Engineering Economics

Fundamentals: EIT Review

Hugh Miller
Colorado School of Mines
Mining Engineering Department
Fall 2008
Basics
Notation
Never use scientific notation

Significant Digits
Maximum of 4 significant figures unless the first digit is a 1, in which case a
maximum of 5 sig figs can be used
In general, omit cents (fractions of a dollar)

Year-End Convention
Unless otherwise indicated, it is assumed that all receipts and disbursements
take place at the end of the year in which they occur.

Numerous Methodologies for Solving Problems

Use the method most easy for you (visualize problem setup)
Concept of Interest
If you won the lotto, would you rather get $1 Million now
or $50,000 for 25 years?
What about automobile and home financing? What type
of financing makes more economic sense?

Interest: Money paid for the use of borrowed money.

Put simply, interest is the rental charge for using an
asset over some period of time and then, returning the
asset in the same conditions as we received it.
In project financing, the asset is usually money
Why Interest exist?
Taking the lenders view of point:
Risk: Possibility that the borrower will be unable to pay
Inflation: Money repaid in the future will value less
Transaction Cost: Expenses incurred in preparing the loan
agreement
Opportunity Cost: Committing limited funds, a lender will
be unable to take advantage of other opportunities.
Postponement of Use: Lending money, postpones the
ability of the lender to use or purchase goods.

From the borrowers perspective .

Interest represents a cost !
Simple Interest
Simple Interest is also known as the Nominal Rate of Interest

Annualized percentage of the amount borrowed (principal) which

is paid for the use of the money for some period of time.

Suppose you invested $1,000 for one year at 6% simple rate; at the end
of one year the investment would yield:

$1,000 + $1,000(0.06) = $1,060

This means that each year interest gives $60

How much will you earn (including principal) after 3 years?

$1,000 + $1,000(0.06) + $1,000(0.06) + $1,000(0.06) = $1,180

Note that for each year, the interest earned is only calculated over $1,000.
Does this mean that you could draw the $60 earned at the end of each year?
Terms
In most situations, the percentage is not paid at the end of the period, where the interest
earned is instead added to the original amount (principal). In this case, interest earned from
previous periods is part of the basis for calculating the new interest payment.
This adding up defines the concept of Compounded Interest

Now assume you invested $1,000 for two years at 6% compounded annually;

At the end of one year the investment would yield:

$1,000 + $1,000 ( 0.06 ) = $1,060 or $1,000 ( 1 + 0.06 )

Since interest is compounded annually, at the end of the second year the investment
would be worth:

[ $1,000 ( 1 + 0.06 ) ] + [ $1,000 ( 1 + 0.06 ) ( 0.06 ) ] = $1,124

Principal and Interest for First Year Interest for Second Year

Factorizing:

$1,000 ( 1 + 0.06 ) ( 1 + 0.06 ) = $1,000 ( 1 + 0.06 )2 = $1,124

How much this investment would yield at the end of year 3?

Solving Interest Problems
Step #1: Abstracting the Problem

Interest problems based upon 5 variables:

P, F, A, i, and n

Determine which are given (normally three) and what

needs to be solved
Solving Interest Problems

Step #2: Draw a Cash Flow Diagram

F
Receipts

A1 A2 A3 A4 A5 A6
+
Cash Flow

Time
-

P
Disbursements
Interest Formulas
The compound interest relationship may generally be expressed as:
F = P (1+r)n (1)

Where F = Future sum of money

P = Present sum of money
r = Nominal rate of interest
n = Number of interest periods

Other variables to be introduced later:

A = Series of n equal payments made at the end of each period
i = Effective interest rate per period

Notation: (F/P,i,n) means Find F, given P, at a rate i for n periods

This notation is often shortened to F/P
Interest Formulas
r = Nominal rate of interest
i = Effective interest rate per period

Nominal Interest is the periodic interest rate times the number of

periods per year:

Nominal annual interest rate of 12% based upon monthly

compounding means 1% interest rate per month compounded

When the compounding frequency is annually: r = i

When compounding is performed more than once per year, the

effective rate (true annual rate) always exceeds the nominal
annual rate: i > r
Future Value
Example: Find the amount which will accrue at the end of Year 6 if
$1,500 is invested now at 6% compounded annually.

