Haery Sihombing/ IP

USING COST ANALYSIS IN EVALUATION

1. WHY DO ENGINEERS NEED TO LEARN ABOUT ECONOMICS?

Ages ago, the most significant barriers to engineers were technological. The things that engineers wanted
to do, they simply did not yet know how to do, or hadn't yet developed the tools to do. There are certainly
many more challenges like this which face present-day engineers. However, we have reached the point in
engineering where it is no longer possible, in most cases, simply to design and build things for the sake
simply of designing and building them. Natural resources (from which we must build things) are becoming
more scarce and more expensive. We are much more aware of negative side-effects of engineering
innovations (such as air pollution from automobiles) than ever before.

For these reasons, engineers are tasked more and more to place their project ideas within the larger
framework of the environment within a specific planet, country, or region. Engineers must ask themselves
if a particular project will offer some net benefit to the people who will be affected by the project, after
considering its inherent benefits, plus any negative side-effects (externalities), plus the cost of consuming
natural resources, both in the price that must be paid for them and the realization that once they are used
for that project, they will no longer be available for any other project(s).

Simply put, engineers must decide if the benefits of a project exceed its costs, and must make this
comparison in a unified framework. The framework within which to make this comparison is the field of
engineering economics, which strives to answer exactly these questions, and perhaps more. The
Accreditation Board for Engineering and Technology (ABET) states that engineering "is the profession in
which a knowledge of the mathematical and natural sciences gained by study, experience, and practice is
applied with judgment to develop ways to utilize, economically, the materials and forces of nature for the
benefit of mankind".1

It should be clear from this discussion that consideration of economic factors is as important as regard for
the physical laws and science that determine what can be accomplished with engineering. The following
figure shows how engineering is composed of physical and economic components:

Figure 1 : Physical and Economic Components of an Engineering System

Figure 1 shows how engineering is composed of physical and economic components.

1. Physical Environment : Engineers produce products and services depending on physical laws
(e.g. Ohm's law; Newton's law).

Physical efficiency takes the form:

system output(s)
Physical (efficiency ) = -------------------
system input(s)

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2. Economic Environment : Much less of a quantitative nature is known about economic

environments -- this is due to economics being involved with the actions of people, and the
structure of organizations.

Satisfaction of the physical and economic environments is linked through production and
construction processes. Engineers need to manipulate systems to achieve a balance in attributes
in both the physical and economic environments, and within the bounds of limited resources.
Following are some examples where engineering economy plays a crucial role:

a. Choosing the best design for a high-efficiency gas furnace

b. Selecting the most suitable robot for a welding operation on an automotive assembly line
c. Making a recommendation about whether jet airplanes for an overnight delivery service
should be purchased or leased
d. Considering the choice between reusable and disposable bottles for high-demand
beverages

With items 1 and 2 in particular, note that coursework in engineering should provide sufficient
means to determine a good design for a furnace, or a suitable robot for an assembly line, but it is
the economic evaluation that allows the further definition of a best design or the most suitable
robot.

In item 1 of the list above, what is meant by " high-efficiency"? There are two kinds of efficiency
that engineers must be concerned with. The first is physical efficiency, which takes the form:

System output(s)
Economic (efficiency ) = -----------------
System input(s)

For the furnace, the system outputs might be measured in units of heat energy, and the inputs in units of
electrical energy, and if these units are consistent, then physical efficiency is measured as a ratio
between zero and one. Certain laws of physics (e.g., conservation of energy) dictate that the output from
a system can never exceed the input to a system, if these are measured in consistent units. All a
particular system can do is change from one form of energy (e.g. electrical) to another (e.g., heat). There
are losses incurred along the way, due to electrical resistance, friction, etc., which always yield
efficiencies less than one. In an automobile, for example, 10-15% of the energy supplied by the fuel might
be consumed simply overcoming the internal friction of the engine. A perfectly efficient system would be
the theoretically impossible Perpetual Motion Machine!

The other form of efficiency of interest to engineers is economic efficiency, which takes the form:

system worth
Economic (efficiency ) = -----------------
system cost

You might have heard economic efficiency referred to as "benefit-cost ratio". Both terms of this ratio are
assumed to be of monetary units, such as dollars. In contrast to physical efficiency, economic efficiency
can exceed unity, and in fact should, if a project is to be deemed economically feasible. The most difficult
part of determining economic efficiency is accounting for all the factors which might be considered
benefits or costs of a particular project, and converting these benefits or costs into a monetary equivalent.
Consider for example a transportation construction project which promises to reduce everyone's travel
time to work. How do we place a value on that travel time savings? This is one of the fundamental
questions of engineering economics.

In the final evaluation of most ventures, economic efficiency takes precedence over physical efficiency
because projects cannot be approved, regardless of their physical efficiency, if there is no conceived
demand for them amongst the public, if they are economically infeasible, or if they do not constitute the
"wisest" use of those resources which they require.

There are numerous examples of engineering systems that have physical design but little economic worth
(i.e it may simply be too expensive !!). Consider a proposal to purify all of the water used by a large city by

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boiling it and collecting it again through condensation. This type of experiment is done in junior physical
science labs every day, but at the scale required by a large city, is simply too costly.

ROLE OF UNCERTAINTY IN ENGINEERING

When conducting engineering economic analyses, it will be assumed at first, for simplicity, that benefits,
costs, and physical quantities will be known with a high degree of confidence. This degree of confidence
is sometimes called assumed certainty. In virtually all situations, however, there is some doubt as to the
ultimate values of various quantities. Both risk and uncertainty in decision-making activities are caused by
a lack of precise knowledge regarding future conditions, technological developments, synergies among
funded projects, etc. Decisions under risk are decisions in which the analyst models the decision problem
in terms of assumed possible future outcomes, or scenarios, whose probabilities of occurrence can be
estimated. Of course, this type of analysis requires an understanding of the field of probability. Decisions
under uncertainty, by contrast, are decision problems characterized by several unknown futures for which
probabilities of occurrence cannot be estimated. Other less objective means exist for the analysis of such
problems.

For the purposes of this brief tutorial, we cannot delve further into the analytical extensions required to
accommodate risk or uncertainty in the decision process. We must recognize that these things exist,
however, and be careful about reaching strong conclusions based on data which might be susceptible to
these. Because engineering is concerned with actions to be taken in the future, an important part of the
engineering process is improving the certainty of decisions with respect to satisfying the objectives of
engineering applications.

THE ENGINEERING PROCESS

Engineering activities dealing with elements of the physical environment take place to meet human needs
that arise in an economic setting. The engineering process employed from the time a particular need is
recognized until it is satisfied may be divided into a number of phases:
1. Determination of Objectives
This step involves finding out what people need and want that can be supplied by engineering.
People's wants may arise from logical considerations, emotional drives, or a combination of the
two.
2. Identification of Strategic Factors
The factors that stand in the way of attaining objectives are known as limiting factors. Once the
limiting factors have been identified, they are examined to locate strategic factors -- those factors
which can be altered to remove limitations restricting the success of an undertaking. A woman
who wants to empty the water from her swimming pool might be faced with the limiting factor that
she only has a bucket to do the job with, and this would require far greater time and physical
exertion than she has at her disposal. A strategic factor developed in response to this limitation
would be the procurement of some sort of pumping device which could do the job much more
quickly, with almost no physical effort on the part of the woman.
3. Determination of means (engineering proposals)
This step involves discovering what means exist to alter strategic factors in order to overcome
limiting factors. In the previous example, one means was to buy (or rent) a pump. Of course, if the
woman had a garden hose, she might have been able to siphon the water out of the pump. In
other engineering applications, it may be necessary to fabricate the means to solve problems
from scratch.
4. Evaluation of Engineering Proposals
It is usually possible to accomplish the same result with a variety of means. Once these means
have been described fully, in the form of project proposals, economic analysis can be employed
to determine which among them, if any, is the best means for solving the problem at hand.
5. Assistance in Decision Making
It is commonplace for the final decision-making responsibility to fall on the head(s) of someone
other than the engineer(s). The person(s) so charged, however, may not be sufficiently
knowledgeable about the technical aspects of a proposal to determine its relevant worth
compared to other means. The engineer can help to bridge this gap.

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ENGINEERING ECONOMIC STUDIES

The four key steps in planning an economic study are :
1. Creative Step : People with vision and initiative adopt the premise that better opportunities exist
than are known to them. This leads to research, exploration, and investigation of potential
opportunities.
2. Definition Step : System alternatives are synthesized with economic requirements and physical
requirements, and enumerated with respect to inputs/outputs.
3. Conversion Step : The attributes of system alternatives are converted to a common measure so
that systems can be compared.
Future cash flows are assigned to each alternative, consisting of the time-value of money.
4. Decision Step : Qualitative and quantitative inputs and outputs to/from each system form the
basis for system comparison and decision making. Decisions among system alternatives should
be made on the basis of their differences. For a small number of real world systems there will be
complete knowledge. All facts/information and their relationships, judgements and predictive
behavior become a certainty. For most systems, however, even after all of the data that can be
bought to bear on it has been considered, some areas of uncertainty are likely to remain. If a
decision must be made, these areas of uncertainty must be bridged by consideration of non-
quantitative data/information, such as common sense, judgement and so forth.

Decisions among system alternatives should be made on the basis of their differences.
For a small number of real world systems there will be complete knowledge. Dll facts/information
and their relationships, judgements and predictive behavior become a certainty.

For most systems, however, even after all of the data that can be bought to bear on it has been
considered, some areas of uncertainty are likely to remain. If a decision must be made, these
areas of uncertainty must be bridged by consideration of non-quantitative data/information, such
as common sense, judgement and so forth.

Examples :

1. Infrastructure expenditure decision

2. Replace versus repair decisions
3. Selection of inspection method
4. Selection of a replacement for an equipment

2. WHAT IS COST ANALYSIS?

Cost analysis (also called economic evaluation, cost allocation, efficiency assessment, cost-
benefit analysis, or cost-effectiveness analysis by different authors) is currently a somewhat
controversial set of methods in program evaluation. One reason for the controversy is that these terms
cover a wide range of methods, but are often used interchangeably.

At the most basic level, cost allocation is simply part of good program budgeting and accounting
practices, which allow managers to determine the true cost of providing a given unit of service (Kettner,
Moroney, & Martin, 1990). At the most ambitious level, well-publicized cost-benefit studies of early
intervention programs have claimed to show substantial long-term social gains for participants and cost
savings for the public (Berreuta-Clement, Schweinhart, Barnett, et al., 1984). Because these studies have
been widely cited and credited with convincing legislators to increase their support for early childhood
programs, some practitioners advocate making more use of cost-benefit analysis in evaluating social
programs (Barnett, 1988, 1993). Others have cautioned that good cost-benefit or cost-effectiveness
studies are complex, require very sophisticated technical skills and training in methodology and in
principles of economics, and should not be undertaken lightly (White, 1988). Whatever position you take
in this controversy, it is a good idea for program evaluators to have some understanding of the concepts
involved, because the cost and effort involved in producing change is a concern in most impact
evaluations (Rossi & Freeman, 1993).

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THREE TYPES OF COST ANALYSIS IN EVALUATION:

Cost allocation, cost-effectiveness analysis, and cost-benefit analysis represent a continuum of
types of cost analysis which can have a place in program evaluation. They range from fairly simple
program-level methods to highly technical and specialized methods. However, all have specialized and
technical aspects. If you are not already familiar with these methods and the language used, you should
plan to work with a consultant or read some more in-depth texts (see some suggested references at the
end of this discussion) before deciding to attempt them.

COST ALLOCATION: Cost allocation is a simpler concept than either cost-benefit analysis or cost-
effectiveness analysis. At the program or agency level, it basically means setting up budgeting and
accounting systems in a way that allows program managers to determine a unit cost or cost per unit of
service. This information is primarily a management tool. However, if the units measured are also
outcomes of interest to evaluators, cost allocation provides some of the basic information needed to
conduct more ambitious cost analyses such as cost-benefit analysis or cost-effectiveness analysis. For
example, for evaluation purposes, you might want to know the average cost per child of providing an
after-school tutoring program, including the costs of staff salaries, snacks, and other overhead costs.

Besides budget information, being able to determine unit costs means that you need to be collecting the
right kind of information about clients and outcomes. In many agencies, the information recorded in
service records is based on reporting requirements, which are not always in a form that is useful for
evaluation. If staff in a prenatal clinic simply report the number of clients served by gender, for example,
you might know only that 157 females were served in March. For an evaluation, however, you might want
to be able to break down that number in different ways. For example, do young first-time mothers usually
require more visits than older women? Do single mothers or women with several children miss more
appointments? Is transportation to appointments more of a problem for women who live in rural areas?
Are any client characteristics commonly related to important outcomes such as birth weight of the the
baby? Deciding how to collect enough client and service data to give useful information, without
overburdening staff with unnecessary paperwork requirements, requires a lot of planning. Larger
agencies often hire experts to design data systems, which are called MIS or management-and-
information-systems.
If you are working for an existing agency, your ability to separate out unit costs for services or outcomes
may depend on the systems that are already in place for budgeting, accounting, and collecting service
data. However, if you are in a position to influence these functions, or need to supplement an existing
system, there are a number of texts that discuss the pros and cons of different ways of budgeting,
accounting, and designing MIS or management-and-information-systems (see Kettner, Moroney & Martin,
1990).

COST-EFFECTIVENESS AND COST-BENEFIT STUDIES

Most often, cost-effectiveness and cost-benefit studies are conducted at a level that involves more than
just a local program (such as an individual State Strengthening project). Sometimes they also involve
following up over a long period of time, to look at the long-term impact of interventions. They are often
used by policy analysts and legislators to make broad policy decisions, so they might look at a large
federal program, or compare several smaller pilot programs that take different approaches to solving the
same social problem. People often use the terms interchangeably, but there are important differences
between them.

COST-EFFECTIVENESS ANALYSIS: Cost-effectiveness analysis assumes that a certain benefit or

outcome is desired, and that there are several alternative ways to achieve it. The basic question asked is,
"Which of these alternatives is the cheapest or most efficient way to get this benefit?" By
definition, cost-effectiveness analysis is comparative, while cost-benefit analysis usually considers only
one program at a time. Another important difference is that while cost-benefit analysis always compares
the monetary costs and benefits of a program, cost-effectiveness studies often compare programs on the
basis of some other common scale for measuring outcomes (eg., number of students who graduate from
high school, infant mortality rate, test scores that meet a certain level, reports of child abuse). They
address whether the unit cost is greater for one program or approach than another, which is often much
easier to do, and more informative, than assigning a dollar value to the outcome (White, 1988).

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COST-BENEFIT ANALYSIS: The basic questions asked in a cost-benefit analysis are, "Do the
economic benefits of providing this service outweigh the economic costs" and "Is it worth doing
at all"? One important tool of cost-benefit analysis is the benefit-to-costs ratio, which is the total
monetary cost of the benefits or outcomes divided by the total monetary costs of obtaining them. Another
tool for comparison in cost-benefit analysis is the net rate of return, which is basically total costs minus
the total value of benefits.

The idea behind cost-benefit analysis is simple: if all inputs and outcomes of a proposed alternative can
be reduced to a common unit of impact (namely dollars), they can be aggregated and compared. If
people would be willing to pay dollars to have something, presumably it is a benefit; if they would pay to
avoid it, it is a cost. In practice, however, assigning monetary values to inputs and outcomes in social
programs is rarely so simple, and it is not always appropriate to do so (Weimer & Vining, 1992;
Thompson, 1982; Zeckhauser, 1975).

An example will illustrate some of the differences between Cost-Effectiveness and Cost-Benefit
studies, what they can tell you, and some of the issues that neither can effectively address:
"Suppose the drop-out rate in an inner-city high school is 50%. Prevention Program A enrolls 20 students,
costs $20,000, and 15 of the 20 students (75%) graduate. Thus Program A resulted in 5 additional
graduates at a cost of $20,000, or one additional graduate for every $4,000. Prevention Program B
enrolls 20 students, costs $15,000, and 12 of the 20 students (60%) graduate. Thus Program B resulted
in 2 additional graduates at a cost of $15,000, or one additional graduate for every $7,500 spent.
Although Program B is cheaper ($15,000 compared to $20,000), Program A is more COST-EFFECTIVE
($4,000/each additional graduate, compared to $7,500/additional graduate). A COST-BENEFIT
ANALYSIS in this situation, instead of comparing unit costs, would require estimating the dollar value of
high school graduation (for example, by projecting the difference in lifetime earning capacity of graduates
over drop-outs, and lifetime social service costs), and comparing the monetary value of producing more
graduates to the monetary cost of providing the program in the first place. Neither method effectively
addresses more intangible outcomes of graduation, such as increased self-esteem, or the value of
a peer support system." (White, 1988, p. 430)

WHAT COST ANALYSIS CAN TELL YOU:

x Cost analyses can provide estimates of what a program's costs and benefits are likely to
be, before it is implemented. "Ex-ante" or "before the fact" cost analyses may have to be based
on very rough estimates of costs and expected benefits. However, if a program is likely to be very
expensive to implement, very difficult to "un-do" once it is in place, or very difficult to evaluate,
even a rough estimate of efficiency may be quite valuable in the planning stages (Rossi &
Freeman, 1993).
x Cost analyses may improve understanding of program operation, and tell what levels of
intervention are most cost-effective. A careful cost analysis within a program might tell you, for
example, that it doesn't so much matter whether you have a half-day program or a full-day
preschool program for children, but that the teacher-to-child ratio does matter (that is, children
benefit more from low ratios than they do from longer days). This information might influence
decisions about how many teachers you need to hire, or how many classrooms you need, or how
many children you can serve effectively.
x Cost analyses may reveal unexpected costs. A speech therapy program might unexpectedly
find that it costs more to use paraprofessionals to work with children than professionals, because
the paraprofessionals need more training and supervision, or work with fewer children at a time
(White, 1988). Or, cutting the number of home visits allowed by caseworkers serving a large rural
area (in order to save on mileage reimbursements) might have the unplanned result of higher
long-distance phone bills, because the workers still feel a need to stay in close touch with their
clients.

