ENGINEERING ECONOMICS

CHAPTER: TWO
COST OF MONEY

@INTEREST
@TIME VALUE OF MONEY
@ECONOMIC EQUIVALENCE

Mettu University (Nov. 2021) Abraham. A

Civil Engineering Department
The Time Value of Money
 The way interest operates reflects the fact that
money has a time value
 The amount of interest depends on length of time
and the rate of interest most of the time’ yearly
 It is cost to the borrower and an earning to the
lender above and beyond the sum borrowed or
loaned
The Time Value of Money
 Time value of money: The continuing offer of
banks to pay interest for the temporary use of other
people's money is ample proof that there is a time
value of money.
 Thus, we would always choose to receive $100
today rather than the promise of $100 to be paid
at a future date.
Relations for Discrete Cash Flows with End-of-
Period Compounding
Relations for Discrete Cash Flows with End-
of-Period Compounding
 The Time Value of Money
6

 The change in the amount of money over a given

time period is called Time value of money; it is the
most important concept in engineering economy
 Money has value
 Money can be leased or rented
 The payment is called interest
 If you put $100 in a bank at 9% interest for one time period
you will receive back your original $100 may be plus $9
Time Horizon
 Time span use to determine the investment for
construction, maintenance and benefits
 Mostly estimated to 20 to 30 years depending on
policy and type of road (for highway)
 Commonly termed as economic analysis period
 Interest Rate
8

 Interest is the manifestation of the time value of

money.
 It is the difference between an ending amount of
money and the beginning amount.
 Two types of interest:
 Interest paid
 Interest earned
 Interest Rate
9

 The time unit of the rate is called the interest

period.
 The most common interest period used to state an
interest is one year.
 Shorter period such as percent per month is also
used.
 If time unit is not stated, it is assumed to be one
year.
Interest Rate
 In highway, it is an extra cost charged to a highway
project if used elsewhere that earn higher rather
than highway
 Interest rate- amount of money in the future
 Discount rate- present equivalent amount of money
 Rate of Return (ROR)
11

 Interest earned over a specific period of time

is expressed as a percentage of the original
amount is called Rate of Return.
 The term Return of Investment (ROI) is used

equivalently with ROR in different industries

and settings especially with large capital
funds.
 Interest Rate and Rate of Return
12

 The numerical values of interest rate and

rate of return are the same but the term
interest rate paid is more appropriate for
the borrower’s perspective while the rate
of return earned is better for the
investor’s perspective.
 Simple Interest
13

 It is calculated using the principal only, ignoring any interest

accrued in preceding interest periods
 The total simple interest over several periods is computed as:
F = P + Pin
 Simple interest is interest that is computed only on the original
sum and not on accrued interest.
 Thus if you were to loan a present sum of money P to
someone at a simple annual interest rate i (stated as a
decimal)for a period of n years, the amount of interest you
would receive from the loan would be:
 Interest =(principal) (rate)(number of periods)
Simple Interest
 Total interest earned = P x i x n = Pin
 At the end of n years the amount of money due you,
F, would equal the amount of the loan .P plus the
total interest earned. That is, the amount of money
due at the end of the loan would be
 F = P + Pin
 or F = P(1 + in)
 Compound Interest
15

 Interest that is computed on the original unpaid debt

and the unpaid interest
 Compound interest is most commonly used in practice
 Amount of money due at the end of a loan
 Interest = (principal + all accrued interest)(interest rate)
 F = P(1+i)1(1+i)2…..(1+i)n or
 F = 𝒑(𝟏 + 𝒊)𝒏
Where,
 F = future value and P = present value
 2.1 Single Payment Amount
16

 Formula:
(1+i)n is the single payment compound amount factor.
 Functional notation:

F=P(F/P,i,n) F=5000(F/P,6%,10)
F = P(1+ i ) n
P= f(1/(1+i)n))
 Notation for Calculating a Present Value
17

 P=F(1/(1+i))n=F(1+i)-n is the
single payment present worth factor.
 Functional notation:

P=F(P/F,i,n) P=5000(P/F,6%,10)
Interpretation of (P/F, i, n): a present sum P, given a
future sum, F, n interest periods hence at an interest
rate i per interest period
 Problem
18

 Example 1: How long will it take for an investment

to double at 5% per year (a) simple interest and
(b) compound interest?
 Example 2: A construction company that specializes
in road construction made an investment 10 years
ago that is now worth $1.3M. How much was the
initial investment at an interest rate of 15% per
year if compound interest was conducted?
 Equivalence
19

 Relative attractiveness of different alternatives can

be judged by using the technique of equivalence
 We use comparable equivalent values of
alternatives to judge the relative attractiveness of
the given alternatives
 Equivalence is dependent on interest rate
 Compound Interest formulas can be used to
facilitate equivalence computations
 Technique of Equivalence
20

 Determine a single equivalent value at a point in

time for plan 1.
 Determine a single equivalent value at a point in
time for plan 2.

