Engineering Economy: Applying

Theory to Practice 2nd

Chapter 3:
Equivalence – A Factor Approach

1
Overview
 Define variables in cash flow diagrams
 Notation of engineering economy factors: (P/A,i,N)
 Single-payment factors (P/F,i,N) & (F/P,i,N)
 Uniform-series factors (with A)
 Combining factors for deferred annuities & prepaid
expenses
 Arithmetic gradients
 Geometric gradients

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Cash Flow Assumptions
 Interest compounded once/period
 Cash flows at end-of-period
 Except P at time 0
 Except prepaid expenses
 End of 1 period = beginning of next
 Time 0 = beginning of period 1
 All periods same length

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Notation Introduced in
Chapter 2
 P = single cash flow at time 0 for a set
of cash flows
 F = single cash flow at end of period N
 i = interest rate per period
 N = number of periods

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New Notation
 A = uniform periodic amount
 Same every period from 1 to N
 At end of periods 1 to N
 G = arithmetic gradient
 Constant amount of change
 g = geometric gradient
 Constant rate of change

Ch3 Factors 5
Assumptions Shown on Cash
Flow Diagrams

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Factors – Why and Notation
(P/A,i,N), (P/F,i,N), …
 Why
 Tables easier & less errors than formulas
 Useful for hand solution
 Basis for understanding similar spreadsheet
functions
 Find X given Y at i% over N periods
 X & Y chosen from P, A, F, & G
 Know 1, assume 2 = 0, find other
 Many use only factor notation – not names or
formulas

Ch3 Factors 7
Format for Interest Rate
 OK
 Decimal: .05, .1, …
 Percentage: 5%, 10%, …
 Not OK
 Integer: 5, 10, …
 More likely to confuse with N = integer number of
periods
 Factors not symmetric
 (P/F, 5%, 10) ≠ (P/F, 10%, 5)
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Example Table for i = 10%
10% interest rate
period P/F F/P P/A A/P
1 0.9091 1.100 0.909 1.1000
2 0.8264 1.210 1.736 0.5762
3 0.7513 1.331 2.487 0.4021
4 0.6830 1.464 3.170 0.3155
5 0.6209 1.611 3.791 0.2638
10 0.3855 2.594 6.145 0.1627
15 0.2394 4.177 7.606 0.1315
20 0.1486 6.727 8.514 0.1175

Ch3 Factors 9
PP3.1 Example & Exercise
 Borrow 15,000 at 10% over 5 years
 What is the annual payment? Use
factors

Ch3 Factors 10
PP3.2 Exercise
 Project has first cost of $1.2M, annual
cost savings of $350K, and a salvage
value in year 15 of $.2M. At i = 10%,
what is the PW?

Ch3 Factors 11
PP3.3 Exercise
 Borrow 150,000 over 30 years at 9%

 What is the monthly payment?

Ch3 Factors 12
 Engineering Economy Factors
Find Given
P F (P/F,i,N) Present worth factor
F P (F/P,i,N) Compound amount factor
P A (P/A,i,N) Series present worth factor
A P (A/P,i,N) Capital recovery factor
A F (A/F,i,N) Sinking fund factor
F A (F/A,i,N) Series compound amount factor

Ch3 Factors 13
 Interpolation for N
2.7
ba  dc
2.5 b  adc Dotted line
is true (FP)
2.3
(FP,.1, N )

b
2.1 Interpolated Value d
a
 2.594  b
1.9

1.7 c
1.5
5 6 7 8 9 10
Period
Ch3 Factors 14
Another Visualization of
Interpolation
Year Factor
5 1.611
2 Δ
5 7 x 0.983

10 2.594
Ratios for years & factors are equal
2/5 = Δ/.983 ==> Δ = .393
(F/P,.1,7) = x = 1.611 + .393 = 2.004

Ch3 Factors 15
Interpolation for i
.16
Value  .1615  b
.15 ba  dc
b
.14
a b  adc
(PF,i,10)

d
.13 Dotted line
.12 is true (P/F)

