Are you sure?
This action might not be possible to undo. Are you sure you want to continue?
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2
Factors: How Time and
Interest Affect Money
ENGINEERING ECONOMY, Sixth
Edition
by Blank and
Tarquin
M
c
Gra
w
Hill
Authored by Don Smith, Texas A&M University 2004
2
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
1. Foundations: Overview
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Interpolate Factor Values
5. P/G and A/G Factors
6. Geometric Gradient
7. Calculate i
8. Calculate “n”
9. Spreadsheets
3
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 1
F/P and P/F Factors
4
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.1 Basic Derivations: F/P factor
F/P Factor To find F given P
P
0
F
n
n
…………
.
To Find F given P
Compound forward in time
5
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.1 Derivation by Recursion: F/P
factor
F
1
= P(1+i)
F
2
= F
1
(1+i)…..but:
F
2
= P(1+i)(1+i) = P(1+i)
2
F
3
=F
2
(1+i) =P(1+i)
2
(1+i)
= P(1+i)
3
In general:
F
n
= P(1+i)
n
F
n
= P(F/P,i%,n)
6
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.1 Present Worth Factor from F/P
Since F
n
= P(1+i)
n
We solve for P in terms of F
N
P = F{ 1/ (1+i)
n
} = F(1+i)
n
Thus:
P = F(P/F,i%,n) where
(P/F,i%,n) = (1+i)
n
Thus, the two factors are:
1. F = P(1+i)
n
finds the future worth of P;
2. P = F(1+i)
n
finds the present worth from
F
7
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.1 P/F factor – discounting back in
time
Discounting back from the
future
P
F
n
n
…………
.
P/F factor brings a single
future sum back to a
specific point in time.
8
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 2
P/A and A/P Factors
9
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Example F/P Analysis
Example: P=
$1,000;n=3;i=10%
What is the future value, F?
0 1 2
3
P=$1,000
F = ??
i=10%/year
F
3
= $1,000[F/P,10%,3] = $1,000[1.10]
3
= $1,000[1.3310] = $1,331.00
10
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Example – P/F Analysis
Assume F = $100,000, 9 years from now.
What is the present worth of this amount
now if i =15%?
0 1 2 3 8
9
…………
F
9
=
$100,000
P= ??
i = 15%/yr
P
0
= $100,000(P/F, 15%,9) = $100,000(1/(1.15)
9
)
= $100,000(0.2843) = $28,430 at time t = 0
11
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
Annuity Cash Flow
$A per period
P
= ??
0
………….
.
n
1 2 3 .. ..
n1
12
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
Desire an expression for the
present worth – P of a stream
of equal, end of period cash
flows  A
0 1 2 3 n1
n
A =
given
P
= ??
13
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
Write a Present worth expression
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
−
]
· + + + +
]
+ + + +
]
Term inside the brackets is a geometric
progression.
Mult. This equation by 1/(1+i) to yield a second
equation
[1]
14
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
The second equation
[2]
To isolate an expression for P in terms of A,
subtract Eq [1] from Eq. [2]. Note that
numerous terms will drop out.
2 3 1
1 1 1 1
..
1 (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i
+
]
· + + + +
]
+ + + + +
]
15
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
Setting up the subtraction
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
−
]
· + + + +
]
+ + + +
]
[1]
[2]

1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
] −
· −
]
+ + +
]
=
[3]
2 3 4 1
1 1 1 1 1
...
(1 ) (1 ) (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i i
+
]
· + +
]
+ + + + + +
]
16
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
Simplifying Eq. [3] further
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
] −
· −
]
+ + +
]
1
1
1
(1 )
n
A
P
i i
+
]
· −
]
− +
]
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
]
+ −
· ≠
]
+
]
17
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Uniform Series Present Worth
and Capital Recovery Factors
This expression will convert an annuity
cash flow to an equivalent present worth
amount one period to the left of the first
annuity cash flow.
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
]
+ −
· ≠
]
+
]
/ %, P A i n factor
18
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.2 Capital Recovery Factor
A/P, i%, n
Given the P/A factor
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
]
+ −
· ≠
]
+
]
(1 )
(1 ) 1
n
n
i i
A P
i
]
+
·
]
+ −
]
Solve for A in terms of
P
Yielding….
