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2/5/2016

MS-291: Engineering Economy


(3 Credit Hours)

Announcements

Assignment No. 1 will email it TODAY and will post on FB.


Due Date is 12th February 2016 (next Friday) during class
hours.

2/5/2016

Previous Lecture
Simple and Compound Interest
SPCAF
SPPWF
Today Lecture
- USPWF
- Capital Recovery Factor

Compounding and
Discounting
When we convert a P value into a F using some
rate we call this process . COMPOUNDING
and the rate use is called Interest rate
When we convert F into P using some rate we
call the process Discounting and the rate we
use is called Discount rate
Compounding increase your amount (as its
compounded).discounting decrease your amount
as its (discounted)

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Example
Find the present value of $10,000 to be
received 10 years from now at a discount rate
of 10%
F = $10,000
i or r = 10%
n = 10
P = F (1+i)-n
=> P = 10,000 (1+0.1)-10
= 10,000 x 0.385
= $3850

Class Practice:
Allowed time 5 minutes
Sandy, a manufacturing engineer, just received a yearend bonus of $10,000 that will be invested
immediately. With the expectation of earning at the
rate of 8% per year, Sandy hopes to take the entire
amount out in exactly 20 years to pay for a family
vacation when the oldest daughter is due to graduate
from college. Find the amount of funds that will be
available in 20 years?

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A Standard Notation

Instead of writing the full formulas of SPCAF and SPPWF for


simplicity there is a standard notation

This notations includes two cash flows symbols, interest rate and
number of periods

General form is: (X/Y, i, n) which means X represents what is


sought, Y is given, i is interest rate and n is number of periods
Examples:

Equation with
factor formula

Name
Single-payment compound
amount
Single-payment present
worth

F = P(1+i)n
P = F(1+i)-n

Notation

(F/P, i, n)

Standard Notation
Equation

Find/
Given

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

F/P

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

P/F

Using Standard Notation


Example
What will be the future value of Rs. 100,000
compounded for 17 years at rate of interest
(F/P, i, n)
10% ?
F= (1+ i)n or F = P(1+0.1)n now writing that
in standard notation we have
F = P(F/P, i, n)
F = 100,000(F/P, 10%, 17)
That value you
get from Table

F = 100,000 (5.054)

F= 505400

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SPCAF and SPPWF


P = F(1+i)-n

F = P(1+i)n

The term (1+i)n is known


as Single Payment
Compound Amount Factor
(SPCAF)

It is also refer as F/P factor

This is a converting factor,


when multiplied by P
yields the future amount
F of initial amount P
after n years at interest
rate i

The term (1+i)n is known as


Single Payment Present Worth
Factor (SPPWF)

It is also refer as P/F factor

This is a converting factor, when


multiplied by F yields the present
amount P of initial amount F
after n years at interest rate i

From Single Payments to


Annuity
Normally, in real world we do not face Single
payments mostly instead faces cash flows
such as home mortgage payments and
monthly insurance payments etc
An annuity is an equal annual(periodic)
series of cash flows. It may be equal annual
deposits, equal annual withdrawals, equal
annual payments, or equal annual receipts.
The key is equal, annual cash flows

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Uniform Series Present Worth


Factor (P/A factor)
P=?
t = given
1

n1

Can we use Single


Payment Present Worth
Factor (P/F, i%, n), to get
P for this cash flow ?

t=0

A = given
A

1
+
(1 + )

= [

1
(1 + )
(

+ .+

1
(1 + )

. +
(

1
(1 + )

] . (1)

Multiply Eq(1) by (P/F, i, n) factor and subtract the equation(1) from Eq (2)

+ .+

+ .+

] ..(2)

Uniform Series Present Worth


Factor (P/A factor)
Subtracting Eq(1)
from Eq(2)

= [

(1 + )
(

+
(

= [

= [

= [
=

+ .+

1
1+

+ .+

1]

1
]
(1 + )

] ..(2)

] . (1)

= [

1]
)

1]

(1 + ) 1
(1 + )

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Uniform Series Present Worth Factor


