is: "p p = D a . Hence. The Internal Revenue Service specifies restrictions on the tax life of a piece of property. the tax life may not be equal to the economic life of the asset. Hence. Two of these will be considered here: the straight-line method and the sum-of-the-year's-digits method. however. n is a dimensionless number. The book value. of years remaining (first cost " salvage value sum . is D= FC " SV n (38) where FC is the first cost of the asset including delivery and installation costs. D is analogous to the quantity a for this method. Specifically.year' s . the number of years of the tax life of the object. The annual depreciation. i%. and n.digits ) (40) The number of years remaining. The investment tax credit is the fraction of an investment outlay in a given year that can be claimed as a credit against income tax due for that year. Straight-line depreciation derives its name from the fact that the book value of the asset decreases linearly with time. the investment tax credit (it has been as high as 10 percent) effects a direct reduction in income tax. after j years of service with the straight-line method of depreciation is BVj = FC " j •D (39) The straight-line depreciation results in a uniform annual series of deductions. Several methods of depreciation are used.of . is the sum (1+ 2 + … + n) which is equal to [(n)(n +1)/2]. thus.depreciation in that it effects a reduction in income tax. it leaves the book value of the property unchanged. includes the year for which the depreciation is being determined. Hence. (40) can be written as March 14. Eq. The sum-of-the-year's-digits. (n . SV is the salvage value.

The life of the property. n. and the salvage value of the property is specified to be zero. n& + 2 (FC " SV ) ) . it is 1/SYD. In contrast. The first year this fraction is n/SYD. . 1995). for example. this fraction is equal to 1/n and is independent of j in the straight-line method. The depreciation for the j-th year of an asset's cost recovery period is given by: Dj = (CRj) (First Cost) = CRj•FC. 2007 34 . 5. 7 and 10 years. i%. the recovery period n. Note that the sum of CRj for j = 1 to (n+1) is 1. is specified by the government ! according to the type of property under consideration. 2. The book value with the SYD depreciation schedule for the j-th year is BV j = FC " j (2n " j + 1) ( FC " SV ) n (n + 1) (42) The derivation of Eq. ..Dj = 2 (n " j + 1) ( FC " SV ) n (n + 1) (41) The accelerated nature of this method is seen by comparing the fraction Dj /(FC " SV ) versus j. whereas the n-th year. (42) is left as an exercise. .000. in the determination of the present value of the income tax reduction effected through the depreciation of the asset. p= n (n + 1) i (43) This quantity is useful. It will also be left as an exercise to show that the present value of all of the annual depreciations for the tax life of the asset with the SYD depreciation schedule is ' #p %* (n " $ a . j = 1. that is. The book value at the end of the j-th year is: j BVj = FC ! " Dk k =1 (45) March 14. (n+1) (44) where the factors CRj are specified in Table 4 for recovery periods of 3. The Accelerated Cost Recovery System (ACRS) and the Modified Accelerated Cost Recovery System (MACRS) are accelerated depreciation schedules that are to be used in the United States for property placed into service after 1981 and 1986. respectively (see Lindeburg.

Specifically. ir. If the inflation and interest rates are constants.Table 4 MACRS Depreciation Factors. closely related to the rate of inflation. ri < 0. with inflation ri > 0. and its effect on the evaluation of the economic viability of alternative energy systems. CRj (see Lindeburg. the net effect on the merit of an investment is small or negligible.320 0. The influence of inflation on the future worth f of a present value p is to decrease it by a factor (1 + ri) each year where ri is the rate of inflation.245 0. risk.066 0. is not clear. the real interest rate.066 0. after n years.092 0.100 0.089 0.065 0. 1995) j: n=3 n=5 n=7 n = 10 1 2 3 4 5 6 7 8 9 10 11 0. taking into account the influences of inflation.333 0. of course.089 0.115 0. the future value was previously shown to be: f = p (1+ i ) n (47) Hence.074 0. the rate of interest charged by lending organizations is composed of three components that account for inflation. Interest rates are. Typical introductory books on engineering economy do not consider the subject of inflation.089 0.445 0. then the future worth of an investment p.144 0. (46) and (47) as: (1+ ir ) = or 1+ i 1+ ri March 14.115 0.2 Inflation and Fuel Escalation Rates The role of inflation in investment analysis. is: " 1+ i % ' f = p$ # 1+ ri & n (46) Without inflation or deflation.033 4. The prevailing opinion appears to be that since most quantities inflate at a similar rate.200 0.115 0.074 0.125 0. follows from eqs.148 0. or deflation.065 0. and profit.180 0.045 0.192 0. 2007 35 .175 0.143 0.058 0.