A/P,i%,n factor
The present worth
point of an annuity
cash flow is always one
period to the left of the
first A amount
19
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 3
F/A and A/F Factors
20
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 F/A and A/F Derivations
Annuity Cash Flow
0
………….
.
N
$A per period
$F
Find $A given the
Future amt.  $F
21
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display. 2.3 Sinking Fund and Series
Compound amount factors (A/F and
F/A)
Take advantage of what we already
have
Recall:
Also:
1
(1 )
n
P F
i
]
·
]
+
]
(1 )
(1 ) 1
n
n
i i
A P
i
]
+
·
]
+ −
]
Substitute “P”
and simplify!
22
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 A/F Factor
By substitution
we see:
Simplifying we
have:
Which is the
(A/F,i%,n) factor
1 (1 )
(1 ) (1 ) 1
n
n n
i i
A F
i i
] ] +
·
] ]
+ + −
] ]
(1 ) 1
n
A
i
i
F ·
]
]
+ −
]
23
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 F/A factor from the A/F Factor
Given:
Solve for F in
terms of A
(1 ) 1
n
i
A F
i
]
·
]
+ −
]
)
=A
(1 1
F
n
i
i
]
+ −
]
]
24
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 F/A and A/F Derivations
Annuity Cash Flow
0
………….
.
N
$A per period
$F
Find $F given the
$A amounts
25
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 Example 2.5
Formosa Plastics has major fabrication
plants in Texas and Hong Kong.
It is desired to know the future worth of
$1,000,000 invested at the end of each
year for 8 years, starting one year from
now.
The interest rate is assumed to be 14%
per year.
26
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 Example 2.5
•
A = $1,000,000/yr; n = 8 yrs, i = 14%/yr
•F
8
= ??
27
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 Example 2.5
Solution:
The cash flow diagram shows the annual
payments starting at the end of year 1
and ending in the year the future worth is
desired. Cash flows are indicated in $1000
units. The F value in 8 years is
F = l000(F/A,14%,8) =
1000( 13.23218) = $13,232.80 =
13.232 million 8 years from now.
28
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 Example 2.6
How much money must Carol deposit
every year starting
,
l year from now at
5.5% per year in order to accumulate
$6000 seven years from now?
29
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.3 Example 2.6
Solution
The cash How diagram from Carol's
perspective fits the A/F factor.
A= $6000 (A/F,5.5%,7) =
6000(0.12096) = $725.76 per year
The A/F factor Value 0f 0.12096 was
computed using the A/F factor formula
30
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 4
Interpolation in Interest
Tables
31
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 Interpolation of Factors
•
All texts on Engineering economy will
provide tabulated values of the various
interest factors usually at the end of the
text in an appendix
•
Refer to the back of your text for those
tables.
32
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 Interpolation of Factors
•
Typical Format for Tabulated Interest
Tables
33
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 Interpolation (Estimation
Process)
•
At times, a set of interest tables may not
have the exact interest factor needed for
an analysis
•
One may be forced to interpolate
between two tabulated values
•
Linear Interpolation is not exact because:
•
The functional relationships of the
interest factors are nonlinear
functions
•
Hence from 25% error may be present
with interpolation.
34
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 An Example
•
Assume you need the value of the A/P
factor for i = 7.3% and n = 10 years.
•
7.3% is most likely not a tabulated value
in most interest tables
•
So, one must work with i = 7% and i = 8%
for n fixed at 10
•
Proceed as follows:
35
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 Basic Setup for Interpolation
•
Work with the following basic
relationships
36
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2. 4 i = 7.3% using the A/P
factor
•
For 7% we would observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL
N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 1.9672 0.5083 0.0724 13.8164 0.14238
A/P,7%,10) = 0.14238
37
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2. 4 i = 7.3% using the A/P
factor
•
For i = 8% we observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL
N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 2.1589 0.4632 0.0690 14.4866 0.14903
(A/P,8%,10) = 0.14903
38
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2. 4 Estimating for i = 7.3%
•
Form the following relationships
39
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4 Final Estimated Factor Value
•
Observe for i increasing from 7% to 8%
the A/P factors also increases.