(USPWF)
P=?
A = given
1

n1

t=0

t = given

To find P of such series of A we cannot use P=F(P/F, i, n) because we


do not have a single amount but a uniform series in which cash flows
occurs in equal amounts (in each period) and in consecutive interest
periods.
Yes P/F can be use for each A separatelybut thats a lengthy process
Uniform Series Present Worth Factor (USPWF) represented as P/A is
used to calculate the equivalent P value in year 0 for uniform end-of-period
series of A values beginning at the end of period 1 and extend

Mathematically:

(1 + ) 1
(1 + )

Capital Recovery Factor (CRF)


=

(1 + ) 1
(1 + )

(1 + )
(1 + ) 1

P = given

t = given
1

A=?

n-1

t=0

The term in bracket is called Capital Recovery Factor (CRF)


or A/P factor and it calculates the equivalent uniform annual
worth A over n yearshttps://www.epnuffic.nl/en
for a given P in year 0, when the
interest rate is i
Name
Uniform Series
Present Worth
Capital Recovery

Equation with factor


formula
=
=

(1 + ) 1
(1 + )

(1 + )
(1 + ) 1

Notation

(P/A, i, n)
(A/P, i, n)

Standard Notation
Equation

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

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Example 1: Uniform Series


Present Worth (P/A)
A chemical engineer believes that by modifying the structure of a
certain water treatment polymer, his company would earn an extra
$5000 per year. At an interest rate of 10% per year, how much
could the company afford to spend now to just break even over a 5
year project period?
The cash flow diagram is as follows:

Solution:
A = 5000

A = $5000

i = 10%

n=5

Which factor should be used ?

P = A(P/A, i, n)
0

i =10%
P=?

P = 5000(P/A,10%,5)
= 5000(3.7908)
= $18,954

Spread Sheet Functions


Our course book (Blank and Tarquin) from time to time refers to
Spread sheet functions
You will also be come across various Spread sheet formulas
while reading the book
We are going to Ignore that parts because you cannot use it in
exams. Yes you will need it while doing projects in real life, but
applying that from EXCEL is not difficult if you know what it
mean.
However, to get familiar with it, I will give you one home
assignment to do it with help of Excel sheet, after doing a
session on it in class

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Factor Values for


Untabulated i or n
There are 3 ways to find factor values for
untabulated i or n values
1. Use formula
2. Use spreadsheet function
3. Linearly interpolate in interest tables

Formula or spreadsheet function is fast & accurate


Interpolation is only approximate

Factor Values for Untabulated i


or n
Linear Interpolation
Factor value
axis

formula

f2

Example
Linear
assumption

unknown

( )

Determine the value of (F/P, 8.3%, 10)


We have value of 8% and 9% only in
Tables
from Factor Tables for F/P

8 % ... 2.1589
8.3% (x).. unknown
9 % ... 2.3674

f1
=

X1

Required
X

i or n axis

X2

= 2.1589 +

( )

(2.3674 2.1589)
= 2.2215

Absolute Error = 2.2215 2.2197


= 0.0018

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Uniform Series Compound Amount


Factor (USCAF) F = ?
t = given

n-1

A = given

Similar to Uniform Series Present Worth Factor we have


Uniform Series Compound Amount Factor which is given
as follows (only the term in the parenthesis)
=

(1 + ) 1

The term in the parenthesis is called Uniform Series


Compound Amount Factor (USCAF) represented as F/A, to
multiply with given uniform amount gives future worth of a
uniform series

What is meant by Sinking Fund ?

2/5/2016

Sinking Fund Factor (SFF)


F = given

t = given

n-1
n
A=?

Sinking Fund Factor can be obtained from USCA and given as:

(1 + ) 1

(1 + ) 1

The term in the brackets is Sinking Fund Factor and is used to determines
the uniform annual series A that is equivalent to a given future amount F

Practice
An industrial engineer made a modification to a chip manufacturing process that
will save her company $10,000 per year. At an interest rate of 8% per year, how
much will the savings amount to in 7 years?

Solution:

The cash flow diagram is:

A = $10,000

F=?

i = 8%

A =10,000
i =8%
n =7

F = A(F/A, i, n)
F = 10,000(F/A,8%,7)

= 10,000(8.9228)
= $89,228

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Class Practice:
4 Minutes
Question No. A
The president of Ford Motor
Company wants to know the
equivalent future worth of
a $1 million capital
investment each year for 8
years, starting 1 year from
now. Ford capital earns at a
rate of 14% per year.

