Lecture in

Engineering Economy
by Engr. Denver G. Magtibay

But as it is written, Eye has not seen, nor

ear heard, neither have entered into the
heart of man, the things which God has
prepared for them that love him.
-1 Corinthians 2:9
A. Simple Interest
 It is the interest earned by the principal alone
over a given period of time usually counted in
number of days, months or in years.

1. Ordinary Simple Interest

Basis: 360 days/year, 30 days/month, 12 months/year
2. Exact Simple Interest
Basis: 365 days/year, 366 days/leap year

Note: A year which is exactly divisible by 4 is a leap

year. Century year not divisible by 400 are not
considered leap year.
Formulas (Simple Interest)

 I=Pin
 F=P+I =P(1+in)

I=interest
P=present worth or the principal
i=rate of interest per period
n=number of interest periods
F=future worth or the accumulated amount
 B. Types of Interest Rates
1. i = rate of interest per period
Ex. 3% per quarter, 5% per month, 10% per year
2. j = nominal rate of interest
It is the rate of interest that specifies the number of interest
periods in one year.
Ex. 12% compounded quarterly which means the interest is
paid 4 times a year of 3% per quarter
3. ie = effective rate of interest
It is the actual rate of interest in one year. Effective rate of
interest is equal to the rate of interest if compounded
annually. However, effective rate of interest is greater
than the rate of interest for other method of
compounding say, semi-annually, quarterly and etc.
i ≥j≥i
Therefore: e
Formulas (Types of Interest Rates)
 i = j/a
 ie = (1+i)a –1 = (1+j/a)a –1
Methods of Computing Number of payments per year (a)
Annually 1
Semi-annually 2
Quarterly 4
Bi-monthly 6
Monthly 12
Daily 365

Note: To convert one nominal interest to another (i.e.

monthly to quarterly), just equate the effective
interest of the two.
 C. Compound Interest
 It is the method of paying interest where the interest
earned on the previous period is added to the
principal for the succeeding period and earn interest
too. Hence, in other words, it is the interest on the
top of interest.
Formulas (Compound Interest)
 F=P(1+i)na = P(1+j/a)na

a = number of payments per year

n = number of years
F = future worth
P = present worth
i = interest rate per period
j = nominal rate
D. Continuous Compounding of Interest
 If interest is compounded continuously it can be
noted that the rate of change of the principal is
equal to the product of the rate of interest
compounded continuously and the principal at
any time.
Formulas (Compounding Continuously)
 F = Pern
 ie = er-1

F = future worth
P = present worth
r = rate of interest compounded continuously
n = number of periods
E. Discount and Discount Rate
 Discount is the difference between the future
worth (F) and the present worth (P).
 Rate of discount is the discount on one unit
negotiable substance in one unit of time
Formula (Discount and Discount Rate)
 D = F – P = Fnd
 i = d/(1-d) = D/P

F = future worth
P = present worth
D = discount
d = discount rate
i = interest rate
n = number of interest periods

Note: Future worth is always greater than present worth

F. Cash Flow Diagram
 It is a graphical representation of cash flows (the vertical
arrows) which are drawn in time scale (the horizontal
number line).

Formula:
At the focal date,
∑inflows = ∑outflows
G. Annuity
 Annuity is a series of equal payments occurring
at equal period or interval of time, while
amortization is a method of paying debt
including the principal and interest which is
usually done in a series of equal payments
occurring at equal period or interval of time.
I. Ordinary Annuity
 It is an annuity where payments (A) are made at
Cash Flow Diagram
the end of each period.
(ordinary Annuity)

0 1 2 3 4(n-1) n

A A A A A A
A
F
P

 Note: In solving any kind of annuity, the nominal

interest rate should be appropriate with the
number of payments per year.
II. Deferred Annuity
 It is an annuity where payments are made late by
several periods from the start of annuity.

Cash Flow Diagram

(Deferred Annuity)
0 1 2 3……...n
0 1 2 m

A A A A A
F
n periods
P m + n periods
III. Annuity Due
 It is the annuity where the payments started at
the beginning of the annuity periods.