Method #1: Direct Calculation

(F/P,i,n)
F = P (1+r)n

Given Find F
n=
P=
i=
Future Value
Example: Find the amount which will accrue at the end of Year 6 if
$1,500 is invested now at 6% compounded annually.

Method #1: Direct Calculation

(F/P,i,n)
F = P (1+r)n

Given Find F
n = 6 years F = (1,500)(1+0.06)6
P = $ 1,500 F = $ 2,128
r = 6.0 %
Future Value
Example: Find the amount which will accrue at the end of Year 6
if $1,500 is invested now at 6% compounded annually.

Method #2: Tables

The value of (1+i)n = (F/P,i,n) has been tabulated for various i and n.

From the handout, use the table with interest rate of 6% to find the
appropriate factor. The first step is to layout the problem as follows:

F = P (F/P,i,n)
F = 1500 (F/P, 6%, 6)
F = 1500 ( )=
Future Value
Example: Find the amount which will accrue at the end of Year 6
if $1,500 is invested now at 6% compounded annually.

Method #2: Tables

The value of (1+i)n = (F/P,i,n) has been tabulated for various i and n.

Obtain the F/P Factor, then calculate F:

F = P (F/P,i,n)
F = 1500 (F/P, 6%, 6)
F = 1500 (1.4185) = $2,128
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:

P = F / (1+r)n (2)

Example: If you will need $25,000 to buy a new truck in 3 years, how much
should you invest now at an interest rate of 10% compounded
annually?

(P/F,i,n)

Given Find P
F =
n =
i =
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:

P = F / (1+r)n (2)

Example: If you will need $25,000 to buy a new truck in 3 years, how much
should you invest now at an interest rate of 10% compounded
annually?

Given Find P
F = $25,000 P = F / (1+r)n
n = 3 years P = (25,000) /(1 + 0.10)3
i = 10.0% = $18,783
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:

P = F / (1+r)n (2)

Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 10% compounded annually?

What is the factor to be used? ____________

Solve:
Present Value
If you want to find the amount needed at present in order to accrue a
certain amount in the future, we just solve Equation 1 for P and get:

P = F / (1+r)n (2)

Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 10% compounded annually?

What is the factor to be used? 0.7513

P = F(P/F,i,n) = (25,000)(0.7513) = $ 18,782

Present Value
Example: If you will need $25,000 to buy a new truck in 3 years, how much should
you invest now at an interest rate of 9.5% compounded annually?

Method #1: Direct Calculation: Straight forward - Plug and Crank

Method #2: Tables: Interpolation

Which table in the appendix will be used? Tables i = 9% & 10%

What is the factor to be used? A13 (9%): 0.7722
A14 (10%): 0.7513
Assume 9.5%: 0.7618

P = F(P/F,i,n) = (25,000)(0.7618) = $ 19,044

Engineering Economics
EIT Review
Uniform Series & Effective Interest
Annuities
Uniform series are known as the equal annual
payments made to an interest bearing account
for a specified number of periods to obtain a
future amount.
F

A1 A2 A3 A4 A5 A6
+
Cash Flow

Time
-

P
Annuities Formula
The future value (F) of a series of payments (A) made during (n)
periods to an account that yields (i) interest:

F = A [ (1+i)n 1 ] (5)

Where F = Future sum of money

n = number of interest periods
A = Series of n equal payments made at the end of each period
i = Effective interest rate per period

Derivation of this formula can be found in most engineering

economics texts & study guides

Notation: (F/A,i,n) or if using tables F = A (F/A,i,n)

Example:
What is the future value of a series payments of $10,000 each, for 5
years, if deposited into a savings account yielding 6% nominal interest
compounded yearly?

Draw the cash flow diagram.

F = A [ (1+i)n 1 ] =
i

Check with Factor Values:

F = A (F/A,i,n)
Example:
What is the future value of a series payments of $10,000 each, for 5
years, if deposited in a savings account yielding 6% nominal interest
compounded yearly?

Draw the cash flow diagram.