2007 36 . If it is assumed that fuel. alternative systems must be compared over a period of time. Since some quantities. fossil-fueled systems require a smaller initial investment but are experiencing continually increasing primary energy costs. the prediction of escalation rates is difficult. then the real fuel escalation rate. the fuel escalation rate.ir = i " ri 1+ ri (48) If ri is small. for example. the real interest rate. Unfortunately. reduces to: ir " i # ri (49) For fixed investments. On the other hand. On the other hand. future values include the influence of inflation if actual interest and escalation rates are used. (48). preferably over the economic life of the equipment. The use of a range of escalation rates. may increase at a rate greater than the rate of inflation. Hence. if the inflation rate is small. Costs in base year dollars are easier to comprehend. for example.3 Life-Cycle Costing Solar energy systems. rrf " rf # ri (51) If real interest and escalation rates are used in an economic analysis. for example. is recommended in order to provide insight on the influences of escalating costs on the outcome of the economic analysis. rrf. future values are obtained in terms of constant base year dollars. require a large capital investment in order to gather the "free" energy. 4. businesses expect a real rate of return of about 2 to 5 percent whereas individuals expect a real rate of return of approximately 1 to 3 percent. fuel and electrical power costs. for example. Eq. Such March 14. is rrf = rf " ri 1+ ri (50) Likewise. On the other hand. including the effects of inflation enables the use of actual interest and escalation rates and results in future cash flows that are close to those that actually occur. energy costs. Inflation would similarly reduce the future cost c of an item such as fuel. is escalating at a rate rf. it is necessary to include these influences in estimates of relevant costs. a sensitivity analysis.

is the best of the alternatives based on the provided costs. The two most common methods of life-cycle costing are the present value method and the annual cost method. For example. a. the assumed fuel costs and the assumed fuel escalation rate drastically influence the relative ordering of systems like nuclear. The system with the smallest present value. In the present value method. Life-cycle cost analysis is the conversion of expenses that occur over the n time periods of interest into a single cost number that can be used to compare alternative systems. The ak. 1 2 3 n-1 n a k.3 a k. the costs are treated as if they occurred in n equal annual payments. j %f ( j=0 j=0 (52) Equation (52) shows that a greater value is assigned to expenditures made at the present than those made sometime in the future due to the time value of money. that is. In the annual cost method. the cost number is the present value which for system k is n n $p #j ' pk = " ak.n may be positive due to the salvage value of the system.o.j's are future values if j is greater than zero. j & . For example. all costs throughout the lifetime of the equipment are treated as if they could be paid at the present. solar. hence. ak. Hence. 2007 37 . the costs throughout the n years of interest are converted to a uniform annual amount. Consider.j† is that which occurs for system k at the end of the j-th time period. March 14. however. pk. ak. i%. have to overcome this disadvantage. ak.n The cash flow ak. that the results of the cost analyses are only as good as the input data. which is † The cash flows a k. that is. and the assumed discount rate.n-1 a k. the following cash flow diagram that describes the expenses associated with a particular system. that is. for example. they are predicted quantities based on assumed economic conditions. j (1+ i) = " ak . It should be stressed.j.j could be negative (a net expense) or positive. i.1 a k. Hence. and conventional power plants. the cost number for system k is the uniform annual amount. ak.2 a k. Several meaningful cost numbers could be used to represent the total costs (or economic value) over the n time periods. Systems with large initial costs. the cash flows are converted to the present.o a k. future values are discounted.costing is called life-cycle costing.

