Ch.

2: How Time & Interest Affect Money

▪ Objective:
▪ Derive and use the engineering economy factors
to account for the time value of money
1. Single-payments [F/P and P/F]
2. Present worth [P/A] and capital recovery [A/P]
3. Sinking fund [A/F] and uniform series [F/A]
4. Arithmetic gradient [P/G and A/G] factors
5. Geometric gradient

Chapter 2 - 1 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

Sec. 2.1: Single-Payment Factors

(F/P and P/F)
▪ Derive factors to determine the present (P) or
future (F) worth of a cash flow
▪ F/P factor: To find F given P
▪ P/F factor: To find P given F Fn

i% per period
………
0 1 2 3 4 n-1 n

P0
Chapter 2 - 2 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Derivation by Recursion: F/P factor
▪ The factor P/F is known as the single-payment
present worth factor (SPPWF)
▪ What is the general formula?
i% Fn
F1 F2 F3 Fn-1

P = given

F1 = P + Pi = P(1+i)
F2 = F1(1+i)  F2 = P(1+i)(1+i) … thus,
F2 = P(1+i)2
F3 = F2(1+i) = P(1+i)2 + P(1+i)2 i
= P(1+i)2 (1+i) … thus,
F3 = P(1+i)3
Chapter 2 - 3 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

F/P: Find F given P

▪ In general:
▪ Standard Notation: F = P(F/P, i%, n)
▪ Factor Formula : Fn = P(1+i)n
▪  Fn finds the future worth of P
▪ Excel Function: =FV(i%, n, , P)

Chapter 2 - 4 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 P/F factor – Discounting Back in Time
▪ P/F factor brings a single future sum back to a
specific point in time
▪ Solve for P in terms of F
P = F [ 1/ (1+i)n] = F(1+i)-n
▪ Thus:
Standard Notation: P = F(P/F, i%, n)
Excel Function: =PV(i%, n, , F)

Chapter 2 - 5 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

Example 1
▪ An industrial engineer received a bonus of $12,000 that
he will invest now. He wants to calculate the equivalent
value after 24 years, when he plans to use all the
resulting money as the down payment on an island
vacation home. Assume a rate of return of 8% per year
for each of the 24 years. Find the amount he can pay
down, using both the standard notation and the factor
formula.

Find F
8%
......
0 1 2 3 22 23 24

$12,000
Chapter 2 - 6 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Example 2
▪ An independent engineering consultant reviewed records
and found that the cost of office supplies varied as shown in
the pie chart. If the engineer wants to know the equivalent
value in year 10 of only the three largest amounts, what is it
at an interest rate of 5% per year?.

Chapter 2 - 7 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

Ch. 2: How Time & Interest Affect Money

Continue ……

1. Single-payments [F/P and P/F]

2. Present worth [P/A] and capital recovery [A/P]
3. Sinking fund [A/F] and uniform series [F/A]
4. Arithmetic gradient [P/G and A/G] factors
5. Geometric gradient

Chapter 2 - 8 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Sec. 2.2: P/A and A/P Factors – Uniform
Series
▪ Annuity Cash Flows – conditions
▪ cash flows are equal,
▪ uninterrupted and
▪ flow at the end of each interest period
▪ To find P given A - Cash flow profile for P/A
factor are as follows
Find P i% per interest period
......
0 1 2 3 n-2 n-1 n
$A per interest period
(given)

Chapter 2 - 9 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

(P/A) Factor

 (1 + i)n − 1
P = A n 
for i  0
 i (1 + i ) 
▪ This expression will convert an annuity cash flow (A)
to an equivalent present worth (P) amount one
period to the left of the first annuity cash flow
▪ Notation: (P/A,i%,n) factor
▪ Excel: =PV(i%,n,A)

Chapter 2 - 10 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Capital Recovery Factor
(A/P, i%, n)
▪ The (A/P, i%, n) factor ….

 i(1 + i)n 
A= P 
 (1 + i) − 1
n

▪ Excel: =PMT(i%, n, P)

Chapter 2 - 11 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Example 3
▪ 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?
16%
A = $600

0 1 2 3 4 5 6 7 8 9

P=?

Chapter 2 - 12 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Sec. 2.3: Sinking Fund and Uniform-
Series Compound Factors (F/A and A/F)
▪ Suppose we are interested in the future amount
F of a fund to which we contribute A dollars each
period and on which we earn interest at a rate of
i per period
▪ Cash flow diagram for (A/F) factor
F = given

i% / period
0 1 2 3 4
……… n-1 n

………
A=?
Chapter 2 - 13 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Derivation by Substitution: A/F Factor

▪ Recall what we derived earlier for A/P and P/F;

 i(1 + i)n   1 
A= P  , but P = F  n 
 (1 + i) − 1  (1 + i) 
n

 1   i(1 + i)n   i 
A= F n   A= F 
 (1 + i)   (1 + i) − 1  (1 + i ) − 1 
n n

Chapter 2 - 14 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 A/F: Find A given F
▪ In general:
▪ Standard Notation: A = F(A/F, i%, n)

▪ Factor Formula, or  
i
A =: F 
(sinking fund factor), A/F 
 (1 + i ) − 1 
n

▪ Excel Function: PMT(i%, n, , F)

Chapter 2 - 15 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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F/A Factor – From the A/F Factor

▪ The previous equation can be rearranged to find
F for a stated A series in periods 1 through n
F = given

i% / period
0 1 2 3 4
……… n-1 n

………
A=?