•
One then adds the estimated increment
to the 7% known value to yield:
40
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.4. The Exact Value for 7.3%
•
Using a previously programmed
spreadsheet model the exact value for
7.3% is:
41
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2 Section 5
P/G and A/G Factors
42
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Arithmetic Gradient Factors
•
In applications, the annuity cash flow
pattern is not the only type of pattern
encountered
•
Two other types of end of period patterns
are common
•
The Linear or arithmetic gradient
•
The geometric (% per period) gradient
•
This section presents the Arithmetic
Gradient
43
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Arithmetic Gradient Factors
•
An arithmetic (linear) Gradient is a
cash flow series that either increases
or decreases by a constant amount
over n time periods.
•
A linear gradient is always comprised
of TWO components:
44
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Arithmetic Gradient Factors
•
The Two Components are:
•
The Gradient component
•
The base annuity component
•
The objective is to find a closed form
expression for the Present Worth of an
arithmetic gradient
45
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Linear Gradient Example
Assume the following:
0 1 2 3 n1
N
A
1
+G
A
1
+2G
A
1
+(n2)G
A
1
+(n1)G
This represents a positive, increasing arithmetic
gradient
46
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Example: Linear Gradient
•
Typical Negative, Increasing
Gradient: G=$50
The Base Annuity
= $1500
47
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Example: Linear Gradient
•
Desire to find the Present Worth of this
cash flow
The Base Annuity
= $1500
48
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Arithmetic Gradient Factors
•
The “G” amount is the constant
arithmetic change from one time
period to the next.
•
The “G” amount may be positive or
negative!
•
The present worth point is always one
time period to the left of the first cash
flow in the series or,
•
Two periods to the left of the first
gradient cash flow!
49
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Derivation: Gradient Component
Only
Focus Only on the gradient Component
G
+2G
(n2)G
(n1)G
0 1 2 3 n1
N
“0” G
Removed Base annuity
50
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth Point…
The Present worth point of a linear
gradient is always:
2 periods to the left of the
“1G” point or,
1 period to the left of the
very first cash flow in the
gradient series.
DO NOT FORGET THIS!
51
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth Point…
0 1 2 3 4 5 6
7
$100
$200
$300
$400
$500
$600
$700
X
The Present Worth Point of the
Gradient
52
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Gradient Component
$0
$100
$200
$300
$400
$500
$600
X
The Present Worth Point of the
Gradient
0 1 2 3 4 5 6
7
•
The Gradient
Component
53
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth Point…
0 1 2 3 4 5 6
7
Base Annuity – A =
$100
X
The Present Worth Point of the
Gradient
•
PW of the Base Annuity is at t = 0
•PW
BASEAnnuity
=$100(P/A,i%,7)
54
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth: Linear Gradient
The present worth of a linear
gradient is the present worth of the
two components:
1. The Present Worth of the Gradient
Component and,
2. The Present Worth of the Base
Annuity flow
Requires 2 separate calculations!
55
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth: Gradient
Component
The PW of the Base Annuity is simply
the Base Annuity –A{P/A, i%, n} factor
What is needed is a present worth
expression for the gradient
component cash flow.
We need to derive a closed form
expression for the gradient
component.
56
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Present Worth: Gradient
Component
General CF Diagram – Gradient Part Only
0 1 2 3 4 ……….. n1
n
1G
2G
3G
(n
2)G
(n
1)G
0G
We want the PW at time t = 0 (2 periods to the left of
1G)
57
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 To Begin Derivation of P/G,i%,n
Next Step:
Factor out G and rewrite as …..
( / , %, 2) 2 ( / , %, 3) ...
[(n2)G](P/F,i%,n1) + [(n1)G](P/F,i%,n)
P G P F i G P F i · + +
58
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Factoring G out…. P/G factor
{ ¦
P/F,i%,2 P/F,i%, P=G ( )+2( ) +...( 3 P/F,i n1)( %,n)
What is inside of the { }’s?
59
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Replace (P/F’s) with closedform
2 3 n1 n
1 2 n2 n1
P=G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]
Multiply both sides by (1+i)
[1]
60
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Mult. Both Sides By (n+1)…..