WHAT COST ANALYSIS CANNOT TELL YOU:

x Whether or not the program is having a significant net effect on the desired outcomes.
Unless you know for sure that the program is producing a benefit, it doesn't make sense to talk
about the cost of producing that benefit (Rossi & Freeman, 1993). Cost analysis may be
considered an extension of an impact or outcome evaluation, but it cannot take the place of one.

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x Whether the least expensive alternative is always the best alternative. Often political or
social values other than cost need to determine program and policy choices. When there are
competing values or goals involved, cost analysis is often just one factor to be considered, and
we need to have some other way of deciding which factors should take priority.

USING COST ANALYSIS WITH THE STATE STRENGTHENING EVALUATION

GUIDE:
If you are using the Five-Tiered Approach to Program Evaluation outlined in the State Strengthening
Evaluation Guide, cost analyses can be used at several levels:
Tier 1 - Program Definition
At this stage, you will probably be using cost studies based on other people's experience in similar
programs, since you are unlikely to have cost data of your own yet. This means that the estimates you
use will only be approximations, and may not accurately reflect what your program's experience will be.
However, "ex-ante" cost analyses, done in the planning stages before implementing a program, can
potentially prevent some very costly mistakes. If you have access to cost-effectiveness studies of
programs similar to the one you are considering, especially if they allow you to compare the relative costs
and benefits of several different ways of delivering a service, before you have made substantial
investments of time or money, some program design decisions may be easier. One common example in
community-based programs is staffing (eg., deciding whether to use highly-trained professionals to
deliver services, or to rely on less highly-paid paraprofessionals or volunteers). While many people
assume that the paraprofessionals or volunteers are always less expensive, cost-effectiveness studies in
some cases have found that the professionals may be less costly in the long run because they can see
more clients, require less supervision time, or are more effective. Of course, costs also need to be
weighed against other considerations, such as the fact that paraprofessionals recruited from the
community served may more easily gain the trust of clients.

Tier 2 - Accountability
Clearly, fiscal accountability is one of the primary reasons for using any kind of cost analysis as part of
your evaluation. Any responsible program should keep service statistics and financial records that are
accurate and up-to-date enough to be able to determine some very basic information about unit costs,
and funders usually require this. However, the minimal information routinely collected by programs for
fiscal and reporting purposes is not always in a form that lends itself to evaluation uses. Often, unless
advance planning has taken place, this data is too aggregated to reflect outcomes of interest to
researchers and evaluators. At this stage (or earlier), careful consideration should be given to the kinds of
client and cost data that will be needed later, so that it can be built into the accounting and record-keeping
systems of the program (see Kettner, Moroney & Martin, 1990).

Tier 3 - Understanding and Refining

Like any other type of information gathered for evaluation purposes, the cost information collected in Tier
2 for accountability purposes provides programs with a basis for mid-course adjustments and program
refinements, either at the end of a funding cycle, or in the course of implementation.

Tier 4 - Progress Toward Objectives

Using cost information in Tier 4 is closely tied to the program design issues of Tier 1, and the
accountability issues of Tier 2. If appropriate program outcomes and indicators have been identified in
Tier 1, and the appropriate unit cost information is included in the routine data that is collected as part of
Tier 2, then the job of identifying progress toward objectives in Tier 4 becomes much easier.

Tier 5 - Program Impact

When it has been possible to conduct a full-scale cost-benefit analysis over a long period of time, and it
shows significant long-term gains and cost savings in a particular population or problem area, the policy
implications may be great. One of the best-known examples is the Perry Preschool Study (discussed
earlier), which has been credited with persuading lawmakers to sustain or significantly increase their
support for early intervention programs, including Head Start. It is widely believed that one reason that
this study was so influential was the fact that it included a cost-benefit analysis. While monetary cost is
not the only basis for policy decisions, it is usually a very salient one for voters and politicians.

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ADVANTAGES OF USING COST ANALYSIS:

x Promotes fiscal accountability in programs. Too often, program managers can't easily
determine the cost of providing particular services or achieving certain outcomes, because they
aren't systematically collecting the necessary data, either about clients or about costs. At the
least, programs should be able to tell funders (or potential funders) that during a given time
period, they provided a certain level of services to a specific number of clients, and at what cost
(Jacobs, 1988).
x Helps set priorities when resources are limited. Program managers can use cost information
in designing programs, and in budgeting and allocating funds to get the most out of their
resources.
x Can be extremely powerful and persuasive to legislators, policy makers, and other
funders. May help convince them to invest in particular kinds of programs. Some argue that this
advantage of cost-benefit analysis may hold true even when it is not possible to assign monetary
values to all program costs and outcomes; if the effect is strong enough, even a relatively
incomplete cost-benefit analysis may be persuasive (Barnett, 1993).

DISADVANTAGES OF USING COST ANALYSIS:

x Requires a great deal of technical skill and knowledge. A true cost-benefit analysis requires a
solid grounding in economic theory and techniques, which is beyond the training of many
evaluators. It may be necessary to hire a consultant if this type of analysis is desired.
x Critics feel that many cost analyses are overly simplistic, and suffer from serious
conceptual and methodological inadequacies. There is a danger that an overly-simplistic cost-
benefit analysis may set up an intervention to fail, by promoting expectations that are
unrealistically high, and cannot really be achieved. This may result in political backlash which
actually hurts future funding prospects instead of helping.
x There are no standard ways to assign dollar values to some qualitative goals, especially in
social programs. For example, how do we value things like time, human lives saved, or quality
of life?
x Market costs (what people actually pay for something) don't always reflect "real" social
costs. For example, sometimes one person's cost is another person's benefit. Also, market costs
don't necessarily reflect what economists call the "opportunity costs" of choosing to do one thing
instead of another.
x Sometimes there are multiple competing goals, so we need to weight them or prioritize
them in some way. If a program leads to improvement in one area, but more problems in
another, is it still worth doing?
x Sometimes costs and monetary values are considered less important than other, more
intangible values or program outcomes.
x The best-known cost-benefit studies have looked at long-term outcomes, but most
program evaluations don't have the time or resources to conduct long-term follow-up
studies.

HOW TO BUDGET & ALLOCATE COSTS FOR COST EFFECTIVENESS STUDIES:

The type of budgeting and accounting system your program or agency uses may well determine how
much useful cost data is available for evaluating your program, or comparing it to others. Three major
types of budgeting formats commonly used in social service programs will provide different types and
amounts of information (Kettner, Moroney, & Martin, 1990).

The most common format is the Line-Item Budget format, which simply looks at revenues (money
coming in from various sources, including grants, user fees or United Way funds) and expenditures (costs
broken down into broad categories like salaries, rent, utilities, and postage), and tries to ensure that they
balance. The main purpose of a line-item budget is financial control, and the categories are usually too
broad to give much information about the cost of providing a particular service or obtaining a particular
result.

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The Functional Budget format starts with a line-item budget, and takes it a step further. It focuses on
process, or the cost of providing a service. For example, with a Functional Budget, we could determine
that it cost an adoption agency $45,000 to conduct 100 home studies (an activity which is a necessary
part of the process of placing children in permanent homes).

The Program Budget, which also starts with a line-item budget, looks at the same information from the
point of view of outcomes, or the cost of achieving a result. For example, if the 100 home studies resulted
in actually placing 50 children in adoptive homes, the Program Budget would allow us to say that it cost
the agency $45,000 to place 50 children, which is an outcome.

Another way to look at this is that functional budgets measure productivity, and program budgets
measure the cost of achieving goals and objectives.

COMMON STEPS IN DEVELOPING PROGRAM & FUNCTIONAL BUDGETS (Kettner,

et al., 1990):
1. Develop a line-item budget that shows all expenditures. This is the minimal level of budgeting and
accounting that is required by many funders, such as the United Way. Some funders require a specific
format, so that the categories used are standard across the programs that they fund.
2. Determine the agency's program structure. A distinct program is a set of activities or services
designed to accomplish a specific set of agency goals and objectives. Many agencies have several
different programs.
3. Identify all direct costs and indirect costs. Direct costs are those that benefit only one program (for
example, salaries of staff who work only for one program, or supplies and equipment used only for that
program). Indirect costs or "overhead" costs are those that benefit or are shared by more than one
program (for example, several programs in an agency might share the same building, and be served by
the same bookkeeping and secretarial staff, utilities, or janitorial services).
4. Assign direct costs to the appropriate program or project. This is usually fairly straightforward. If
one county agent has full-time responsibility for operating your State Strengthening project, for example,
then 100% of his or her salary and benefits would be assigned as an expense to that project in the
budget. If a staff member spends 50% of his or her time on the State Strengthening project and 50% on
another assignment, then half of that person's salary and benefits would be assigned to the State
Strengthening project as a direct cost.
5. Allocate indirect costs to programs. Deciding how to divide up the indirect (shared) cost pool among
several programs in the agency can be much more complicated and technical. The actual practice of
allocating or dividing up the indirect costs is usually best left to an accountant. There are several methods
for doing this, each with particular advantages and disadvantages (see Kettner, et al., 1990). Although
cost allocation of indirect costs can be a time-consuming step, it is considered well worth doing because
of the increased information it provides about the real costs of providing services.
6. Determine total program costs. The total cost of a particular program (such as your State
Strengthening project) is the sum of the direct costs, and the portion of indirect costs that is allocated to
that program.
Once we have this information about total program costs, then we can calculate unit costs. For a
Functional Budget, this involves defining the units of service for each program (eg., hours of day care
provided, meals delivered, home studies conducted), and calculating the cost per unit of service. In the
adoption agency example above, the unit cost of conducting a home study would be $450 (total program
cost divided by number of units of service provided). For a Program Budget, the final steps are
determining the total cost of achieving the outcome objectives for the year, and calculating the cost per
outcome. Using the adoption example again, we can say that the adoption agency described above
successfully placed children in adoptive homes at a unit cost of $900/child (total program costs divided
by the number of successful outcomes).

COST-EFFICIENCY & COST-EFFECTIVENESS STUDIES: From the point of view of program

evaluation, both the Program and Functional Budgeting systems are more useful than a Line-Item
Budget. Unit cost information allows for useful comparisons of the costs of delivering services and getting
results. With this information, we can look at the unit cost of one adoption agency compared to another, to

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see whether one operates more efficiently. We can also compare the unit cost (per child) of adoptive
placement to the unit cost (per child) of placement in foster care or residential treatment. This is basically
what happens in a cost-effectiveness study.
In general, a cost-effectiveness study is more appropriate than a cost-benefit analysis when your goals or
outcomes can't easily be quantified or monetized, or when there are multiple competing goals. As with
budgeting and cost allocation, there are a variety of approaches to cost-effectiveness studies. The
approach that is best for your purposes will depend on a number of factors. A good source of more
detailed information about deciding what approach is most appropriate, and conducting the various types
of cost-effectiveness studies, is Weimer & Vining (1992).

HOW TO CONDUCT A COST-BENEFIT ANALYSIS:

Cost-benefit analysis is by far the most complex and controversial of the three methods of costs analysis
we have discussed. It should not be attempted by those who lack technical expertise in this area.
However, for some purposes, it is also one of the most powerful methods. For those who decide to
undertake a cost-benefit analysis in spite of the difficulties, Barnett (1993) outlines a nine step process.
Various standard texts are recommended for more in-depth information (see below).
x Step 1: Define the Scope or Perspective of the Analysis - The first step is to describe the
alternative(s) to be evaluated, and determine whose perspective will guide the evaluation. A
narrow cost analysis might look only at the monetary costs and benefits to the individual
participant or target of services, or to a particular funder or agency. A broader perspective might
attempt to look at a wide range of costs and consequences (intended and unintended, direct and
indirect) for society as a whole. A program that is not cost-effective from the perspective of a
particular agency within its limited mission and budget may well be cost-effective from the
perspective of society, because it saves expenses or prevents problems in other areas. Rossi
and Freeman (1993) note that because different stakeholders may have different values and
priorities, mixing different viewpoints is likely to result in "confused specifications and overlapping
or double counting." Whether we like it or not, the perspective chosen for cost evaluation may
have political implications. Therefore, while there are limitations to any one perspective, it is
important for the evaluator to clearly state his or her position.
x Step 2: Conduct Cost Analysis - The next step is to identify and estimate the monetary value of
all resources used in the intervention, not just the budgetary costs. Some costs, such as salaries
of direct service staff, rental of office space, or program supplies, are obvious and simple to
determine. Indirect costs of supervision and administration need to be included as well. Other
resources and costs may go well beyond the items that are usually included in an agency budget.
Sometimes "overhead" (like office space or supervision) is provided as an in-kind service by an
existing agency, but since there are probably some additional demands made on the time of the
agency staff, this should be figured into the "real" cost of the intervention (what would you have to
pay if the time or space had not been donated)?. What about the value of the time of program
volunteers (what would you have to pay them if they weren't volunteering their services)? Barnett
argues that parent time is a frequently ignored cost factor in intervention programs for children; if
a high level of parent involvement is required (for example, teaching the child, conducting
physical therapy exercises, or attending many meetings and appointments), it may represent a
cost savings to the agency, but a cost to the parent because there may be less time available for
paid work, housework, spending time with other children in the family, or just the cuddling and
nurturing aspects of being a parent.
x Step 3: Estimate Program Effects - This is where more traditional impact or outcome evaluation
methods come in. As noted earlier, if we don't know that there is a significant beneficial effect of
our program, there is little point in asking how much it costs to get the effect, or whether it is more
cost-effective than another kind of program. Many texts on evaluation can assist you in designing
a valid evaluation (Rossi & Freeman, 1993; State Strengthening Evaluation Guide, 1997). Often it
is not possible to use a true experimental design in evaluating community-based programs, but
there are a number of quasi-experimental designs available (Cook & Campbell, 1979). Also, don't
forget that it is often possible to use existing data to estimate program effects, as well. If you are
looking at an ongoing program, or one that is based on a national model (such as the Parents As
Teachers program), check to see if formal evaluations have already been done elsewhere. You
may also be able to get useful information from the program's service statistics, or from local,
state, or federal census data.

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x Step 4: Estimate the Monetary Value of Outcomes - This is one of the most difficult and
controversial aspects of conducting a cost-benefit analysis, and it may require the help of
consultants. Some cost-savings are easier to estimate than others. For example, we may have
data that the average cost of placing a child in residential treatment is $20,000 a year, so if we
are able to prevent 20 children from being placed in residential treatment, the estimated savings
is 20 X $20,000. However, other important outcomes may be much less obvious, and much
harder to estimate.
x Step 5: Account for the Effects of Time - One of the trickiest and most technical aspects of
cost-benefit analysis, especially for longitudinal studies that follow clients or outcomes over a
period of years, is discounting of costs and calculating rates of return for alternative uses of the
money (such as investing it). This includes taking into account the effects of inflation on the value
of the dollar over time, or figuring the depreciation in the value of things like buildings and other
capital equipment. Similar issues apply in estimating the value of benefits over a period of time.
For example, if we want to look at the projected life-time earnings of a teenager who stays in
school due to a drop-out prevention program compared to one who does not, we need to make
projections about wages. If we want to look at whether the government will eventually recover its
investment in the drop-out program through the taxes he or she will pay on the increased income,
we need to make projections about future tax rates as well. These projections all require
assumptions. Unless you or someone on the program staff has expertise in this area, it is strongly
advised that you seek out a skilled consultant to help with this step.
x Step 6: Aggregate and Apply a Decision Rule - If you are looking at the costs and benefits on
several outcomes (which is often the case), how will you decide which has priority? If a program
for pregnant teenagers results in healthier babies (and lower hospital costs), but not in fewer
repeat pregnancies, which outcome is more important?
x Step 7: Describe Distributional Consequences - This is related to choosing your perspective of
analysis. It involves specifying who gains and who loses under different conditions (because in
some cases, one party's benefit is another party's loss). This may be a highly controversial and
political step in the process.
x Step 8: Conduct Sensitivity Analysis - This step involves identifying the assumptions behind
your cost estimates, and considering how critical they are to your calculations. If one of your
assumptions turns out not to be accurate, or if conditions change during the time of your study
(for example, the minimum wage goes up, affecting salary costs), will that change your whole
conclusion, or is the effect strong enough that there is some leeway?
x Step 9: Discuss the Qualitative Residual - Since there are almost always some things that
can't be quantified or given monetary values, it is important that your report include some
discussion of these issues. A frank description of some of these qualitative issues in your report
can help round out your conclusions, and reduce the chances of your study being used
inappropriately.