for example. If only the benefits are considered. capital costs. these methods are used. 47 and 48): # Annual Nominal & #Expected General & Real Interest Rate " $ ') $ ' %Market Discount Rate ( % Inflation Rate ( (54) The Annual Nominal Market Discount Rate is the current rate charged by banks on loans. in comparing the costs associated with two alternatives to yield the present worth of these costs and the equivalent uniform annual cost (EUAC). ri. hence. in heating and cooling studies because the annual cost. Given i. etc. the present worth of these benefits and the equivalent uniform annual March 14. (53) The annual cost method is especially meaningful. n = *' ak . the projected changes in unit fuel costs and hourly maintenance costs. 2007 38 ." a % ak = pk $ . ak.3 both require a specified interest rate."a % ) n ( j . in fuel costs.$ . i%. the general rate of inflation and the escalation rates of fuel costs.. provides an estimate of the average energy cost in $/GJ (or $/MBTU). considered in Section 4. This energy cost facilitates comparisons between conventional and alternative energy sources.4 Rate of Return Analysis The two common methods of life-cycle costing. Since the influence of inflation is implicit in the interest rates charged by banks. and other costs. these costs are to be expressed in "constant" dollars. The first is to determine the "real" costs in terms of constant base year dollars. These quantities are not only dependent on the system but are also dependent on the interest rate and the economic conditions. the present value method and the annual cost method. for example. and the escalation rates. in maintenance charges. only "real" price changes are included. The base year would usually correspond to n = 0. divided by the amount of energy supplied during the year. There are two general ways to handle the influences of interest and escalating costs. 4. maintenance costs. The resultant costs. n #p & + j=0 #p & . The interest rate in this case is the "real" interest rate. With this method. Qk. rf and rm respectively. The other way to determine the costs is to use the actual interest rates and respective escalation rates. include the effects of inflation. which can be approximated by (See eqs. are only those that occur due to differences between the general rate of inflation. for example. That is. in this case. j (1+ i) . The difficult part of life-cycle costing is the determination of the ak.j's. the cash flows found in this manner are close to those that actually occur. specifically. i%.

000. i.000 2 i=? 9 10 Equating the present worth of the costs to the present worth of the benefits gives: $80. hence: Net Present Worth = 0 or Equivalent Uniform Annual Cost = Equivalent Uniform Annual Benefit The interest rate paid by the borrower on a loan is the rate of return the lender receives from the loan.000 (p/a. the interest rate is the calculated quantity in the rate of return analysis. 2007 39 . the rate of return on this investment is analogous to the interest the lender receives from a loan. is defined as the interest rate at which the benefits are equal to the costs.000 $12. and the salvage value of the truck at the end of this ten year period is $30.000 1 $80.000. i.1: A company is considering purchasing a truck for $80. the internal rate of return (IRR).000 each year for the 10 year life of the truck.000 (p/f. What is their rate of return on this investment? Solution: The cash flow diagram is: $42. the rate of return (RR).benefit (EUAB) would be calculated and compared. Specifically. Example 4. Assume this purchase saves the company $12.000 $12.000 $12.000 = $12. also called. If both the costs and the benefits are specified. the net present worth (NPW) would be calculated where Net Present Worth " {PW of Benefits} # {PW of Costs} (55) In contrast to the present value method and the annual cost method. 10) March 14. If one invested in capital equipment. 10) + $30.

2007 40 .3%.075 Thus. the accuracy of the assumptions (n = 10.The variation of the present worth of the benefits with i is given in the following table: i% PW of benefits 0 $150.236 11. SV = $30.3 % $80. the rate of return on their investment is 11. March 14.000 10 % $85.000) does not justify the determination of four significant digits. Clearly.301 11 % $81.