F = A [ (1+i)n 1 ] = 10,000 [ (1+0.06)5 1 ] = 10,000 [ 1.3382 1 ]

i 0.06 0.06
= $ 56,370

Checking with Factor Values:

F = A (F/A,i,n)
= 10,000 (F/A, 6%, 5)
= 10,000 ( 5.6371 )
= $ 56,370
Sinking Fund
We can also get the corresponding value of an annuity (A) during (n)
periods to an account that yields (i) interest to be able to get the future
value (F) :

Solving for A: A = i F / [ (1+i)n 1 ] (6)

Notation: A = F (A/F,i,n)

Example:
How much money would you have to save annually in order to buy a car
in 4 years which has a projected value of $18,000? The savings account
offers 4.0% yearly interest.
Sinking Fund
Example:
How much money do we have to save annually to buy a car 4 years from
now that has an estimated cost of $18,000? The savings account offers
4.0 % yearly interest.

A = i F / [ (1+i)n 1 ]
A = (0.04 x 18,000) / [ (1.04)4 -1 ] = 720 / 0.170 = $4,239

A = F (A/F,i,n)
A = (18,000)(A/F,4.0,4) = (18,000)(0.2355) = $4,239
Present Worth of an Uniform Series
Sometimes it is required to estimate the present value (P) of a series of
equal payments (A) during (n) periods considering an interest rate (i)

From Eq. 1 and 5

P = A [ (1+i)n 1 ] (7)
i (1+i)n

Notation: P = A (P/A,i,n)

Example:
What is the present value of a series of royalty payments of $50,000
each for 8 years if nominal interest is 8%?

P=
Present Worth of an Uniform Series
Example:
What is the present value of a series of royalty payments of $50,000
each for 8 years if nominal interest is 8%?

P = A [ (1+i)n 1 ] = 50,000 [ (1+0.08)8 1 ] = 50,000 [ 1.8509 1 ]

i (1+i)n 0.08 (1.08)8 0.1481

= $ 287,300

P = A (P/A,i,n) = (50,000)(P/A,8,8) = (50,000)(5.7466) = $ 287,300

Uniform Series Capital Recovery
This is the corresponding scenario where it is required to estimate the value of a
series of equal payments (A) that will be received in the future during (n) periods
considering an interest rate (i) and are equivalent to the present value of an
investment (P)

Solving Eq. 7 for A

A = i P (1+i)n (8)
(1+i)n -1
Notation: A = P (A/P,i,n)

Example:
If an investment opportunity is offered today for $5 Million, how much must it yield
at the end of every year for 10 years to justify the investment if we want to get a
12% interest?

A=
Uniform Series Capital Recovery
Example:
If an investment opportunity is offered today for $5 Million, how much
must it yield at the end of every year for 10 years to justify the
investment if we want to get a 12% interest?

A = i P (1+i)n = 0.12 x 5 (1+0.12)10 = 0.6 [ 3.1058 ]

(1+i)n -1 (1.12)10 - 1 2.1058

= 0.8849 Million $ 884,900 per year

Engineering Economics
EIT Review
Varying Compounding Periods
Effective Interest
Solving Interest Problems
Example:
An investment opportunity is available which will yield $1000 per
year for the next three years and $600 per year for the following two
years. If the interest is 12% and the investment has no terminal
salvage value, what is the present value of the investment?

What is Step #1?

Solving Interest Problems
Example:
An investment opportunity is available which will yield $1000 per
year for the next three years and $600 per year for the following two
years. If the interest is 12% and the investment has no terminal
salvage value, what is the present value of the investment?

Step #1
What are we trying to solve? P

What are the known variables? A, i, n

Solving Interest Problems

Step #2: Draw a Cash Flow Diagram

PV (?) Receipts

A1 A2 A3
A4 A5

Time
A1 + A2 + A3 = $1000

A4 + A5 = $600
Solving Interest Problems
Step #2: Draw a Cash Flow Diagram Method #1
P = A1 (P/A1, i, n1) + A2 (P/A2, i, n2)
= ($600)(P/A1, 12, 5) + ($400)(P/A2, 12, 3)
= $3,124