1
1 2 n2 n1
1 2 n2 n1
P(1+i) =G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]
[2]
•
We have 2 equations [1] and [2].
•
Next, subtract [1] from [2] and
work with the resultant equation.
61
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2 3 n1 n
1 2 n2 n1
P=G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]
2.5 Subtracting [1] from [2]…..
1
1 2 n2 n1
1 2 n2 n1
P(1+i) =G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]

(1 ) 1
(1 ) (1 )
n
n n
i n
i i
G
P
i i
]
·
]
+ −
−
+
]
+
62
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 The P/G factor for i and N
( / , %, ) P G i N factor
(1 ) 1
(1 ) (1 )
n
n n
i n
i i
G
P
i i
]
·
]
+ −
−
+
]
+
63
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Further Simplification on P/G
2
(1 ) 1
( / , %, )
(1 )
N
N
i iN
P G i N
i i
+ − −
·
+
Remember, the present worth point of any
linear gradient is 2 periods to the left of the
1G cash flow or, 1 period to the left of the
“0G” cash flow.
P=G(P/G,i,n)
64
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Extension – The A/G factor
Some authors also include the derivation of the A/G factor.
A/G converts a linear gradient to an equivalent annuity cash flow.
Remember, at this point one is only working with gradient component
There still remains the annuity component that you must also handle separately!
65
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 The A/G Factor
Convert G to an equivalent A
( / , , )( / , , ) A G P G i n A P i n ·
How to do it…………
66
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 A/G factor using A/P with P/G
The results follow…..
(1 ) 1
(1 ) (1 )
n
n n
i n
i i
G
P
i i
]
·
]
+ −
−
+
]
+
(A/P,i,n)
(1 )
(1 ) 1
n
n
i i
i
]
+
]
+ −
]
67
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Resultant A/G factor
(A/G,i,n) =
1
(1 ) 1
n
n
A G
i i
]
· −
]
+ −
]
(1 ) 1
(1 ) (1 )
n
n n
i n
i i
G
P
i i
]
·
]
+ −
−
+
]
+
(A/P,i,n)
(1 )
(1 ) 1
n
n
i i
i
]
+
]
+ −
]
68
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Gradient Example
•
Consider the following cash flow
0 1 2 3 4
5
$100
$200
$300
$400
$500
Find the present worth if i = 10%/yr; n = 5
yrs
Present Worth Point is here!
And the G amt. = $100/period
69
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Gradient Example Base
Annuity
•
First, The Base Annuity of $100/period
0 1 2 3 4
5
A = +$100
•PW(10%) of the base annuity = $100(P/A,10%,5)
•PW
Base
= $100(3.7908)= $379.08
•Not Finished: We need the PW of the gradient
component and then add that value to the $379.08
amount
70
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Focus on the Gradient
Component
0 1 2 3 4
5
$0
$100
$200
$300
$400
We desire the PW of the Gradient
Component at t = 0
P
G@t=0
= G( P/G,10%,5 ) = $100( P/G,10%,5 )
71
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 The Set Up
0 1 2 3 4
5
$0
$100
$200
$300
$400
P
G@t=0
= G(P/G,10%,5) = $100(P/G,10%,5)
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
]
+ −
−
]
+ +
]
Could substitute n=5,
i=10% and G = $100 into
the P/G closed form to get
the value of the factor.
72
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 PW of the Gradient
Component
P
G@t=0
= G(P/G,10%,5) = $100(P/G,10%,5)
Calculating or looking up the
P/G,10%,5 factor yields the
following:
P
t=0
= $100(6.8618) = $686.18 for
the gradient PW
P/G,10%,5)
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
] + −
−
]
+ +
]
Sub. G=$100;i=0.10;n=5
6.861
8
73
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Gradient Example: Final
Result
• PW(10%)
BaseAnnuity
= $379.08
•PW(10%)
Gradient Component
= $686.18
•
Total PW(10%) = $379.08 + $686.18
•
Equals $1065.26
•
Note: The two sums occur at t =0 and
can be added together – concept of
equivalence
74
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Example Summarized
0 1 2 3 4
5
$100
$200
$300
$400
$500
This Cash Flow…
Is equivalent to $1065.26 at time 0 if the
interest rate is 10% per year!
