ENGINEERING ECONOMICS

Presented by
Dr Zahoor

Lecture 4 1
Revision

2
 Opportunity Cost
• An opportunity cost is the benefit that is foregone by engaging a
business resource in a chosen activity instead of engaging that
same resource in the foregone activity.
• Example: Suppose your wealthy uncle gives you $75,000 when
you graduate from high school. It is enough to put you through
college
(5 years at $15,000 per year). It is also enough for you to open a
business making web pages for small companies instead of going
to college. You estimate you would make $20,000 per year with
this business.

– If you decide to go to college you give up the opportunity to make $20,000 per
year
– Your opportunity cost is $20,000
– Your total cost per year is $35,000

3
 Compound Interest Example

 P = Principal amount
End of Beginning Interest Ending
 i = Interest rate Year Balance earned Balance
 N = Number of interest
periods 0 $1,000
 Example:
1 $1,000 $80 $1,080
 P = $1,000
 i = 8% 2 $1,080 $86.40 $1,166.40
 N = 3 years
3 $1,166.40 $93.31 $1,259.71
F = P (1+i)n
4
 Compound Interest Example
$1,259.71

F = P (1+i)n

0 1 2

F  $1, 000(1  0.08)3

$1,000
 $1, 259.71

5
 Present Value Example

If you want to have $800 in savings at the end of four

years, and 5% interest is paid annually, how much do
you need to put into the savings account today?

i = 0.05, n = 4, F = $800
P = F/(1+i)n = F(1+i)-n ( P = F (P/F,i,n) )
= 800/(1.05)4 = 800 (1.05)-4 = 800 (0.8227) = $658.16.

Single Payment Present Worth Formula

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

6
The yellow Pages in the text book tabulate:

Compound Amount Factor

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

Present Worth Factor

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

These terms are in columns 2 and 3, identified as

Compound Amount Factor: “Find F Given P: F/P”
Present Worth Factor: “Find P Given F: P/F”

7
 Quarterly Compounded Interest - Example
Example. You put $500 in a bank for 3 years at 6% compound
interest per year. Interest is compounded quarterly.

The bank pays you i = 0.06/4 = 0.015 every 3 months;

1.5% for 12 periods (4 periods per year  3 years).
At the end of three years you have:
F = P (1+i)n = 500 (1.015)12 = 500 (1.19562)  $597.81

Note. Usually the stated interest is for a 1-year period. If it is

compounded quarterly then an interest period is 3 months long. If
the interest is i per year, each quarter the interest paid is i/4 since
there are four 3-month periods a year.

8
 Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?

9
 Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?

0 1 2 3 4 5

$400
$600

10
 Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?

P = F/(1+i)n = F(1+i)-n
0 1 2 3 4 5

$400
$600
Interest is compounded yearly

P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16

11
 Example
Example. In 3 years, you need $400 to pay a debt. In two more years, you need
$600 more to pay a second debt. How much should you put in the bank today
to meet these two needs if the bank pays 12% per year?

0 1 2 3 4 5

Interest is compounded yearly
P = 400(P/F,12%,3) + 600(P/F,12%,5)
= 400 (0.7118) + 600 (0.5674)
= 284.72 + 340.44 = $625.16
$400
$600
Interest is compounded monthly
P = 400(P/F, 12%/12, 3*12) +
600(P/F, 12%/12, 5*12)
= 400(P/F, 1%, 36) + 600(P/F, 1%, 60)
= 400 (0.6989) + 600 (0.5504)
= 279.56 + 330.24 = $609.80

12
Example: Points of view - Borrower & Investor
Borrower point of view:You borrow money from the bank to start
a business.

Year Cash Year Cash

flow flow
0 -P 0 +P
1 0 1 0
2 0 2 0
3 +400 3 -400
4 0 4 0
5 +600 5 -600

Investors point of view:You invest your money in a bank and buy

a bond. 13
 Course topics and schedule
Week Topic Reading
Introduction, Study Skills , Engineering Economics, Decision Making
1 Chapter 1
Process
2 Cost Concept Chapter 2
Chapter 18,
3 Accounting systems, Balance Sheet, Income sheet
Handouts
4 Time value of Money Chapter 3
5 Interest and Equivalence (Annuity) Chapter 3 & 4
7 Rate of Return Chapter 7
8 Deprecation Chapter 11
9 Profit Centre Analysis Hand outs
10 Financial Analysis Chapter 8,9
11 Cash Flow Analysis Chapter 12
12 Benefit Cost Analysis Chapter 9
13 Income Tax Chapter 15
14 Financing Chapter 16
15 Financial Decision Making Chapter 17
16 Project Presentations
17 Final Exam
 Annuity
The fixed/specified income payable
at stated intervals
for a fixed or a contingent period

Annuity= allowance, pension, income, stipend

15
 Example
You borrowed $5,000 from a bank at 8% interest rate and you
have to pay it back in 5 years.
Plan C: Pay in five end-of-year payments.