$17. determine the corresponding annual yield with daily compounding in a 365 day year. The interest rate paid on one year certificates of deposit is advertised as 6. What is the total of the 48 deposits? Compare your results with those from Part (a).323 5.81 percent.000. (b) $544. That is. 4.1 (a) What is the interest charged the first month on a $150. Show that the lower annual yield with continuous compounding is a consequence of banks basing the daily interest rate on a year length of 360 days.25. (a) Calculate the effective annual yield with continuous compounding using an interest rate.318.745.08.000 mortgage described in Problem 5.31. This problem shows that a 100% error in the salvage value has the same influence as a 10% error in a present value if I is 12% and n is 20 years. with an annual yield of 6.000 March 14.67 What yearly deposit would have to be made at the end of each year for 12 years to accumulate a fund of $12.716%. (a) What is the monthly payment and the total amount repaid? (b) What monthly deposit would have to be make at the end of each month for 48 months in order to accumulate a fund of $20. determine the present value of a $1.000 on the last payment date.000 home mortgage if the effective annual interest rate is 10 percent? (b) What is the monthly payment if the term of the mortgage is 25 years? (c) What is the total amount paid when the loan is fully amortized? Answers: (a) $1.000 on the last deposit date with which to purchase this automobile? Assume an interest rate of 6% compounded monthly is being paid on all deposits.812% The high initial cost of a solar heating system is not easily balanced by the high future fuel costs that are incurred with conventional fossil fuel systems if the discount rate is high. compounded daily. $6733.000 fuel cost that occurs 20 years from today if the discount rate is 12%. Compare the amount the homeowner received from this sale with the unpaid principal on the $150. is to be repaid in 48 monthly payments. (ii) sold the house after 5 years for $150. 2007 41 . the homeowner who took out the $150. Answers: (a) $561.16.63 2. (c) $395. PROBLEMS 1. (b) 10% compounded weekly. $6531.689. of 0.196. (b) 6.2 Assume.000 mortgage. for simplicity.92. Determine also the total of the 12 deposits for both parts (a) and (b). $24. Note: It is difficult to make accurate estimates of salvage values in a life-cycle cost analysis.000 automobile loan at 10% interest. Received from sale: $141.70 A $20. Answers: (a) 6.348. 5.5. (b) $369. and (iii) paid the realtor a 6% sales commission.70. compounded monthly. ic. For example.065/yr. 3. Assume an interest rate of: (a) 10% compounded yearly.5 percent.1 (i) paid no down payment. Answers: (a) $507. Answer: $103. (b) $1. Answer: Unpaid principal: $140.

000 units a year. (a) How much more can the company afford to invest in the highly automated plant? (b) Repeat Part (a) assuming that the profit per unit is reversed. what would be the quarterly payment? 9. Neither plant is estimated to have a significant salvage value at the end of its 20 year life. $50 per unit for the first 10 years and $150 per unit for the last ten years.2. Assume all profits are realized at the end of the respective year and the discount rate to be applied to these future profits is 18% per year.1 What semiannual deposit would result in the desired amount? Assume the deposits are made at the end of each six-month period including the period ending 6 years from present. the fraction of the board paid by the $1000 is to remain constant) and the net rate of return after inflation is 6%.669 6. 2007 42 . March 14. Both plants are designed to have a life of 20 years and to meet the demand of 100.2 What sum of money would you have to deposit today to have the required amount available at the end of 6 years? 9. 7. Compare the answers to parts (a) and (b). (b) $133. 9. than the conventional plant.50 per $100 of loan means that one must repay $109. a constant.000 undergraduate scholarships in perpetuity. 9.000 mortgage described in Problem 5.1 is in the 31% Federal tax bracket. 9. 9. An interest charge of $9. Due to reduced labor costs.3 Assume the homeowner who took out the $150. Do your answers make sense? Note that if the resulting higher quality product is needed in order to remain competitive. the first 10 years and $50 higher the next 10 years.3. You intend to have $20. 8.5.1. (a) Assuming the university's endowments earn a constant rate of return of 10% per year what must be the amount of your gift? (b) Assuming the scholarships are to be increased annually to account for inflation (for example.000 available 6 years from the present to replace your car. the automated plant results in a fixed profit per unit that is $150 higher. and other cost reductions.333 Consider two proposed manufacturing plants: a conventional plant and a highly automated one. that is. pays $4000/yr in real estate taxes on this home. Assume you earn 6% interest compounded quarterly on your savings. What reduction in Federal income tax paid by this home owner results from the first 12 mortgage payments and one $4000 real estate tax payment? Answer: $5.3 If you borrowed $20. What is the effective annual interest rate being charged? Answer: 18.000. warranty work. and can deduct from his Federal taxable income all of his mortgage interest and real estate taxes. what must be the amount of your gift? Answers: (a) $80.5% You are interested in giving your alma mater a gift that will support eight $1.4 Compare the total amounts paid in parts 9.50 per $100 of loan in 12 equal monthly payments. and 9. the company will have to invest in the automated plant regardless of the differences projected with the stated assumptions.000 at the same interest rate and amortized the loan in 6 years with equal payments made at the end of each three-month period.