75
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Shifted Gradient Example: i =
10%
•
Consider the following Cash
Flow
0 1 2 3 4 5 6 7
1. This is a “shifted” negative, decreasing
gradient.
2. The PW point in time is at t = 3 (not t = o)
$600
$550
$500
$450
76
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Shifted Gradient Example
•
Consider the following Cash
Flow
0 1 2 3 4 5 6 7
$600
$550
$500
$450
•
The PW @ t = 0 requires getting the PW @ t
=3;
•Then using the P/F factor move PW
3
back to
t=0
77
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Shifted Gradient Example
•
Consider the following Cash
Flow
•
The base annuity is a $600 cash flow for 3
time periods
0 1 2 3 4 5 6 7
$600
$550
$500
$450
78
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Shifted Gradient Example: Base
Annuity
•
PW of the Base Annuity: 2
Steps
A = $600
0 1 2 3 4 5 6 7
P
3
=600(P/A,10%,4)
P
3
P
0
P
0
=P
3
(P/F,10%,3)
P
0
= [600(P/A,10%,4)](P/F,10%,3)
3.1699
0.7513
P
0baseannuity
= $1428.93
79
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.5 Shifted Gradient Example:
Gradient
•
PW of Gradient Component: G = 
$50
0 1 2 3 4 5 6 7
P
3
P
0
P
0
=P
3
(P/F,10%,3)
0G
1G 2G
3G
P
3Grad
= +50(P/G,10%,4)
P
0grad
= {+50(P/G,10%,4)}(P/F,10%,3)
4.3781
0.7513
=$164.46
80
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 6
Geometric Gradient
81
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients
•
An arithmetic (linear) gradient changes by
a fixed dollar amount each time period.
•
A GEOMETRIC gradient changes by a fixed
percentage each time period.
•
We define a UNIFORM RATE OF CHANGE
(%) for each time period
•
Define “g” as the constant rate of change
in decimal form by which amounts increase
or decrease from one period to the next
82
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Increasing
•
Typical Geometric Gradient Profile
•Let A
1
= the first cash flow in the series
0 1 2 3 4 …….. n1
n
A
1
A
1
(1+g)
A
1
(1+g)
2
A
1
(1+g)
3
A
1
(1+g)
n1
83
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Decreasing
•
Typical Geometric Gradient Profile
•Let A
1
= the first cash flow in the series
A
1
A
1
(1g)
A
1
(1g)
2
A
1
(1g)
3
A
1
(1g)
n1
0 1 2 3 4 …….. n1
n
84
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Derivation
•
First Major Point to Remember:
•A
1
does NOT define a Base Annuity;
•
There is no BASE ANNUITY for a
Geometric Gradient!
•
The objective is to determine the Present
Worth one period to the left of the A
1
cash
flow point in time
•
Remember: The PW point in time is one
period to the left of the first cash flow – A
1
!
85
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Derivation
•
For a Geometric Gradient the
following parameters are required:
•
The interest rate per period – i
•
The constant rate of change – g
•
No. of time periods – n
•The starting cash flow – A
1
86
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Starting
• P
g
= The A
j
’s time the respective
(P/F,i,j) factor
•
Write a general present worth
relationship to find P
g
….
2 1
1 1 1 1
1 2 3
(1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
A A g A g A g
P
i i i i
−
+ + +
· + + + +
+ + + +
Now, factor out the A1 value and rewrite
as..
87
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients
1 2 1
1
2 3
1 (1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i
−
]
+ + +
· + + + +
]
+ + + +
]
(1)
(1+g)
Multuply both sides by to create another equation
(1+i)
1 2 1
1
2 3
(1+g) (1+g) 1 (1 ) (1 ) (1 )
...
(1+i) (1+i) (1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i
−
]
+ + +
· + + + +
]
+ + + +
]
(2)
Subtract (1) from (2) and the result is…..
88
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients
1
1
1+g (1 ) 1
1
1+i (1 ) 1
n
g
n
g
P A
i i
+
]
+
 `
− · −
]
+ +
. ,
]
Solve for P
g
and simplify to yield….
