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ME443 CH3a PDF
ME443 CH3a PDF
•Introduction
•Interest Calculations
•Single Sums of Money
•Series of Cash Flows
•Multiple Compounding
•Continuous Compounding
•Equivalence
•Changing Interest Rates
•Inflationary Effects
•Bond Problems
0 -10MTL -10MTL
Which one
1 +7MTL +1MTL is better?
2 +5MTL +3MTL
3 +3MTL +5MTL
Alt. C
Which one
Alt. D is better?
Alt. E
E-F
$2,500
$5,000
Engineering Economy and ME 443 3.12
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Solution
0.7972 0.5674
P -5000 3000 (P/F 12,2) 2500 (P/F 12,5)
0.4523 0.3606
4000 (P/F 12,7) 2000 (P/F 12,9)
0.3220
3500 (P/F 12,10) -$369.50
And,
n
F A t F/P i, n - t
t 1
Engineering Economy and ME 443 3.13
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Example 3.8
Given the previous series of CF’s, determine FW at EOP 10
using an interest rate of 12% per compounding period.
3.1058 2.4760
F -5000 (F/P 12, 10) 3000 (F/P 12, 8)
1.7623 1.4049
2500 (F/P 12, 5) 4000 (F/P 12, 3)
1.1200
2000 (F/P 12,1) 3500 - $1147.15
Engineering Economy and ME 443 3.14
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Possible Series of Cash Flows:
a) Uniform Series of CF
At=A t=1, 2, 3, …, n
b) Gradient Series of CF
0 t 1
At
A t 1 G t 2, ..., n
c) Geometric Series of CF
A1 t 1
At
A t 1 1 j t 2, 3, ..., n
Engineering Economy and ME 443 3.15
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Uniform Series of CF:
• All CF’s in the series are equal
n
P A1 i P AP/A i, n
t
t 1
1 i n 1 uniform series
P/A i, n n
Example 3.9
i1 i PW factor
3.3522 0.6575
P 150M P/A 15,5) P/F 15,3 330,610,725TL
• deferring the first withdrawal for 3 years hence reduces the
deposit to about its half
Engineering Economy and ME 443 3.17
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
• Similarly,
i1 i n
A P
1 i n
1
i1 i n
A/P i, n Capital Recovery Factor
1 i 1
n
Example 3.10
A debt of 1BTL is incurred at t=0. What is the amount of
three equal payments at t=1, 2, and 3 that will repay the debt
if money is worth 10% compounded per period?
0.4021
A PA/P i, n 1B A/P 10,3 402,100,000TL
5.8666
F5 500 M F/A 8, 5
2,933,300, 000TL
1.4693
F10 2 ,933 ,300 ,000 F/P 8, 5
4,309,898, 000TL
A/F i, n Sinking Fund Factor
i
1 i 1
n
Example 3.12
What equal annual deposits
must be made at t=2, 3, 4, 5
and 6in order to accumulate
15BTL at t=8 if money is worth
10% compounded annually?
0 t 1
At
A t -1 G t 2, 3, ..., n
• First positive cash flow occurs at the end of 2nd time period.
• Size of CF in gradient series occurring at the end of period t is
given by:
At = (t-1)G t = 1, …, n
Engineering Economy and ME 443 3.22
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
PW equivalent of a gradient series is obtained:
n n n
P A t 1 i t 1 G 1 i G t 11 i
t t t
t 1 t 1 t 1
1 - 1 ni 1 i n
P G 2
i
P/A i, n n P/F i, n
P G
i
P/A i, n n P/F i, n
P/G i, n Gradient Series, PW Factor
i
1 n
A G A/F i, n G A/G i, n Gradient to Uniform Series
i i Conversion Factor
Engineering Economy and ME 443 3.23
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Example 3.13
An individual deposits an annual bonus into a savings account
that pays 8% compounded annually. The size of the bonus
increases by 500MTL/year; the initial bonus was 1.5BTL.
Determine how much will be in the fund immediately after the
fifth deposit?
5.8666
F1 1.5B F/A 8, 5 8,799,900,000TL
1.8465 5.8666
F2 500M A/G 8, 5F/A 8, 5 5,416,338,000TL
F F1 F2 8,799,900,000 5,416,338,000 14,216,238,000TL
Example 3.14
Land is purchased for 25BTL. It is agreed that this amount will
be paid for over a 5-year period with annual payments, using a
12% annual compound interest rate. Each payment is to be
2BTL less than the previous payment. Determine the size of the
last payment.