Class Practice
Question No. A
i= 14%
n = 8 years
A= 10,000

F=?
i = 14%

1 2

A = $10,000

Which factor should be used ?

F = A(F/A, i, n)
F = 1000( F/A, 14%,8)
= 1000(13.2328)
$13,232.80

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Class Practice:
4 Minutes
Question No. B
A company that makes selfclinching fasteners expects
to purchase new
production-line equipment
in 3 years. If the new units
will cost $350,000, how
much should the company
set aside each year, if the
account earns 10% per
year?

Class Practice
Question No. B
i= 10%
n = 3 years
A= ?
F = 350, 000
F = 350,000

i = 10%
1

A=?

A = 350,000 (A/F, i, n)
A = 350,000(A/F,10%,3)
= 350,000(0.30211)
= $105,739

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Graded Class Assignment

Class Assignment
Allowed time 5 minutes
Take a paper sheet
Write down your name and Registration number on
top of the paper sheet
Those who talk will get Zero
When I announce time overstop writing

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Class Practice A:
Allowed Time 7
A chemical product company is considering investment in
cost saving equipment. If the new equipment will cost
$220,000 to purchase and install, how much must the
company save each year for 3 years in order to justify the
investment, if the interest rate is 10% per year?

Class Practice:
Allowed Time 7
A chemical product company is considering investment in
cost saving equipment. If the new equipment will cost
$220,000 to purchase and install, how much must the
company save each year for 3 years in order to justify the
investment, if the interest rate is 10% per year?
The cash flow diagram is as follows:
A=?

Solution:
P = 220,000
I = 10%
n=3
Which factor should be used ?

P = $220,000

i =10%

A = P(A/P, i, n)
A = 220,000(A/P,10%,3)
= 220,000(0.40211)
= $88,464

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Practice B: 5 minutes
How much money should you be willing to pay now for
a guaranteed $600 per year for 9 years starting next
year, at a rate of return of 16% per year?

Example 2.3
How much money should you be willing to
pay now for a guaranteed $600 per year for
9 years starting next year, at a rate of return
of 16% per year?
Solution:
P=?
i = 16%
n=9
Which factor should be used ?

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

A = $600

t=0

P=?

A = $600(P/A,16%, 9) 600(4.6065) = $2763.90

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From Uniform Series to


Gradient

We started with single amount payments

We moved to uniform series (Annuities) its present


or future values

Real world dont have uniform series benefits/costs


normally

We cannot exclude the possibilities of Arithmetic or


Geometric Gradient Series cash flows

Example

You bought a used car with one year warranty


expected costs during first year will
be fuel and insurance that is $2500

let assume that cost of repair is


increasing by $200 every year
what will be the amount in Second Year ?
0

n-1

Base amount
$2500
$2700

Gradient (G) = $200

$2900
$2500+(n-2)200
$2500+(n-1)200

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Arithmetic Gradient Factors


(P/G, A/G)
Cash flows that increase or decrease by a constant amount
are considered arithmetic gradient cash flows.
The amount of increase (or decrease) is called the gradient
$2000
$1500

$175
$125
$100

$150

$500

G = $25
Base = $100

Cash Flow Formula

$1000

G = -$500
Base = $2000

Gradient
series
could be
both: cash
inflow (as
given
here) or
Outflows

CFn = base amount + (n-1)G

Arithmetic Gradient Factors


(P/G, A/G)

When we have a Gradient Series we


cannot apply Single Amount Present
Worth/Future Worth factors or Uniform
Series factors
We have to use a different methodology to
address problems related to gradient cash
flows.