A1 A2 A3 A4 A 5
A1 A2 A3

+
Time Time

A1 = A2 = A3 = A4 = A5 = $600 A1 = A2 = A3 = $400
Solving Interest Problems
Step #2: Draw a Cash Flow Diagram Method #2
P = A1 (P/A1, i, n1) + A2 (P/A2, i, n2)(P/F, i, n3)
= ($1000)(P/A1, 12, 3) + ($600)(P/A2, 12, 2)(P/F, 12, 3)
= $3,124

A1 A2 A3
P A4 A5

+
Time Time

A1 = A2 = A3 = $1000 A4 = A5 = $600
Varying Payment and Compounding Intervals
Thus far, problems involving time value of money have
assumed annual payments and interest compounding
periods
In most financial transactions and investments, interest
compounding and/or revenue/costs occur at frequencies
other than once a year (annually)
An infinite spectrum of possibilities
Sometimes called discrete, periodic compounding
In reality, the economics of project feasibility are simply
complex annuity problems with multiple receipts &
disbursements
Compounding Frequency
Compounding can be performed at any interval
(common: quarterly, monthly, daily)
When this occurs, there is a difference between nominal
and effective annual interest rates
This is determined by:

i = (1 + r/x)x 1

where: i = effective annual interest rate

r = nominal annual interest rate
x = number of compounding periods per year
Compounding Frequency
Example: If a student borrows $1,000 from a finance
company which charges interest at a compound
rate of 2% per month:

What is the nominal interest rate:

r = (2%/month) x (12 months) = 24% annually

What is the effective annual interest rate:

i = (1 + r/x)x 1

i = (1 + .24/12)12 1 = 0.268 (26.8%)

Nominal and Effective
Annual Rates of Interest
The effective interest rate is the rate compounded once a year which is
equivalent to the nominal interest rate compounded x times a year
The effective interest rate is always greater than or equal to the nominal
interest rate

The greater the frequency of compounding the greater the difference

between effective and nominal rates. But it has a limit Continuous
Compounding.

Frequency Periods/year Nominal Rate Effective Rate

Annual 1 12% 12.00%

Semiannual 2 12% 12.36%
Quarterly 4 12% 12.55%
Monthly 12 12% 12.68%
Weekly 52 12% 12.73%
Daily 365 12% 12.75%
Continuously 12% 12.75%
Compounding Frequency
It is also important to be able to calculate the effective
interest rate (i) for the actual interest periods to be used.

The effective interest rate can be obtained by dividing the

nominal interest rate by the number of interest payments
per year (m)

i = (r/m)

where: i = effective interest rate for the period

r = nominal annual interest rate
When Interest Periods Coincide with Payment Periods

When this occurs, it is possible to directly use the

equations and tables from previous discussions (annual
compounding)
Provided that:
(1) the interest rate (i) is the effective rate for the period
(2) the number of years (n) must be replaced by the
total number of interest periods (mn), where m
equals the number of interest periods per year
When Interest Periods Coincide with Payment Periods

Example: An engineer plans to borrow $3,000 from his company

credit union, to be repaid in 24 equal monthly
installments. The credit union charges interest at the
rate of 1% per month on the unpaid balance. How
much money must the engineer repay each month?

A = P (A/P, i, mn) = i P (1+i)n

(1+i)n -1

A = ($3000) (A/P, 1%, 24) = $141.20

When Interest Periods Coincide with Payment Periods
Example: An engineer wishes to purchase an $80,000 lakeside lot
(real estate) by making a down payment of $20,000 and
borrowing the remaining $60,000, which he will repay on a
monthly basis over the next 30 years. If the bank charges
interest at the rate of 9% per year, compounded monthly,
how much money must the engineer repay each month?

i = (r/m) = (0.095/12) = 0.00792 (0.79%)

A = P (A/P, i, mn) = i P (1+i)n

(1+i)n -1

A = ($60000) (A/P, 0.79%, 360) = $504.50

Total amount repaid to the bank?

When Interest Periods are Smaller than Payment Periods

When this occurs, the interest may be compounded

several times between payments.