.11 c
.10
20% 21% 22% 23% 24% 25%
Interest Rate

Ch3 Factors 16
Single-Payment Factors
(P & F )
 (F /P, i, N) = (1 + i)N (3.1)

 (P /F, i, N) = (1 + i)−N (3.2)

(FP,i,5)

F
P (PF,i,5)

0 1 2 3 4 5
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(P/F ) & (F/P ) vs. N
3
(PF, i, N ) and (FP, i, N)

2.5
(FP,10%,N)
2
(FP,5%,N)
1.5

1
(PF,5%,N)
0.5
(PF,10%,N)
0
0 1 2 3 4 5 6 7 8 9 10
Period

Ch3 Factors 18
(P/F ) & (F/P ) vs. i
7
6 (FP,i,10)
(PF,i,N ) and (FP,i,N )

5
4
3
(FP,i,5)
2
(PF,i,10)
1 (PF,i,5)
0
0% 5% 10% 15% 20%
Interest Rate

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Uniform Flows – (P/A )
(A/P ), (A/F ), & (F/A ) similar
 P = A [(1+i )N − 1] / [i (1+i )N] (3.3)

 (P/A, i, N ) = [(1+i )N − 1] / [i (1+i )N]

(PA,i,N )

A A A A

0 1 2 ⬃ N1 N

0 1 2 ⬃ N1 N Ch3 Factors 20

PP3.4 Example Loan $8000
borrowed, Nominal 12% interest, Payments for 5 years

 Annual payment =

 Monthly payment =

 Does annual = 12 * monthly ?

 Why or why not?

Ch3 Factors 21
 Uniform Factors vs. N
Limit as N  infinity; (A/P )  i ; (P/A )  1/i

16 .40
(PA,5%,N)
14 .35
12 .30
(PA,10%,N)
10 .25

(AP,i,N)
(PA,i,N)

8 .20
(AP,5%,N)
6 (AP,10%,N) .15
4 .10
2 .05
0 0
0 5 10 15 20 25 30
Period

Ch3 Factors 22
 Uniform Factors vs. i
Limit as i  0; (P/A )  N; (A/P )  1/N

10 1
(PA,i,10)
8 0.8

(AP,i,N)
(PA,i,N)

6 0.6
(PA,i,5)
4 0.4
(AP,i,5)
2 0.2
(AP,i,10)
0 0
0% 5% 10% 15% 20%
Interest Rate

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Combining Factors for Deferred
Annuities & Prepaid Expenses
 Deferred Annuities
 Benefits delayed by multi-period project
design & construction
 Costs not incurred until warranty expires
 Prepaid or beginning-of-period costs
 Insurance, leases, tuition, …
 Beginning periods 1 to N treated as end 0
to N – 1
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Deferred Annuities
 Cash flow series
 Periods 1 to D = $0
 Periods D + 1 to N = AD
 P = AD (P/A, i, N-D) (P/F, i, D)

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PP3.5 Deferred Annuities Exp.
After 5 years of development, a new material will save $750K/yr for
the following 15 years, i = 10%; Find PW?

 P = AD (P/A, i, N-D) (P/F, i, D)

 P=

 Show alternate Eq. gets same result

 P = AD (P/A, i, N) – AD (P/A, i, D)
 P=

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Prepaid Expenses
Uniform beginning-of-period cash flows

 Leases, insurance, tuition, memberships

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 Example of Leasing a Crane
0 1 2 3 4 5

$40,000

 P = −40,000 (P/A, 12%, 5) (1+.12)

= −40,000*3.605*1.12 = −$161,500
 P = −40,000 [1 + (P/A, 12%, 4)]
= −40,000 [1 + 3.037] = −$161,500
Ch3 Factors 28
 Links between (P/A ) & (P/F )
5
(PF,10%,6)
4
(PF,10%,5)
(PA,10%,N)

3 (PF,10%,4)
(PF,10%,3)
2
(PF,10%,2)
1
(PF,10%,1)
0
1 2 3 4 5 6 7 8
Period

Ch3 Factors 29
Link between (A/P ) & (A/F )
 (A/F,i,N) = (A/P,i,N) − i (3.13)
 Save time by looking up fewer factors
 Check your table look-ups