▪ Solve for F in  (1 + i)n − 1

▪ terms of A F=A  
 i 
Chapter 2 - 16 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 F/A: Find F given A
▪ In general:
▪ Standard Notation: F = A(F/A, i%, n)

 (1 + i)n − 1
▪ F=A 
Factor Formula, F/A: 
 i 
▪ Excel Function: FV(i%, n, , A)

▪ Note: F occurs in the same period as the last A

Chapter 2 - 17 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Example 4
Formosa Plastics has major fabrication plants in
Texas and Hong Kong. It is desired to know the
future worth of a $1 million invested at the end of
each year for 8 years, starting one year from now.
The interest rate is assumed to be 14% per year.
i = 14% F=?
0 1 2 3 4 5 6 7 8

A = $1,000,000

Chapter 2 - 18 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Example 5
How much money must Carol deposit every year
starting 1 year from now at 5.5% per year in order to
accumulate $6000 ?
F = $6000

i = 5.5%
0 1 2 3 4 5 6 7

A=?

Chapter 2 - 19 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Ch. 2: How Time & Interest Affect Money

Continue ……

1. Single-payments [F/P and P/F]

2. Present worth [P/A] and capital recovery [A/P]
3. Sinking fund [A/F] and uniform series [F/A]
4. Arithmetic gradient [P/G and A/G] factors
5. Geometric gradient

Chapter 2 - 20 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Sec. 2.5: Arithmetic Gradient Factors
(P/G and A/G)
▪ An arithmetic gradient is a cash flow series that
either increases or decreases by a constant
amount
▪ The cash flow, whether income or payment,
changes by the same arithmetic amount each
period, known as gradient (G)
▪ For example: if an engineer predicts that the
cost of maintaining a machine will increase by
$500 per year until the machine is retired, a
gradient series is involved and the amount of
the gradient is $500

Chapter 2 - 21 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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P/A Factor
How to find the present worth (P) for the following
example?

P=?

i = given
0 1 2 3 4
……… n-1 n

………
A = given

Chapter 2 - 22 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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11
 Linear Gradient
But what if the annuity cash flows increased (or
decreased) with the same arithmetic amount each
period as follow?

P=?

i = given
0 1 2 3 4
……… n-1 n

………
CFn = given
The Base Annuity
= A (constant)

Chapter 2 - 23 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Arithmetic Gradient Factors

▪ The Two Components are (P/A + P/G):
▪ The base annuity component – find P/A
▪ The Gradient component – find P/G
▪ The objective is to find a closed form
expression for the Present Worth of an
arithmetic gradient

Requires 2 separate calculations!

Chapter 2 - 24 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Example: Arithmetic Gradient Series

▪ The diagram is of an arithmetic gradient series

with a base amount of $1500 and a gradient of
$50
▪ The origin of the series is at the end of the first
period

Chapter 2 - 25 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Arithmetic Gradient Factors

▪ The gradient G can be either positive or
negative:
▪ If G > 0, the series is referred to as an
increasing gradient series
▪ If G < 0, it is a decreasing gradient series
▪ The present worth point is always one time
period to the left of the first cash flow in the
series or,
▪ Two periods to the left of the first gradient cash
flow!

Chapter 2 - 26 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Arithmetic Gradient Factors
▪ Focus Only on the gradient Component
(n-1)G

ZERO “G” (n-2)G

‫داﯾﻣﺎ اول ﻛﺎش ﻓﻠو ھو‬ +2G

‫اﻻﻧﯾوﺗﻲ ﺳوا ﻛﺎن ال‬ +1G
‫ﺟﻲ ﺗزﯾد او ﺗﻧﻘص‬

Removed Base annuity

0 1 2 3 n-1 N

Chapter 2 - 27 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Arithmetic (Linear) Gradient Series

▪ Calculating cash flow in year n (CFn):
CFn = base amount + (n-1)G
Example (2.8)
▪ The base amount is $80,000 and the total revenue
increases is
▪ Increase in 9 years = 200,000 – 80,000 = $120,000
▪ G = increase / (n-1) = 120,000 / (9-1) = $15,000.00

Chapter 2 - 28 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Present Worth Factor – P/G Factor
n for g is the The Present worth factor (P/G) can be expressed in
same n for A the following form:
gradient series
P = G(P/G, i%, n) present-worth factor

G  (1 + i)n − 1 n 
P=  − 
i  i(1 + i) n
(1 + i)n 

Remember, the present worth point of any linear

gradient is 2 periods to the left of the 1-G cash
flow or, 1 period to the left of the “0-G” cash flow.

