ENGINEERING ECONOMY

(GE401)

CHAPTER 2

Factors: How Time

and
Interest Affect
Money

Foundations:
Overview
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Interpolate Factor Values
5. P/G and A/G Factors
6. Geometric Gradient
7. Calculate i
8. Calculate n

F/P and P/F Factors

Basic Derivations: F/P
factor
F/P Factor To find F
given P

Derivation by Recursion: F/P

factor
F = P(1+i)
1

F = F (1+i)..but:
2 1

F = P(1+i)(1+i) = P(1+i)2
2

F =F (1+i) =P(1+i) 2 (1+i)

3 2
= P(1+i) 3
In general:
Fn = P(1+i)n
Fn = P(F/P,i%,n)
Present Worth Factor
from F/P
Since Fn = P(1+i)n
We solve for P in terms of
FN
P = F{ 1/ (1+i)n} = F(1+i)-
n
Thus:
P = F(P/F,i%,n) where
(P/F,i%,n) = (1+i)-n

Thus, the two factors are:

1. F = P(1+i)n finds the future

worth of P;
2. P = F(1+i)-n
finds the present worth
from F
P/F factordiscounting back in
time
Discounting back from the
future

Example- F/P Analysis

Example:
P= 1,000; n=3; i=10%
What is the future
value, F?
Example P/F Analysis
Assume F = $100,000, 9 years
from now.
What is the present worth
of this amount nowif i
=15%?

P/A and A/P Factors

Uniform Series Present
Worth and Capital
Recovery Factors
Annuity Cash Flow

Uniform Series Present

Worth and Capital
Recovery Factors
Desire an expression
for the present worth
P of a stream of
equal, end of period
cash flows A
Uniform Series Present
Worth and Capital
Recovery Factors
Write a Present worth
expression

Uniform Series Present

Worth and Capital
Recovery Factors
The second equation
Uniform Series Present
Worth and Capital
Recovery Factors

Setting up the
subtraction

Uniform Series Present

Worth and Capital
Recovery Factors

Simplifying Eq. [3] further

Uniform Series Present
Worth and Capital
Recovery Factors

This expression will

convert an annuity cash
flow to an equivalent
present worth amount
one period to the left of
the first annuity cash
flow.

Capital Recovery
Factor A/P, i%, n
F/A and A/F Factors
F/A and A/F
Derivations

Sinking Fund and Series

Compound amount
factors (A/F and F/A)
A/F Factor

F/A factor from the A/F

Factor
F/A and A/F
Derivations

Example:
Formosa Plastics has
major
fabrication plants in
Riyadh and in Jaddh. It is
desired to know the
future worth of
$1,000,000 invested at
the end of each year for 8
years, starting one year
from now.
The interest rate is
assumed to be 14% per
year.

Sol. Example:
A = $1,000,000/yr; n = 8 yrs, i =
14%/yr
F8 = ??
Solution of Example
The cash flow diagram shows
the annual payments starting
at the end of year 1 and
ending in the year the future
worth is desired.

Cash flows are indicated in $1000

units. The F value in 8 years is
F = l000(F/A,14%,8) =
1000(13.23218)
= $13,232.80 = 13.232 million
8 years
from now.

Example:
How much money must Carol
deposit every year starting, l year
from now at 5.5% per year in
order to accumulate $6000 seven
years from now?

Solution of Example
The cash How diagram from
Carol's perspective fits the A/F
factor.
A= $6000 (A/F,5.5%,7)
=6000(0.12096)
= $725.76 per year
The A/F factor Value 0f 0.12096
was computed using the A/F
factor formula
Interpolation in Interest
Tables
Interpolation of
Factors
All texts on Engineering
economy will provide
tabulated values of the
various interest factors
usually at the end of the text
in an appendix
Refer to the back of your
text for those tables.

Interpolation of
Factors
Typical Format for Tabulated
Interest Tables
Interpolation (Estimation
Process)

At times, a set of interest tables

may not have the exact interest
factor needed for an analysis
One may be forced to interpolate
between two tabulated values
Linear Interpolation is not exact
because:
The functional relationships of the
interest factors are non-linear
functions
 Hence from 2-5% error may be
present
with interpolation.

An Example
Assume you need the value of
the A/P factor for i = 7.3% and n =
10 years.
7.3% is most likely not a
tabulated value in most
interest tables
So, one must work with i =
7% and i = 8% for n fixed at
10
Proceed as follows

Basic Setup for

Interpolation
Work with the following basic
relationships
i = 7.3% using the A/P
factor
For 7% we would observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL IN
AMT. FACTOR WORTH FUND AMOUNT RECOVERY F/P P/F
A/F F/A A/P
10 1.9672 0.5083 0.0724 13.8164 0.14238

i = 7.3% using the A/P

factor
For i = 8% we observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL
N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 2.1589 0.4632 0.0690 14.4866 0.14903
Estimating for i =
7.3%
Form the following
relationships