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
89
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient P/A
factor
•
This is the (P/A,g,i,n) factor and is valid if
g is not equal to i.
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
90
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient P/A
factor
•
Note: If g = i we have a division by “0” –
undefined.
•
For g = i we can derive the closed form PW
factor for this special case.
•We substitute i for g into the P
g
relationship to yield:
91
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient: i = g
Case
g 1
1 1 1 1
P =A ...
(1+i) (1+i) (1+i) (1+i)
 `
+ + + +
. ,
1
(1 )
g
nA
P
i
·
+
For the case i =
g
92
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradients:
Summary
•
P
g
= A
1
(P/A,g,i,n)
1
(1 )
g
nA
P
i
·
+
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
g not = to
i
Case: g =
i
93
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient: Notes
•
The geometric gradient requires
knowledge of:
•A
1
, i, n, and g
•
There exist an infinite number of
combinations for i, n, and g: Hence
one will not find tabulated tables for
the (P/A, g,i,n) factor.
94
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient: Notes
•
You have to calculated either from
the closed form for each problem or
apply a preprogrammed spreadsheet
model to find the needed factor value
•
No spreadsheet builtin function for
this factor!
95
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient:
Example
•
Assume maintenance costs for a
particular activity will be $1700 one
year from now.
•
Assume an annual increase of 11%
per year over a 6year time period.
96
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient:
Example
•
If the interest rate is 8% per year,
determine the present worth of the
future expenses at time t = 0.
•
First, draw a cash flow diagram to
represent the model.
97
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient Example (+g)
•
g = +11% per period; A1 = $1700; i =
8%/yr
0 1 2 3 4 5 6
7
$1700
$1700(1.11)
1
$1700(1.11)
2
$1700(1.11)
3
$1700(1.11)
5
PW(8%) = ??
98
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Solution
303: Use "g" 667: use fbar
Geometric Gradients
"E" or g or fbar = 11%
i= 8%
N= 7
P/A,g,i,n factor is…… 7.04732
First Amt= 1,700.00 $
P. Value = 11,980.44 $
•
P = $1700(P/A,11%,8%,7)
•
Need to calculate the P/A factor from
the closedform expression for a
geometric gradient.
•
From a spreadsheet we see:
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
99
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient ( g )
•
Consider the following problem with
a negative growth rate – g.
0 1 2 3 4
g = 10%/yr; i = 8%; n = 4
A
1
=
$1000
$900
$810
$729
P
0
=??
We simply apply a “g” value = 0.10
100
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.6 Geometric Gradient (g
value)
•
Evaluate:
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
1
1
1
1
g i
n
g
g
i
P A
i g
]
+
 `
−
]
+
. ,
]
· ≠
]
−
]
]
]
For a negative g
value = 0.10
303: Use "g" 667: use fbar
Geometric Gradients
"E" or g or fbar = 10%
i= 8%
N= 4
P/A,g,i,n factor is…… 2.87637
First Amt= 1,000.00 $
P. Value = 2,876.37 $
101
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 7
Determination of an
Unknown Interest Rate
102
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 When the i – rate is unknown
•
A class of problems may deal with
all of the parameters know except the
interest rate.
•
For many applicationtype problems,
this can become a difficult task
•
Termed, “rate of return analysis”
•
In some cases:
•
i can easily be determined
•
In others, trial and error must be
used
103
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 Example: i unknown
•
Assume on can invest $3000 now in
a venture in anticipation of gaining
$5,000 in five (5) years.
•
If these amounts are accurate, what
interest rate equates these two cash
flows?
104
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 Example: i unknown
•
The Cash Flow Diagram is…
0 1 2 3 4
5
$3,000
$5,000
•
F = P(1+i)
n
•
5,000 = 3,000(1+i)
5
•
(1+i)
5
= 5,000/3000 =
1.6667
105
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 Example: i unknown
•
Solution:
0 1 2 3 4
5
$3,000
$5,000
•
(1+i)
5
= 5,000/3000 =
1.6667
•
(1+i) = 1.6667
0.20
•
i = 1.1076 – 1 = 0.1076 =
10.76%
106
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 For “i” unknown
•
In general, solving for “i” in a time
value formulation is not straight
forward.