Cash Flow Diagram

(Annuity Due)

1 2 3 4 5 (n-1) n

A A A A A A A

F
P n – 1 periods
IV. Perpetuity
 It is an annuity where payments are made
indefinitely or forever.

0 1 2 3....... n → 

A A A A

P
V. Annuity w/ Continuous Compounding
 Simply an ordinary annuity with a given
continuous compounding interest rate.

1. Convert the compounded continuously interest

(r) to effective interest: ie = er-1
2. Use the formula of ordinary annuity.
Calculator Techniques!!!

 Ordinary Annuity
Start=1 End=na
 Annuity Due
Start=0 End=na-1
 Deferred Annuity
Start=stated End=stated
H. Applications of Annuity
 There are so many topics where the principle of
annuity can be applied. To mention some of them,
we have the following:

I. Bond Value
II. Capitalized Cost
III. Arithmetic Gradient
IV. Geometric Gradient
I. Bond Value
 It is the present worth or cost of a bond or the amount
being paid to own a bond.

 Note: I = Fr if I is not given, C = F if not given

P=bond value
I=income per period through ownership of bond
F=face value, par value or the amount printed
r=bond rate
i=yield of interest
n=maturity period
C=redemption cost, the value of the bond in the end
II. Capitalized Cost (CC)
 It is the sum of the first cost (FC) and the present
worth of the following costs:
a. Annual Maintenance and Operational Cost (MC)
b. Cost of Repair (CR)
c. Renewal Cost (RC)

However, these 3 factors may not be all present in

a certain property but definitely at least one of
the 3 factors will be included. Furthermore,
capitalized cost may be considered the amount
of money needed at present to purchase a
property or to construct a project for continuous
service.
Formula (Capitalized Cost)

L=useful life
k=interval of repair (factor of L)
Note: If RC is not given, use RC=FC-SV-CR where
SV=salvage value
If MC is not constant, use the formula of annuities.
III. Arithmetic Gradient
 It is a series of payments with common difference
occurring at equal period or interval of time.

P=PA+PG F=FA+FG
Calculator Techniques!!!
1. Go to mode STAT, then choose A+BX
X Y
1 Initial Payment
2 Initial Payment + increase

2. Go to Regression, then store a to A, store b to B

3. Then, use this formula

n= number of periods
IV. Geometric Gradient
 It is a series of payments with common ratio
occurring at equal period or interval of time.
Calculator Techniques!!!
1. Go to mode STAT, then choose ABX
X Y
1 Initial Payment
2 Initial Payment +/- (Initial Payment x rate of change)

2. Go to Regression, then store a to A, store b to B

3. Then, use this formula

n= number of periods
I. Depreciation
 Depreciation is usually defined as the decrease in
worth of property due to passage of time. There
are two types of depreciation namely,
1. Physical Depreciation – it is due to the
deterioration caused by various chemical and
mechanical factors on the materials composing
the property.
2. Functional Depreciation – it is due to the
decrease in the demand of the equipment of
which it was designed such as obsolescence
and changes in methods of production.
I. Straight Line Method (SLM)
 It is the simplest method in evaluating
depreciation. The depreciation charge (d) is
kept constant every year.

d = constant depreciation charge per year

Dn = total depreciation after n years
Cn = book value after n years
Co = original cost
CL = salvage value
L = useful life
II. Sinking Fund Method (SFM)
 It is a method of evaluating the depreciation
where interest is included and still the
depreciation charge is constant every year.

d = constant depreciation charge per year

Dn = total depreciation after n years
Cn = book value after n years
Co = original cost
CL = salvage value
L = useful life
i = interest rate
III. Sum of the Year’s Digit Method (SYDM)
 It is the method evaluating depreciation where the
depreciation charge varies from year to year.

SYD = sum of the year’s digit

dn = depreciation charge of nth year
Dn = total depreciation after n years
Cn = book value after n years
Co = original cost
CL = salvage value
IV. Declining Balance Method (DBM)
 Also called Matheson’s Formula, it is a method
of evaluating where the depreciation charge is a
constant percentage of a book value at the
beginning of the year. It can be noted that the
depreciation charge varies from year to year. It
is also called constant percentage method.

k= constant percentage in the declining book value

Note: DBM is not applicable if salvage value = 0

V. Double Declining Balance Method (DDBM)
 It is a method of evaluating depreciation which is
very similar to DBM.

This time the term k is simply replaced by 2/L.