Final Estimated Factor

Value
Observe for i increasing from
7% to 8% the A/P factors also
increases.
One then adds the estimated
increment to the 7% known value
to yield:

The Exact Value for

7.3%
 Using a previously
programmed spreadsheet
model the exact value for
7.3% is:

P/G and A/G Factors

Arithmetic Gradient
Factors
In applications, the annuity
cash flow pattern is not the
only type of pattern
encountered
Two other types of end of
period patterns are common
The Linear or arithmetic
gradient
The geometric (% per period)
gradient
This section presents the
Arithmetic Gradient

Arithmetic Gradient
Factors
An arithmetic (linear)
Gradient is a cash flow series
that either increases or
decreases by a constant
amount over n time periods.
A linear gradient is always
comprised of TWO
components:

Arithmetic Gradient
Factors
The Two Components
are:
The Gradient component
The base annuity
component
The objective is to find a
closed form expression
for the

Present Worth of an
arithmetic gradient

Linear Gradient Example

Example: Linear
Gradient
Typical Negative, Increasing
Gradient:
G=$50

Example: Linear
Gradient
Desire to find the Present
Worth of this cash flow
Arithmetic Gradient
Factors

The G amount is the

constant arithmetic change
from one time period to the
next.

The G amount may be

positive or negative!

The present worth point

is always one time period
to the left of the first
cash flow in the series or,
Two periods to the left of
the first gradient cash
flow!

Derivation: Gradient Component

Only
Focus Only on the gradient
Component

Present Worth Point

The Present worth point
of a linear gradient is
always:
2 periods to the left

of the 1G point or,

1 period to the left of

the very first cash flow

in the gradient series.

DO NOT FORGET
THIS!
Present Worth Point
Gradient Component

Present Worth Point

PW of the Base Annuity is at

t=0
PWBASE Annuity=$100(P/A,i
%,7)
Present Worth: Linear
Gradient
The present worth of a
linear gradient is the
present worth of the two
components:
1. The Present Worth of the
Gradient Component and,
2. The Present Worth of the
Base Annuity flow
Requires 2 separate
calculations!

Present Worth: Gradient

Component
The PW of the Base
Annuity is simply the
Base Annuity A{P/A, i%,
n} factor
What is needed is a
present worth expression
for the gradient
component cash flow.
We need to derive a
closed form expression
for the gradient
component.

Present Worth: Gradient

Component
General CF Diagram
Gradient Part Only
To Begin- Derivation of P/G,i
%,n

Next Step:
Factor out G and re-write
as ..

Factoring G out. P/G

factor

What is inside of the

{ }s?
Replace (P/Fs) with closed-
form
Multiply both sides by
(1+i)

Mult. Both Sides By (n+1)

..

We have 2 equations [1] and

[2].
Next, subtract [1] from [2]
and work with the resultant
equation.

Subtracting [1] from [2]

..
The P/G factor for i and N
Extension The A/G factor
Some authors also
include the
derivation of the A/G
factor.
A/G converts a linear
gradient to an equivalent
annuity cash flow.
Remember, at this point one
is only working with gradient
component There still
remains the annuity
component that you must
also handle separately!

The A/G Factor

Convert G to an
equivalent A
How to do it

A/G factor using A/P with

P/G

The results follow..

Resultant A/G factor
Gradient Example
Consider the following cash
flow

Gradient Example- Base

Annuity
First, The Base Annuity of
$100/period
PW(10%) of the base annuity =
$100(P/A,10%,5)
PWBase = $100(3.7908)= $379.08
Not Finished: We need the PW of the
gradient component and then add that
value to the $379.08 amount

Focus on the Gradient

Component

We desire the PW of the

Gradient
Component at t = 0
The Set Up

PW of the Gradient
Component

Calculating or looking up
the
P/G,10%,5 factor yields
the following:
Pt=0 = $100(6.8618) =
$686.18 for the gradient
PW

Gradient Example: Final

Result
PW(10%)Base Annuity =
$379.08
PW(10%)Gradient Component =
$686.18
Total PW(10%) = $379.08 +
$686.18
Equals $1065.26
Note: The two sums occur
at t =0 and can be added
together concept of
equivalence

Example Summarized
This Cash Flow

Shifted Gradient Example: i

=10%

Consider the following Cash

Flow

Shifted Gradient
Example
Consider the following Cash
Flow
1. This is a shifted
negative, decreasing
gradient.
2. The PW point in time is at t
= 3 (not t = o)

Shifted Gradient
Example
Consider the following Cash
Flow

The base annuity is a $600

cash flow for 3 time periods
Shifted Gradient
Example: Base Annuity
PW of the Base Annuity: 2
Steps

Shifted Gradient Example:

Gradient
PW of Gradient
Component: G = -$50
Geometric Gradient
Geometric Gradients
An arithmetic (linear)
gradient changes by a fixed
dollar amount each time
period.
A GEOMETRIC gradient
changes by a fixed
percentage each time period.
We define a UNIFORM RATE
OF CHANGE (%) for each time
period
Define g as the constant
rate of change in decimal
form by which amounts
increase or decrease from one
period to the next
Geometric Gradients:
Increasing
Typical Geometric Gradient
Profile
Let A1 = the first cash flow in the
series

