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Review CH 02
Review CH 02
(GE401)
CHAPTER 2
►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 = F (1+i)…..but:
2 1
F = P(1+i)(1+i) = P(1+i)2
2
Setting up the
subtraction
Capital Recovery
Factor A/P, i%, n
F/A and A/F Factors
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.
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)
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
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:
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
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
DO NOT FORGET
THIS!
Present Worth Point…
Gradient Component
Present Worth Point…
How to do it…………
Gradient Example
• Consider the following cash
flow
Gradient Example- Base
Annuity
• First, The Base Annuity of
$100/period
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
Example Summarized
This Cash Flow…
Shifted Gradient Example: i
=10%
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
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
Geometric Gradients
Subtract (1) from (2) and the
result is…..
Geometric Gradients
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.
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)
Chapter Summary
• This chapter presents the
fundamental time value of
money relationships common
to most engineering
economic analysis
calculations