Interest Chapter 2

How Time &

Affect Money?

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Models

1. P/F vs F/P
2. P/A vs A/P
3. A/F vs F/A
4. P/G

MENG 300 - Engineering Economics

5. A/G
6. P/g i≠g
7. P/g i=g

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 F/P
vs
Single

P/F
Factors
Payment

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Single-Payment Factors (F/P & P/F)

F = P . (1 + i)n P = F . (1 + i) - n
F = P . (F/P, i, n) P = F . (P/F, i, n)

MENG 300 - Engineering Economics

i

0 1 2 ... n

P 4
 Dr. Yaser Al-Alawi
Example 1
• Hewlett-Packard (HP) has completed a study
indicating that $50,000 in reduced maintenance this
year on one processing line resulted from improved
integrated circuit fabrication technology based on
rapidly changing designs.

MENG 300 - Engineering Economics

• If HP considers these types of savings worth 20% per
year, find the equivalent value of this result after 5
years.
• If the $50,000 maintenance savings occurs now, find
its equivalent value 3 years earlier with interest at
20% per year.
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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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Uniform
Series
Payments
P/A vs A/P
F/A vs A/F

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 0

P
1
A

2
Uniform-Series: (P/A)

...
n

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Derivation
 1 1 1 1 
=P A 1
+ 2
+ .. + n −1
+ n 
 (1 + i ) (1 + i ) (1 + i ) (1 + i ) 

Divide by (1+i) then subtract it from above.

P  1 1 1 1 
= A 2
+ 3
+ .. + n
+ n +1 
1+ i  (1 + i ) (1 + i ) (1 + i ) (1 + i ) 

MENG 300 - Engineering Economics

−i  1 1 
= P A n +1
− 
1+ i  (1 + i ) (1 + i ) 

 (1 + i ) n − 1 
P A n 
for i ≠ 0
 i (1 + i ) 
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 Dr. Yaser Al-Alawi
(P/A) and (A/P)

 (1 + i ) n − 1   i (1 + i ) n 
P A n 
for i ≠ 0 A= P n 
 i (1 + i )   (1 + i ) − 1 

P = A . (P/A, i, n) A = P . (A/P, i, n)

MENG 300 - Engineering Economics

Excel: Excel:
P = PV (i%,n,A) A = PMT (i%,n,P)

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 Dr. Yaser Al-Alawi
Example 2
• You are about to take a loan from a bank to buy a
brand-new car that costs BD 7,500. The bank charges
12% per year on car loan.
• How much money do you have to pay the bank every
year for four years in order to payback the loan?

MENG 300 - Engineering Economics

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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Sinking Fund Factor (A/F) & (F/A)
A i

0 1 2 ... n

 1   i (1 + i ) n 
A= F n  
 (1 + i )  (1 + i ) n
− 1  F

MENG 300 - Engineering Economics

 i   (1 + i ) n − 1 
A= F  F = A 
 (1 + i ) − 1 
n
 i 
A = F . (A/F, i, n) F = A . (F/A, i, n)
Excel: Excel:
A = PMT (i%,n, , F) F = FV (i%,n, , A) 13
 Dr. Yaser Al-Alawi
Example 3
• How much money must Carol deposit every year
starting one year from now at 5% per year in order to
accumulate $6,000 seven years from now?

MENG 300 - Engineering Economics

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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Interpolation in Interest Tables

• When using tabulated interest tables, one might be

forced to approximate a factor that is not tabulated
• Can apply linear interpolation to approximate
• See Table 2-4

MENG 300 - Engineering Economics

• Factors are nonlinear functions; hence linear
interpolation will yield errors in the 2-4% range
• Example: Determine the value of the A/P factor for an
interest rate of 7.3% and n of 10 years.