Both at the same interest rate and at the same time point.

•Judge the relative attractiveness of the

two alternatives from the comparable
equivalent values.
 Problem
21

 Example 3: At an interest rate of 8% per year,

10,000 birr today is equivalent to how much (a) 2
year from now and (b) 2 year ago?

 Answer: a) F=11664
b) P=8573.39
 Engineering Economic Analysis Calculation
22

 Generally involves compound interest formulas

(factors)
 Compound interest formulas (factors) can be
evaluated by using one of the three methods
 Interestfactor tables
 Calculator

 Spreadsheet
Given the choice of these two plans which would
you choose?
Year Plan 1 Plan 2
0 $5,000
1 $1,000
2 $1,000
3 $1,000
4 $1,000
5 $1,000
Total $5,000 $5,000
To make a choice the cash flows must be altered
so a comparison may be made. 23
 An Example of Future Value
24

Example 4 :If $500 were deposited in a bank savings

account, how much would be in the account three
years hence if the bank paid 6% interest
A) Compounded quarterly?

B) Compounded semi-annually?
C) compounded annually?
2.2 uniform series
A) present worth (P/A)
B) Capital recovery (A/P)
C) Compound amount (F/A)
D) Sinking Fund (A/F)

P=The equivalent present worth

A=equivalent uniform annual worth
A) uniform series: present worth (P/A)

 The objective of this mode of investment is to find the

present worth of an equal payment made at the end
of every interest period for n interest periods at an
interest rate of i compounded at the end of every
interest period.
 It is the P/A factor used to calculate the equivalent P
value in year 0 for a uniform end-of-period series of
A values beginning at the end of period 1 and
extending for n periods.
A) uniform series: present worth (P/A)

 P = present worth
 A = annual equivalent payment

 i = interest rate

 n = No. of interest periods

The term in brackets is the conversion factor referred

to as the uniform series present worth factor (USPWF).
A) uniform series: present worth Amount (P/A)

 Example 5: How much money should you be willing to

pay now for a guaranteed $600 per year for 9 years
starting next year, at a rate of return of 16% per
year?
 answer P = ($2763.93).

 Example 6: A company wants to set up a reserve which

will help the company to have an annual equivalent
amount of Rs. 1,000,000 for the next 20 years towards
its employees welfare measures. The reserve is assumed
to grow at the rate of 15% annually. Find the single-
payment that must be made now as the reserve amount.
 answer P = Rs. 6,259,331
uniform series: present worth (P/A) and Capital
Recovery Factor (A/P)
B) uniform series: Capital Recovery Amount (A/P)

 The objective of this mode of investment is to find

the annual equivalent amount (A) which is to be
recovered at the end of every interest period for n
interest periods for a loan (P) which is sanctioned
now at an interest rate of i compounded at the end
of every interest period

 The term in brackets is called the capital recovery

factor (CRF), or A/P factor. It calculates the
equivalent uniform annual worth A over n years for
a given P in year 0, when the interest rate is i.
 B) uniform series: Capital Recovery Amount (A/P)

Fig. Cash flow diagram of equal-payment series capital recovery

amount.

P = present worth (loan amount)

A = annual equivalent payment (recovery amount)
i = interest rate
n = No. of interest periods
B) uniform series: Capital Recovery Amount (A/P)

 Example 7: A bank gives a loan to a company to

purchase an equipment worth 1,000,000 Birr at an
interest rate of 18% compounded annually. This amount
should be repaid in 15 yearly equal installments. Find
the installment amount that the company has to pay to
the bank.
 Ans: A=196,402.78 Birr

 Example 8: An engineer who is about to retire has

accumulated $50, 000 in a savings account that pays
6% per year, compounded annually. Suppose that the
engineer wishes to withdraw a fixed sum of money at
the end of each year for 10 years. What is the
maximum amount that can be withdrawn?
 Ans: A= $6793.40
 C) Uniform series: Compound amount (F/A)

 In this type of investment mode, the objective is to find

the future worth of n equal payments which are made
at the end of every interest period till the end of the
nth interest period at an interest rate of i compounded
at the end of each interest period.
 C) Uniform series: Compound amount (F/A)