3. FUNDAMENTAL ECONOMIC CONCEPTS

Economics deals with the behavior of people, and as such, economic concepts are usually qualitative in
nature, and not universal in application.

UTILITY
x Utility is the power of a good or service to satisfy human needs.

VALUE
x Designates the worth that a person attaches to an object or service.
x Is a measure or appraisal of utility in some medium of exchange.
x Is not the same as cost or price.

CONSUMER AND PRODUCER GOODS

1. Consumer goods : Consumer goods are the goods and services that directly satisfy human
wants. For example, TV, shoes, houses.

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2. Producer goods : Producer goods are the goods and services that satisfy human wants
indirectly as a part of the production or construction process. For example, factory equipment,
industrial chemicals ands materials.

UTILITY OF GOODS
1. Consumer goods : Basic human needs of food, clothing and shelter. In commercial
advertisements, emphasis is given to senses not reasoning. The utility in this case is considered
objectively and/or subjectively.
2. Producer goods : The utility stems for their means to get to an end. The utility in this case is
considered objectively.

ECONOMY OF EXCHANGE
1. Occurs when utilities are exchanged by two or more people.
2. It is possible because consumer utilities are evaluated subjectively.
3. Represents mutual benefit in exchange.
4. Persuasion in exchange. Salesperson.

ECONOMY OF ORGANIZATION
Through organizations, ends can be attained or attained more economically by:
1. Labor saving
2. Efficiency in manufacturing or capital use

CLASSIFICATION OF COST
A key objective in engineering applications is the satisfaction of human needs, which will nearly always
imply a cost.

Economic analyses may be based on a number of cost classifications:

1. First (or Initial) Cost : Cost to get activity started such as property improvement, transportation,
installation, and initial expenditures.
2. Operation and Maintenance Cost : They are experienced continually over the usefull life of the
activity.
3. Fixed Cost : Fixed costs arise from making preparations for the future, and includes costs
associated with ongoing activities throughout the operational life-time of that concern. Fixed costs
are relatively constant; they are decoupled from the system input/output, for example.
4. Variable Cost : Variable costs are related to the level of operational activity (e.g. the cost of fuel
for construction equipment will be a function of the number of days of use).
5. Incremental or Marginal Cost : Incremental (or marginal) cost is the additional expense that will
be incurred from increased output in one or more system units (i.e. production increase). It is
determined from the variable cost.
6. Sunk Cost : It cannot be recovered or altered by future actions. Usually this cost is not a part of
engineering economic analysis.
7. Life-Cycle Cost : This is cost for the entire life-cycle of a product, and includes feasibility, design,
construction, operation and disposal costs.

SUPPLY AND DEMAND (not covered)

1. Demand curve shows the number of units people are willing to buy and cost per unit (decreasing
curve).
2. Supply curve shows the number of units that vendors will offer for sale and unit price (increasing
curve).
3. The intersection defines the exchange price.
4. Elasticity of demand. Price changes and their effect on demand changes. It depends on whether
the consumer product is a necessity or a luxury.

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5. Law of diminishing return. A process can be improved at a rate with a diminishing return.
Example: cost of inspection to reduce cost of repair and lost production.

INTEREST RATE
Interest is a rental amount charged by financial institutions for the use of money.
1. Called also the rate of capital growth, it is the rate of gain received from an investment.
2. It is expressed on an annual basis.
3. For the lender, it consists, for convenience, of (1) risk of loss, (2) administrative expenses, and (3)
profit or pure gain.
4. For the borrower, it is the cost of using a capital for immediately meeting his or her needs.

TIME VALUE OF MONEY

The time-value of money is the relationship between interest and time. i.e.

Figure 2 : Time-Value of Money

Money has time-value because the purchasing power of a dollar changes with time.

EARNING POWER OF MONEY

The earning power of money represents funds borrowed for the prospect of gain. Often these funds will
be exchanges for goods, services, or production tools, which in turn can be employed to generate and
economic gain.

PURCHASING POWER OF MONEY

The prices of goods and services can go upward or downward, and therefore, the purchasing power of
money can change with time.
1. Price Reductions : Caused by increases in productivity and availability of goods.
2. Price Increases : Caused by government policies, price support schemes, and deficit financing.

EXAMPLE ECONOMIC STUDIES

x Design and Economy
x Elimination of overdesign should not be an objective.
x Designing for economic production
x Economy in the design of producer goods
x Design for the economy of maintenance
x Design for the economy of shipping
x Economy of interchangeable design

Economy of Material Selection

Standardization and Simplification

x Selection of Personnel
x Range of human capacities
x Range of human capacities
x Economy of proficiency
x Economy of specialization
x Economy of dependability

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Economy of Resource Input for Organizations

x Tangible versus intangible inputs and their evaluations

Knowledge and Information

x Tangible versus intangible inputs and their evaluations Qualitative versus quantitative

CASH FLOW DIAGRAMS

Cash flow diagrams are a means of visualizing (and simplifying) the flow of receipts and disbursements
(for the acquisition and operation of items in an enterprise).

The diagram convention is as follows:

x Horizontal Axis : The horizontal axis is marked off in equal increments, one per period, up to the
duration of the project.
x Revenues : Revenues (or receipts) are represented by upward pointing arrows.
x Disbursements : Disbursements (or payments) are represented by downward pointing arrows.

All disbursements and receipts (i.e. cash flows) are assumed to take place at the end of the year in which
they occur. This is known as the "end-of-year" convention.

Arrow lengths are approximately proportional to the magnitude of the cash flow.
Expenses incurred before time = 0 are sunk costs, and are not relevant to the problem.
Since there are two parties to every transaction, it is important to not that cash flow directions in cash flow
diagrams depend upon the point of view taken.

Example :

Figure 3 : Typical Cash Flow Diagrams

Figure 3 shows cash flow diagrams for a transaction spanning five years. The transaction begins with a
$1000.00 loan. For years two, three and four, the borrower pays the lender $120.00 interest. At year five,
the borrower pays the lender $120.00 interest plus the $1000.00 principal.

1. Cash Flow over Time : Upward arrow means positive flow, downward arrow means negative
flow. There are two cash flows to each problem (borrower and lender flows).
2. Net Cash Flow : The arithmetic sum of receipts (+) and disbursements (-) that occur at the same
point in time.

INTEREST FORMULAE
Interest formulae play a central role in the economic evaluation of engineering alternatives.

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TYPES OF INTEREST
1. Simple Interest : I = Pni.
P = Principal
i = Interest rate
n = Number of years (or periods)
I = Interestt.

Interest is due at the end of the time period. For fractions of a time period, multiply the interest by
the fraction.

Example : Suppose that $50,000 is borrowed at a simple interest rate of 8% per annum. At the
end of two years the interest owed would be:
I = $ 50,000 * 0.08 * 2
= $ 8,000

2. Compound Interest : The interest of the interest.

Example : A loan of $1,000 is made at an interest of 12% for 5 years. The interest is due at the
end of each year with the principal is due at the end of the fifth year. The following table shows
the resulting payment schedule:

Principal P = $1000.00
Interest Rate i = 0.12.
Number of years (or periods) n = 5.

================================================================
Amount at Interest at Owed amount at
Year start of year end of year end of year Payment
================================================================
1 $1000.00 $120.00 $1120.00 $120.00
2 $1000.00 $120.00 $1120.00 $120.00
3 $1000.00 $120.00 $1120.00 $120.00
4 $1000.00 $120.00 $1120.00 $120.00
5 $1000.00 $120.00 $1120.00 $120.00

Example : A loan of $1,000 is made at an interest of 12% for 5 years. The principal and interest
are due at the end of the fifth year. The following table shows the resulting payment schedule:

Principal P = $1000.00
Interest Rate i = 0.12.
Number of years (or periods) n = 5.

================================================================
Amount at Interest at Owed amount at
Year start of year end of year end of year Payment
================================================================
1 $1000.00 $120.00 $1120.00 $0.00
2 $1120.00 $134.40 $1254.40 $0.00
3 $1254.40 $150.53 $1404.93 $0.00
4 $1404.93 $168.59 $1573.52 $0.00
5 $1573.52 $188.82 $1762.34 $1762.34

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A. INTEREST FORMULAE (Discrete Compounding and Discrete Payments)

Notations:
i = The annual interest rate
n = The number of annual interest periods
P = A present principal sum
A = A single payment, in a series of n equal payments, made at the end of each annual interest period
F = A future sum, n annual interest periods hence

1. Single-Payment Compound-Amount Factor

F = P.[1 + i]^n

Example 1 : Let the principal P = $1000, the interest rate i = 12%, and the number of periods n = 4
years. The future sum is:

F = $1000 [1 + 0.12] ^ 4
= $1,573.5

Figure 4 : Cash Flow for Single Payment Compound Amount

Figure 4 shows the cash flow for the single present amount (i.e. P = 1000) and the single future
amount (i.e. F = $1,573.5).

2. Single-Payment Present-Worth Factor

F
P = =======
[1 + i]^n

The factor 1.0/[ 1 + i ]^n is known as the single-payment present-worth factor, and may be used to find
the present worth P of a future amount F.

Example 1 : Let the future sum F = $1000, interest rate i = 12%, and number of periods n = 4 years.
The single payment present-worth factor is:

F $1000.00
P = ========= = ============== = $635.50.
[1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $635.50.

Example 2 : Let the future sum F = $1,573.5, the interest rate i = 12%, and the number of periods n
= 4 years. The single payment present-worth factor is:

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F $1573.50
P = ========= = ============== = $1000.00.
[1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $1000.00.

3. Equal Payment-Series Compound Amount Factor

Some economic studies require the computation of a single factor value that would accumulate from a
series of payments occurring at the end of succeeding interest periods.

Figure 5 : Schematic of Equal Payment-Series Compount Amounts

Figure 5 represents this scenario in graphical terms. At the end of Year 1 a payment of $ A begins the
accumulation of interest at rate i% for (n-1) years. At the end of Year 2 a payment of $ A begins the
accumulation of interest at rate i% for (n-2) years. End of year payments of $ A continue until Year N
(or n as written below).

The total accumulatio of funds at Year N is simply the sum of $A payments multiplied by the
appropriate single-payment present-worth factors. In tabular format we have:

End of Compound Amount at Total

Year the end of n Years Compound Amount
==========================================================
1 $ A . [ 1 + i ] ^ (n - 1)
2 $ A . [ 1 + i ] ^ (n - 2)
3 $ A . [ 1 + i ] ^ (n - 3)

n - 1 $ A . [ 1 + i ]
n $ A
==========================================================
$ F
==========================================================

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The total compound amount is simply the sum of the compound amounts for years 1 though n. This
summation is a geometric series:

F = A + A.[1 + i] + A.[1+i]^2 + ..... + A.[1+i]^(n-1)

With a little bit of mathematical manipulation, it can be shown;

[ 1 + i ]^n - 1
F = A * ------------------
i

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1
F = 100 * ----------------------- = 477.9
0.12

4. Equal-Payment Series Sinking-Fund Factor

Given a future amount F, the equal payments compound-amount relationship is:
i
A = F * ------------------
[ 1 + i ]^n - 1

A = required end-of-year payments to accumulate a future amount F.

Example 1: Let F = 1000, i = 12%, and n = 4 years.

0.12
A = 1000 * -------------------- = 209.2
[ 1 + 0.12 ]^4 - 1

5. Equal-Payment-Series Capital-Recovery Factor

A deposit of amount P is made now at an interest rate i. The depositor wishes to withdraw the
principal plus earned interest in a series of year-end equal payments over N years, such that when
the last withdrawl is made there should be no funds left in the account.

Figure 6 : Schematic of Equal-Payment-Series Capital Recovery

Figure 6 summarizes the flow of disbursements and receipts (from the depositors point of view) for
this scenario.

Equating the principle $P (plus accumulated interest) with the accumulation of equal payments $A
(plus appropriate interest) gives:

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[ [ 1 + i ]^n - 1 ]
P [ 1 + i ]^n = A -----------------------
i

which can be rearranging to give:

i * [ 1 + i ]^n
A = P * ---------------------
[ 1 + i ]^n - 1

This is the case of loans (mortgages).

Example 1: Let P = 1000, i = 12%, and n = 4 years

0.12 * [ 1 + 0.12 ]^4

A = $1000 * ----------------------------- = $329.2
[ 1 + 0.12 ]^4 - 1

6. Equal-Payment-Series Present-Worth Factor

This can be described as

[ 1 + i ]^n - 1
P = A * ---------------------
i * [ 1 + i ]^n

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1
P = 100 * ----------------------------- = 303.7
0.12 * [ 1 + 0.12 ]^4

7. Uniform Gradient-Series Factor

Often periodic payments do not occur in equal amounts, and may increase or decrease by constant
amounts (e.g. $100, $120, $140, $160 .... $200).

The gradient (G) is a value in the cash flow that starts with 0 at the end of year 1, G at the end of year
2, 2G at the end of year 3, and so on to (n-1)G at the end of year n.

This can be described as

*- -*
| 1 n |
A = G . | - - --------------- |
| i [ 1 + i ]^n - 1 |
*- -*

Example 1 : Let G = 100, i = 12%, and n = 4 years.

*- -*
| 1 4 |
A = $100 . | ---- - ------------------ | = $ 135.9
| 0.12 [ 1 + 0.12 ]^4 - 1 |
*- -*

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B. DISCRETE AND CONTINUOUS COMPOUNDING (compounding frequency)

Nominal interest rate : is expressed on an annual basis. Financial institutions refer to this rate as annual
percentage rate (APR).
Effective interest rate : is an interest rate that is compounded using a time period less than a year. The
nominal interest rate in this case is the effective rate times the number of compounding periods in a year.
Then, it is referred to as nominal rate compounded at the period less than a year.
Example : If the effective rate is 1% per month, it follows that the nominal rate is 12% compounded
monthly.

Relationship between the two rates. Let's define:

r = nominal interest rate per year
i = effective interest rate in the time interval
l = length of the time interval (in years)
m = reciprocal of the length of the compounding period (in years)

Therefore, the effective interest rate for any time interval is given by:
*- -* ^ l*m
| r |
i = | 1 + --- | - 1.0
| m |
*- -*

Clearly if l*m = 1, then i is simply r/m.

The product l*m is called c = the number of compounding periods in the time interval l. Note that c should
be > 1.

Continuous compounding: The limiting case for the effective rate is when compounding is performed
an infinite times in a year, that is continuously. Using l = 1, the following limit produces the continuously
compounded interest rate

*- -* ^ m
| r |
i_a = Limit | 1 + --- | - 1.0
m->infinity | m |
*- -*

resulting into and effective interest rate

i_a = e^r - 1

Example :

================================================================
Compounding Number of Effective interest Effective annual
frequency Periods rate per period interest rate
================================================================

Annually 1.0 18% 18.00%

Semiannually 2.0 9% 18.81$
Quarterly 4.0 4.5% 19.25%
Monthly 12.0 1.5% 19.56%
Weekly 52.0 0.3642% 19.68%
Daily 365.0 0.0493% 19.74%
Continuously infinity 0.0000% 19.72%

Interest Formulas (Continuous Compounding and Discrete Payments)

Interest Formulas (Continuous Compounding and Continuous Payments)
Handout. (Table)

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ECONOMIC EQUIVALENCE INVOLVING INTEREST

Why? It is common in engineering to compare alternatives.

THE MEANING OF EQUIVALENCE

In engineering economy two things are said to be equivalent when they have the same effect. Unlike
most individual involved with personal finance, industrial decision makers using engineering economics
are not so much concerned with the timing of a project's cash flows as with the profitability of that project.
This means that mechanisms are needed to compare projects involving receipts and disbursements
occurring at different times, with the goal of identifying an alternative having the largest eventual
profitability [Lindeberg82].

EQUIVALENCE CALCULATIONS INVOLVING A SINGLE FACTOR

The interest equations are affected by three factors: (a) amounts, (b) times of occurrence of amounts, and
(c) rate of interest.

1. Single-Payment Compound-Amount Factor

F = P.[1 + i]^n

Example 1 : Let P = $1000, i = ??, n = 4 years, and F = $1200. The interest rate is

F = $1200.00 = $1000.00 [1 + i ]^4

Rearranging terms in this equation gives i = 1.2^0.25 - 1 = 0.046635.

Example 2 : Let P = $1000, i = 10%, n = ?? years, and F = $1200.

F = $1200.00 = $1000.00 [1 + 0.10 ]^n

Rearranging terms in this equation gives n = 1.91 years.

2. Single-Payment Present-Worth Factor

F
P = ---------
[1 + i]^n

Example 1 : Let F = $1000, i = 12%, n = 4 years, and P = ?

$1000.00
P = -------------------- = $635.5
[1 + 0.12]^4

3. Equal-Payment-Series Compound-Amount Factor

[ 1 + i ]^n - 1
F = A * ---------------------
i

The derivation of this formula can be found on page 46 of the economics text.