a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
1 5,000 400 5,400 852 1,252
2 4,148 332 4,480 920 1,252
3 3,227 258 3,485 994 1,252
4 2,233 179 2,412 1,074 1,252
5 1,160 93 1,252 1,160 1,252
SUM 1,261 5,000 6,261 16
 Annuity

• A (Annuity) occurs at the end of each period for

N periods with interest rate at i % per period,
such that
– P (present equivalent value) occurs one interest
period before the first A (uniform amount)
– F (future equivalent value) occurs at the same
time as the last A, and N periods after P, and
– A (annual equivalent value) occurs at the end of
periods 1 through N, inclusive

17
 Annuity- Uniform Payment Series
F

0 1 2 N
A A A

0 1 2 N

0 N

18
 Annuity- Interest Formulas (Uniform Payment)

A uniform series of payments or receipts represents:

A collection of end-of-period cash payments or receipts arranged in a uniform

series and continuing for n periods. Such a series is equivalent to P or F at
interest rate i, given the constant cash payment (or receipt) designated as A
(based on the term “annuity”, a regular payment).

Consider a 4-yr period:

A A A A
| | | |
F = 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4
| | | |A
| | | A(1+i)1
| | A(1+i)2
| A(1+i)3
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Uniform series (contin.)

F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Now, multiply by (1+i)

(1+i) F = A(1+i)4 + A(1+i)3 + A(1+i)2 + A(1+i)

- F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Solve for the difference

i F = A(1+i)4 - A

= A[(1+i)4 - 1] Thus, F = A[(1+i)4 - 1] / i

In general,  1  i n  1
F  A 
 i 
\ uniform series
compound-amount factor
20
Uniform series (contin.)

If we turn this around and solve for A, we obtain:

 i 
A  F 
 1  i   1
n

\ uniform series
sinking-fund factor

21
Uniform series (contin.)

If we turn this around and solve for A, we obtain:

 i 
A  F 
 1  i   1
n

\ uniform series
sinking-fund factor

Example: Set up a uniform-payment investment (college fund) with the goal

of having $80,000 after 20 years, invested at 6% compounded annually. What
is the required annual payment?

A = $80,000(.06)/[1.0620 –1] = $80,000(.06/2.207135) = $2174.77

OR
A = F (A/F, 6%, 20) = $80,000(.0272) = $2176
22 ( ~ $182/mo.)
 Sinking Funds

A sinking fund is a separate fund into which one makes

a uniform series of money deposits (A) with the goal
of accumulating some desired future sum (F) at a
given future point in time.

Sinking fund is an annuity that is invested for a specific

purpose and is continued for a pre-defined period.

Examples:
To buy a new car in 3 years time.

23
 Sinking Funds

• The constant periodic amount, at a constant

interest rate that must be deposited to
accumulate a future value.

• A = F(A/F, i, n)
 i 
A  F 
 1  i   1
n

24
Finding A when Given F

25
 Finding an Annuity Value (Sinking Fund)

F
i
A F
0 1 2 3 (1  i )  1
N
N

A=?  F ( A / F ,i, N )

Example:
 Given: F = $5,000, N = 5 years, and i = 7%
 Find: A

26
 Finding an Annuity Value (Sinking Fund)

F
i
A F
0 1 2 3 (1  i )  1
N
N

A=?  F ( A / F ,i, N )

Example:
 Given: F = $5,000, N = 5 years, and i = 7%
 Find: A
 Solution: A = $5,000(A/F,7%,5) = $869.50
 A = $5,000 (0.1739) = $869.50
27
 Finding an Annuity Value (Sinking Fund)

Example: Set up a uniform-payment investment (college

fund) with the goal of having $80,000 after 20 years, invested
at 6% compounded annually. What is the required annual
payment?

28
 Finding an Annuity Value (Sinking Fund)

Example: Set up a uniform-payment investment (college

fund) with the goal of having $80,000 after 20 years, invested
at 6% compounded annually. What is the required annual
payment?

A = $80,000(.06)/[1.0620 –1] = $80,000(.06/2.207135)

= $2174.77

OR
A = F (A/F, 6%, 20) = $80,000(.0272) = $2176

29
 Present Worth

In general,  1  i n  1
F  A 
 i 

If we replace F with the single-payment

compounding expression, we obtain:

30
 Present Worth

In general,  1  i n  1
F  A 
 i 

If we replace F with the single-payment

compounding expression, we obtain:

 1  i n  1
 1  i n  1
P1  i  P  A n 
 i 1  i  
n
 A 
 i 

The present value of a series of uniform future payments.

This expression is used to calculate the present worth, given
the regular annuity payment.
The term in the brackets (P/A, i%, n) is
31
Uniform series Present Worth factor
 Convert Present to Annual

 i(1  i)  n
A P 
 (1  i)  1
n

Remember: The present is

always one period before the
first annual amount!

The term in the brackets (A/P, i%, n) is

Uniform series Capital recovery factor

32
 Example: Present Worth
Our consulting firm would like to purchase a used testing machine
from an independent testing/inspection lab, and we make two
offers:
1) a lump-sum of $40,000 or
2) monthly payments of $1200 over 3 years at a 6% annual interest
rate. Which option do you think the testing lab would prefer,
assuming it has to replace the sold machine?