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Arithmetic
Gradient
Series
Payments
P/G
A/G

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 Dr. Yaser Al-Alawi
Arithmetic Gradient given Present
(P/G)

An = A + ( n-1)G

A3 = A + 2G

Base amount A2 = A + G
A1 = A

MENG 300 - Engineering Economics

0 1 2 3 .-. . n

P 18
 Dr. Yaser Al-Alawi
The Concept An = A + ( n-1)G

A3 = A + 2G

Base amount A2 = A + G
A1 = A

0 1 2 3 .-. . n

MENG 300 - Engineering Economics

PA
PG
PT = PA + PG
PT
PA = A (P/A, i, n) PG = G (P/G, i, n)
 ? 19
 ( n-1)G

Dr. Yaser Al-Alawi

Derivation
2G
G

0 1 2 3 .-. . n

PG

PG = G (P/F, i, 2) + 2G (P/F, i, 3) + . . . + (n-1)G (P/F, i, n)

MENG 300 - Engineering Economics

Multiply it by (1+i) to create equation (2);
Subtract (1) from the equation (2) and simplify Yields…
𝐺𝐺 (1 + 𝑖𝑖)𝑛𝑛 −1 𝑛𝑛
𝑃𝑃 = −
𝑖𝑖 𝑖𝑖(1 + 𝑖𝑖)𝑛𝑛 (1 + 𝑖𝑖)𝑛𝑛

(1 + 𝑖𝑖)𝑛𝑛 −𝑖𝑖𝑖𝑖 − 1
𝑃𝑃 = 𝐺𝐺. PG = G (P/G, i, n)
𝑖𝑖 2 (1 + 𝑖𝑖)𝑛𝑛 20
 Dr. Yaser Al-Alawi
Arithmetic Gradient given Annuity
(A/G)
An = A + ( n-1)G

A3 = A + 2G

Base amount A2 = A + G
A1 = A

MENG 300 - Engineering Economics

0 1 2 3 .-. . n

AT
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 Dr. Yaser Al-Alawi
The Concept An = A + ( n-1)G

A3 = A + 2G

Base amount A2 = A + G
A1 = A

0 1 2 3 .-. . n

MENG 300 - Engineering Economics

A
+
AG

AT = A + AG

AG = G (A/G, i, n)
? 22
 ( n-1)G

Dr. Yaser Al-Alawi

Derivation
2G
G

0 1 2 3 .-. . n

AG

AG = PG (A/P, i, n)
(1 + 𝑖𝑖)𝑛𝑛 −𝑖𝑖𝑖𝑖 − 1 𝑖𝑖(1 + 𝑖𝑖)𝑛𝑛

MENG 300 - Engineering Economics

𝐴𝐴𝐺𝐺 = 𝐺𝐺. 2 𝑛𝑛
.
𝑖𝑖 (1 + 𝑖𝑖) (1 + 𝑖𝑖)𝑛𝑛 −1
(1 + 𝑖𝑖)𝑛𝑛 −𝑖𝑖𝑖𝑖 − 1
= 𝐺𝐺. Take common factor: [(1+i)n – 1]
𝑖𝑖[ 1 + 𝑖𝑖 𝑛𝑛 − 1]
1 𝑛𝑛
𝐴𝐴𝐺𝐺 = 𝐺𝐺. − AG = G (A/G, i, n)
𝑖𝑖 1 + 𝑖𝑖 𝑛𝑛 − 1 23
 Dr. Yaser Al-Alawi
Example 4
• Three contiguous countries in Florida have agreed to pool tax
resources already designated for country-maintained bridge
refurbishment.
• At a recent meeting, the country engineers estimated that a
total of $500,000 will be deposited at the end of next year into
an account for the repair of old and safety-questionable
bridges throughout the three-country area.

MENG 300 - Engineering Economics

• They estimated that the deposits will increase by $100,000 per
year for only 9 years thereafter, then cease. if county funds
earns interest at a rate of 5% per year.
• Determine the equivalent:
a. Present Worth
b. Annual series amounts
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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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Decreasing (G)

Dr. Yaser Al-Alawi

Base amount An = A – ( n-1)G
A2 = A – G A3 = A – 2G
A1 = A

0 1 2 3 .-. . n

MENG 300 - Engineering Economics

PA
PG
PT = PA – PG
PT
PA = A (P/A, i, n) PG = G (P/G, i, n)
  26
Geometric
Gradient
Series
Payment
P/g i≠g
P/g i=g

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 Dr. Yaser Al-Alawi
Geometric Gradient Series (P/g)
• g = the constant rate of change

An = A 1( 1 + g)(n – 1)

A3 = A1(1 + g)2

MENG 300 - Engineering Economics

Base amount
A1 A2 = A1(1 + g)