Example 1 : Let A = $100.00, i = 10%, and F = $1000.00. How many years n are needed ?
[ 1 + 0.12 ]^n - 1
$1000.00 = $100.00 * -----------------------
0.12

Rearranging the terms in this equation gives n = 7.27 years.

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4. Equal-Payment-Series Sinking-Fund Factor

i
A = F * ---------------
[ 1 + i ]^n - 1

Example 1 : Paying towards a future amount. Let F = $1000.00, i = 12%, and n = 4 years. What is A ?

0.12
A = $1000.00 * ------------------------------ = $209.20
1 + 0.12 ]^4 - 1

5. Equal-Payment-Series Capital-Recovery Factor

i * [ 1 + i ]^n
A = P * --------------------------
[ 1 + i ]^n - 1

Example 1 : Paying back a loan. Let P = $1000, i = 12%, n = 4 years, and A = ?

0.12 * [ 1 + 0.12 ]^4

A = 1000 * ------------------------------- = 329.2
[ 1 + 0.12 ]^4 - 1

6. Equal-Payment-Series Present-Worth Factor

[ 1 + i ]^n - 1
P = A * -------------------------
i * [ 1 + i ]^n

Example 1 : Let A = 100, i = 10%, and n = 8 years.

[ 1 + 0.10 ]^8 - 1
P = 100 * ----------------------------- = 533.49
0.10 * [ 1 + 0.10 ]^8

7. Uniform Gradient-Series Factor

As explained above, the gradient (G) is a value in the cash flow that starts with 0 at the end of year 1,
G at the end of year 2, 2G at the end of year 3, and so on to (n-1)G at the end of year n.

This can be described as

*- -*
| 1 n |
A = G . | - - --------------- |
| i [ 1 + i ]^n - 1 |
*- -*

Example 1 : Let G = 100, i = 12%, n = 4 years, and A = ??

*- -*
| 1 4 |
A = 100.| ---- - ------------------ | = 135.9.
| 0.12 [ 1 + 0.12 ]^4 - 1 |
*- -*

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EQUIVALENCE CALCULATIONS INVOLVING CASH FLOW

Two cash flows need to be presented along the same time period using a similar format to facilitate
comparison. When interest is earned, monetary amounts can be directly added only if they occur at the
same point in time.

1. EQUIVALENCE BETWEEN CASH FLOWS

Equivalent cash flows are those that have the same value.

Example : Two equivalent cash flows.

Cash Flow 1 Cash Flow 2

=====================================================
P = $1000.00 P = $0.00
i = 12% i = 12%
n = 4 years n = 4 years
F = $0.00 F = $$1000*[1+0.12]^4 = $1,573.50

The equivalence can be established at any point in time. Arbitrarily setting n = 8 years, for example,
gives:

For cash flow 1 : F = $1000.0 * [1 + 0.12]^8 = $2475.96

For cash flow 2 : F = $1573.5 * [1 + 0.12]^4 = $2475.96

Note : Two or more distinct cash flows are equivalent if they are equivalent to the same cash flow.

2. EQUIVALENCE FOR DIFFERENT INTEREST RATES

Example 1 : Given the following cash flow:

===================================================
Interest rate applicable
from previous year (t-1)
Year End Amount to current year end (t)
===================================================
0 $0.00 NA
1 $200.00 12% compounded quarterly
2 $0.00 12% compounded quarterly
3 $100.00 7% compounded annually
4 $100.00 10% compounded annually
5 $100.00 10% compounded annually

The above cash flow can be converted to its present value as follows:

Assuming the following cash flow:

===================================================
Time (Year End) Receipts Disbursements
===================================================
0 $0.00 -$1000.00
1 $0.00 -$500.00
2 $482.00 $0.00
3 $482.00 $0.00
4 $482.00 $0.00
5 $0.00 -$250.00
6 $482.00 $0.00
7 $482.00 $0.00

In this case, equivalence states that the actual interest rate earned on an investment is the one that sets
the equivalent receipts to the equivalent disbursements.

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For the above table, the following equality can be set:

$1000 + $500.00 (P/F,i,1) + $250(P/F,i,5) = $482(P/A,i,3)(P/F,I,1) + $482.00 (P/A,i,2)(P/F,i,5)

By trial and error i = 10% will make the above equation valid. The equivalence can be made at any point
of reference in time, it does not need to be the origin (time = zero) to produce the same answer.

If the receipts and disbursement of cash flow are equivalent for some interest rate, the cash flows of any
equivalent portion of the investment are equal at that interest rate to the negative (-) of the equivalent
amount of t= he cash flows that constitute the remaining portion on the investment.

For example, break-up the above cash flow between year 4 and 5. Perform the equivalence at the 4th
year produces the following:

-1000(F/P,10,4)-500(F/P10,3)+482(F/A,10,3) = -(-250(P/F,10,1)+482(P/A,10,2)(P/F,10,1))

-1000(1.464)-500(1.331)+482(3.310) = -$(-250(0.9091)+482(1.7355)(0.9091))

-$534 = -$534

3. EQUIVALENCE CALCULATIONS WITH MORE FREQUENT COMPOUNDS

1. Compounding and Payment Periods Coincide
Assume for example that
Interest = 10% compounded semiannually => 5% per semiannual period
Payments are done semiannually for three years => 3(2) = 6 periods
The calculations from here on are the same as before.

2. Compounding More Frequent than Payments

Calculations based on the compounding period:

Example 1 : Payments = 100 at year end for three years; Interest = 6% per year compounded
quarterly.
I = 6/4 = 1.25%
F = $100 (F/P,1.25,8) + $100 (F/P,1.25,4) + $100
= $318.8

Effective interest rate for l = 1 year,

o *- -*^l *- -*^4
o | r | | 6 |
o i = | 1 + --- | - 1 = | 1 + --- | - 1 = 6.14%
o | m | | 4 |
o *- -* *- -*

The solution of the previous example is

F = $100 (F/A,6.14,3) = $318.80

Example 2 : Assume that end of month payments = 100 with interest of 15% continuous
compounding. What is the accumulated amount after 5 years ? The number of periods =12*5 =
60 years. The interest per month is 1/12= 1.25%. Then,

*- -* *- -*
| e^(rn) - 1 | | e^0.0125*60 - 1 |
F = A | ---------- | = $100.00 * | --------------- | = $8,865
| e^r -1 | | e^0.0125 - 1 |
*- -* *- -*

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3. Compounding Less Frequent than Payments

Usually no interest is paid for funds deposited during an interest period. In this case, funds earn
interest after completing the next interest period.

BOND PRICES AND INTEREST

Suppose you can buy a bond for $900 that has a face value of $1000 with 6% annual interest that is paid
semiannually. The bond matures in 7 years. The yield to maturity is defied as the rate of return on the
investment for its duration. Using equivalence, the following expression can be developed:

$900 = $30 (P/A,i,14) + $1000 (P/F,i,14)

By trial and error, it can be determined that i = 3.94% per semiannual period.
The nominal rate is 2(3.94) = 7.88%.
The effective rate is 8.04%.
The bond market.

EQUIVALENCE CALCULATIONS FOR LOANS

The effective interest rate for a loan is defines as the rate that sets the= receipts equal to the
disbursements on an equivalent basis.

REMAINING BALANCE OF A LOAN

Suppose a five-year loan of $10,000 (with interest of 16% compounded quarterly with quarterly
payments) is to be paid off after the 13th payment. What is the balance?

The quarterly payment is

$10,000 (A/P,4,20) = $10.000 (0.0736) = $736.00

The balance can be based on the remaining payments as

$736 (P/A,4,7) = $736 * (6.0021) = $4418.

PRINCIPAL AND INTEREST PAYMENTS

Consider the case of a loan with fixed rate and constant payment A. Define the following:

I_t = Interest payment of A at time t.

B_t = Portion of payment of A to reduce balance at time t.
A = I_t + B_t for t = 1, 2, .... n

The balance at end of (t-1) is given by => A(P/A,i,n-(t-1)).

Therefore,
I_t = A(P/A,i,n-(t-1))(i)
B_t = A - I_t
= A[1-(P/A,i,n-(t-1))(i)]

Since

P/F,i,n = 1 - (P/A,i,n)(i) => B_t = A(P/F,i,n-t+1)

Example : For P = $1000.00 (loan), n = 4, and i = 15%, the following table can be constructed:
The payment is A = $1000(A/P,15,4) = $1000(0.3503) = $350.30

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===============================================================
Year Loan Interest
End Payment Payment on Principal Payment
===============================================================
1 $350.30 $350.30(P/F,15,4) = $200.30 $150.00
2 $350.30 $230.32 $119.98
3 $350.30 $264.90 $85.40
4 $350.30 $304.62 $45.68
TOTAL $1401.12 $1000.14 $401.06

ECONOMIC EQUIVALENCE INVOLVING INFLATION

MEASURE OF INFLATION AND DEFLATION
The price index is the ratio between the current price of a commodity or service to the price at some
earlier reference time. For example, the base year is 1967 (index =100), and the commodity price is
$1.46/lb.
The price in 1993 is $5.74/lb.
Therefore, the 1993 index is 5.74/1.4 = 393.2

Note : Actual Consumer price index (CPI) and annual inflation rates for 1965 are shown in Table 5.1 of
the Economics Text.

ANNUAL INFLATION RATE

The annual inflation rate at t+1 can be computed as

CPI(t+1) - CPI(t)
-------------------------
CPI(t)

Assume the average inflation rate = f. The average rate can be computed as

CPI(t) [ 1 + f ] ^ n = CPI(t+n)

Example : Let the CPI(1966) = 97.2 and the CPI(1980) = 246.80. The average rate of inflation over the
14 year interval is:

*- -* ^ (1/14)
| 246.80 |
f = | -------- | - 1.0 = 6.88% per year.
| 97.2 |
*- -*

PURCHASING POWER OF MONEY

Purchasing power at time t in reference to time t-n is

CPI(t-n)
--------------
CPI(t)

Now let's define k = annual rate of loss in purchasing power. Therefore the average rate of loss of
purchasing power is

CPI(t+n) [ 1 - k] ^ n = CPI(t)

It follows that
1
[ 1 + f ]^n = -----------
[ 1 - k ]^n

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This equation relates the average f inflation rate to k, the annual rate of loss in purchasing power.

CONSTANT DOLLARS
By definition
1
Constant dollars = ------------------ (actual dollars)
[ 1 + f] ^ n

When using actual dollars, use the market interest rate (i).
When using constant dollars, use the inflation-free interest rate (i*), defined as

For one year

1+i
i* = ------------ - 1
1+f

For several years

1+i
i* = -------------- - 1
[ 1 + f ]^n

CURRENCY EXCHANGE
Add notes later ......

ECONOMIC ANALYSIS OF ALTERNATIVES

NET CASH FLOW OF INVESTMENT OPPORTUNITIES
Payments and disbursements need to be determined. Then a net cash flow can be developed.

PRESENT-WORTH AMOUNT
It is the difference between the equivalent receipts and disbursements at the present.
Assume F_t is a cash flow at time t, the present worth (PW) is

t=n
PW(i) = sum F(t) * [ 1 + i ] ^ -t
t=0

for any interest -1 < i < infinity.

ANNUAL EQUIVALENT AMOUNT

The annual equivalent amount is the annual equivalent receipts minus the annual equivalent
disbursements of a cash flow. It is used for repeated cash flows per year.

AE (i) = PW (i) * (A/P,i,n)

*- -* *- -*
| t = n | | i(1+i)^n |
= | sum F(t) * [ 1 + i ] ^ -t | * | ------------- |
| t = 0 | | (1+i)^n - 1 |
*- -* *- -*

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Example : Given the following cash flow:

=======================================
Year end Receipts Disbursements
=======================================
0 $0.00 -$1000.00
1 $400.00 $0.00
2 $900.00 -$1000.00
3 $400.00 ....
4 $900.00 -$1000.00
... ....... ....
n-2 $900.00 -$1000.00
n-1 $400.00 $0.00
n $900.00 $0.00

Therefore,

AE(10) = [-1000+400(P/F,10,1)+900(P/F,10,2)](A/P,10,2)

for 10%, or

AE(10) = [-$1000+400(0.9091)+900(0.8265)](0.5762)
= $61.93

FUTURE WORTH AMOUNT

It is the difference between the equivalent receipts and disbursements at some common point in the
future.
t=n
FW (i) = Sum F_t * [ 1 + i ]^[ n - t ]
t=o

for any interest rate -1 < i < infinity.

PW, AE, and FW differ in the point of time used to compare the equivalent amounts.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the interest rate that causes the equivalent receipts of a cash flow to be
equal to the equivalent disbursements = of the cash flow. Solve for i* such that

t=n
0 = PW(i*) = sum F(t) * [ 1 + i* ] ^ -t
t=0

Example : Given the following cash flow:

=======================================
Year end Receipts Disbursements
=======================================
0 $0.00 -$1000.00
1 $0.00 -$800.00
2 $500.00 $0.00
3 $500.00 $0.00
4 $500.00 $0.00
5 $1200.00 $0.00

By trial and error i = 12.8 %.

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MEANING OF IRR
It represents the rate of return on the unrecovered balance of an investment (or loan). The following
equation can be developed for loans:

U_t = U_(t-1) * [ 1 + i^* ] + F_t

where

U_o = Initial amount of loan or first cost of asset (F_o),

F_t = Amount received at the end of period t.
i^* = IRR.

It should be noted that the basic equation for i^* requires the solution of the roots of a nonlinear
(polynomial) function. Therefore, more than one root might exist. The following conditions results in one
root (single i*):

1. F_o =< 0 (the first nonzero cash flow is a disbursement).

2. One change in sign in the cash flow (from disbursements to receipts).
3. PW(0) >0 (the sum of all receipts is greater than the sum of all disbursements).

In case of multiple IRR, other methods can be used.

PAYBACK PERIOD
a. Without Interest : The payback period without interest is the length of time required to recover the first
cost of an investment from the cash flow produced by the investment for an interest rate of zero. It can be
computer as the smallest n that produces

t=n
Sum [ F_t > 0 ]
t=o

b. With Interest : The payback period with interest is the length of time required to recover the first cost
of an investment from the cash flow produced by the investment for a given interest rate. It can be
computer as the smallest n that produces

t=n
Sum F_t * [1 + i]^[-t] >= 0
t=o

ANNOTATED BIBLIOGRAPHY
1. Barnett, W. S. (1993). The economic evaluation of home visiting programs. The Future of Children:
Home Visiting, 3. Center for the Future of Children, the David and Lucile Packard Foundation, 93-112.
The Future of Children journal is available on-line. Some issues can be viewed or downloaded at the following World Wide Web
site, and older hard copy issues can be ordered free of charge at: http://www.futureofchildren.org/
Barnett is a strong advocate of more use of cost-benefit or cost-effectiveness analyses in evaluations of social programs. He has
been involved in conducting several influential cost-benefit studies of home visiting and early intervention programs (including the
well-known Perry Preschool Program study), and reviews several others. He argues that it is more feasible than most evaluators
believe, and provides a relatively detailed discussion of steps and procedures.
2. Barnett, W.S. (1985). Benefit-cost analysis of the Perry Preschool program and its policy implications.
Educational evaluation and policy analysis, 7. 333-342.

