BUS 369: Engineering Economics - Midterm Exam II Solution Key

Maltepe University Industrial Engineering Department, Spring’21

Lect. İsmail Başoğlu, PhD.
1. ABC company would like to invest in a project that requires $50000 capital investment. This capital will be
raised partially by selling company bonds and partially by borrowing a loan.
• ABC will sell 70 bond contracts, each from $500. Having a face value of $800, the bonds will mature in 8
years, and during that period, will pay $15 annual dividend to the holder at the end of each year. 5% of
the bond revenue will be paid as transaction broker’s fee, and the remaining amount will be transferred to
company accounts.
• The remaining part of the required capital will be borrowed from a credit company who will expose ABC
to 15% nominal interest that compounds annually.
What is the cost of the whole capital of $50000? Choose the closest value to your answer.
Solution: After transaction broker’s fee, ABC will have 500 × 0.95 = $475 from each bond. The cost of the
capital raised through any bond is the annually compounding interest rate that solves the following equation:
800 15
475 = 800 × (P/F, i%, 8) + 15 × (P/A, i%, 8) = +
(F/P, i%, 8) (A/P, i%, 8)
The left hand side can be calculated for 9% and 10% interest rates:
800 15
i = 0.09 ⇒ + ≈ 484.51
1.9926 0.18067
800 15
i = 0.10 ⇒ + ≈ 453.23
2.1436 0.18744
The cost of the capital seems to be between 9% and 10%. We use linear interpolation to approximate the cost
of the capital:
9 × (475 − 453.23) + 10 × (484.51 − 475) 291.03
i% = = ≈ 9.30%
484.51 − 453.23 31.28
Only 475 × 70 = $33250 is raised by sale of bonds with CoC = 9.30%. The remaining $16750 is raised from
CoC = 15%. The cost of the whole capital is:

9.30 × 33250 + 15 × 16750

CoC = = 11.2095% ≈ 11.21%
50000
2. An e-commerce company predicts that, from a certain website, there will be a continuous flow of revenue according
to the following diagram, where the red line show the annual continuous flow rate.

If the revenues are immediately transferred to a savings account that pays continuously compounding interest
at annual rate 7%, what is the total accumulated amount in the savings account at the end of the 6th year?
Choose the closest value to your answer.
Solution: It is easier to calculate the present worth, and then the future worth by decomposing the flow into
three continuous uniform series:
 • $200000 per year for the first two years,
• $100000 per year for the first four years,
• $100000 per year for five years,

     
P = 200000 P/Ā, 7%, 2 + 100000 P/Ā, 7%, 4 + 100000 P/Ā, 7%, 5
200000 100000 100000
= 0.53582 + 0.28663 + 0.23704
= $1, 144, 011

The future worth in the end of six years is:

F = P × [F/P, 7%, 6] = 1, 144, 011 × e0.07×6 = $1, 741, 141

3. Consider the following cash flow diagram given in annual resolution:

Under annually compounding interest at rate 9% per year, the present worth at year zero and the future worth
at the end of the 20th year are the same for this cash flow diagram. What is the value of A0 ? Choose the closest
value to your answer.
Solution: Because:
20
F W (i%) = P W (i%) × (1 + i)
if P W (9%) = F W (9%), then this means:

P W (9%) = F W (9%) = AW (9%) = 0

The annual worth is:

AW (9%) = A0 + 10 × (A/G, 9%, 20) − 1600 × (A/P, 9%, 20)

Once we plug in the compound amount factors, we have:

AW (8.5%) ≈ A0 + 10 × 6.7674 − 1600 × 0.10955 = A0 + 67.674 − 175.28 = 0

Then A0 ≈ $107.61.
4. Consider an investment that consists of:
• an initial cost of $10000 (at time zero),
• no transactions in the first five years,
• starting by the end of the 6th year, end of the year revenues of $5000 per year for 5 years,
• and a salvage value of $2500 at the end of the 10th year.
 What is the annual rate of return for this investment? Choose the closest value to your answer.
Solution: The rate of return is the annual interest rate that makes both the present worth and the future worth
equal to zero. Let us formulate the future worth:

F W (i%) = −10000 × (F/P, i%, 10) + 5000 × (F/A, i%, 5) + 2500

By trial and error one can determine the rate of return to be somewhere between 12% and 15%.