0 1 2 3 .-. . n

Pg 28
Derivation

Dr. Yaser Al-Alawi

A1 A1 (1 + g ) A1 (1 + g ) 2 A1 (1 + g ) n −1
Pg
Start with: = + + + ... +
(1 + i )1 (1 + i ) 2 (1 + i )3 (1 + i ) n
Factor out A1 out and re-write (1)
 1 (1 + g )1 (1 + g ) 2 (1 + g ) n −1 
=Pg A1  + 2
+ 3
+ ... + n 
 (1 + i ) (1 + i ) (1 + i ) (1 + i ) 
(2)
Multiply by (1+g)/(1+i) to obtain Eq. (3 )

(1+g) (1+g)  1 (1 + g )1 (1 + g ) 2 (1 + g ) n −1 
Pg
= A1  + + + ... +  (3)
(1+i) (1+i)  (1 + i ) (1 + i ) 2 (1 + i )3 (1 + i ) n 

Subtract Eq. (2 ) from Eq. (3 ) to yield

MENG 300 - Engineering Economics

 1+g   (1 + g ) n 1 
Pg  = − 1 A1  n +1
− 
 1+i   (1 + i ) 1+ i 
Solve for Pg and simplify to yield….

  1 + g n 
1 −   
If: g = i
 1 + i   g≠i
Pg A1 
 i−g  nA1



 Pg =
(1 + i )
Pg = A1 (P/A1, g, i, n) 29
 Dr. Yaser Al-Alawi
Decreasing (g)
• g = the constant rate of change

Base amount
A1
A2 = A1(1 – g)

A3 = A1(1 – g)2

An = A 1( 1 – g)(n – 1)

MENG 300 - Engineering Economics

0 1 2 3 .-. . n

  1 + g n 
1 −   
1 + i
Pg
= Pg A1     g≠i
 i−g 
 
 

Pg = A1 (P/A1, g, i, n) 30
 Dr. Yaser Al-Alawi
Example 5
• Engineers at SeaWorld, a division of Busch Gardens,
Inc., have completed an innovation on an existing
water sports ride to make it more exciting.
• The modification costs only $8000 and is expected to
last 6 years with a $1300 salvage value for the solenoid
mechanisms.

MENG 300 - Engineering Economics

• The maintenance cost is expected to be high at $1700
the first year, increasing by 11% per year thereafter.
• Determine the equivalent present worth of the
modification & maintenance cost. The interest rate is
8% per year.
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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Finding n or i

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Unknown Interest Rate (i)
Solved by: F
i=?
• Trail & Error
• Numerical Method 0 1 .... n

P
To find unknown i:
• For Single Payment  use, tables/formula

MENG 300 - Engineering Economics

• For uniform series, & gradients  use, tables.

EXCEL:
• Uniform A value: = RATE(number_years, A,P,F)
• Varying A values: = IRR(first_cell:last_cell, guess value)
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 Dr. Yaser Al-Alawi
Example 6

If Laurel can make an investment in a friends’ business of

$3,000 now in order to receive $5,000 five years from
now:
a. Determine the rate of return?

MENG 300 - Engineering Economics

b. If Laurel can receive 7% per year interest on a
certificate of deposit, which investment should be
made?

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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Example 7
• Professional Engineers Inc., requires that $500 per year be placed
into a sinking fund account to cover any unexpected major rework
on field equipment.
• In one case, $500 was deposited for 15 years & covered a rework
costing $10,000 in year 15.

MENG 300 - Engineering Economics

• What rate of return did this practice provide to the company?

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 Solution

MENG 300 - Engineering Economics Dr. Yaser Al-Alawi

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 Dr. Yaser Al-Alawi
Unknown Number of Years (n)

• Class of problems where the number of time periods

(years) is the unknown
• In single payment type problems, solving for n is
straight forward

MENG 300 - Engineering Economics

• In other types of cash flow profiles, solving for n
requires trial and error or spreadsheet
• In Excel, given A, P, and/or F, and i% values apply:
= NPER(i%,A,P,F) to return the value of n

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 Dr. Yaser Al-Alawi
Example 8
• How long will it take for a $1000 to double if
the interest rate is 5% per year?
$2 k
i = 5%

MENG 300 - Engineering Economics

0 1 ....
n= ?

$1 k

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