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3. Berreuta-Clement, J. R., Schweinhart, L. J., Barnett, W. S. , et al. (1984). Changed lives: The effects of
the Perry Preschool program on youths through age 19. Monographs of the High/Scope Educational
Research Foundation, no. 8. Ypsilanti, MI: High/Scope Press.
One of the best-known and most influential longitudinal studies of the effects of early intervention programs. The influence of this
study on funders and policy makers is often attributed to its use of a cost-benefit analysis to show that funding intensive
programs for low-income preschoolers can be a good long-term investment for society.
4. Callor, S., Betts, S. C., Carter, R., & Marczak, M. (1997). State Strengthening Evaluation Guide.
Tucson, AZ: USDA/CSREES & University of Arizona.
Program development and evaluation manual designed by the Evaluation Collaboration for use in State Strengthening Projects.
Based on the five-tiered model of evaluation of Jacobs (1988). The manual may be viewed or downloaded from the World Wide
Web at: http://ag.arizona.edu/fcr/fs/cyfar/evalgde.htm
5. Cook, T. D., & Campbell, D. T. (1979). Quasi-experimentation: Design and analysis issues for field
settings. Boston: Houghton-Mifflin Co.
This is a standard reference on quasiexperimental research designs, which are commonly used for evaluation of community-
based programs.
6. Jacobs, F.H. (1988). The five-tiered approach to evaluation: Context and implementation. In H.B.
Weiss, & F.H. Jacobs (Eds.), Evaluating family programs. New York: Aldyne de Gruyter.
This chapter describes a model of evaluation of community-based programs which served as the basis for the model used in the
State Strengthening Evaluation Guide.
7. Kettner, P. M., Moroney, R. M., & Martin, L. L. (1990). Designing and managing programs: An
effectiveness-based approach. Newbury Park, CA: Sage.
Useful discussion of the pros and cons of several budgeting systems (line-item, functional, and program budgeting) in terms of
facilitating the calculation of unit costs. Emphasizes that cost allocation is time-consuming and requires careful choices about
methodology. Concludes that despite the difficulties of setting up such a budgeting system, it is worth the time and effort for
programs to be able to accurately determine true unit costs and program costs. Although the advantages are primarily discussed
in terms of practical benefits for program managers, the ability to accurately allocate costs and value of services is also a
prerequisite for cost-benefit analysis as a long-term evaluation strategy.
8. Mishan, E. J. (1988). Cost-benefit analysis (4th ed.). London: Unwin Hyman.
An economics textbook, and one of the standard references for cost-benefit analysis techniques. Although fairly technical and
mathematically oriented, this book is intended to be accessible to serious non-economists who are willing to devote some time
and effort to learning the theory and techniques. Includes a sometimes whimsical discussion of the problems of valuing
intangibles, such as time.
9. Rossi, P. H., & Freeman, H. E. (1993). Evaluation: A systematic approach (5th ed.). Newbury Park:
Sage Publications, pp. 363-401.
A standard evaluation text. Rossi and Freeman take the position that while "efficiency assessment" (their term for cost-benefit
and cost-effectiveness analyses) is highly technical therefore not always feasible, all program evaluators should at least have
some understanding of the basic concepts involved. This is because impact evaluations always implicitly involve issues of how
much effort or cost is required to achieve a desired outcome.
10. Thompson, M. S. (1980). Benefit-cost analysis for program evaluation. Beverly Hills: Sage.
Another basic text, which elaborates on the quantitative aspects of benefit-cost (or cost-benefit) analysis. Includes in-depth
discussions of issues of discounting and cost adjustments.
11. Weimer, D. L., & Vining, A. R. (1992). Policy analysis: Concepts and practice (2nd ed.). Englewood
Cliffs, NJ: Prentice Hall.
Fairly technical discussion aimed at professional policy analysts; assumes a background in economics. Useful discussion and
flow chart distinguishes five related approaches and when they are appropriate to use: Benefit-Cost Analysis, Qualitative Benefit-
Cost Analysis, Modified Benefit-Cost Analysis, Cost-Effectiveness Analysis, and Multi-Goal Analysis. Appropriateness of each
method is determined primarily by 1) whether the relevant impacts and inputs can be readily quantified and monetized, and 2)
whether there are goals or benefits other than economic efficiency which need to be incorporated into the analysis.
12. White, K. R. (1988). Cost analyses in family support programs (pp. 429-443). In H. B. Weiss & F. H.
Jacobs (Eds.), Evaluating family programs. New York: Aldyne de Gruyter.
Suggests use of general term "cost analyses". Basically takes a skeptical approach, noting that "present conceptualizations of
cost analysis are overly simplistic, expectations are unrealistically high, and much of what is labeled as cost-effectiveness or
cost-benefit research suffers from serious conceptual and methodological inadequacies" (p.429).
13. Zeckhauser, R. (1975). Procedures for valuing lives. Public Policy, 23(4), 419-464.

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ENGINEERING ECONOMICS

Introduction:
The objective of this module is to describe the return to capital in the form of interest (or profit) and
to illustrate how basic equivalence calculations are made with respect to the time value of capital in
engineering economy studies.

The following concepts will be discussed in this module.

x Simple interest
x Compound interest
x The Concept of Equivalence
x Comparing Alternatives

Concept of Equivalence
To compare alternatives that provide the same service over extended periods of time when interest
is involved, we must reduce them to an equivalent basis that is dependent on: ---If two alternatives
are economically equivalent, then they are equally desirable.

Equivalence factors are needed in engineering economy to make cash flows (CF) at different points
in time comparable. For example, a cash payment that has to be made today cannot be compared
directly to a cash flow that must be made in 5 years.

Since the time value of money changes according to:

1.The interest rate,
2.The amount of money involved,
3.The timing of receipt or payment,
4. The manner in which interest is compounded,

We need a way to reduce CF's at different times to an equivalent basis. Equivalence factors allow
us to do so.

Principles of Equivalence
x Equivalent cash flows have the same economic value at the same point in time.
x Cash flows that are equivalent at one point in time are equivalent at any point in time.
x Conversion of a cash flow to its equivalent, at another point in time must reflect the interest
rate(s) in effect for each
period between the equivalent cash flows.
x Equivalence between receipts and disbursements: the interest rate that sets the receipts
equivalent to the disbursements is
the actual interest rate (IRR).
x Economic equivalence is established, in general, when we are indifferent between a future
payment, or series of payments, and a present sum of money.

Notation and Cash Flow Diagrams (CFDs)

The following notation is utilized in formulas for compound interest calculations:
I = effective interest rate per interest period
N = number of compounding periods
P = present sum of money; the equivalent value of one or more cash flows at a reference point in
time called present
F= future sum of money; the equivalent value of one or more cash flows at a reference point in time
called future
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series continuing for
a specified number of periods, starting at the end of the first period and continuing through the last
period

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1. The Horizontal line is a time scale, with progression of time moving from left to right. The period
(e.g., year, quarter, month) labels can be applied to intervals of time rather than to points on the
time scale.
2. The arrows signify cash flows and are placed at the end of the period. If a distinction needs to be
made, downward arrows represent expenses (negative cash flows or cash outflows) and upward
arrows represent receipts (positive cash flows or cash inflows).
3. The cash flow diagram is dependent on the point of view. The situations shown in the figure were
based on the cash flows as seen by the lender. If the directions of all arrows had been reversed, the
problem will have to be diagrammed from borrower's viewpoint.

Cash Flow Diagram

Simple Interest
The amount of interest earned (or paid) is directly proportional to the principal of the loan, the umber
of interest periods for which the principal is committed, and the interest rate per period.

The total interest, I, earned or paid may be computed in the formula.

I=(P)(N)(i)
Where,
P = principal amount lent or borrowed
N = number of interests periods (e.g., years)
i = interest rate per interest period

Compound Interest
The amount of interest earned (or paid) per interest period depends on the remaining principal of
the loan plus any unpaid interest charges.

Example
Loan $1000 for 3 years at 10% per year.
(1) (2)=(1)x10% (3)=(1)+(2)
Period
Amount Owed @ Interest Amount Amount Owed @
Beginning of Period for Period End of Period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

Thus the interest earned after three years will be $331.

A graphical comparison of simple interest and compound interest is given in Figure 4-1. As the
number of periods increases, the difference in the compound and simple becomes greater. The

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difference is due to the effect of compounding, which is essentially the calculation of interest on
previously earned interest. This difference would be much greater for larger amounts of money,
higher interest rates, or greater number of years. Thus, simple interest does consider the time value
of money but does not involve the compounding of interest. Compound interest is much more
common in practice than simple interest.

Figure 4-1. Illustration of Simple versus Compound Interest

Finding F When Given P: F/P

If an amount of P dollars is invested at a point in time and i% is the interest rate per period, the
amount will grow to a fuure amount of P+Pi=P(1+ i) by the end of one period; by the end of the
second period, the amount will grow to P(1+ i)(1+ i)=P(1+ i)^2; at the end of N periods the amount
will grow to F=P(1+ i)^N. The quanity (1+ i)^N is called the single payment compound amount
factor.

The F/P factor converts a single cashflow or an equivalent cash flow in a year after it. Another way
to think of it is, a F/P factor moves a cash flow forward in time.

Finding P When Given F: P/F

The P/F factor converts a single cash flow in the future to an equivalent cash flow in a year before it.
Another way to think of it is, a P/F factor moves a cash flow backwards in time.

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Annuities
Annuities are a series of equal cash flows that occur every period. Don't let the name mislead you;
these cash flows are not restricted to years. Monthly car payments can be treated as monthly
annuities, likewise for equal CF's that occur every quarter, or every six months.

Two factors are used to convert annuities to single cash flow equivalents F/A and P/A.
Likewise, A/F and A/P factors allow us to convert single cash flows into an equivalent
series of annuities. It should be noted that the formulas and tables to be presented are
derived such that A occurs at the end of each period, and thus:

1. P (present equivalent value) occurs one interest period before the first A (uniform amount).
2. F (future equivalent value) occurs at the same time as the last A, and N periods after P.
3. A (annual equivalent value) occurs at the end of periods 1 through N, inclusive.

We'll look at each individually

Finding F When Given A: F/A

The F/A factor converts an annuity to an equivalent cash flow in the year in which the annuity
ends.The F/A factor collapses a series of cash flows forward in time. Note that the F/A factors
transforms an annuity to a single cash flow that occurs in the same year the annuity terminates.

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If a cash flow in the amount of A dollars occurs at the end of each period for N periods and i% is the
interest (profit or growth) rate per period, the future equivalent value F, at the end of the Nth period
is obtained by summing the future equivalents of each of the cash flows. Thus,

Finding P When Given A: P/A

The P/A factor converts an annuity to an equivalent cash flow in a year before it. The P/A factor
collapses a series of cash flows backward in time. Note that the P/A factors transforms an annuity
to a single cash flow that occurs one year before the annuity begins.

P can be calculated by,

Finding A When Given F: A/F

The A/F factor converts a cash flow to a past annuity series. An A/F factor expands a single cash
flow backward in time. The A/F factor creates an annuity series that ends in the same time period
as the single cash flow with N equal cash flows. A can be calculated from the following equation

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Finding A When Given P: A/P

The A/P factor converts a cash flow to a future annuity series. An A/P factor expands a single cash
flow forward in time. The A/P factor creates an annuity series that begins in the first time period
following the single cash flow with N equal cash flows.

A can be calculated by,

Deferred Annuities
Up to this point, we have been discussing ordinary annuities where the first cash flow is
made at the end of the first period. A deferred annuity exists when the first cash flow does
not begin until J periods after the zeroth period, as shown in the figure below.

Besides the fact that the annuity begins in year j, we can use the factors presented before to
work with it. However, we will have to exercise a bit of care and in some cases we will need
to use multiple factors.

Find P0 of the deferred annuity

Let's begin by finding the present day equivalent (P0) of the deferred annuity, instead of sing a
straight P/A factor we will have to combine it with a P/F factor.

First, we use a P/A factor to collapse the annuity into a single cash flow in year j.
Pj = A (P/A, i, n-j)
Next, a P/F factor is used to bring Pj back to year zero.
P0 = Pj (P/F, i, j)

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Treating the cash flows in a step-by-step manner can be tedious, it is easier to combine the factors
into one equation by substituting for Pj in the second expression, giving:
P0 = [A (P/A, i, n-j)](P/F, i, j)

Next, a P/F factor is used to bring Pj back to year zero.

P0 = Pj (P/F, i, j)

Treating the cash flows in a step-by-step manner can be tedious, it is easier to combine the factors
into one equation by substituting for Pj in the second expression, giving:

P0 = [A (P/A, i, n-j)](P/F, i, j)

Working with Multiple Factors

Only in the simplest of cases will one equivalence factor be needed to find the correct solution. The
following examples illustrate how multiple factors are used simultaneously.

Example 1: Summing Factors

Find the present equivalent of the following CFD (i=5%). In this case, we have to transform each
cash flow into its equivalent in year 0 using a P/F factor. We'll build the expression for P0 one step
at a time,

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  Haery Sihombing/ IP

P0 = 750(P/F,5%,3) + ...

Brings the first 750 cash flow to year 0

P0 = 750(P/F,5%,3) + 1500(P/F,5%,6) + ..

Now we've brought the $1500 cash

flow to the present

P0 = 750(P/F,5%,3) + 1500(P/F,5%,6) - 500(P/F,5%,9)

Finally we've brought the negative 500

cash flow back to the present.
Remember the convention with CFD's
that positive cash flows point up while
negative cash flows use arrows
pointing down.

So, our final expression for the present equivalent is:

P0 = 750(P/F,5%,3) + 1500(P/F,5%,6) - 500(P/F,5%,9)

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  Haery Sihombing/ IP

Multiple Factors, part 2

A sequence of factors can also be multiplied together to obtain a solution, as you saw with deferred
annuities. The following example illustrates the same idea.

Find the present equivalent of the CFD shown below (i=12%)

While a single correct sequence of CFs does not exist, we have to be careful to include all the cash
flows in the CFD. One sequence:

First, we move the single cash flows at EOY2 -1000(P/F,12%,2) - 2000(P/F,12%,10)

and EOY10 to year zero.

Next, we move the first series of annuities to +1000(P/A,12%,4) x (P/F,12%,3)

the present day. The P/A factor will convert
the 1000 annuities to a single, positive cash
flow in year 3. The P/F factor then converts
the single cash flow in year 3 to its year 0
equivalent.

Finally, we treat the second annuity in a +1500(P/A,12%,3) x (P/F,12%,7)

similar fashion. The P/A factor will convert the
1500 annuities to a single, positive cash flow
in year 7. The P/F factor then converts the
single cash flow in year 7 to its year 0
equivalent.

Putting it all together to find P0:

P0 = -1000(P/F,12%,2) - 2000(P/F,12%,10) + 1000(P/A,12%,4)(P/F,12%,3) +

1500(P/A,12%,3)(P/F,12%,7)
Since there usually are multiple ways to solve such a problem, the following solutions are also
correct:

We could treat the annuities as one of $1000 in years 4 through 10 and a second annuity of $500 in
years 8, 9, and 10.

P0 = -1000(P/F,12%,2) - 2000(P/F,12%,10) + 1000(P/A,12%,7)(P/F,12%,3) +

500(P/A,12%,3)(P/F,12%,7)
Another way to solve the problem: bring the -2000 cash flow to year 2, then move both back to year
0 together.

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  Haery Sihombing/ IP

P0 = [-1000 - 2000(P/F,12%,8)](P/F,12%,2) + 1000(P/A,12%,4)(P/F,12%,3) +

1500(P/A,2%,3)(P/F,12%,7)
Finally, we could find the year 7 equivalent of both annuities and move that cash flow back to year
0.

P0 =-1000(P/F,12%,2) - 2000(P/F,12%,10) + [1000(F/A,12%,4)

+1500(P/A,12%,3)](P/F,12%,7)

Gradient cash flows: A/G

In some cases, it may be necessary to convert a series of gradient cash flows into a series of equal
annuities using the A/G factor.

For example, convert the following into an annual series of equal cash flows in years 1 through 6.
(i=9%)

We know that G= -25, and N=6 so

A= -25(A/G, 9%, 6)

Note that even though there is no cash flow in year 1 with the gradient cash flows, with the annuity
cash flows there is a cash flow in year 1.

Gradient Cash Flows: P/G

A uniform gradient of cash flows occurs when a series of cash flows increases or decreases by the
same amount every period. For example, if costs increase by $200 every year for the next 8 years,
we have a uniform gradient.

Gradients are either positive or negative, as shown below.

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Gradients can be confusing, although in the generic cases shown above we'd say that the gradient
occurs in years 1 through N there is no cash flow in year 1.

If we had the cash flow given below, we can use the P/G factor to find the present equivalent
(i=8%).

P0 = 50(P/G, 8%, 5)

For more complex cases, it is usually easiest to decompose a cash flow into two parts: an annuity
and a gradient so that

P = A(P/A, i, N) + G(P/G, i, N)

Where

A = the magnitude and sign of the annual cash flow (equal to the magnitude of the first observed
cash flow,
G = the magnitude and sign of the gradient cash flow
i = the interest rate
N = the number of periods over which the annuity and gradient occur.

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Applications of Money-Time Relationships:

Introduction:
When we talk of alternatives, we mean distinct, independent solutions to a given problem (Mutually
Exclusive Alternatives).
The problem may be the purchase of a new piece of machinery, in which case the alternatives are
different models of the desired machine. Another problem could be deciding how to save money for
a child's college education, in which case the alternatives could include savings vehicles such as
savings accounts, bonds, or stock investments.
Alternatives can be broadly classified as either investment alternatives or cost alternatives.
Investment alternatives involve an initial, first time cost (usually in year zero - the present) with net
positive future cash flows (Revenue minus Costs). Unless otherwise stated, Do Nothing is always
an alternative when choosing from a set of investment alternatives. Do Nothing would be the most
desirable choice if none of the investment alternatives is profitable at the given MARR.
Cost alternatives involve an initial, first time cost and further cost cash flows during the life of the
project. When cost alternatives are being considered, Do Nothing is rarely a feasible option. The
organization must spend the money with no chance to recover it. The most desirable cost
alternative is the one that minimizes the total cost (as measured by PW, AW, or FW).

Determining the Minimum Attractive Rate of Return:

The Minimum Attractive Rate of Return (MARR) is usually a policy issue resolved by the top
management of an organization in view of numerous considerations. Among these considerations
are the following:
1. The amount of money available for investment, and the source and cost of these funds (i.e.,
equity funds or borrowed funds).
2. The number of good projects available for investment and their purpose (i.e., whether they
sustain present operations and are essential, or expand on present operations and are elective).
3. The amount of perceived risk associated with investment opportunities available to the firm and
the estimated cost of administering projects over short planning horizons versus long planning
horizons.
4. The type of organization involved (i.e., government, public utility, or competitive industry)

The Present Worth Method:

The Present Worth method evaluates the desirability of an alternative relative to some base point in
time called the present (usually year 0). Basically, it looks at the present equivalent of all the cash
flows of an alternative's study period.