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 Arithmetic Gradients
Combined with Uniform Annual
A0 A0
4G
3G 0 1 2 3 4 5
2G
G
0G
G0 A
4G
3G
2G
0 1 2 3 4 5 A G
0G

0G
A G 0 1 2 3 4 5
2G
3G
4G
G0
A
0G
G
2G
0 1 2 3 4 5 3G
4G

Ch3 Factors 31
Gradient Tables Assume 1st
Cash Flow of G Series is 0!!!!
(PG,i,5) (AG, i,5)

0G G 2G 3G 4G

0 1 2 3 4 5

A A A A A

0 1 2 3 4 5

0 1 2 3 4 5

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Gradient for Repair Costs 3-year
warranty  O&M = $15K/yr & then climb $2.5K/yr
1 2 3 4 5 6 7 8 9 10

$15,000
$17,500
$20,000
$22,500
$25,000
$27,500
$30,000
$32,500

 Gradient is 8 years since $0 cash flow at end year 3

 P = −15,000 (P/A,12%,10)
− 2500 (P/G,12%,8) (P/F,12%,2)
= −15K*5.650 − 2.5K*14.471*.7972 = −$113.6K

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Geometric Gradients
g = constant rate of increase
 At = A1 (1 + g)(t−1) (3.22)
 At = At−1 (1 + g) (3.23)
$70
Annual Salary (Thousands)

60 Geometric

50 Arithmetic

40

30
0 2 4 6 8 10 12 14
Year
Ch3 Factors 34
Geometric Gradients
 Volume
 Item price (commodity’s inflation rate)
 Value $ (economy’s inflation rate)
 Interest rate
 Until Chapter 15 on inflation
 Assume item & economy inflating at same rate
 Assume all values stated as constant-value $s

Ch3 Factors 35
Geometric Gradient Formulas
 Assume A1 for period 1 then g per
period
 (P/A,g,i,N) =
For i ≠ g
 [1−(1+g)N(1+i )−N] / (i −g) (3.24)
For i = g
 (P/A,g,i,N) = N / (1 + i ) (3.25)

Ch3 Factors 36
Example 3.19 i = 10%, more efficient motor costs
$3K, lasts 5 yrs, salvage = $0, saves $800 in yr 1, increasing by
8%/yr

$800 $864 $933 $1008 $1088

0 1 2 3 4 5

$3000

 (P/A,8%,10%,5)
= [1 − (1 + .08)5(1 + .1)−5] / (.1 − .08)
= (1 − .9123)/.02 = 4.3831
 PW = −3000 + 800 * 4.3831 = $506.5
Ch3 Factors 37
Equivalent Discount Rate for g
&i
 If g < i, let (1 + x) = (1 + i )/(1 + g)
PW = [A1/(1 + g)] (P/A,x,N) (3.26)

 If g = i
PW = [A1/(1 + g)] N (3.27)

 If g > i, let (1 + x) = (1 + g)/(1 + i )

PW = [A1/(1 + i )] (F/A, x, N) (3.28)
Ch3 Factors 38
Example 3.19 Revisited i = 10%, more
efficient motor costs $3K, lasts 5 yrs, salvage = $0, saves $800 in
yr 1, increasing by 8%/yr

 Since g = 8% < i = 20% use Eq. 3.26

 let (1 + x) = (1 + i )/(1 + g)
x = 1.1/1.08 – 1 = 1.852%

PW = –3000 + [A1/(1 + g)] (P/A,x,N)

= –3000 + [800/1.08] (P/A,1.852%,5)
= –3000 + 740.7*4.734 = $506.5

Ch3 Factors 39
Topics Covered
 Defined P, F, A, G, i, & N
 Notation for engineering economy factors
 Use i = 5% or .05 not 5
 Single-payment factors (P/F,i,N) & (F/P,i,N)
 Uniform-series factors (with A)
 Deferred annuities – warranties, etc.
 Prepaid expenses – rent, leases, insurance, tuition
 Arithmetic gradients
 Geometric gradients

Ch3 Factors 40