Trucks that cost $50. insurance. and salvage value are to be neglected. what is the savings in income tax effected by using the SYD method of depreciation? Assume an interest rate of 9 percent compounded annually and a salvage value of zero. 16. Make your expression applicable regardless of the signs used for the cash flows. (49). What is the average monthly savings in fuel costs over the 20-year period if fuel costs escalate at monthly rates of 1/2. 17. The interest rate is 8 percent compounded monthly. (48).000 and the amount of the final payment. a and p. Derive Eq.000 per month. If an asset costs $100. All costs can be assumed to be paid at the end of the year. 11. The maintenance cost of the system is $500 the first year and this cost is expected to escalate at the rate of 3 percent per year.10. n. The initial amount of the mortgage is Mo. A solar water and space heating system costing $5.2 Determine the number of payments required to accumulate $5. 10. is received on all deposits.1 Derive an expression for the number of payments. Make your expression applicable regardless of the signs used for the cash flows.000 is to be determined. taxes. a constant. Yearly payments are to be made on an n-year mortgage. A pumping station costs $70. 2007 43 . and the annually compounded rate of interest being charged is i. 11.000 are to be leased at the rate of $1. The number of months required to accumulate $5. The payments are made at the beginning of each month. What is the uniform annual cost of this system if the interest rate is 12 percent compounded annually? 14. 11. 10.000 results in a reduction in fuel costs at current prices which is just equal to the monthly payments on the 20-year mortgage. respectively? What is the monthly cost of the fuel displaced by the solar heating system at the end of the 20th year? 13. Maintenance costs.1 Derive an expression for the number of periods required to recover the original investment at the specified rate of return. Derive an expression for the present value of the income tax reduction effected by using the sum-of-the-year's-digits method instead of the straight line method. The taxes and insurance on the system are $800 per year.000 and has an expected economic life of 25 years. A 12% effective annual return is to be achieved with monthly compounding. a and f.2 How many months are required to recover the original investment with the desired annual return? 12. and 1%.000 and has a 20-year tax life. Derive Eq. March 14. 2/3. compounded monthly. Assume income taxes are paid each year during the n-year tax life of an asset at a tax rate of 50 percent. 15. Assume that $200 is deposited at the end of each three-month period and an interest rate of 6%.

