INTRODUCTION

 Previous topics showed that interest is the basis for

determining whether different patterns of cash flows are
equivalent. Rather than comparing patterns of cash flows
from first principles, it is usually easier to use functions that
define mathematical equivalence among certain common
cash flow patterns. These functions are called compound
interest factors. We discuss a number of these common cash
flow patterns, along with their associated compound interest
factors, in this chapter.
INTRODUCTION
 This chapter opens with an explanation of how cash flow
patterns that engineers commonly use are simplified
approximations of complex reality. Next, we discuss four
simple, discrete cash flow patterns and the compound
interest factors that relate them to each other. There is then
a brief discussion of the case in which the number of time
periods considered is so large that it is treated as though the
relevant cash flows continue indefinitely.
1. TIMING OF CASH FLOWS AND MODELLING
 The actual timing of cash flows can be very complicated and
irregular. Unless some simple approximation is used, comparisons
of different cash flow sequences will be very difficult and
impractical. Consider, for example, the cash flows generated by a
relatively simple operation like a service station that sells gasoline
and supplies and also services cars. Some cash flows, like sales of
gasoline and minor supplies, will be almost continuous during the
time the station is open. Other flows, like receipts for the servicing
of cars, will be on a daily basis. Disbursements for wages may be
on a weekly basis. Some disbursements, like those for a manager’s
salary and for purchases of gasoline and supplies, may be monthly.
Disbursements for insurance and taxes may be quarterly or
semiannually. Other receipts and disbursements, like receipts for
major repairs or disbursements for used parts, may be irregular.
TIMING OF CASH FLOWS AND MODELLING
 An analyst trying to make a comparison of two projects with
different, irregular timings of cash flows might have to record
each of the flows of the projects, and then, on a one-by-one basis,
find summary equivalent values such as present worth that would
be used in the comparison. This activity would be very time-
consuming and tedious if it could be done, but it probably could
not be done because the necessary data would not exist. If the
projects were potential rather than actual, the cash flows would
have to be predicted. This could not be done with great precision
for either size or timing of the flows. Even if the analysis were of
the past performances of ongoing operations, it is unlikely that it
would be worthwhile to maintain a databank that contained the
exact timing of all cash flows.
TIMING OF CASH FLOWS AND MODELLING
 Because of the difficulties of making precise calculations of
complex and irregular cash flows, engineers usually work with
fairly simple models of cash flow patterns. The most common type
of model assumes that all cash flows and all compounding of cash
flows occur at the ends of conventionally defined periods, such as
months or years. Models that make this assumption are called
discrete models. In some cases, analysts use models that assume
cash flows and their compounding occur continuously over time;
such models are called continuous models. Whether the analyst
uses discrete modelling or continuous modelling, the model is
usually an approximation. Cash flows do not occur only at the ends
of conventionally defined periods, nor are they actually
continuous. We emphasize discrete models throughout the book
because they are more common and more readily understood by
persons of varied backgrounds.
2. COMPOUND INTEREST FACTORS FOR DISCRETE
COMPOUNDING
 Compound interest factors are formulas that define
mathematical equivalence for specific common cash flow
patterns. The compound interest factors permit cash flow
analysis to be done more conveniently because tables or
spreadsheet functions can be used instead of complicated
formulas. This section presents compound interest factors
for four discrete cash flow patterns that are commonly used
to model the timing of receipts and disbursements in
engineering economic analysis.
The four patterns are:
1. A single disbursement (money spent) or receipt (money
received)
2. A set of equal disbursements or receipts over a sequence
of periods, referred to as an annuity
3. A set of disbursements or receipts that change by a
constant amount from one period to the next in a
sequence of periods, referred to as an arithmetic gradient
series
4. A set of disbursements or receipts that change by a
constant proportion from one period to the next in a
sequence of periods, referred to as a geometric gradient
series
The principle of discrete compounding requires several
assumptions:
1. Compounding periods are of equal length.
2. Each disbursement and receipt occurs at the end of a
period. A payment at time O can be considered to occur at
the end of period - 1.
3. Annuities and gradients coincide with the ends of
sequential periods.
3. COMPOUND INTEREST FACTORS FOR SINGLE
DISBURSEMENTS OR RECEIPTS
 In many situations, a single disbursement or receipt is an
appropriate model of cash flows. For example, the salvage
value of production equipment with a limited service life will
be a single receipt at some future date. An investment today
to be redeemed at some future date is another example.
 Figure 3.1 illustrates the general form of a single
disbursement or receipt. Two commonly used factors relate a
single cash flow in one period to another single cash flow in a
different period. They are the compound amount factor and
the present worth factor.
 The compound amount factor, denoted by (F/P,i,N), gives
the future amount, F, that is equivalent to a present amount,
P, when the interest rate is i and the number of periods is N.
The value of the compound amount factor is easily seen as
coming from Equation F = P(1 + i)N, the compound interest
equation, which relates present and future values:
F = P(1 + i)N
In the symbolic convention used for compound interest
factors, this is written,
F = P(1 + i)N = P(F/P,i,N)
so that the compound amount factor is,
(F/P,i,N) = (1 + i)N
 A handy way of thinking of the notation is (reading from left
to right): “What is F, given P, i, and N ?”