One widely used approach to this type of problem is to

determine the effective interest rate for the given interest
period, and then treat each payment separately.
When Interest Periods are Smaller than Payment Periods
Example: Approach #1
An engineer deposits $1,000 in a savings account at the end of each year. If
the bank pays interest at the rate of 6% per year, compounded quarterly, how
much money will have accumulated in the account after 5 years?

Effective Interest Rate: i = (6%/4) = 1.5% per quarter

F = P (F/P,i,mn)

F = $1000(F/P,1.5%,16) + $1000(F/P,1.5%,12) + $1000(F/P,1.5%,8) +

$1000(F/P,1.5%,4) + $1000(F/P,1.5%,0)

Using formulas or tables: F = $5,652

When Interest Periods are Smaller than Payment Periods

Another approach, often more convenient, is to calculate

an effective interest rate for the given payment period,
and then proceed as though the interest periods and the
payment periods coincide.

i = (1 + r/x)x 1
When Interest Periods are Smaller than Payment Periods

Example: Approach #2

An engineer deposits $1,000 in a savings account at the end of each year. If

the bank pays interest at the rate of 6% per year, compounded quarterly, how
much money will have accumulated in the account after 5 years?

i = (1 + r/x)x 1 = (1 + 0.06/4)4 1 = 0.06136 (6.136%)

F = $1,000 (F/A,6.136%,5)

Using formula: F = $5,652

When Interest Periods are Larger than Payment Periods
When this occurs, some payments may not have been deposited for an
entire interest period. Such payments do not earn any interest during that
period.

Interest is only earned by those payments that have been deposited or

invested for the entire interest period.

Situations of this type can be treated in the following manner:

Consider all deposits that were made during the interest period to have been
made at the end of the interest period (i.e., no interest earned during the period)

Consider all withdrawals that were made during the interest period to have been
made at the beginning of the interest period (i.e., earning no interest)

Then proceed as though the interest periods and the payment periods coincide.
When Interest Periods are Larger than Payment Periods
Example: A person has $4,000 in a savings account at the beginning of a
calendar year; the bank pays interest at 6% per year, compounded
quarterly. Given the transactions presented in the following table (next
slide), find the account balance at the end of the calendar year.

Effective Interest Rate (i) = 6%/4 = 1.5% per quarter

When Interest Periods are Larger than Payment Periods
Example:
Date Deposit Withdrawal Effective Date
Jan. 10 $175 Jan. 1st (beginning 1st Q)
Feb. 20 $1,200 Mar. 31th (end of 1st Q)
Apr. 12 $1,800 April 1st (beginning 2nd Q)
May 5 $65 June 30 (end of 2nd Q)
May 13 $115 June 30 (end of 2nd Q)
May 24 $50 April 1st (beginning 2nd Q)
June 21 $250 April 1st (beginning 2nd Q)
Aug. 10 $1,600 Sept. 30 (end of 3rd Q)
Sept. 12 $800 July 1st (beginning 3rd Q)
Nov. 27 $350 Oct. 1 (beginning 4th Q)
Dec. 17 $2,300 Dec. 31 (end of 4th Q)
Dec. 29 $750 Oct. 1 (beginning 4th Q)
When Interest Periods are Larger than Payment Periods
Example: A person has $4,000 in a savings account at the beginning of a
calendar year; the bank pays interest at 6% per year, compounded
quarterly. Given the transactions presented in the following table (next
slide), find the account balance at the end of the calendar year.

F = ($4000-$175)(F/P,1.5%,4) + ($1200-$2100)(F/P,1.5%,3) +
($180-$800)(F/P,1.5%,2) + ($1600-$1100)(F/P,1.5%,1) + $2300

Using formula: F = $5,287

 Continuous Compounding

Continuous Compounding can be thought of as a limiting

case example, where the nominal annual interest rate is
held constant at r, the number of interest periods becomes
infinite, and the length of each interest period becomes
infinitesimally small.