Chapter 2 - 29 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Present Worth Factor – P/G Factor

▪ Conversion diagram from an arithmetic gradient
to a present worth

Chapter 2 - 30 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 The A/G factor G – (A/G, i%, n)
▪ Convert an arithmetic gradient G (without the
base amount) for n years into an equivalent
uniform series of A value
▪ A = G(P/G, i%, n) (A/P, i%, n)

G  (1 + i)n − 1 n   i(1 + i)n 

P=  − 
i  i(1 + i)n (1 + i)n   (1 + i)n − 1

1 n 
A=G − 
 i (1 + i ) − 1 
n

Chapter 2 - 31 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Annul Series Factor – A/G Factor

▪ Conversion diagram from an arithmetic gradient
series to an equivalent uniform annual series

Chapter 2 - 32 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 F/G factor – G(F/G, i%, n)
▪ Convert an arithmetic gradient G (without the
base amount) for n years into an equivalent
future value at year n
▪ The future worth factor (F/G) can be expressed in
the following form:
F = G(F/G, i%, n)

Chapter 2 - 33 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Example – Future Worth Factor

▪ Suppose that you make a series of annual
deposits into a bank account that pays 10%
interest. The initial deposit at the end of the first
year is $1,200. The deposit amounts decline by
$200 in each of the next four years. How much
would you have immediately after the fifth
deposit?

Chapter 2 - 34 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Example – Future Worth Factor
F = F1 – F2

F = A1(F/A,10%,5) – $200(F/G,10%,5)
= $1,200(6.105) – $200(11.051) = $5,115.00

Chapter 2 - 35 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Ch. 2: How Time & Interest Affect Money

Continue ……

1. Single-payments [F/P and P/F]

2. Present worth [P/A] and capital recovery [A/P]
3. Sinking fund [A/F] and uniform series [F/A]
4. Arithmetic gradient [P/G and A/G] factors
5. Geometric gradient

Chapter 2 - 36 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Sec. 2.6: Geometric Gradient Series
Factors
▪ What is the arithmetic (or linear) gradient?
▪ In geometric gradient series, cash flow
increases or decreases from period to period by
a constant percentage (%)
▪ Define “g” as the constant rate of change in
decimal form by which amounts increase or
decrease from one period to the next

Chapter 2 - 37 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Cash flow of Increasing Geometric

Gradient Series

▪ Typical Geometric Gradient

Profile
▪ Let A1 = the first cash flow
in the series
▪ A1 is NOT
considered a
base amount as
in linear gradient

Chapter 2 - 38 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Cash flow of decreasing Geometric
Gradient Series

There is no
BASE ANNUITY
for a Geometric
Gradient!

Chapter 2 - 39 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Derivation of (P/A, g, i, n)
We need to find the value of the present worth at time =
0 based on geometric gradient series cash flows starting
at the end of period 1 with an amount A1 and increasing
by a constant rate of g each period
  1 + g n 
1 −   
1+ i  
Pg = A1(P/A, g, i% ,n) Pg = A1   gi
 i−g 
 
 
Note: If g = i (special case) – we have a division by “0” – undefined

nA1
For the case g = i Pg =
(1 + i)

Chapter 2 - 40 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 To Use the (P/A,g,i,n) Factor
▪ A1 is the starting cash flow
▪ There is NO base amount associated with a
geometric gradient
▪ The remaining cash flows are generated from
the A1 starting value
▪ No tables available to tabulate this factor…too
many combinations of i% and g% to support
tables
▪ No spreadsheet built-in function for this factor!

Chapter 2 - 41 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Example – Geometric Gradient Factor

▪ Engineers at a specific company need to make some
modifications to an existing machine. The
modification costs only $8,000 and is expected to
last 6 years with a $1,300 salvage value. The
maintenance cost is expected to be high at $1,700
the first year, increasing by 11% per year thereafter.
Determine the equivalent present worth of the
modification and maintenance cost. The interest rate
is 8% per year.

Chapter 2 - 42 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Solution – Geometric Gradient Factor
▪ First, draw a cash flow diagram to
represent the model

Chapter 2 - 43 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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Example – Geometric Gradient Factor

▪ The present worth value is comprised of three
components
o The present modification cost = $8,000
o The present value of the future salvage value
o The present value of all the maintenance
values throughout the 6 years and these are
represented by the geometric gradient series

PT = –8,000 + 1,300(P/F,8%,6) – Pg

Chapter 2 - 44 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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 Example – Geometric Gradient Factor

PT = –8,000 + 1,300(P/F, 8%, 6) – Pg

But, Pg = A1(P/A, g, i, n)

Pg = 1,700 (P/A,11%,8%,6)

PT = – 8,000 + 819.26 – 1,700 × 5.9559

= $ –17,305.85

Chapter 2 - 45 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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End of Chapter 2

Chapter 2 - 46 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

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