Geometric Gradients:
Decreasing
Typical Geometric Gradient
Profile
Let A1 = the first cash flow in the
series

Geometric Gradients:
Derivation
 First Major Point to
Remember:
A1 does NOT define a Base
Annuity;
There is no BASE ANNUITY
for a Geometric Gradient!
The objective is to determine
the Present Worth one period
to the left of the A1 cash flow
point in time
Remember: The PW point in
time is one period to the left
of the first cash flow A1!
Geometric Gradients:
Derivation

For a Geometric Gradient

the following parameters are
required:
The interest rate per
period i
The constant rate of
change g
No. of time periods n
The starting cash flow
A1

Geometric Gradients:
Starting

Pg = The Ajs time the

respective (P/F,i,j) factor
Write a general present
worth
relationship to find Pg.

Now, factor out the A1 value and

rewrite as..

Geometric Gradients
Subtract (1) from (2) and the
result is..

Geometric Gradients
Geometric Gradient P/A
factor

This is the (P/A,g,i,n) factor

and is valid if g is not equal to
i.

Geometric Gradient P/A

factor
Note: If g = i we have a division
by 0 undefined.
For g = i we can derive the closed
form PW factor for this special
case.
We substitute i for g into the Pg
relationship to yield:

Geometric Gradient: i = g
Case
Geometric Gradients:
Summary

Geometric Gradient:
Notes
The geometric gradient
requires
knowledge of:
A1, i, n, and g
There exist an infinite
number of combinations for
i, n, and g: Hence one will
not find tabulated tables for
the (P/A,g,i,n) factor.

Geometric Gradient:
Notes
You have to calculated
either from the closed form
for each problem or apply a
pre-programmed
spreadsheet model to find
the needed factor value
No spreadsheet built-in
function for this factor!

Geometric Gradient:
Example
Assume maintenance
costs for a particular
activity will be $1700 one
year from now.
Assume an annual
increase of 11% per year
over a 6-year time period.

Geometric Gradient:
Example
If the interest rate is 8% per
year,
determine the present
worth of the future
expenses at time t = 0.
First, draw a cash flow
diagram to represent the
model.
Geometric Gradient Example
(+g)
g = +11% per period; A1 =
$1700; i = 8%/yr

Solution
P=
$1700(P/A,11%,8%,7)
Need to calculate the P/A
factor from the closed-form
expression for a geometric
gradient.
From a spreadsheet we
see:
Geometric Gradient (
-g )
Consider the following
problem with a negative
growth rate g.

We simply apply a g value =

-0.10

Geometric Gradient (-g

value)
Determination of an
Unknown Interest
Rate

When the i rate is

unknown
A class of problems may
deal with all of the
parameters know except
the interest rate.
For many application-type
problems, this can become a
difficult task
Termed, rate of return
analysis
In some cases:
i can easily be
determined
In others, trial and error
must be used

Example: i unknown
Assume on can invest $3000
now in a venture in
anticipation of gaining $5,000
in five (5) years.
If these amounts are
accurate, what interest rate
equates these two cash
flows?

Example: i unknown
The Cash Flow Diagram
is

Example: i unknown
For i unknown
In general, solving for
i in a time value
formulation is not
straight forward.
More often, one will
have to resort to some
form of trial and error
approach as will be
shown in future sections.
A sample spreadsheet
model for this problem
follows.
Example of the IRR
function

Determination of
Unknown Number of
Years
Unknown Number of
Years
Some problems require
knowing the number of time
periods required given the
other parameters
Example:
How long will it take for
$1,000 to double in value if
the discount rate is 5% per
year?
Draw the cash flow diagram
as.

Unknown Number of
Years

i = 5%/year; n is
unknown!
Unknown Number of
Years
Solving we have..

Fn=? = 1000(F/P,5%,x):
2000 = 1000(1.05)x
Solve for x in closed
form

Unknown Number of
Years
Solving we have..
(1.05)x = 2000/1000
Xln(1.05) =ln(2.000)
X = ln(1.05)/ln(2.000)
X = 0.6931/0.0488 =
14.2057 yrs
With discrete compounding
it will take 15 years to a
mass $2,000 (have a little
more that $2,000)

No. of Years NPER

function
From Excel one can
formulate as:

Chapter Summary
 This chapter presents the
fundamental time value of
money relationships common
to most engineering
economic analysis
calculations

Derivations have been

presented for:

Present and Future Worth-

P/F and F/P

Annuity Cash flows P/A,

A/P, F/A and A/F

Gradients P/G, A,G and

P/A,g,i,n

One must master these

basic time value of money
relationships in order to
proceed with more
meaningful analysis that can
impact decision making.

These relationships are

important to you
professionally and in your
personal lives.
Master these concepts!!!