Engineering Economy and ME 443 3.25
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Example 3.14 (continued)
-
3.6048 6.3970
25B A 1 P/A 12, 5 2B P/G 12, 5
25B 2B 6.3970
A1
3.6048
10,484,354,000TL
A 5 A 1 4G
10,484,354,000 - 4 2,000,000,000
2,484,354,000TL
Engineering Economy and ME 443 3.27
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Geometric Series of Cash Flows:
CF at time t can be given by:
A t A t -1 1 j t 2, 3, ..., n
j = %change in
or the size of CF
A t A 1 1 j t 1, 2, ..., n
t -1
1 j
n n t
P A 1 1 j 1 i A 1 1 j
t 1 t 1
t 1 t 1 1 i
1 1 jn 1 i n
A 1 i j
1- j
P
nA 1
i j
1 i
P A 1 P/A i, j, n
1 F/P j, n P/F i, n
P A1 i j j0
i- j
Engineering Economy and ME 443 3.29
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Example 3.15
A professional sports team has negotiated a 5-year contract with
one of its super stars. The contract calls for a salary of
$1,125,000 the first year followed by 10% annual increases.
The salary will be paid out over a 20-year period, with the
amount paid each year being 10% greater than the previous
year. The general manager of the team and the athlete’s agent
agree that the present worth of the contract will be equated to
the PW of the payments using an annual compounding rate of
10%.
a) General manager wishes to compute the PW equivalent cost to the
team. They have been able to invest money and earn a 15% annual
return.
Engineering Economy and ME 443 3.30
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Example 3.15 (continued):
b) The athlete wants to know how much will be paid each of the first 5
years, how much will be paid the 20th year and PW equivalent of
contract if money is worth i) 5%, ii) 8%,
iii) 10% over 20 years.
Solution:
a) PW equivalent of contract for the general manager:
3.9858
P A 1 P/A 1 15, 10, 5 1,125,000 3.9858 $4,484,025
b) General manager and agent agreed that the amount to be paid to
the athlete the first year can be determined by setting PW
equivalent of payments=PW equivalent of contract at 10%.
Engineering Economy and ME 443 3.31
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Solution (continued):
18.1818 4.5455
A 1 P/A 1 10, 10, 20 1,125,000 P/A 1 10, 10, 5
A 1 $281,253
k' th year payment :
A k 281,253F/P 10, k - 1
A 2 $309,378
A 3 $340,316
A 20 $1,720,116
Engineering Economy and ME 443 3.32
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
Solution (continued):
PW equivalent of the contract :
P 281,253P/A 1 i, 10, 20
for i 5% : P 281,253 30.7105 $8,637,423
for i 8% : P 281,253 22.1686 $6,234,988
for i 10% : P 281,253 18.1818 $5,113,687
• Note that PW equivalent of the agreed payment plan is even less
than that of the original contract for the general manager:
11.7790
P 281,253 P/A 1 15, 10, 20 $3,312,880
Engineering Economy and ME 443 3.33
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Series of Cash Flows
• FW equivalent of the geometric series is obtained by multiplying
the value of the geometric series PW factor and (F/P i, n) to obtain:
1 i n 1 jn
A 1 i j
F i- j
nA 1 1 i i j
n -1
m m
• 8% compounded semiannually:
0.08
r 0.08, m 2 i 0.04
2
i eff F/P 4, 2 1 0.0816
• 18% compounded monthly:
0.18
r 0.18, m 12 i 0.015
12
i eff F/P 1.5, 12 1 0.1956 19.56%
Engineering Economy and ME 443 3.37
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Multiple Compounding
Example 3.18
Somebody borrows $50,000 and pays the loan with interest after
27 months. He pays back $65,000. What is the interest rate for
this transaction?
Let interest period be a quarter (3-month period):
F PF/P i, 9 1 i
65,000
1.3
9
50,000
1 i 1.0296 i 0.0296 2.96%
i eff 1 i 1 1 0.0296 1 0.1237 12.37%
4 4
4
Engineering Economy and ME 443 3.39
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Multiple Compounding
Solution(continued):
1 0.0066 60 1
F 500F/A 0.66%, 60 500 $36,688
0.0066
In the second part however it is assumed that money deposited
during a quarter can not earn any interest.
iq= 2%
1st quarter 2nd quarter 3rd quarter ... 20th quarter
0 1 2 19 20
0 1 2 3 4 5 6 7 8 9 56 57 58 59 60
...
...