An alternative is profitable if its PW (MARR)>=0. When choosing from a set of alternatives, the most
desirable is the alternative with the most positive present worth.

To find PW as a function of i % (per interest period) of a series of cash inflows and outflows, it is
necessary to discount future amounts to the present by using the interest rate over the appropriate
study period (years, for example) in the following manner:

Where
i = effective interest rate, or MARR, per compounding period
k= index for each compounding period
Fk= future cash flows at the end of period k
N = number of compounding periods in the planning horizon (i.e., study period)

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The Future Worth Method

The Future Worth method evaluates the desirability of an alternative relative to some future point in
time, such as the end of the study period.

An alternative is profitable if its FW(MARR)>=0. When choosing from a set of alternatives, the most
desirable is the alternative with the most positive annual worth.

The Annual Worth Method

The Annual Worth method evaluates the desirability of an alternative as an equal annual series of
cash flows during the study period. Basically, it looks at the annual equivalent of all the cash flows
of an alternative.

An alternative is profitable if its AW (MARR)>=0. When choosing from a set of alternatives, the most
desirable is the alternative with the most positive annual worth.

The AW of a project is annual equivalent revenues or savings (R) minus annual equivalent
annual expenses (E), less its annual equivalent Capital Recovery (CR) amount, which is
can be calculated by,

CR(i%)=I(A/P, i%, N)-S(A/F, i%, N)

where,

I= initial investment for the project

S=salvage(market) value at the end of the study period
N=project study period

An annual equivalent value pf R, E and CR is computed for the study period, N, which is usually in
years. In equation form the AW, which is a function of i%, is N, which is usually in years. The AW
can be calculated by the following formula,

AW(i%)=R-E-CR(i%)

Also, we need to notice that the AW of a project is equivalent to its PW and FW. That is,
AW=PW(A/P, i%,N) and AW=FW(A/F,i%,N). Hence, it can be computed for a project from these
equivalent values.

The AW worth is most useful when comparing alternatives with unequal expected lives.

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Example I: Choosing among investment alternatives.

ABC Company is evaluating three new product lines. All relevant estimates are supplied in the table
below. If the company's MARR is 15%, which alternative should they pursue?

PRODUCT A PRODUCT B PRODUCT C

Investment 120,000 140,500 150,000
Est. Annual Sales 45,000 53,000 52,000
Est. Annual Expenses 13,500 18,000 12,000
Salvage Value 10,000 5,000 12,000
Expected Life 6 years 6 years 6 years

Solution
Although no method was specified, PW is usually the most straightforward to use. Since all
products have expected lives of 6 years, PW is a good choice. We'll also assume that the study
period is 6 years. Now, we just have to calculate the PW of each alternative. Remember, since
these are investment alternatives, Do Nothing is also a possible choice, if none of the alternatives
prove profitable with a MARR of 15%.

PWA = -$120,000 + (45,000-13,500)(P/A, 15%,6) + 10,000(P/F, 15%, 6)

PWA = -$120,000 + 31,500(3.7845) + 10,000(0.4323)
PWA = $3,535

PWB = -$140,500 + (53,000-18,000)(P/A, 15%,6) + 5,000(P/F, 15%, 6)

PWB = -$140,500 + 35,000(3.7845) + 5,000(0.4323)
PWB = -$5,381

PWC = -$150,000 + (52,000-12,000)(P/A, 15%,6) + 12,000(P/F, 15%, 6)

PWC = -$150,000 + 40,000(3.7845) + 12,000(0.4323)
PWC = $6,567

Since PWB<0, it can immediately be ruled out as an option since at a MARR of 15% it is not
profitable. The final choice must be made between products A and B, both have PW>0. Since
PWC>PWA, Product C is the final choice, since it is the most profitable - even though it has the
highest initial investment.

Final Choice - Go with Product C

Ex. II: Choosing among cost alternatives.

ABC Company must install a water purification system to comply with local clean water laws. All
relevant estimates for systems on the market are supplied in the table below. If the company's
MARR is 12%, which alternative should they pursue?

A B C
Investment 80,000 88,000 94,000
Estimated Annual Expenses 8,000 6,200 5,800
Salvage Value 22,000 26,000 31,000
Expected Life 15 years 15 years 15 years

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Solution:
Although no method was specified, PW is usually the most straightforward to use. Since all 3
products have expected lives of 15 years, PW is a good choice. We'll also assume that the study
period is 15 years. Now, we just have to calculate the PW of each alternative.

Remember, since these are cost alternatives, Do Nothing is not a possible choice, none of the
alternatives will be profitable with a MARR of 12% (since they involve mostly negative cash flows)
but the company must choose one.

PWA = -$80,000 - 8,000(P/A, 12%,15) + 22,000(P/F, 12%, 15)

PWA = -$80,000 - 8,000(6.8109) + 22,000(0.1827)
PWA = -$130,468

PWB = -$88,000 - 6,200(P/A, 12%, 15) + 26,000(P/F, 12%, 15)

PWB = -$88,500 - 6,200(6.8109) + 26,000(0.1827)
PWB = -$125,477

PWC = -$94,000 - 5,800(P/A, 12%, 15) + 31,000(P/F, 12%, 15)

PWC = -$94,000 - 5,800(6.8109) + 31,000(0.1827)
PWC = -$127,840

Since we have cost alternatives, we want to choose the one that has the least negative present
worth, that is the one that costs the least over the study period. System B is the final choice, since it
is the least costly- even though it is not the least expensive to install or operate.

Final Choice - Go with System B

We can verify our answer using the AW method:

AWA = -$80,000(A/P, 12%, 15) - 8,000 + 22,000(A/F, 12%, 15)

AWA = -$80,000(0.1468) - 8,000 + 22,000(0.0315)
AWA = -$19,051

AWB = -$88,000(A/P, 12%, 15) - 6,200 + 26,000(A/F, 12%, 15)

AWB = -$88,500(0.1468) - 6,200 + 26,000(0.0315)
AWB = -$18,299

AWC = -$94,000(A/P, 12%, 15) - 5,800 + 31,000(A/F, 12%, 15)

AWC = -$94,000(0.1468) - 5,800 + 31,000(0.0315)
AWC = -$18,623

Confirming our PW calculations, AW also indicates System B to be the least expensive.

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Ex. III: Alternatives with different useful lives.

Two possible investment alternatives are under consideration for a study period of 10 years. Given
the data in the table and a MARR of 10%, which alternative would you choose? State all
assumptions

Do Nothing Invest in A Invest in B

Initial Investment (I) 0 $40k $60k
Annual revenues (R) 0 8k 12k
Annual expenses (E) 0 2k 1.5k
Salvage Value (SV) 0 10k (EOY 10) 25k (EOY 5)
Useful life, in years N/A 10 5

Solution
In this case the useful life of Investment B is shorter than the study period of 10 years, so we can
assume repeatability, we will invest in B in years 0 and 5 - repeating it twice.

Since we are assuming repeatability, it is easiest to use the Annual Worth method to compare the
alternatives. That way, we only need to compute the AW for each during its useful life.

AWA = -$40k(A/P, 10%, 10) + ($8k - 2k) + 10k(A/F, 10%, 10)

AWA = -$40k(0.1627) + $6k + 10k(0.0627)
AWA = $0.119k = $119

AWB = -$60k(A/P, 10%, 5) + ($12k - 1.5k) + 25k(A/F, 10%, 5)

AWB = -$60k(0.2638) + $10.5k + 25k(0.1638)
AWB = -$1.233k = -$1,223

Since we are looking at investment alternatives, we want to choose the most profitable project. B is
not profitable while A is just profitable at the chosen MARR, so the final selection would be
alternative A.

Why not use PW?

In cases where repeatability is assumed, comparing the AW over the useful lives of alternatives is
preferable. It is computationally less work than using the PW. If PW was used however, one would
need to compare the PW over the study period. In this case:

PWA = -$40k + ($8k - 2k)(P/A, 10%, 10) + 10k(P/F, 10%, 10)

would be compared to,

PWB = -$60k + ($12k - 1.5k)(P/A,10%,10) + 25k(P/F, 10%, 5) -60k(P/F,10%,5)

+25k(P/F, 10%,10)

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Ex. IV: Cost Alternatives with different useful lives.

Your plant must add another boiler to its steam generating system. Bids have been obtained from
two boiler manufacturers as follows:

Boiler A Boiler B
Capital Investment $50,000 $120,000
Useful Life (N) 20 years 40 years
Salvage Value at EOY N 10,000 20,000
9,000 3,000 increasing 300 per year
Annual Operating Costs
after the first year

If the MARR is 10% per year, which boiler would you recommend? State all assumptions.

Solution:
First, the choice involves cost alternatives, so Do Nothing is not an option - the plant must add
another boiler. From the data we can assume that the study period is 40 years, and since the useful
life of Boiler A is 20 years, we must assume repeatability.

Once again we will use the Annual Worth method to compare the alternatives. That way, we only
need to compute the AW for each during its useful life.

AWA = -$50,000(A/P, 10%, 20) + 10,000(A/F, 10%, 20) - 9,000

AWA = -$50,000(0.1175) + 10,000(0.0175) - 9,000
AWA = -$14,704
For Boiler B, operating costs increase by $300 each year after year 1 so a gradient will be needed
to solve the problem.

AWB = -$120,000(A/P, 10%, 40) + 20,000(A/F, 10%, 40) -3000 -300(A/G,10%,40)

AWB = -$120,000(0.1023) + 20,000(0.0023) -3000 -300(9.0962)
AWB = -$17,962
Since we are considering cost alternatives, we want to choose the least costly project. Because
boiler B is about $3,200 more expensive per year to own and operate than Boiler A, we recommend
that Boiler A should be purchased.

Ex. V: Alternatives involving electrical efficiency.

Two electric motors X and Y are being considered to drive a centrifugal pump. One of the motors
must be selected. Each motor is capable of delivering 50 horsepower (output) to the pumping
operation. It is expected that the motors will be in use 1000 hours per year.

If electricity costs $0.07 per kilowatt-hour, which motor should be selected if MARR=8% per year?
Refer to the data below.

Pump X Pump Y
Initial cost $1,200 $1,000
Electrical efficiency 0.82 0.77
Annual Maintenance cost $60 $100
Useful Life 5 years 5 years
Salvage value at end of useful life 0 0

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Solution:
First, the choice involves cost alternatives, so Do Nothing is not an option - a pump must be
purchased.

Any of the equivalent worth methods can be used to make the recommendation, we'll use AW and
then check the answer using PW.

Motor X
Each pump has three costs associated with it: the initial purchase cost, the annual maintenance
cost, and the annual operating cost (consumption of electricity - Cx). The first two are given to us
and we have enough data to calculate the third as follows:

Cx = Electrical Input x (conversion factor from hp to kW) x (hours of operation) x (cost of electricity)
[HINT: Check your units to make sure the final number is in the correct units]

Electrical input refers to the electrical efficiency of the pump. Both motors output 50hp but require
different amounts of input since neither is 100% efficient. Since efficiency=ouput/input, we can find
the electrical input of pump X as follows:

Input = Output/Efficiency = 50 hp/0.82

We know electricity costs $0.07 per kW-hr and we need 1000 hours per year. Finally, we find that
1hp = 0.746kw. We are ready to find Cx:

Cx = (50 hp/ 0.82) x (0.746 kW/hp) x (1000 hrs / year) x ($0.07/kw-hr)

Cx = $3,184.15 per year [Checking units shows that all but $ in the numerator and years in the
denominator cancel out - giving us $ per year]

To find the AW of X we use:

AWX = -$1,200(A/P, 8%, 5) -$60 -$3,184.15

AWX = -$1,200(0.2505) -$60 -$3,184.15
AWX = -$3,544.75

Motor Y
A similar approach is used to calculate the AW of Motor Y:

AWX = -$1,000(A/P, 8%, 5) - $100 - (50hp/0.77) x(0.746kw/hp) x(1000hrs/yr)

x($0.07/kw-hr)
AWX = -$1,000(0.2505) - $100 - 3,390.91
AWX = -$3,741.41

To minimize the expense of operating the pump, choose pump X.

Confirm with PW
PWX = -$1,200 + (-$60 -$3,184.15)(P/A,8%,5)
PWX = -$1,200 + (-$60 -$3,184.15)(3.9927)
PWX = -$14,152.92
PWY = -$1,000 + (-$100 -$3,390.91)(P/A,8%,5)
PWY = -$1,000 + (-$100 -$3,390.91)(3.9927)
PWY = -$14,938.16
As we should expect, PW confirms that Pump X is the better alternative.

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We can also use PW to double check our AW calculations:

AWX = PWX (A/P,8%,5)

AWX = -$14,152.92(0.2505) = $3,545
AWY = PWY (A/P,8%,5)
AWX = -$14,938.16(0.2505) = $3,742

Overview of Terminology for The Time Value of Money and Comparing of

Alternatives Module:

Terminology: Brief Definition:

Series of equal cash flows that occur every period. Don't let the name
Annuities mislead you; these cash flows are not restricted to years
The amount of interest earned (or paid) per interest period depends on
Compound Interest the remaining principal of the loan plus any unpaid interest charges.
Annuity where the first cash flow does not begin until some J periods
Deferred Annuity after the zeroth period

The concept that items are of the same type or desirability. If two
Equivalence alternatives are economically equivalent, then they are equally desirable.

Future Worth Method that evaluates the desirability of an alternative relative to some
Method future point in time, such as the end of the study period.
Interest the profit in goods or money that is made on invested
MARR Minimum Attractive Rate of Return
Present Worth Method that evaluates the desirability of an alternative relative to some
Method base point in time called the present
The amount of interest earned (or paid) is directly proportional to the
Simple Interest principal of the loan, the number of interest periods for which the
principal is committed, and the interest rate per period.

49
 ENGINEERING ECONOMICS
Factor Name Converts Symbol Formula
Single Payment
to F given P (F/P, i%, n) (1 + i)n
Compound Amount
Single Payment
to P given F (P/F, i%, n) (1 + i) –n
Present Worth
Uniform Series i
to A given F (A/F, i%, n)
Sinking Fund 1  i n  1
i 1  i 
n
Capital Recovery to A given P (A/P, i%, n)
1  i n  1
Uniform Series
to F given A (F/A, i%, n)
1  i n  1
Compound Amount i
Uniform Series 1  i n  1
to P given A (P/A, i%, n)
i 1  i 
Present Worth n

Uniform Gradient 1  i n  1  n
to P given G (P/G, i%, n)
i 2 1  i  i 1  i 
Present Worth n n

Uniform Gradient †
to F given G (F/G, i%, n)
1  i n  1  n
Future Worth i2 i
Uniform Gradient 1 n
to A given G (A/G, i%, n) 
Uniform Series
NOMENCLATURE AND DEFINITIONS
A ..........Uniform amount per interest period
B ..........Benefit
BV ........Book Value
C ..........Cost
d...........Combined interest rate per interest period
Dj .........Depreciation in year j
F ..........Future worth, value, or amount
f............General inflation rate per interest period
G ..........Uniform gradient amount per interest period
i............Interest rate per interest period
ie...........Annual effective interest rate
m ..........Number of compounding periods per year
n...........Number of compounding periods; or the expected
life of an asset
P ..........Present worth, value, or amount
r ...........Nominal annual interest rate
Sn..........Expected salvage value in year n
Subscripts
j............at time j
n...........at time n
†...........F/G = (F/A – n)/i = (F/A) u (A/G)
i 1  i n  1
NON-ANNUAL COMPOUNDING
§ r·
m
ie ¨1  ¸  1
© m¹
BREAK-EVEN ANALYSIS
By altering the value of any one of the variables in a
situation, holding all of the other values constant, it is
possible to find a value for that variable that makes the two
alternatives equally economical. This value is the break-
even point.
Break-even analysis is used to describe the percentage of
capacity of operation for a manufacturing plant at which
income will just cover expenses.
The payback period is the period of time required for the
profit or other benefits of an investment to equal the cost of
the investment.
INFLATION
To account for inflation, the dollars are deflated by the
general inflation rate per interest period f, and then they are
shifted over the time scale using the interest rate per
interest period i. Use a combined interest rate per interest
period d for computing present worth values P and Net P.
The formula for d is
d = i + f + (i u f)
 ENGINEERING ECONOMICS (continued)

A
DEPRECIATION Capitalized Costs = P =
i
C  Sn
Straight Line Dj
n BONDS
Bond Value equals the present worth of the payments the
Accelerated Cost Recovery System (ACRS)
purchaser (or holder of the bond) receives during the life of
Dj = (factor) C the bond at some interest rate i.
A table of modified factors is provided below. Bond Yield equals the computed interest rate of the bond
BOOK VALUE value when compared with the bond cost.
BV = initial cost – 6 Dj RATE-OF-RETURN
TAXATION The minimum acceptable rate-of-return is that interest rate
that one is willing to accept, or the rate one desires to earn
Income taxes are paid at a specific rate on taxable
on investments. The rate-of-return on an investment is the
income. Taxable income is total income less
interest rate that makes the benefits and costs equal.
depreciation and ordinary expenses. Expenses do not
include capital items, which should be depreciated. BENEFIT-COST ANALYSIS
In a benefit-cost analysis, the benefits B of a project should
CAPITALIZED COSTS exceed the estimated costs C.
Capitalized costs are present worth values using an
B – C t 0, or B/C t 1
assumed perpetual period of time.