 The uniform series A begins at the end of year

(period) 1 and continues through the year of the given
F. The last A value and F occur at the same time.
 The term in brackets is called the uniform series
compound amount factor (USCAF), or F/A factor.
 When multiplied by the given uniform annual amount
A, it yields the future worth of the uniform series. It is
important to remember that the future amount F occurs
in the same period as the last A.
Example 10: The president of Ford Motor Company wants to know
the equivalent future worth of a $1 million capital investment each
year for 8 years, starting 1 year from now. Ford capital earns at a
rate of 14% per year.
Ans: F = 1M(F/A,14%,8)= $13,232,760.16
C) Uniform series: Compound amount (F/A)

 Example 11: A student plans to deposit $600 each

year in a savings account, over a period of 10 years. If
the bank pays 6% per year, compounded annually, how
much money will have accumulated at the end of the10-
year period?
 Ans: F = A x (FIA, i%, n) = $600(F/A, 6%, 10) =
$600(13.1808) = $7908.48

 Example 12: A person who is now 35 years old is

planning for his retired life. He plans to invest an equal
sum of $10,000 at the end of every years. The bank
gives 20% interest rate, compounded annually. Find the
maturity value of his account when he is 60 years old.
Ans: ($4,719,810.83)
 D) Uniform series: Sinking Fund (A/F)

 In this type of investment mode, the objective is to find

the equivalent amount (A) that should be deposited at
the end of every interest period for n interest periods
to realize a future sum (F) at the end of the nth
interest period at an interest rate of i.
D) Uniform series: Sinking Fund (A/F)

 A = equal amount to be deposited at the end of

each interest period
 n = No. of interest periods
 i = rate of interest
 F = single future amount at the end of the nth
period
 The expression in brackets in Equation is the A/F or
sinking fund factor. It determines the uniform annual
series A that is equivalent to a given future amount
F.
 Uniform series: Sinking Fund (A/F)

 The uniform series A begins at the end of year (period) 1

and continues through the year of the given F. The last A
value and F occur at the same time.

 Example 13: A company has to replace a present

facility after 15 years at an outlay of $500,000. It
plans to deposit an equal amount at the end of every
year for the next 15 years at an interest rate of 18%
compounded annually. Find the equivalent amount that
must be deposited at the end of every year for the next
15 years.
 A= $8,201.39
2.3 Arithmetic Gradient Factors :
present worth(P/G)
A) Arithmetic Gradient: present worth Amount (P/G)
B) Arithmetic Gradient: The equivalent uniform
annual series Amount (A/G)
C) Arithmetic Gradient: future worth Amount (F/G)
A) Arithmetic Gradient: present worth Amount (P/G)

 An arithmetic gradient series is a cash flow series that

either increases or decreases by a constant amount
each period. The amount of change is called the
gradient.
A) Arithmetic Gradient: present worth Amount (P/G)

 G = constant arithmetic change in cash flows from

one time period to the next; G may be +ve or -ve.
 CFn = base amount + ( n - 1 )G
G  1  i   1 n 
n
PG    n
i  i1  i n
1  i  
 The total present worth PT for a series that includes
a base amount A and conventional arithmetic
gradient must consider the present worth of both the
uniform series defined by A and the arithmetic
gradient series. The addition of the two results in PT
A) Arithmetic Gradient: present worth Amount (P/G)

 PT = PA ± PG
 Where: PA is the present worth of the uniform series
only,
 PG is the present worth of the gradient series only,
and
 the +or - sign is used for an increasing (+G) or
decreasing (-G) gradient,
 A) Arithmetic Gradient: present worth Amount (P/G)

Remember: The conventional arithmetic gradient starts

in year 2, and P is located in year 0.
It is expressed as an engineering economy relation ; PG = G(P/G,i,n)
Note: the gradient begins between years1 and 2. This is called a conventional gradient.
 A) Arithmetic Gradient: present worth Amount (P/G)

 Example 14: Neighboring parishes in Louisiana have

agreed to pool road tax resources already designated
for bridge refurbishment. At a recent meeting, the
engineers estimated that a total of $500 will be
deposited at the end of next year into an account for
the repair of old and safety-questionable bridges
throughout the area. Further, they estimate that the
deposits will increase by $100 per year for only 9
years thereafter, then cease. Determine the equivalent
(a) present worth, if public funds earn at a rate of 5%
per year.
A) Arithmetic Gradient: present worth Amount (P/G)
A) Arithmetic Gradient: present worth Amount (P/G)

 PT = 500(P/A,5%,10) + 100(P/G,5%,10)
 = 500(7.7217) + 100(31.6520)
 ANS: PT= $7026.05
 B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)

 The objective of this mode of investment is to find the

annual equivalent amount of a series with an amount A1
at the end of the first year and with an equal increment
(G) at the end of each of the following n -1 years with
an interest rate i compounded annually.
B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)

 The corresponding equivalent annual worth AT is the sum of

the base amount series annual worth AA and gradient series
annual worth AG. The formula to compute A under this
situation is:
 AT = A1±AG 1 
n
AG  G   
 i 1  i n
 1 

 The expression in brackets in Equation is called the arithmetic

gradient uniform series factor and is identified by (A/G,i,n).
B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)
B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)

 Example 15: from above example [14] determine

annual series amounts, if public funds earn at a rate
of 5% per year.