500
500/month
1000
1.4568 22.8406
F 500 F/P 2,19 1500 F/A 2, 19 1000 $ 35 ,989 1500 1500 1500
Engineering Economy and ME 443 3.40
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Multiple Compounding
Example 3.20
Somebody makes semi-annual deposits of 1.5BTL into an account that
pays interest equivalent to 12% compounded monthly. Determine the
account balance immediately before the tenth deposit.
hence, F = Pern
cont. comp. single sum
F = P(F/P r,n) F.W. factor
CF diagram: r=8%
0 1 2 3 4 5 6 7 8 9 10
1.5BTL/year
4.1228
1.503 1.0618
F 1.5B( F/A 2,4 ) ( F/P 2,7 ) A 1 ( F/P 2,3 )
1.5B 4.1228 1.1503
A 3, 450 , 231,000 TL
2.0618
Engineering Economy and ME 443 3.48
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Continuous Compounding
In the case of the geometric series, the size of the
tth CF will be assumed to be given by:
At=At-1ec t=2, …, n
or,
At=A1e(t-1)c t=1, …, n
c=nominal comp. rate of increase in the size of CF
(P/A1 r,c,n): cont. comp. geo. series P.W. factor
(F/A1 r,c,n): cont. comp. geo. series F.W. factor
Engineering Economy and ME 443 3.49
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Continuous Compounding
Example 3.23
Somebody receives an annual bonus from his employer. He
wishes to deposit the bonus in a fund that pays interest at a
rate of 8% compounded continuously. His first bonus is
1BTL. The size of his bonus is expected to increase at a rate
of 4% a year. How much money will be in the fund
immediately before the tenth deposit?
A1 1BTL r 8% c 4% n 10
14.6224 1.0833
F 1BTL(F/A1 8,4,9) (F/P 8,1) 15,840,446,000TL
Engineering Economy and ME 443 3.50
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Equivalence
Two CF series or profiles are said to be equivalent at some
specified interest rate k%, if their PW (or any other worth)
are equal using that interest rate k%.
Example 3.24
What single sum of money at t=4 is equivalent to the CF
profile shown below. Use a 12% interest rate in analysis.
2B 2B
0 1 2 3 4 5 6 4
3B 2B X=?
5B 4B
Engineering Economy and ME 443 3.51
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Equivalence
Example 3.24 (solution)
4.7793 4.1273 1.5735 1.6901
X 5B(F/A12,4) -1B(P/G12,4)(F/P12,4) - 2B(P/A12,2)
14,021,993,000TL
Example 3.25
Given the two CF profiles shown below, for what value of X
are the two series equivalent using an interest rate of 10%?
inc. by $X/year
inc. by $8,000/year $16,000+6X
$80,000 from year3
$24,000 $16,000
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
$200,000 $140,000
Engineering Economy and ME 443 3.52
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Equivalence
Example 3.25 (solution) 5.3349 16.0287
PW(10) -200,000 24,000(P/A 10,8) 8,000(P/G 10,8)
5.3349 12.7631 0.9091
-140,000 16,000(P/A 10,8) X(P/G 10,7)(P/F 10,1)
110,909
X $9,559
12.7631 0.9091
Example 3.26
Assume payments of 2B, 3B and 5B TL are received at t=3,4,
and 5 respectively. For what interest rate, five equal payments
of 1,756M TL occurring at t=1,2,3,4 and 5 respectively
are equivalent to the previous payments?
Engineering Economy and ME 443 3.53
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Equivalence
Example 3.26 (solution)
5BTL 1,756M TL/year
2BTL 3BTL
0 1 2 3 4 5
0 1 2 3 4 5
FW(i) 2(F/P i,2) 3(F/P 1) 5
1.756(F/A i,5)
Let i 8%,
2 1.1664 3 1.08 5 10,572,800 ,000TL
1.756 5.8666 10,301,750 ,000TL 10,572,800 ,000TL
Engineering Economy and ME 443 3.54
Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Equivalence
Example 3.26 (solution cont.’d)
Let i 10%
2 1.21 31.1 5 10,720,555,000TL
1.756 6.1051 10,720,555,000TL 10,720,000,000TL
i 10%
0 1 2 3 4 5 6 7 8 9 10
5BTL
1.1449 1.2712 1.5530
F 5B(F/P 7,2)(F/P 8,3) (1 0.045)10 11,300,934,000TL
Example 3.39
Consider two CF series for a project over a 3-year period. Expenses
are 10 BTL to start, with operating and maintenance costs of 2 BTL in
the first year, increasing at an escalation rate of 15% per year.
Incomes begin in year 1 at 8 BTL and decrease at a rate of 20% per
year. If the general inflation rate is 10% and the real discount rate is
7%, find PW of project using the two methods.
rangingfrom1 throughk