 The compound amount factor is useful in determining the

future value of an investment made today if the number of
periods and the interest rate are known.

 The compound amount factor and the present worth

factor are fundamental to engineering economic analysis.
Their most basic use is to convert a single cash flow that
occurs at one point in time to an equivalent cash flow at
another point in time.
 The present worth factor, denoted by (P/F,i,N), gives the
present amount, P, that is equivalent to a future amount, F,
when the interest rate is i and the number of periods is N.
The present worth factor is the inverse of the compound
amount factor, (F/P,i,N). That is, while the compound
amount factor gives the future amount, F, that is equivalent
to a present amount, P, the present worth factor goes in the
other direction. It gives the present worth, P, of a future
amount, F. Since (F/P,i,N) = (1 + i)N,
 A traditional and still useful method for determining the
value of a compound interest factor is to use tables.

 Search and keep; Table 1: “Compound Interest Factor”, for

your future activities.
 Submit your files using PDF format as assignment.(Refer to
your Canvass Account for other details.)
EXAMPLE:
How much money will be in a bank account at the end of 15
years if $100 is invested today and the nominal interest rate
is 8 percent compounded semiannually?

Since a present amount is given and a future amount is to be

calculated, the appropriate factor to use is the compound
amount factor, (F/P,i,N). There are several ways of choosing i
and N to solve this problem. The first method is to observe
that, since interest is compounded semiannually, the
number of compounding periods, N, is 30. The interest rate
per six-month period is 4 percent. Then,
 The bank account will hold $324.34 at the end of 15 years.

Alternatively, we can obtain the same results by using the

interest factor tables.

F = 100(3.2434) (factor from Table 1)