The effective annual interest rate in continuous

compounding is expressed by the following equation:

i = limm[(1 + r/m)m 1] = er - 1
 Continuous Compounding

Example: A savings bank is selling long-term savings

certificates that pay interest at the rate of 7 % per year,
compounded continuously. What is the actual annual
yield of these certificates?

i = er 1 = e0.075 1 = 0.0779 (7.79%)

Continuous Compounding
Discrete payments:
If interest is compounded continuously but payments are
made annually, the following equations can be used:

F/P = ern A/P = (er 1) / (1 e-rn)

P/F = e-rn P/A = (1 e-rn) / (er 1)
F/A =(ern 1) / (er 1) A/F =(er 1) / (ern 1)

Where: n = the number of years

r = nominal annual interest rate
Continuous Compounding (Discrete payments)
Example: A savings bank offers long-term savings
certificates at 7 % per year, compounded continuously.
If a 10-year certificate costs $1,000, what will be its value
upon maturity?

F = P x (F/P,r,n) = P x ern

F = ($1,000) x e(0.075)(10) = $2,117

Continuous Compounding (Discrete payments)
If interest is compounded continuously but payments are
made (x) times per year, the previous formulas remain
valid as long as r is replaced by r/x and with n being
replaced by nx.
Example: A person borrows $5,000 for 3 years, to be
repaid in 36 equal monthly installments. The interest
rate is 10% per year, compounded continuously. How
much must be repaid at the end of each month?
(A/P,r/x,nx) (A/P,10/12,36)
A = (P) [(er 1) / (1 e-rn)]
= ($5,000) [(e0.10/12 1) / (1 e-(0.10/12)(12x3))]
= $161.40
Gradient Series
Thus far, most of the course discussion has focused on uniform-
series problems

A great many investment problems in the real world involve the

analysis of unequal cash flow series and can not be solved with the
annuity formulas previously introduced

As such, independent and variable cash flows can only be analyzed

through the repetitive application of single payment equations

Mathematical solutions have been developed, however, for two

special types of unequal cash flows:
Uniform Gradient Series
Geometric Gradient Series
Uniform Gradient Series

A Uniform Gradient Series (G) exists when cash flows either increase or
decrease by a fixed amount in successive periods.

In such cases, the annual cash flow consists of two components:

(1) a constant amount (A1) equal to the cash flow in the first period
(2) a variable amount (A2) equal to (n-1)G

As such: AT = (A1) + (A2)

A2 = G [(1/i) (n/i)(A/F,i,n)]

where: [(1/i) (n/i)(A/F,i,n)] is called the uniform gradient factor

and is written as (A/G,i,n)

Therefore: AT = (A1) + G(A/G,i,n))

 Uniform Gradient Series

Example: An engineer is planning for a 15 year retirement. In order to

supplement his pension and offset the anticipated effects of inflation and
increased taxes, he intends to withdraw $5,000 at the end of the first year,
and to increase the withdrawal by $1,000 at the end of each successive
year. How much money must the engineer have in this account at the start
of his retirement, if the money earns 6% per year, compounded annually?

$19000
Want to Find: P
$18000

$8000
Given: A1, G, i, and n
$7000
$6000
$5000

T=0

1 2 3 4 14 15

P
Uniform Gradient Series

Example:

AT = (A1) + G(A/G,i,n)

A2 = G(A/G,i,n) = $1000 (A/G,6%,15) = $1000 (5.926) = $5926

AT = $5000 + $5926 = $10,926

P = AT (P/A,i,n) = $10,926 (P/A,6%,15) = $10,926 (9.7123) = $106,120

Geometric Gradient Series

Since receipts and expenditures rarely increase or decrease every period

by a fixed amount, Uniform Gradient Series (G) problems have limited
applicability

With Geometric Gradients, the increase or decrease in cash flows between

periods is not a constant amount but a constant percentage of the cash flow
in the preceding period.

Like Uniform Gradients, Geometric Gradients limited applicability but are

sometimes used to account for inflationary cost increases

AK = A (1 + j)K-1

Where: j equals the percent change in the cash flow between periods
A is the cash flow in the initial period
AK is the cash flow in any subsequent period
Geometric Gradient Series

Present Value of the series equals:

n
P = A (1 + j)-1 [(1 + j)/(1 + i)]-K
K=1

For i = j: P = (n x A ) / (1 + i)
For i j: P = A [1(1-j)n (1+i)-n] / (i - j)

Nomenclature: P = A (P/A,i,j,n)