F W (12%) = −10000 × 3.1058 + 5000 × 6.3528 + 2500 ≈ 3205.76

F W (15%) = −10000 × 4.0456 + 5000 × 6.7424 + 2500 = −4243.67

Approximating the rate of return by linear interpolation:

12 × 4243.67 + 15 × 3205.76 99010.44

i∗ % = = ≈ 13.29%
3205.76 − (−4243.67) 7449.43

However, the true rate of return by a root-finder is 13.4%.

5. To a savings account, the deposits will be made on quarterly basis for 5 years in the form of a gradient series.
Suppose that, the first quarter $10000 has been deposited, and every next quarter’s deposited amount will be
$400 less than the previous deposited amount. Currently, the savings account pays nominal interest at rate 20%
and the interest compounds quarterly. How much more would have been accumulated in the account in the end
of 5 years, if the interest were to compound continuously with the same nominal interest rate? Choose the closest
value to your answer.
Solution: Currently, quarterly effective interest rate is 0.20
4 = 0.05. Then, the balance in the end of 5 years
would be:
F = [10000 − 400 (A/G, 5%, 20)] (F/A, 5%, 20) = $226131.90
The above compound factors are calculated through direct formula.
Now, suppose the same cash flow occurs under continuous compounding. In that case, the quarterly interest rate
would be r = 0.20
4 = 0.05 = 5%, and we can use continuous compounding factors:

F = (10000 − 400 [A/G, 5%, 20]) [F/A, 5%, 20] = (10000 − 400 × 7.8646) × 33.5137 = $229708.26

which is $3576.36 more than the previous value, approximately.

6. Consider a savings account that pays continuously compounding interest at annual rate 15%. The revenues
received from a certain e-commerce website are directed to this savings account immediately. According to the
statistics obtained from the web site:

• in months January, February, and March, there has been a continuous flow of $10000 per month at constant
speed,
• in months from April to September (inclusively), there has been a continuous flow of $15500 per month at
constant speed,
• in months October, November, and December, there has been a continuous flow of $10000 per month at
constant speed,
to the savings account. What is the total accumulated amount in the savings account at the end of the year?
Choose the closest value to your answer.
Solution: Average cash flows are changing dynamically in different months. Therefore, we need to take monthly
15
interest rate as r = 12 = 1.25%, compounding continuously. Actually, in all months, there is a constant and
continuous inflow of $10000 per month. Additionally, there is a constant and continuous inflow of $5500 per
 month from April to September (for six months). We need to handle two cash flows separately. The accumulated
amount is:
   
F = 10000 × F/Ā, 1.25%, 12 + 5500 × F/Ā, 1.25%, 6 [F/P, 1.25%, 3]
= 10000 × 12.9467 + 5500 × 6.2307 × 1.0382
= $165044.90

7. Consider a cash flow diagram that is 10 years long. Under a continuously compounding MARR, the present
worth is $6000 and the future worth in the end of 10 years is $12702. What is the annual worth, i.e. equivalent
uniform annual series? Choose the closest value to your answer.
Solution: The corresponding unknown MARR, r is the one that solves the following equation.
1 12702
F = P [F/P, r%, n] ⇒ 12754.83 = 6000 × e10r ⇒ r = ln = 0.075 = 7.5%
10 6000

Then, the annual worth is:

e0.075 − 1
AW [7.5%] = P [A/P, 7.5%, 10] = 6000 × = $885.66
1 − e−0.075×10

8. Consider a processing center that can be purchased at $25000 today and will have a 10 years of useful lifetime,
in the end of which the processing center is expected to have a salvage value of $5000. The annual maintenance
costs are expected to start at $600 at the end of the first year, and each year thereafter, will increase by 5%
compared to the previous year. Instead of owning this processing center, if we intend to lease it for 10 years at a
constant annual rental, what is the fair rental amount under an 8% MARR that compounds annually? Choose
the closest value to your answer.
Solution: We need to find the EUAC of the processing center under 8% annually compounding MARR. Let us
calculate the capital recovery cost first:

CR (8%) = 25000 × (A/P, 8%, 10) − 5000 × (A/F, 8%, 10) = $3380.59

In order to calculate the annual worth of the maintenance costs, we first need to determine the present worth of
the geometric gradient series (A0 = 600, f = 0.05, i = 0.08, n = 10), then multiply it with the capital recovery
factor.
h  n i
A0 1 − 1+f
1+i
A (8%) = × (A/P, 8%, 10) ≈ 4910.14 × 0.14903 ≈ $731.76
i−f

EU AC (8%) = CR (8%) + A (8%) = 3380.59 + 731.76 = $4112.35