F = 324.34
A second solution to the problem is to calculate the effective
yearly interest rate and then compound over 15 years at this
rate.
When the effective yearly rate for each of 15 years is applied
to the future worth computation, the future worth is,
4. COMPOUND INTEREST FACTORS FOR ANNUITIES
 The next four factors involve a series of uniform receipts or
disbursements that start at the end of the first period and
continue over N periods, as illustrated in Figure 3.2. This
pattern of cash flows is called an annuity. Mortgage or lease
payments and maintenance contract fees are examples of
the annuity cash flow pattern. Annuities may also be used to
model series of cash flows that fluctuate over time around
some average value. Here the average value would be the
constant uniform cash flow. This would be done if the
fluctuations were unknown or deemed to be unimportant for
the problem.
 The sinking fund factor, denoted by (A/F,i,N), gives the size,
A, of a repeated receipt or disbursement that is equivalent to
a future amount, F, if the interest rate is i and the number of
periods is N. The name of the factor comes from the term
sinking fund. A sinking fund is an interest-bearing account
into which regular deposits are made in order to accumulate
some amount.
 The equation for the sinking fund factor can be found by
decomposing the series of disbursements or receipts made
at times 1, 2, . . . , N, and summing to produce a total future
value. The formula for the sinking fund factor is,
 The sinking fund factor is commonly used to determine how
much has to be set aside or saved per period to accumulate
an amount F at the end of N periods at an interest rate i. The
amount F might be used, for example, to purchase new or
replacement equipment, to pay for renovations, or to cover
capacity expansion costs. In more general terms, the sinking
fund factor allows us to convert a single future amount into a
series of equal-sized payments, made over N equally spaced
intervals, with the use of a given interest rate i.
 The uniform series compound amount factor, denoted by
(F/A,i,N), gives the future value, F, that is equivalent to a
series of equal-sized receipts or disbursements, A, when the
interest rate is i and the number of periods is N. Since the
uniform series compound amount factor is the inverse of the
sinking fund factor,
 The capital recovery factor, denoted by (A/P,i,N), gives the
value, A, of the equal periodic payments or receipts that are
equivalent to a present amount, P, when the interest rate is i
and the number of periods is N. The capital recovery factor is
easily derived from the sinking fund factor and the
compound amount factor:
 The capital recovery factor can be used to find out, for
example, how much money must be saved over N future
periods to “recover” a capital investment of P today. The
capital recovery factor for the purchase cost of something is
sometimes combined with the sinking fund factor for its
salvage value after N years to compose the capital recovery
formula. See Close-Up 3.1.
 The series present worth factor, denoted by (P/A,i,N), gives
the present amount, P, that is equivalent to an annuity with
disbursements or receipts in the amount, A, where the
interest rate is i and the number of periods is N. It is the
reciprocal of the capital recovery factor:
5. CONVERSION FACTOR FOR ARITHMETIC GRADIENT
SERIES
 An arithmetic gradient series is a series of receipts or
disbursements that starts at zero at the end of the first
period and then increases by a constant amount from period
to period. Figure 3.4 illustrates an arithmetic gradient series
of receipts. Figure 3.5 shows an arithmetic gradient series of
disbursements. As an example, we may model a pattern of
increasing operating costs for an aging machine as an
arithmetic gradient series if the costs are increasing by
(approximately) the same amount each period. Note
carefully that the first non-zero cash flow of a gradient
occurs at the end of the second compounding period, not the
first.
 The sum of an annuity plus an arithmetic gradient series is a
common pattern. The annuity is a base to which the
arithmetic gradient series is added. This is shown in Figure
3.6. A constant-amount increase to a base level of receipts
may occur where the increase in receipts is due to adding
capacity and where the ability to add capacity is limited. For
example, a company that specializes in outfitting
warehouses for grocery chains can expand by adding work
crews. But the crews must be trained by managers who have
time to train only one crew member every six months.
Hence, we would have a base amount and a constant
amount of growth in cash flows each period.
 The arithmetic gradient to annuity conversion factor,
denoted by (A/G,i,N), gives the value of an annuity, A, that is
equivalent to an arithmetic gradient series where the
constant increase in receipts or disbursements is G per
period, the interest rate is i, and the number of periods is N.
That is, the arithmetic gradient series 0G, 1G, 2G, . . . , (N –
1)G is given and the uniform cash flow, A, over N periods is
found. Equation for the arithmetic gradient to
 annuity factor is,
 There is often a base annuity A' associated with a gradient,
as illustrated in Figure 3.6. To determine the uniform series
equivalent to the total cash flow, the base annuity A' must be
included to give the overall annuity:
6. CONVERSION FACTOR FOR GEOMETRIC GRADIENT
SERIES
 A geometric gradient series is a series of cash flows that
increase or decrease by a constant percentage each period.
The geometric gradient series may be used to model
inflation or deflation, productivity improvement or
degradation, and growth or shrinkage of market size, as well
as many other phenomena.
6. CONVERSION FACTOR FOR GEOMETRIC GRADIENT
SERIES
 In a geometric series, the base value of the series is A and the
“growth” rate in the series (the rate of increase or decrease)
is referred to as g. The terms in such a series are given by A,
A(1 + g), A(1 + g)2, . . . , A(1 + g)N–1 at the ends of periods 1, 2,
3, . . . , N, respectively. If the rate of growth, g, is positive, the
terms are increasing in value. If the rate of growth, g, is
negative, the terms are decreasing. Figure 3.7 shows a series
of receipts where g is positive. Figure 3.8 shows a series of
receipts where g is negative.
6. CONVERSION FACTOR FOR GEOMETRIC GRADIENT
SERIES
 The geometric gradient to present worth conversion
factor, denoted by (P/A,g,i,N), gives the present worth, P,
that is equivalent to a geometric gradient series where the
base receipt or disbursement is A, and where the rate of
growth is g, the interest rate is i, and the number of periods
is N.
7. NON-STANDARD ANNUITIES AND GRADIENT
 The standard assumption for annuities and gradients is that
the payment period and compounding period are the same.
If they are not, the formulas given in this chapter cannot be
applied directly. There are three methods for dealing with
this situation:
1. Treat each cash flow in the annuity or gradient
individually. This is most useful when the annuity or gradient
series is not large.
2. Convert the non-standard annuity or gradient to
standard form by changing the compounding period.
3. Convert the non-standard annuity to standard form by
finding an equivalent standard annuity for the compounding
period. This method cannot be used for gradients.
8. PRESENT WORTH COMPUTATIONS WHEN N=∞
 We have until now assumed that the cash flows of a project
occur over some fixed, finite number of periods. For long-
lived projects, it may be reasonable to model the cash flows
as though they will continue indefinitely. The present worth
of an infinitely long uniform series of cash flows is called the
capitalized value of the series. We can get the capitalized
value of a series by allowing the number of periods, N, in the
series present worth factor to go to infinity:
EXERCISES:
1. The Kelowna Go-Kart Klub has decided to build a clubhouse and
track five years from now. It must accumulate $50,000 by the end
of five years by setting aside a uniform amount from its dues at
the end of each year. If the interest rate is 10 percent, how much
must be set aside each year?
2. A car loan requires 30 monthly payments of $199.00, starting
today. At an annual rate of 12 percent compounded monthly, how
much money is being lent?
3. Clarence paid off an $80,000 mortgage completely in 48 months.
He paid $2,000 per month, and at the end of the first year made an
extra payment of $7,000. What interest rate was he charged on the
mortgage?
EXERCISES:

4. Susan Ng owns an eight-year-old Prius automobile. She wants to find the

present worth of repair bills over the four years that she expects to keep
the car. Susan has the car in for repairs every six months. Repair costs are
expected to increase by $50 every six months over the next four years,
starting with $500 six months from now, $550 six months later, and so on.
What is the present worth of the repair costs over the next four years if
the interest rate is 12 percent compounded monthly?

5. Emery’s company, Dry-All, produces control systems for drying grain.

Proprietary technology has allowed Dry-All to maintain steady growth in
the U.S. market in spite of numerous competitors. Company dividends,
all paid to Emery, are expected to rise at a rate of 10 percent per year
over the next 10 years. Dividends at the end of this year are expected to
total $110,000. If all dividends are invested at 10 percent interest, how
much will Emery accumulate in 10 years?
EXERCISES:

6. How much is accumulated over 20 years in a fund that pays 4 percent

interest, compounded yearly, if $1,000 is deposited at the end of every fourth
year?

7. The town of South Battleford is considering building a bypass for truck traffic
around the downtown commercial area. The bypass will provide merchants
and shoppers with benefits that have an estimated value of $500,000 per
year. Maintenance costs will be $125,000 per year. If the bypass is properly
maintained, it will provide benefits for a very long time. The actual life of the
bypass will depend on factors such as future economic conditions that
cannot be forecast at the time the bypass is being considered. It is therefore
reasonable to model the flow of benefits as though they will continue
indefinitely. If the interest rate is 10 percent, what is the present worth of
benefits minus maintenance costs?
EXERCISES:

8. How much money will be in a bank account at the end of 15 years if $100
is deposited today and the interest rate is 8 percent compounded
annually?

9. How much should you invest today at 12 percent interest to accumulate

$1,000,000 in 30 years?

10. City engineers are considering several plans for building municipal
aqueduct tunnels. They use an interest rate of 8 percent. One plan calls
for a full-capacity tunnel that will meet the needs of the city forever. The
cost is $3 000 000 now and $100 000 every 10 years thereafter for repairs.
What is the total present worth of the costs of building and maintaining
the aqueduct?
EXERCISES:

Answer the following Exercises, submit to your Canvass

Account as Problem Set.

Submit your file in PDF format.(Refer to your Canvass Account

for other details.)
 Engineering Economics: Financial Decision making for Engineers,
Fifth Edition,
NIALL M. FRASER and ELIZABETH M. JEWKES)

 Engineering Economy,
Seventh Edition,
LELAND BLANK and ANTHONY TARQUIN

 ENGINEERING ECONOMY,
Sixteenth Edition,
WILLIAN G. SULLIVAN, ELIN M. WICKS, C. PATRICK KOELLING
- END OF THE MODULE -