MODIFIED ACRS FACTORS

Recovery Period (Years)
3 5 7 10
Year Recovery Rate (Percent)
1 33.3 20.0 14.3 10.0
2 44.5 32.0 24.5 18.0
3 14.8 19.2 17.5 14.4
4 7.4 11.5 12.5 11.5
5 11.5 8.9 9.2
6 5.8 8.9 7.4
7 8.9 6.6
8 4.5 6.6
9 6.5
10 6.5
11 3.3
 ENGINEERING ECONOMICS (continued)

Factor Table - i = 0.50%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9950 0.9950 0.0000 1.0050 1.0000 1.0050 1.0000 0.0000
2 0.9901 1.9851 0.9901 1.0100 2.0050 0.5038 0.4988 0.4988
3 0.9851 2.9702 2.9604 1.0151 3.0150 0.3367 0.3317 0.9967
4 0.9802 3.9505 5.9011 1.0202 4.0301 0.2531 0.2481 1.4938
5 0.9754 4.9259 9.8026 1.0253 5.0503 0.2030 0.1980 1.9900
6 0.9705 5.8964 14.6552 1.0304 6.0755 0.1696 0.1646 2.4855
7 0.9657 6.8621 20.4493 1.0355 7.1059 0.1457 0.1407 2.9801
8 0.9609 7.8230 27.1755 1.0407 8.1414 0.1278 0.1228 3.4738
9 0.9561 8.7791 34.8244 1.0459 9.1821 0.1139 0.1089 3.9668
10 0.9513 9.7304 43.3865 1.0511 10.2280 0.1028 0.0978 4.4589
11 0.9466 10.6770 52.8526 1.0564 11.2792 0.0937 0.0887 4.9501
12 0.9419 11.6189 63.2136 1.0617 12.3356 0.0861 0.0811 5.4406
13 0.9372 12.5562 74.4602 1.0670 13.3972 0.0796 0.0746 5.9302
14 0.9326 13.4887 86.5835 1.0723 14.4642 0.0741 0.0691 6.4190
15 0.9279 14.4166 99.5743 1.0777 15.5365 0.0694 0.0644 6.9069
16 0.9233 15.3399 113.4238 1.0831 16.6142 0.0652 0.0602 7.3940
17 0.9187 16.2586 128.1231 1.0885 17.6973 0.0615 0.0565 7.8803
18 0.9141 17.1728 143.6634 1.0939 18.7858 0.0582 0.0532 8.3658
19 0.9096 18.0824 160.0360 1.0994 19.8797 0.0553 0.0503 8.8504
20 0.9051 18.9874 177.2322 1.1049 20.9791 0.0527 0.0477 9.3342
21 0.9006 19.8880 195.2434 1.1104 22.0840 0.0503 0.0453 9.8172
22 0.8961 20.7841 214.0611 1.1160 23.1944 0.0481 0.0431 10.2993
23 0.8916 21.6757 233.6768 1.1216 24.3104 0.0461 0.0411 10.7806
24 0.8872 22.5629 254.0820 1.1272 25.4320 0.0443 0.0393 11.2611
25 0.8828 23.4456 275.2686 1.1328 26.5591 0.0427 0.0377 11.7407
30 0.8610 27.7941 392.6324 1.1614 32.2800 0.0360 0.0310 14.1265
40 0.8191 36.1722 681.3347 1.2208 44.1588 0.0276 0.0226 18.8359
50 0.7793 44.1428 1,035.6966 1.2832 56.6452 0.0227 0.0177 23.4624
60 0.7414 51.7256 1,448.6458 1.3489 69.7700 0.0193 0.0143 28.0064
100 0.6073 78.5426 3,562.7934 1.6467 129.3337 0.0127 0.0077 45.3613

Factor Table - i = 1.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9901 0.9901 0.0000 1.0100 1.0000 1.0100 1.0000 0.0000
2 0.9803 1.9704 0.9803 1.0201 2.0100 0.5075 0.4975 0.4975
3 0.9706 2.9410 2.9215 1.0303 3.0301 0.3400 0.3300 0.9934
4 0.9610 3.9020 5.8044 1.0406 4.0604 0.2563 0.2463 1.4876
5 0.9515 4.8534 9.6103 1.0510 5.1010 0.2060 0.1960 1.9801
6 0.9420 5.7955 14.3205 1.0615 6.1520 0.1725 0.1625 2.4710
7 0.9327 6.7282 19.9168 1.0721 7.2135 0.1486 0.1386 2.9602
8 0.9235 7.6517 26.3812 1.0829 8.2857 0.1307 0.1207 3.4478
9 0.9143 8.5650 33.6959 1.0937 9.3685 0.1167 0.1067 3.9337
10 0.9053 9.4713 41.8435 1.1046 10.4622 0.1056 0.0956 4.4179
11 0.8963 10.3676 50.8067 1.1157 11.5668 0.0965 0.0865 4.9005
12 0.8874 11.2551 60.5687 1.1268 12.6825 0.0888 0.0788 5.3815
13 0.8787 12.1337 71.1126 1.1381 13.8093 0.0824 0.0724 5.8607
14 0.8700 13.0037 82.4221 1.1495 14.9474 0.0769 0.0669 6.3384
15 0.8613 13.8651 94.4810 1.1610 16.0969 0.0721 0.0621 6.8143
16 0.8528 14.7179 107.2734 1.1726 17.2579 0.0679 0.0579 7.2886
17 0.8444 15.5623 120.7834 1.1843 18.4304 0.0643 0.0543 7.7613
18 0.8360 16.3983 134.9957 1.1961 19.6147 0.0610 0.0510 8.2323
19 0.8277 17.2260 149.8950 1.2081 20.8109 0.0581 0.0481 8.7017
20 0.8195 18.0456 165.4664 1.2202 22.0190 0.0554 0.0454 9.1694
21 0.8114 18.8570 181.6950 1.2324 23.2392 0.0530 0.0430 9.6354
22 0.8034 19.6604 198.5663 1.2447 24.4716 0.0509 0.0409 10.0998
23 0.7954 20.4558 216.0660 1.2572 25.7163 0.0489 0.0389 10.5626
24 0.7876 21.2434 234.1800 1.2697 26.9735 0.0471 0.0371 11.0237
25 0.7798 22.0232 252.8945 1.2824 28.2432 0.0454 0.0354 11.4831
30 0.7419 25.8077 355.0021 1.3478 34.7849 0.0387 0.0277 13.7557
40 0.6717 32.8347 596.8561 1.4889 48.8864 0.0305 0.0205 18.1776
50 0.6080 39.1961 879.4176 1.6446 64.4632 0.0255 0.0155 22.4363
60 0.5504 44.9550 1,192.8061 1.8167 81.6697 0.0222 0.0122 26.5333
100 0.3697 63.0289 2,605.7758 2.7048 170.4814 0.0159 0.0059 41.3426
 ENGINEERING ECONOMICS (continued)

Factor Table - i = 1.50%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9852 0.9852 0.0000 1.0150 1.0000 1.0150 1.0000 0.0000
2 0.9707 1.9559 0.9707 1.0302 2.0150 0.5113 0.4963 0.4963
3 0.9563 2.9122 2.8833 1.0457 3.0452 0.3434 0.3284 0.9901
4 0.9422 3.8544 5.7098 1.0614 4.0909 0.2594 0.2444 1.4814
5 0.9283 4.7826 9.4229 1.0773 5.1523 0.2091 0.1941 1.9702
6 0.9145 5.6972 13.9956 1.0934 6.2296 0.1755 0.1605 2.4566
7 0.9010 6.5982 19.4018 1.1098 7.3230 0.1516 0.1366 2.9405
8 0.8877 7.4859 26.6157 1.1265 8.4328 0.1336 0.1186 3.4219
9 0.8746 8.3605 32.6125 1.1434 9.5593 0.1196 0.1046 3.9008
10 0.8617 9.2222 40.3675 1.1605 10.7027 0.1084 0.0934 4.3772
11 0.8489 10.0711 48.8568 1.1779 11.8633 0.0993 0.0843 4.8512
12 0.8364 10.9075 58.0571 1.1956 13.0412 0.0917 0.0767 5.3227
13 0.8240 11.7315 67.9454 1.2136 14.2368 0.0852 0.0702 5.7917
14 0.8118 12.5434 78.4994 1.2318 15.4504 0.0797 0.0647 6.2582
15 0.7999 13.3432 89.6974 1.2502 16.6821 0.0749 0.0599 6.7223
16 0.7880 14.1313 101.5178 1.2690 17.9324 0.0708 0.0558 7.1839
17 0.7764 14.9076 113.9400 1.2880 19.2014 0.0671 0.0521 7.6431
18 0.7649 15.6726 126.9435 1.3073 20.4894 0.0638 0.0488 8.0997
19 0.7536 16.4262 140.5084 1.3270 21.7967 0.0609 0.0459 8.5539
20 0.7425 17.1686 154.6154 1.3469 23.1237 0.0582 0.0432 9.0057
21 0.7315 17.9001 169.2453 1.3671 24.4705 0.0559 0.0409 9.4550
22 0.7207 18.6208 184.3798 1.3876 25.8376 0.0537 0.0387 9.9018
23 0.7100 19.3309 200.0006 1.4084 27.2251 0.0517 0.0367 10.3462
24 0.6995 20.0304 216.0901 1.4295 28.6335 0.0499 0.0349 10.7881
25 0.6892 20.7196 232.6310 1.4509 30.0630 0.0483 0.0333 11.2276
30 0.6398 24.0158 321.5310 1.5631 37.5387 0.0416 0.0266 13.3883
40 0.5513 29.9158 524.3568 1.8140 54.2679 0.0334 0.0184 17.5277
50 0.4750 34.9997 749.9636 2.1052 73.6828 0.0286 0.0136 21.4277
60 0.4093 39.3803 988.1674 2.4432 96.2147 0.0254 0.0104 25.0930
100 0.2256 51.6247 1,937.4506 4.4320 228.8030 0.0194 0.0044 37.5295

Factor Table - i = 2.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9804 0.9804 0.0000 1.0200 1.0000 1.0200 1.0000 0.0000
2 0.9612 1.9416 0.9612 1.0404 2.0200 0.5150 0.4950 0.4950
3 0.9423 2.8839 2.8458 1.0612 3.0604 0.3468 0.3268 0.9868
4 0.9238 3.8077 5.6173 1.0824 4.1216 0.2626 0.2426 1.4752
5 0.9057 4.7135 9.2403 1.1041 5.2040 0.2122 0.1922 1.9604
6 0.8880 5.6014 13.6801 1.1262 6.3081 0.1785 0.1585 2.4423
7 0.8706 6.4720 18.9035 1.1487 7.4343 0.1545 0.1345 2.9208
8 0.8535 7.3255 24.8779 1.1717 8.5830 0.1365 0.1165 3.3961
9 0.8368 8.1622 31.5720 1.1951 9.7546 0.1225 0.1025 3.8681
10 0.8203 8.9826 38.9551 1.2190 10.9497 0.1113 0.0913 4.3367
11 0.8043 9.7868 46.9977 1.2434 12.1687 0.1022 0.0822 4.8021
12 0.7885 10.5753 55.6712 1.2682 13.4121 0.0946 0.0746 5.2642
13 0.7730 11.3484 64.9475 1.2936 14.6803 0.0881 0.0681 5.7231
14 0.7579 12.1062 74.7999 1.3195 15.9739 0.0826 0.0626 6.1786
15 0.7430 12.8493 85.2021 1.3459 17.2934 0.0778 0.0578 6.6309
16 0.7284 13.5777 96.1288 1.3728 18.6393 0.0737 0.0537 7.0799
17 0.7142 14.2919 107.5554 1.4002 20.0121 0.0700 0.0500 7.5256
18 0.7002 14.9920 119.4581 1.4282 21.4123 0.0667 0.0467 7.9681
19 0.6864 15.6785 131.8139 1.4568 22.8406 0.0638 0.0438 8.4073
20 0.6730 16.3514 144.6003 1.4859 24.2974 0.0612 0.0412 8.8433
21 0.6598 17.0112 157.7959 1.5157 25.7833 0.0588 0.0388 9.2760
22 0.6468 17.6580 171.3795 1.5460 27.2990 0.0566 0.0366 9.7055
23 0.6342 18.2922 185.3309 1.5769 28.8450 0.0547 0.0347 10.1317
24 0.6217 18.9139 199.6305 1.6084 30.4219 0.0529 0.0329 10.5547
25 0.6095 19.5235 214.2592 1.6406 32.0303 0.0512 0.0312 10.9745
30 0.5521 22.3965 291.7164 1.8114 40.5681 0.0446 0.0246 13.0251
40 0.4529 27.3555 461.9931 2.2080 60.4020 0.0366 0.0166 16.8885
50 0.3715 31.4236 642.3606 2.6916 84.5794 0.0318 0.0118 20.4420
60 0.3048 34.7609 823.6975 3.2810 114.0515 0.0288 0.0088 23.6961
100 0.1380 43.0984 1,464.7527 7.2446 312.2323 0.0232 0.0032 33.9863
 ENGINEERING ECONOMICS (continued)

Factor Table - i = 4.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9615 0.9615 0.0000 1.0400 1.0000 1.0400 1.0000 0.0000
2 0.9246 1.8861 0.9246 1.0816 2.0400 0.5302 0.4902 0.4902
3 0.8890 2.7751 2.7025 1.1249 3.1216 0.3603 0.3203 0.9739
4 0.8548 3.6299 5.2670 1.1699 4.2465 0.2755 0.2355 1.4510
5 0.8219 4.4518 8.5547 1.2167 5.4163 0.2246 0.1846 1.9216
6 0.7903 5.2421 12.5062 1.2653 6.6330 0.1908 0.1508 2.3857
7 0.7599 6.0021 17.0657 1.3159 7.8983 0.1666 0.1266 2.8433
8 0.7307 6.7327 22.1806 1.3686 9.2142 0.1485 0.1085 3.2944
9 0.7026 7.4353 27.8013 1.4233 10.5828 0.1345 0.0945 3.7391
10 0.6756 8.1109 33.8814 1.4802 12.0061 0.1233 0.0833 4.1773
11 0.6496 8.7605 40.3772 1.5395 13.4864 0.1141 0.0741 4.6090
12 0.6246 9.3851 47.2477 1.6010 15.0258 0.1066 0.0666 5.0343
13 0.6006 9.9856 54.4546 1.6651 16.6268 0.1001 0.0601 5.4533
14 0.5775 10.5631 61.9618 1.7317 18.2919 0.0947 0.0547 5.8659
15 0.5553 11.1184 69.7355 1.8009 20.0236 0.0899 0.0499 6.2721
16 0.5339 11.6523 77.7441 1.8730 21.8245 0.0858 0.0458 6.6720
17 0.5134 12.1657 85.9581 1.9479 23.6975 0.0822 0.0422 7.0656
18 0.4936 12.6593 94.3498 2.0258 25.6454 0.0790 0.0390 7.4530
19 0.4746 13.1339 102.8933 2.1068 27.6712 0.0761 0.0361 7.8342
20 0.4564 13.5903 111.5647 2.1911 29.7781 0.0736 0.0336 8.2091
21 0.4388 14.0292 120.3414 2.2788 31.9692 0.0713 0.0313 8.5779
22 0.4220 14.4511 129.2024 2.3699 34.2480 0.0692 0.0292 8.9407
23 0.4057 14.8568 138.1284 2.4647 36.6179 0.0673 0.0273 9.2973
24 0.3901 15.2470 147.1012 2.5633 39.0826 0.0656 0.0256 9.6479
25 0.3751 15.6221 156.1040 2.6658 41.6459 0.0640 0.0240 9.9925
30 0.3083 17.2920 201.0618 3.2434 56.0849 0.0578 0.0178 11.6274
40 0.2083 19.7928 286.5303 4.8010 95.0255 0.0505 0.0105 14.4765
50 0.1407 21.4822 361.1638 7.1067 152.6671 0.0466 0.0066 16.8122
60 0.0951 22.6235 422.9966 10.5196 237.9907 0.0442 0.0042 18.6972
100 0.0198 24.5050 563.1249 50.5049 1,237.6237 0.0408 0.0008 22.9800