•
More often, one will have to resort to
some form of trial and error approach
as will be shown in future sections.
•
A sample spreadsheet model for this
problem follows.
107
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.7 Example of the IRR function
=IRR($D7:$D12)
108
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 8
Determination of Unknown
Number of Years
109
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.8 Unknown Number of Years
•
Some problems require knowing the
number of time periods required
given the other parameters
•
Example:
•
How long will it take for $1,000 to
double in value if the discount rate is
5% per year?
•
Draw the cash flow diagram as….
110
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.8 Unknown Number of Years
0 1 2 . . . . . .
……. n
P = $1,000
F
n
= $2000
i = 5%/year; n is unknown!
111
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.8 Unknown Number of Years
•
Solving we have…..
0 1 2 . . . . . .
……. n
P =
$1,000
F
n
=
$2000
•F
n=?
= 1000(F/P,5%,x): 2000 =
1000(1.05)
x
•
Solve for “x” in closed form……
112
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.8 Unknown Number of Years
•
Solving we have…..
•
(1.05)
x
= 2000/1000
•
Xln(1.05) =ln(2.000)
•
X = ln(1.05)/ln(2.000)
•
X = 0.6931/0.0488 = 14.2057 yrs
•
With discrete compounding it will
take 15 years to amass $2,000 (have
a little more that $2,000)
113
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.8 No. of Years – NPER function
•
From Excel one can formulate as:
=NPER(C23,C22,C20,C21
)
114
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2: Section 9
Spreadsheet Application –
Basic Sensitivity Analysis
115
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.9 Basic Sensitivity Analysis
•
Sensitivity analysis is a procedure
applied to a formulated problem
whereby one can assess the impact of
each input parameter relating to the
output variable.
•
Sensitivity analysis is best
performed using a spreadsheet
model.
•
The procedure is to vary the input
parameters within certain ranges and
observe the change on the output
variable.
116
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.9 Basic Sensitivity Analysis
•
By proper modeling, one can
perform “whatif” analysis on one or
more of the input parameters and
observe any changes in a targeted
output (response) variable
•
Commercial addin packages are
available that can be linked to Excel
to perform such an analysis
•
Specifically: Palisade Corporation’s
TopRank Excel addin is most
appropriate.
117
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.9 Basic Sensitivity Analysis
•
When you build your own models,
devise an approach to permit varying
at least one of the input parameters
and store the results of each change
in the output variable…then plot the
results.
•
If a small change in one of the input
parameters represents a significant
change in the output variable then…
•
That input variable is “sensitive”
118
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.9 Basic Sensitivity Analysis
•
If an input parameter is deemed
“sensitive” then some effort should
go into the estimation of that
parameter
•
Because it does influence the
response (output) variable.
•
Less sensitive input parameters may
not have as much effort required to
estimate as those input parameters
do not have that much impact on the
targeted response variable.
119
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
2.9 Basic Sensitivity Analysis
•
When you build your own models,
devise an approach to permit varying
at least one of the input parameters
and store the results of each change
in the output variable…then plot the
results.
•
If a small change in one of the input
parameters represents a significant
change in the output variable then…
•
That input variable is “sensitive”
120
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
CHAPTER 2:
Summary of Important Points
M
c
Gra
w
Hill
121
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
Chapter Summary
•
This chapter presents the
fundamental time value of money
relationships common to most
engineering economic analysis
calculations
•
Derivations have been presented for:
•
Present and Future Worth P/F and
F/P
•
Annuity Cash flows – P/A, A/P, F/A
and A/F
•
Gradients – P/G, A,G and P/A,g,i,n
122
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
Chapter Summary
•
One must master these basic time
value of money relationships in order
to proceed with more meaningful
analysis that can impact decision
making.
•
These relationships are important to
you professionally and in your
personal lives.
•
Master these concepts!!!
123
Copyright © The McGrawHill Companies, Inc. Permission required for reproduction or display.
M
c
Gra
w
Hill
ENGINEERING ECONOMY, Sixth
Edition
Blank and
Tarquin
End of Slide Set
This action might not be possible to undo. Are you sure you want to continue?
Use one of your book credits to continue reading from where you left off, or restart the preview.