 VI. Service-Output Method (SOM)
 This is a method of evaluating depreciation based on
the actual number of hours used or number of units
produced.

H = total number of expected operating hours within useful life

Hn = number of hours used at the nth year
T = total number of expected units within useful life
Tn = number of units produced at the nth year
J. Depletion
 For wasting assets the decrease in cost is not
called depreciation but depletion. It is the annual
charge that is made for the maintenance of
investment in wasting assets such as mines,
timber land, oil and gas wells.
Percentage or Depletion Allowance Method
 The depletion charge during a year is a fixed
percentage of the gross income. As required, it
should not exceed 50% of the net taxable income
for that year. Net taxable income is obtained by
subtracting all expenses excluding depletion charge
from the gross income and report whichever is less.
a. Gross Income (GI) Basis:
d=(fixed % allowance)x(GI)
b. Net Income (NI) Basis:
d=(0.50)(NI)
NI= GI – Expenses Excluding Depletion

Note: Compare the results of a and b and choose

whichever is less!
K. Sunk Cost (SC)
 It is defined as the cost which cannot be
recovered due to certain reasons. This cost or
expense is the result when trading in equipment
without knowing the current book value.
Furthermore, it is one among the costs
calculation where depreciation is applied.

SC = Cn – Trade In Value

Note: Trade in Value is also called Re-Sale Value

L. Break-Even Analysis
I. Break-Even Point (BEP)
II. Unhealthy Point (UHP)
III. Income and Profit Relation
 I. Break-Even Point (BEP)
 It is the point in economic study where the sales
volume is just enough to pay the costs of
production which are the fixed cost and the variable
cost. Hence, there is no profit or loss.

Sales or Income = Fixed Cost + Variable Cost

Fixed Cost = cost not affected by number of units
Variable Cost = affected by number of units
(Materials Cost per unit + Labor Cost per unit + Other
Variable Cost per unit) (x)
Sales or Income = (Selling Price per unit) (x)
x = number of units sold and needed at BEP
 II. Unhealthy Point (UHP)
 It is a point in economic study where the sales volume is
just enough to pay the dividends.

Sales or Income = Fixed Cost + Variable Cost +

Dividends
 III. Income and Profit Relation

Sales or Income = Fixed Cost + Variable Cost +

Dividends + Profit

Note: If the term profit is calculated NEGATIVE, it

means LOSS.
L. Comparison of Alternatives
In engineering practices, comparison and selection of
alternatives for a design, a process, an equipment, a method
is always encountered. In this light, the engineer should
know on what are the basis of selection.

These are,

1. The alternative should require the least amount of capital

2. The alternative can produce satisfactory results.

However, there are cases where it is necessary to choose the

alternative, requiring bigger amount of capital for a certain
reason
1. Present Worth Cost Method (PWCM)
1 − (1 + i ) − L 
PWC = C0 +  AAE   − C L (1 + i ) −L

 i 
2. Future Worth Cost Method (FWCM)
 (1 + i ) L
− 1
FWC = C0 (1 + i ) +  AAE 
L
 − CL
 i 
3. Equivalent Uniform Annual Worth Cost Method (EUACM)
C0 i CLi
EUAC = −L
+  AAE −
1 − (1 + i ) (1 + i ) − 1
L

Where:
∑AAE = sum of actual annual expenses
1. Annual Maintenance and Operational Cost
2. Taxes and Insurance
3. Annual Labor Cost
4. Annual Power Cost

Adopt the alternative with the least PWC, FWC, EUAC.

M. Benefit-Cost Ratio
 Before a government or an organization pursues
a project, there are several questions they need
to answer. Like, how much will be the cost, how
much will be the benefits and the disbenefits from
the projects and others. These questions are
commonly answered by considering the term
which is known as the Benefit-Cost Ratio (B/C). It
should be noted that B/C≥1 the project is good
and economical.