29. Derive an expression for this interest rate. The effective annual interest rate. The equipment is purchased with a cash down-payment. Determine the present value of the fuel savings if a car's fuel consumption could be cut in half. Assume the discount rate id represents the true value of money. The estimated annual reduction in the heating and cooling costs of this home with this change is $200. 19. and Mo are 15 years. Mk. p/a.02 yrs. Consider a piece of equipment that has an installed cost. What is the equivalent uniform annual cost? Answers: p = $21.000.345. If a series of payments is being made at a frequency of m payments per year. for example. is specified. a payment period of five months. i. (c) 7. where n > nm.0%. (a) What is the pay back period for this investment at an effective annual interest rate of 10%? What did the person ignore who arrived at a pay back period of 2. 8%. 21.2 If n. based on the time period between payments is required for use in the interest formulas. Answers: (a) 3. what is the present value of these costs? Assume all costs occur at the end of the year and an interest rate of 10%.20/gallon) = $600/yr. Assume the annual heating and cooling costs occur at the end of the year.700.5? Is your expression valid if m is greater than one but not an integer.95 44 March 14. Mo. what is the homeowners rate-of-return on this investment? (c) Repeat parts (a) and (b) if the annual saving is only $100. (12. 23.. Assume: (i) an infinite car life.500 the first year and $1. supplied by taking out an nm year mortgage which has an annually compounded interest charge im. (b) 40. what is the amount of interest paid the seventh year? 18. Assume the addition of 6" of insulation in the attic of a home would cost $500. p/g.9%. m = 0. f/a. 2007 . i.600 the second year. approaches zero. 22.4? 20. FC. DP. and $160. for example. (ii) an interest rate of 10% per year.). Is your expression valid if m is less than unity. Discuss your result. respectively. . and p/c. The annual maintenance cost of a small manufacturing facility with an assumed life of 25 years is $2. n.. ie. If this cost increases by $100 in each succeeding year (a3 = $1. Derive an expression for the present value of the cost of this equipment over its economic life.1 Derive an expression for the remaining principal at the end of the k-th year. deduce the limits of these quantities as i approaches zero.000 miles/yr) x (20 miles/gallon) x ($1. 19. Also determine these limits mathematically from the expressions for the respective factors given in Table 3. (iii) an annual fuel cost of $600: for example.800. i.5 yrs? (b) If this $200 savings persists over the estimated 30 years of the remaining life of this home. 17.294. The dependence of the economic value of money on time disappears as the interest. compounded annually. biannual payments. the interest rate. Utilizing this fact and the respective cash flow diagrams for f/p. m = 2. Describe verbally the basis for your answers. and with the balance.17. a4 = $1. a = $2.27 yrs.

and the term of the mortgage is 15 years. a procrastinator. (b) an 8% interest rate and a 30 year term. Mary starts on her 21st birthday and makes her last investment on her 40th birthday. you elected the 15 year. the real estate taxes paid on this home during the first year are $2500. EIT Review Manual. Ratio: 14. R. March 14. the remaining unpaid principal. Professional Publications. two engineering graduates of identical age. and your taxable income is decreased by the total of the interest and real estate taxes paid. starts 5 years later on his 26th birthday and makes a deposit every year for 40 years.3 Denoting the amount of the initial mortgage as Mo.5% mortgage. 6. Belmont.1 only assume a uniform annual rate of return of 6 percent. John.451. monthly payment including the prorated real estate tax. Answers: Mary: $1. the remaining unpaid principal at the end of the k-th month as Mk. Determine also the ratios of the final account value to the total savings invested.1 Determine the monthly payment required to fully amortize a $165.k.744. after tax. an IRA) for their retirement by making $2000 annual deposits on their birthdays. Ratio: 43. and the cumulative interest and principal paid. determine the value of Mary’s and John’s accounts at retirement. in the first k payments. (b) Determine the reduction in your federal tax liability during the first twelve-month period.5 percent. Assume: (a) the rate of interest. Mary and John. derive expressions for Mk and the total interest paid. 7.. Itot. (c) Determine the net. 13-1 and 13-2.000 home mortgage and the total amount of interest paid when the loan is fully amortized.55 25. compounded monthly. CA.61 John: $1.2 Assume this is your home. is 7. Why is the rate of interest higher for the 30 year term? 24. and the rate of interest per month as i.. REFERENCES Lindeburg. 25. 1995.2 Repeat 25. 24.652.24. Assume that they both retire on their 65th birthday and that John adds $2000 to his account on the day he retires. pp. Inc. both start investment plans (for example. M. 2007 45 .163.. you are in the 31% federal income tax bracket.1 If their accounts earned a uniform annual rate of return of 11%. 25. (a) Generate a spreadsheet showing for each of the 180 payments: the monthly interest paid. the monthly principal paid.

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