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Solving Arithmetic Gradient


related problems
Present value of the Arithmetic Gradient series can be
calculated as follows:
1. Find the gradient and base
2. Cash flow diagram maybe helpful if you draw it
3. Break the gradient series into a Uniform series and a
Gradient Series as shown on next slide
4. The formula for calculating present value of the
Arithmetic Gradient series is as follows;

PT =

PA

PG

5. Calculate PA and PG and use the above formula to


get the present value of the Arithmetic Gradient

Arithmetic Gradient Factors


(P/G, A/G)
The base amount is A and the Gradient is G in the
following graph
CFn = base amount + (n-1)G

Cash Flow Formula

Important!!!
PG series start
with year 2

A+(n-1) G
A+3G

(n-1)G
3G

A+2G
A+G

=
0

+
0

PT =

2G

PA

PG

2/5/2016

Arithmetic Gradient Factors


(P/G, A/G)
PT =

PA

PG

PA = A(P/A, i, n) or Uniform Series Present worth


Factor
PG = G(P/G, i, n) or Arithmetic Gradient Present
Worth Factor you can use table for it too.
Alternatively, PG can also be calculated by
following formula
G (1 i ) n 1
n
PG

i i (1 i ) n
(
1

i)n

PG

Or

G (1 i ) n in 1

i
i 2 (1 i ) n

Arithmetic Gradient Factors


(P/G, A/G)
Equivalent cash flows:
$175
$150
$125
$100

$100

$50
$25

=>

0
0

G = $25

PA

$P = $100(P/A,i,4) + $25(P/G,i,4)

Note: the gradient series


(PG) by convention starts
in year 2.

Note: Annuity series (PA)


starts from year 1.

Base = $100

PT =

$75

PG
PG

G (1 i )n 1
n

i i (1 i )n
(1 i )n

Where PA = Present worth uniform series (P/A, i,n) and PG = present worth of the gradient series (P/G,i, n)

2/5/2016

Example (Problem 2.25)


Profits from recycling paper, cardboard, aluminium,
and glass at a liberal arts college have increased at a
constant rate of $1100 in each of the last 3 years.
If this years profit (end of year 1) is expected to be
$6000 and the profit trend continues through year 5,
(a) what will the profit be at the end of year 5 and
(b) what is the present worth of the profit at an interest
rate of 8% per year?

G = $1100,

Base = $6000

Example (Problem 2.25)


(a)
(b)

what will the profit be at the end of year 5 &


what is the present worth of the profit at an interest rate of 8% per
year?

G = $1100

Base = $6000
$10400
$9300

$8200

$1100

1 2

=>

$7100
$6000
0

$4400
$3300
$2200

$6000

Find the cash flows as follows:


CF = Base + G(n-1)
CF1 = 6000 + 1100(1-1)= 6000
CF2 = 6000 + 1100(2-1)= 7100
CF3 = 6000 + 1100(3-1)= 8200
CF4 = 6000 + 1100(4-1)= 9300
CF5 = 6000 + 1100(5-1)= 10400

PT =
PA
P = A(P/A, i, n)
P = 6000(P/A, 8%, 5)

P=

6000(3.9927)

P = 32066

+
PG
G(P/G, i, n)

+
+ 1100(P/G, 8%, 5)
+ 1100(7.3724)

4 5

2/5/2016

Practice Question: 5 minutes


Neighboring parishes in Louisiana have agreed to pool
road tax resources already designated for bridge
refurbishment. At a recent meeting, the engineers
estimated that a total of $500,000 will be deposited at
the end of next year into an account for the repair of
old and safety-questionable bridges throughout the area.
Further, they estimate that the deposits will increase
by $100,000 per year for only 9 year thereafter, then
cease. Determine the equivalent: present worth, if public
funds earn at a rate of 5% per year.
5%

Uniform Series Factors

Athematic Gradient

Sinking
Fund
(A/F)

Compound
Amount
(F/A)

Capital
Recovery
(A/P)

Present Gradient
Worth
Present Worth
(P/A)
(P/G)

Gradient
Uniform
Series (A/G)

0.09069

11.0266

0.14069

7.1078

26.1268

3.6758

10

0.07950

12.5779.

0.12950

7.7217

31.6520

4.0991

Solution

Base = 500,000
PT =
PA +
PG
Gradient = 100,000
PT = 500(P/A,5%,10) + 100(P/G,5%,10)
= 500(7.7217)
+ 100(31.6520)
Taking units in 1000
=$7026.05 or .. ($7,026,050)
P=?
Base = 500
0 1
2
3
4
5
6
7
8
9 10
Gradient =100
i= 5%
$500
$600
n=1+9 = 10
$700
$800

$900
$1000

$1100

$1200

$1300
$1400

2/5/2016

Thank You