Factor Table - i = 6.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9434 0.9434 0.0000 1.0600 1.0000 1.0600 1.0000 0.0000
2 0.8900 1.8334 0.8900 1.1236 2.0600 0.5454 0.4854 0.4854
3 0.8396 2.6730 2.5692 1.1910 3.1836 0.3741 0.3141 0.9612
4 0.7921 3.4651 4.9455 1.2625 4.3746 0.2886 0.2286 1.4272
5 0.7473 4.2124 7.9345 1.3382 5.6371 0.2374 0.1774 1.8836
6 0.7050 4.9173 11.4594 1.4185 6.9753 0.2034 0.1434 2.3304
7 0.6651 5.5824 15.4497 1.5036 8.3938 0.1791 0.1191 2.7676
8 0.6274 6.2098 19.8416 1.5938 9.8975 0.1610 0.1010 3.1952
9 0.5919 6.8017 24.5768 1.6895 11.4913 0.1470 0.0870 3.6133
10 0.5584 7.3601 29.6023 1.7908 13.1808 0.1359 0.0759 4.0220
11 0.5268 7.8869 34.8702 1.8983 14.9716 0.1268 0.0668 4.4213
12 0.4970 8.3838 40.3369 2.0122 16.8699 0.1193 0.0593 4.8113
13 0.4688 8.8527 45.9629 2.1329 18.8821 0.1130 0.0530 5.1920
14 0.4423 9.2950 51.7128 2.2609 21.0151 0.1076 0.0476 5.5635
15 0.4173 9.7122 57.5546 2.3966 23.2760 0.1030 0.0430 5.9260
16 0.3936 10.1059 63.4592 2.5404 25.6725 0.0990 0.0390 6.2794
17 0.3714 10.4773 69.4011 2.6928 28.2129 0.0954 0.0354 6.6240
18 0.3505 10.8276 75.3569 2.8543 30.9057 0.0924 0.0324 6.9597
19 0.3305 11.1581 81.3062 3.0256 33.7600 0.0896 0.0296 7.2867
20 0.3118 11.4699 87.2304 3.2071 36.7856 0.0872 0.0272 7.6051
21 0.2942 11.7641 93.1136 3.3996 39.9927 0.0850 0.0250 7.9151
22 0.2775 12.0416 98.9412 3.6035 43.3923 0.0830 0.0230 8.2166
23 0.2618 12.3034 104.7007 3.8197 46.9958 0.0813 0.0213 8.5099
24 0.2470 12.5504 110.3812 4.0489 50.8156 0.0797 0.0197 8.7951
25 0.2330 12.7834 115.9732 4.2919 54.8645 0.0782 0.0182 9.0722
30 0.1741 13.7648 142.3588 5.7435 79.0582 0.0726 0.0126 10.3422
40 0.0972 15.0463 185.9568 10.2857 154.7620 0.0665 0.0065 12.3590
50 0.0543 15.7619 217.4574 18.4202 290.3359 0.0634 0.0034 13.7964
60 0.0303 16.1614 239.0428 32.9877 533.1282 0.0619 0.0019 14.7909
100 0.0029 16.6175 272.0471 339.3021 5,638.3681 0.0602 0.0002 16.3711
 ENGINEERING ECONOMICS (continued)

Factor Table - i = 8.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9259 0.9259 0.0000 1.0800 1.0000 1.0800 1.0000 0.0000
2 0.8573 1.7833 0.8573 1.1664 2.0800 0.5608 0.4808 0.4808
3 0.7938 2.5771 2.4450 1.2597 3.2464 0.3880 0.3080 0.9487
4 0.7350 3.3121 4.6501 1.3605 4.5061 0.3019 0.2219 1.4040
5 0.6806 3.9927 7.3724 1.4693 5.8666 0.2505 0.1705 1.8465
6 0.6302 4.6229 10.5233 1.5869 7.3359 0.2163 0.1363 2.2763
7 0.5835 5.2064 14.0242 1.7138 8.9228 0.1921 0.1121 2.6937
8 0.5403 5.7466 17.8061 1.8509 10.6366 0.1740 0.0940 3.0985
9 0.5002 6.2469 21.8081 1.9990 12.4876 0.1601 0.0801 3.4910
10 0.4632 6.7101 25.9768 2.1589 14.4866 0.1490 0.0690 3.8713
11 0.4289 7.1390 30.2657 2.3316 16.6455 0.1401 0.0601 4.2395
12 0.3971 7.5361 34.6339 2.5182 18.9771 0.1327 0.0527 4.5957
13 0.3677 7.9038 39.0463 2.7196 21.4953 0.1265 0.0465 4.9402
14 0.3405 8.2442 43.4723 2.9372 24.2149 0.1213 0.0413 5.2731
15 0.3152 8.5595 47.8857 3.1722 27.1521 0.1168 0.0368 5.5945
16 0.2919 8.8514 52.2640 3.4259 30.3243 0.1130 0.0330 5.9046
17 0.2703 9.1216 56.5883 3.7000 33.7502 0.1096 0.0296 6.2037
18 0.2502 9.3719 60.8426 3.9960 37.4502 0.1067 0.0267 6.4920
19 0.2317 9.6036 65.0134 4.3157 41.4463 0.1041 0.0241 6.7697
20 0.2145 9.8181 69.0898 4.6610 45.7620 0.1019 0.0219 7.0369
21 0.1987 10.0168 73.0629 5.0338 50.4229 0.0998 0.0198 7.2940
22 0.1839 10.2007 76.9257 5.4365 55.4568 0.0980 0.0180 7.5412
23 0.1703 10.3711 80.6726 5.8715 60.8933 0.0964 0.0164 7.7786
24 0.1577 10.5288 84.2997 6.3412 66.7648 0.0950 0.0150 8.0066
25 0.1460 10.6748 87.8041 6.8485 73.1059 0.0937 0.0137 8.2254
30 0.0994 11.2578 103.4558 10.0627 113.2832 0.0888 0.0088 9.1897
40 0.0460 11.9246 126.0422 21.7245 259.0565 0.0839 0.0039 10.5699
50 0.0213 12.2335 139.5928 46.9016 573.7702 0.0817 0.0017 11.4107
60 0.0099 12.3766 147.3000 101.2571 1,253.2133 0.0808 0.0008 11.9015
100 0.0005 12.4943 155.6107 2,199.7613 27,484.5157 0.0800 12.4545

Factor Table - i = 10.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.9091 0.9091 0.0000 1.1000 1.0000 1.1000 1.0000 0.0000
2 0.8264 1.7355 0.8264 1.2100 2.1000 0.5762 0.4762 0.4762
3 0.7513 2.4869 2.3291 1.3310 3.3100 0.4021 0.3021 0.9366
4 0.6830 3.1699 4.3781 1.4641 4.6410 0.3155 0.2155 1.3812
5 0.6209 3.7908 6.8618 1.6105 6.1051 0.2638 0.1638 1.8101
6 0.5645 4.3553 9.6842 1.7716 7.7156 0.2296 0.1296 2.2236
7 0.5132 4.8684 12.7631 1.9487 9.4872 0.2054 0.1054 2.6216
8 0.4665 5.3349 16.0287 2.1436 11.4359 0.1874 0.0874 3.0045
9 0.4241 5.7590 19.4215 2.3579 13.5735 0.1736 0.0736 3.3724
10 0.3855 6.1446 22.8913 2.5937 15.9374 0.1627 0.0627 3.7255
11 0.3505 6.4951 26.3962 2.8531 18.5312 0.1540 0.0540 4.0641
12 0.3186 6.8137 29.9012 3.1384 21.3843 0.1468 0.0468 4.3884
13 0.2897 7.1034 33.3772 3.4523 24.5227 0.1408 0.0408 4.6988
14 0.2633 7.3667 36.8005 3.7975 27.9750 0.1357 0.0357 4.9955
15 0.2394 7.6061 40.1520 4.1772 31.7725 0.1315 0.0315 5.2789
16 0.2176 7.8237 43.4164 4.5950 35.9497 0.1278 0.0278 5.5493
17 0.1978 8.0216 46.5819 5.5045 40.5447 0.1247 0.0247 5.8071
18 0.1799 8.2014 49.6395 5.5599 45.5992 0.1219 0.0219 6.0526
19 0.1635 8.3649 52.5827 6.1159 51.1591 0.1195 0.0195 6.2861
20 0.1486 8.5136 55.4069 6.7275 57.2750 0.1175 0.0175 6.5081
21 0.1351 8.6487 58.1095 7.4002 64.0025 0.1156 0.0156 6.7189
22 0.1228 8.7715 60.6893 8.1403 71.4027 0.1140 0.0140 6.9189
23 0.1117 8.8832 63.1462 8.9543 79.5430 0.1126 0.0126 7.1085
24 0.1015 8.9847 65.4813 9.8497 88.4973 0.1113 0.0113 7.2881
25 0.0923 9.0770 67.6964 10.8347 98.3471 0.1102 0.0102 7.4580
30 0.0573 9.4269 77.0766 17.4494 164.4940 0.1061 0.0061 8.1762
40 0.0221 9.7791 88.9525 45.2593 442.5926 0.1023 0.0023 9.0962
50 0.0085 9.9148 94.8889 117.3909 1,163.9085 0.1009 0.0009 9.5704
60 0.0033 9.9672 97.7010 304.4816 3,034.8164 0.1003 0.0003 9.8023
100 0.0001 9.9993 99.9202 13,780.6123 137,796.1234 0.1000 9.9927
 ENGINEERING ECONOMICS (continued)

Factor Table - i = 12.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.8929 0.8929 0.0000 1.1200 1.0000 1.1200 1.0000 0.0000
2 0.7972 1.6901 0.7972 1.2544 2.1200 0.5917 0.4717 0.4717
3 0.7118 2.4018 2.2208 1.4049 3.3744 0.4163 0.2963 0.9246
4 0.6355 3.0373 4.1273 1.5735 4.7793 0.3292 0.2092 1.3589
5 0.5674 3.6048 6.3970 1.7623 6.3528 0.2774 0.1574 1.7746
6 0.5066 4.1114 8.9302 1.9738 8.1152 0.2432 0.1232 2.1720
7 0.4523 4.5638 11.6443 2.2107 10.0890 0.2191 0.0991 2.5515
8 0.4039 4.9676 14.4714 2.4760 12.2997 0.2013 0.0813 2.9131
9 0.3606 5.3282 17.3563 2.7731 14.7757 0.1877 0.0677 3.2574
10 0.3220 5.6502 20.2541 3.1058 17.5487 0.1770 0.0570 3.5847
11 0.2875 5.9377 23.1288 3.4785 20.6546 0.1684 0.0484 3.8953
12 0.2567 6.1944 25.9523 3.8960 24.1331 0.1614 0.0414 4.1897
13 0.2292 6.4235 28.7024 4.3635 28.0291 0.1557 0.0357 4.4683
14 0.2046 6.6282 31.3624 4.8871 32.3926 0.1509 0.0309 4.7317
15 0.1827 6.8109 33.9202 5.4736 37.2797 0.1468 0.0268 4.9803
16 0.1631 6.9740 36.3670 6.1304 42.7533 0.1434 0.0234 5.2147
17 0.1456 7.1196 38.6973 6.8660 48.8837 0.1405 0.0205 5.4353
18 0.1300 7.2497 40.9080 7.6900 55.7497 0.1379 0.0179 5.6427
19 0.1161 7.3658 42.9979 8.6128 63.4397 0.1358 0.0158 5.8375
20 0.1037 7.4694 44.9676 9.6463 72.0524 0.1339 0.0139 6.0202
21 0.0926 7.5620 46.8188 10.8038 81.6987 0.1322 0.0122 6.1913
22 0.0826 7.6446 48.5543 12.1003 92.5026 0.1308 0.0108 6.3514
23 0.0738 7.7184 50.1776 13.5523 104.6029 0.1296 0.0096 6.5010
24 0.0659 7.7843 51.6929 15.1786 118.1552 0.1285 0.0085 6.6406
25 0.0588 7.8431 53.1046 17.0001 133.3339 0.1275 0.0075 6.7708
30 0.0334 8.0552 58.7821 29.9599 241.3327 0.1241 0.0041 7.2974
40 0.0107 8.2438 65.1159 93.0510 767.0914 0.1213 0.0013 7.8988
50 0.0035 8.3045 67.7624 289.0022 2,400.0182 0.1204 0.0004 8.1597
60 0.0011 8.3240 68.8100 897.5969 7,471.6411 0.1201 0.0001 8.2664
100 8.3332 69.4336 83,522.2657 696,010.5477 0.1200 8.3321

Factor Table - i = 18.00%

n P/F P/A P/G F/P F/A A/P A/F A/G
1 0.8475 0.8475 0.0000 1.1800 1.0000 1.1800 1.0000 0.0000
2 0.7182 1.5656 0.7182 1.3924 2.1800 0.6387 0.4587 0.4587
3 0.6086 2.1743 1.9354 1.6430 3.5724 0.4599 0.2799 0.8902
4 0.5158 2.6901 3.4828 1.9388 5.2154 0.3717 0.1917 1.2947
5 0.4371 3.1272 5.2312 2.2878 7.1542 0.3198 0.1398 1.6728
6 0.3704 3.4976 7.0834 2.6996 9.4423 0.2859 0.1059 2.0252
7 0.3139 3.8115 8.9670 3.1855 12.1415 0.2624 0.0824 2.3526
8 0.2660 4.0776 10.8292 3.7589 15.3270 0.2452 0.0652 2.6558
9 0.2255 4.3030 12.6329 4.4355 19.0859 0.2324 0.0524 2.9358
10 0.1911 4.4941 14.3525 5.2338 23.5213 0.2225 0.0425 3.1936
11 0.1619 4.6560 15.9716 6.1759 28.7551 0.2148 0.0348 3.4303
12 0.1372 4.7932 17.4811 7.2876 34.9311 0.2086 0.0286 3.6470
13 0.1163 4.9095 18.8765 8.5994 42.2187 0.2037 0.0237 3.8449
14 0.0985 5.0081 20.1576 10.1472 50.8180 0.1997 0.0197 4.0250
15 0.0835 5.0916 21.3269 11.9737 60.9653 0.1964 0.0164 4.1887
16 0.0708 5.1624 22.3885 14.1290 72.9390 0.1937 0.0137 4.3369
17 0.0600 5.2223 23.3482 16.6722 87.0680 0.1915 0.0115 4.4708
18 0.0508 5.2732 24.2123 19.6731 103.7403 0.1896 0.0096 4.5916
19 0.0431 5.3162 24.9877 23.2144 123.4135 0.1881 0.0081 4.7003
20 0.0365 5.3527 25.6813 27.3930 146.6280 0.1868 0.0068 4.7978
21 0.0309 5.3837 26.3000 32.3238 174.0210 0.1857 0.0057 4.8851
22 0.0262 5.4099 26.8506 38.1421 206.3448 0.1848 0.0048 4.9632
23 0.0222 5.4321 27.3394 45.0076 244.4868 0.1841 0.0041 5.0329
24 0.0188 5.4509 27.7725 53.1090 289.4944 0.1835 0.0035 5.0950
25 0.0159 5.4669 28.1555 62.6686 342.6035 0.1829 0.0029 5.1502
30 0.0070 5.5168 29.4864 143.3706 790.9480 0.1813 0.0013 5.3448
40 0.0013 5.5482 30.5269 750.3783 4,163.2130 0.1802 0.0002 5.5022
50 0.0003 5.5541 30.7856 3,927.3569 21,813.0937 0.1800 5.5428
60 0.0001 5.5553 30.8465 20,555.1400 114,189.6665 0.1800 5.5526
100 5.5556 30.8642 15,424,131.91 85,689,616.17 0.1800 5.5555
which saves us $2,000,000 - 1 on our Project I
bond issue.

But wait! Bank 3 says they will give us 6% nominal interest rate
compounded weekly:

i effective = + - 1 = 6.17998 %, such that

And if we can find a bank which pays 6% nominal interest rate

compounded continuously:
r
effective = e - =e
0.06
- 1 = 0.0618365, such that

Project has been told that they may win their bid to house the
Bush Library, if they can guarantee that they can fund the upkeep and
repairs in perpetuity forever.) The library is expected to cost $2000
every two months for light bulbs, plus $100,000 every 12 months for minor
repairs, plus an additional $5,000,000 every 5 years for a complete
refurbishing of the facility. How much must be deposited today to
guarantee the funding of these expenses? Assume a nominal interest rate
of 6%, compounded monthly.
repairs, and then continue depositing $8110 each month forever, and you
will always be able to withdraw $100,000 at the end of every year.

Now let's change the a3 into a monthly (the bank's compounding period)
annuity. Setting the value needed ($2000 every two months) to the Future
value needed, and realizing that we are paid 0.005% per period, and that
we have two periods to get the money:

A3 per payment period, n)

$2,000 (Use column, 0.005 table, 2 payments)
= $997.60

This says that if you will invest $997.60 dollars each month as an annuity
(you must follow the rules - first deposit goes in at the end of the first
month,) for a total of 2 months, you will have $2,000 at the end of the 2
month period. You can then withdraw this to make your necessary
repairs, and then continue depositing $997.60 each month forever, and
you will always be able to withdraw $2,000 at the end of every 2 month
period.

Now let's change the into a monthly (the bank's compounding period)
annuity. Setting the value needed ($5,000,000 every 60 months) to the
Future value needed, and realizing that we are paid 0.005% per period,
and that we have 60 periods to get the money:

per payment period, n)

$5,000,000 (Use column, 0.005 table, 60 payments)
= $71,500

This says that if you will invest $71,500 dollars each month as an annuity
(you must follow the rules - first deposit goes in at the end of the first