ANS: Here, too, it is necessary to consider the gradient

and the base amount separately. The total annual
series AT is occurs in years 1 through 10.
 AT = 500 + 100(A/G,5%,10) = 500 + 100(4.0991)

Ans: AT= $909.91 per year

B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)

 Example 16: A person is planning for his retired life. He has 10

more years of service. He would like to deposit 20% of his
salary, which is 4,000 br. at the end of the first year, and
thereafter he wishes to deposit the amount with an annual
increase of 500 br. for the next 9 years with an interest rate of
15%. Find the total amount at the end of the 10th year of the
above series.

 Solution: A1 = Rs. 4,000 G = Rs. 500 i = 15% n = 10 years

A=?&F=?
 B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)
A = A1±AG
A= A1+
A= A1 + G(A/G, i, n)
A= 4,000 + 500(A/G, 15%, 10)
A= 4,000 + 500*3.3832
A= 5,691.60 birr
This is equivalent to paying an equivalent amount of
5,691.60 at the end of every year for the next 10 years.
The future worth sum of this revised series at
the end of the 10th year is obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 5,691.60(20.304)
= 115,562.25 birr
B) Arithmetic Gradient: The equivalent uniform annual
series Amount (A/G)

 Example 17: A person is planning for his retired life. He has 10

more years of service. He would like to deposit Rs. 8,500 at the end
of the first year and thereafter he wishes to deposit the amount with
an annual decrease of Rs. 500 for the next 9 years with an interest
rate of 15%. Find the total amount at the end of the 10th year of
the above series.
 Solution: A1 = Rs. 8,500 G = – Rs. 500 i = 15% n = 10 years
A=?&F=?
 Ans: A=Rs. 6,808.40 F= Rs. 1,38,237.75
C) Arithmetic Gradient: future worth Amount (F/G)

 An F/G factor (arithmetic gradient future worth

factor) to calculate the future worth FG of a
gradient series can be derived by multiplying the
P/G and F/P factors. The resulting factor, (F/G,i,/i),
in brackets, and engineering economy relation is
 2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

 A geometric gradient series is a cash flow series that either increases or

decreases by a constant percentage each period. The uniform change is
called the rate of change.
g = constant rate of change, in decimal form, by which cash flow values
increase or decrease
from one period to the next. The gradient g can be + or - .
A = initial cash flow in year 1 of the geometric series
Pg = present worth of the entire geometric gradient series, including the initial
amount, A1
2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

 It is common for annual revenues and annual costs

such as maintenance, operations, and labor to go
up or down by a constant percentage, for example,
+5% or -3% per year. This change occurs every
year on top of a starting amount in the first year of
the project.
 Note that the initial cash flow A1 is not considered
separately when working with geometric gradients.
2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

  1  g 
n

1    
Pg  A1   1 i  
 i g 
 
 

The term in brackets is the (P/A,g,i,n) or geometric

gradient series present worth factor for values of g not
equal to the interest rate i.
 2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

The (P/A,g,i,n) factor calculates Pg in period t =0 for a

geometric gradient series starting in period 1 in the amount
A, and increasing by a constant rate of g each period.
2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

 Example 18: A coal-fired power plant has upgraded

an emission control valve. The modification costs only
$8000 and is expected to last 6 years with a $200
salvage value. 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 and maintenance cost at 8%
per year.
2.4) Geometric Gradient Series Factors: (Pg/A1) and
“g” present worth

 Solution:

Cost: always negative

Salvage: always positive
Revenue: always positive
 Nominal and Effective Interest Rates
62

 Nominal interest rate, r, is an interest rate that does

not include any consideration of compounding.
 Effective interest rate is the actual rate that applies
for a stated period of time .
 The compounding of interest during the time period
of the corresponding nominal rate is accounted for
by the effective interest rate. It is commonly
expressed on an annual basis as the effective
annual rate, ia, but any time basis can be used.
 Effective Annual Interest Rate
63

 Symbols used:
 r= nominal interest rate per year
 m= number of compounding period per year

 i= effective interest rate per compounding period

=r/m
 ia= effective interest rate per year

ia  1  i   1
m
 Effective Interest Rate for Continuous
64
Compounding
 When the compounding period is continuously,
the value of m approaches infinity, then the
effective interest rate can be calculated as:

i  e 1
r