# 1

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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
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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
7. Calculate i
8. Calculate “n”
3
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CHAPTER 2: Section 1
F/P and P/F Factors
4
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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
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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
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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
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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
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CHAPTER 2: Section 2
P/A and A/P Factors
9
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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
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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
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2.2 Uniform Series Present Worth
and Capital Recovery Factors
Annuity Cash Flow
\$A per period
P
= ??
0
………….
.
n
1 2 3 .. ..
n-1
12
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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 n-1
n
A =
given
P
= ??
13
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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
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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
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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
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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
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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
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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
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CHAPTER 2: Section 3
F/A and A/F Factors
20
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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 McGraw-Hill Companies, Inc. Permission required for reproduction or display. 2.3 Sinking Fund and Series
Compound amount factors (A/F and
F/A)
have
Recall:
Also:
1
(1 )
n
P F
i
]
·
]
+
]
(1 )
(1 ) 1
n
n
i i
A P
i
]
+
·
]
+ −
]
Substitute “P”
and simplify!
22
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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
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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
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2.3 F/A and A/F Derivations
Annuity Cash Flow
0
………….
.
N
\$A per period
\$F
Find \$F given the
\$A amounts
25
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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
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2.3 Example 2.5

A = \$1,000,000/yr; n = 8 yrs, i = 14%/yr
•F
8
= ??
27
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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
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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
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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
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CHAPTER 2: Section 4
Interpolation in Interest
Tables
31
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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
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2.4 Interpolation of Factors

Typical Format for Tabulated Interest
Tables
33
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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 non-linear
functions

Hence from 2-5% error may be present
with interpolation.
34
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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
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2.4 Basic Setup for Interpolation

Work with the following basic
relationships
36
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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
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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
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2. 4 Estimating for i = 7.3%

Form the following relationships
39
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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
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2.4. The Exact Value for 7.3%

Using a previously programmed
spreadsheet model the exact value for
7.3% is:
41
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CHAPTER 2 Section 5
P/G and A/G Factors
42
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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 geometric (% per period) gradient

This section presents the Arithmetic
43
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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
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The Two Components are:

The base annuity component

The objective is to find a closed form
expression for the Present Worth of an
45
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Assume the following:
0 1 2 3 n-1
N
A
1
+G
A
1
+2G
A
1
+(n-2)G
A
1
+(n-1)G
This represents a positive, increasing arithmetic
46
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Typical Negative, Increasing
The Base Annuity
= \$1500
47
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Desire to find the Present Worth of this
cash flow
The Base Annuity
= \$1500
48
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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
49
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Only
Focus Only on the gradient Component
G
+2G
(n-2)G
(n-1)G
0 1 2 3 n-1
N
“0” G
Removed Base annuity
50
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2.5 Present Worth Point…
The Present worth point of a linear

2 periods to the left of the
“1G” point or,

1 period to the left of the
very first cash flow in the
DO NOT FORGET THIS!
51
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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
52
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\$0
\$100
\$200
\$300
\$400
\$500
\$600
X
The Present Worth Point of the
0 1 2 3 4 5 6
7

Component
53
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2.5 Present Worth Point…
0 1 2 3 4 5 6
7
Base Annuity – A =
\$100
X
The Present Worth Point of the

PW of the Base Annuity is at t = 0
•PW
BASEAnnuity
=\$100(P/A,i%,7)
54
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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
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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
component cash flow.
We need to derive a closed form
component.
56
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Component
General CF Diagram – Gradient Part Only
0 1 2 3 4 ……….. n-1
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
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2.5 To Begin- Derivation of P/G,i%,n
Next Step:
Factor out G and re-write as …..
( / , %, 2) 2 ( / , %, 3) ...
[(n-2)G](P/F,i%,n-1) + [(n-1)G](P/F,i%,n)
P G P F i G P F i · + +
58
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2.5 Factoring G out…. P/G factor
{ ¦
P/F,i%,2 P/F,i%, P=G ( )+2( ) +...( 3 P/F,i n-1)( %,n)
What is inside of the { }’s?
59
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2.5 Replace (P/F’s) with closed-form
2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]
Multiply both sides by (1+i)
[1]
60
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2.5 Mult. Both Sides By (n+1)…..
1
1 2 n-2 n-1
1 2 n-2 n-1
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
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2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
]
+ + + +
]
]
2.5 Subtracting [1] from [2]…..
1
1 2 n-2 n-1
1 2 n-2 n-1
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
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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
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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
1-G cash flow or, 1 period to the left of the
“0-G” cash flow.
P=G(P/G,i,n)
64
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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
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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
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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
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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
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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
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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
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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
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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
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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
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
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Result
• PW(10%)
BaseAnnuity
= \$379.08
•PW(10%)
= \$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
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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
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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
2. The PW point in time is at t = 3 (not t = o)
\$600
\$550
\$500
\$450
76
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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
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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
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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
0-baseannuity
= -\$1428.93
79
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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
= +50(P/G,10%,4)
P
= {+50(P/G,10%,4)}(P/F,10%,3)
4.3781
0.7513
=-\$164.46
80
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CHAPTER 2: Section 6
81
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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
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Increasing

•Let A
1
= the first cash flow in the series
0 1 2 3 4 …….. n-1
n
A
1
A
1
(1+g)
A
1
(1+g)
2
A
1
(1+g)
3
A
1
(1+g)
n-1
83
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Decreasing

•Let A
1
= the first cash flow in the series
A
1
A
1
(1-g)
A
1
(1-g)
2
A
1
(1-g)
3
A
1
(1-g)
n-1
0 1 2 3 4 …….. n-1
n
84
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Derivation

First Major Point to Remember:
•A
1
does NOT define a Base Annuity;

There is no BASE ANNUITY for a

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
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Derivation

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
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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
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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
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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
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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
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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
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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
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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
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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
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You have to calculated either from
the closed form for each problem or
model to find the needed factor value

this factor!
95
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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 6-year time period.
96
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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
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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
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2.6 Solution
303: Use "g" 667: use f-bar
"E" or g or f-bar = 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 closed-form expression for a

1
1
1
1
g i
n
g
g
i
P A
i g
]
+
| `

]

+
. ,
]
· ≠
]

]
]
]
99
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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
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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 f-bar
"E" or g or f-bar = -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
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CHAPTER 2: Section 7
Determination of an
Unknown Interest Rate
102
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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 application-type 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
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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
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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
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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
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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
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2.7 Example of the IRR function
=IRR(\$D7:\$D12)
108
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CHAPTER 2: Section 8
Determination of Unknown
Number of Years
109
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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
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2.8 Unknown Number of Years
0 1 2 . . . . . .
……. n
P = \$1,000
F
n
= \$2000
i = 5%/year; n is unknown!
111
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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
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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
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2.8 No. of Years – NPER function

From Excel one can formulate as:
=NPER(C23,C22,C20,C21
)
114
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CHAPTER 2: Section 9
Basic Sensitivity Analysis
115
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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
model.

The procedure is to vary the input
parameters within certain ranges and
observe the change on the output
variable.
116
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2.9 Basic Sensitivity Analysis

By proper modeling, one can
perform “what-if” analysis on one or
more of the input parameters and
observe any changes in a targeted
output (response) variable

available that can be linked to Excel
to perform such an analysis

appropriate.
117
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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
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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
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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
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CHAPTER 2:
Summary of Important Points
M
c
Gra
w
Hill
121
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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
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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
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M
c
Gra
w
Hill
ENGINEERING ECONOMY, Sixth
Edition
Blank and
Tarquin
End of Slide Set