33
 Example: Present Worth
Our consulting firm would like to purchase a used testing machine
from an independent testing/inspection lab, and we make two
offers:
1) a lump-sum of $40,000 or
2) monthly payments of $1200 over 3 years at a 6% annual interest
rate. Which option do you think the testing lab would prefer,
assuming it has to replace the sold machine?

Ploan = $1200 [P/A, 0.5%, 36] = $1200(32.871) = $39,445

The lab would prefer the $40k payment now, because it is greater
than the present worth of the proposed loan terms.

Note: Floan = $1200[F/A, 0.5%, 36] = $1200(39.336) = $47,203

34
• This is how mortgages and car loans work:
– The bank gives you an amount P today
– You pay equal amounts A until you have paid the loan
plus interest
• In the first year:
– You pay mainly interest, and little of the principal
• In the last year:
– You pay mainly the principal, and little interest
– Since little of your original loan P is still owed
35
 Capital-Recovery Factor
Finding A when Given P

• The series of uniform payments that will recover

an initial investment.

36
Finding A when Given P

37
Sinking Fund Factor
Find A, given F, I, N

 i 
A  F 
N
 (1  i)  1

Capital Recovery (Annuity) Factor

Find A, given P, I, N
 i(1  i) N 
A  P 
 (1  i)  1
N

Present Worth Factor

Find P, given A, I, N
 (1  i) N  1
P  A N 
 i(1  i) 
38
 Convert Present to Annual
You borrowed $5,000 from a bank at 8% interest rate and you
have to pay it back in 5 years.
Plan C: Pay in five end-of-year payments.

a b c d e f
Int. Owed Total Owed
Year Amnt. Princip. Total
Owed int*b b+c Payment Payment
1 5,000 400 5,400 852 1,252
2 4,148 332 4,480 920 1,252
3 3,227 258 3,485 994 1,252
4 2,233 179 2,412 1,074 1,252
5 1,160 93 1,252 1,160 1,252
SUM 1,261 5,000 6,261 39
 Example (cont'd)
You borrowed $5,000 from a bank at 8% interest rate and you
have to pay it back in 5 years.
Plan C: Pay in five end-of-year payments.

40
 Convert Annual to Present

• Alternatively, we can write present-worth

expressions for all years, and add them

 (1  i)n  1 
P  A n 
for i  0
 i(1  i) 

 The term in the brackets is (P/A, i%, n) is

Uniform series present worth factor

41
 Examples

• Switch from one time period to another:

– $1000 at time 0 = ?? at time 10
• F = P (1+i)n
• F = $1000 (1+i)10
• How much should I invest now to get an
amount F in 6 years?
• We know that F = P (1+i)6
• So we can show that P = F/(1+i)6

42
 A more complicated example

• How much to invest (at 5%) to get:

– $1200 in year 5
– $1200 in year 10
– $1200 in year 15
– $1200 in year 20
• P = F/(1+i)n
– Invest $1200/(1.05)5 + $1200/(1.05)10 +
$1200/(1.05)15 + $1200/(1.05)20 = $2706

43
 Numerical example

• Invest $1000 now for 64 years at 6%:

– $1000 (1.06)64 = $41,647
– Things get big over time!
• Invest $1000 each year for 64 years at 6%:
– F = A [(1+i)n - 1]/i
• = $1000 [(1.06)64 - 1]/.06 = $677,450
– This is really big!

44
Find F When A is Given (Future Value of an
annuity)
F
(1  i )  1
N
FA
0 1 2 3
N i
A  A( F / A, i , N )
Example :
• Given: A = $5,000, N = 5 years, and i = 6%
• Find: F
• Solution: F = $5,000(F/A,6%,5) = $28,185.46

45
 Validation

$5,000(1  0.06)  $6,312.38

4
F =?

$5,000(1  0.06)  $5,955.08

3
i = 6%

$5,000(1  0.06)  $5,618.00

2
0 1 2 3 4 5

$5,000(1  0.06)1  $5,300.00

$5,000(1  0.06)  $5,000.00
0 $5,000 $5,000 $5,000 $5,000 $5,000

$28.185.46

46
Finding an Annuity Value (Find A When F is Given)

F
i
A F
0 1 2 3 (1  i )  1
N
N

A=?  F ( A / F ,i, N )

Example:
 Given: F = $5,000, N = 5 years, and i = 7%
 Find: A
 Solution: A = $5,000(A/F,7%,5) = $869.50

47
 Multiple Payments
• How much do you need
to deposit today (P) to
$25,000
withdraw $25,000 at n
=1, $3,000 at n = 2, and
$3,000 $5,000 $5,000 at n =4, if your
0

1 2 3 4
account earns 10%
annual interest?

48
Uneven Payment Series $25,000

$3,000 $5,000
0

1 2 3 4

$25,000
P

$3,000 $5,000
0 0 0

1 2 3 4
+ 1 2 3 4
+ 1 2 3 4
P2
P4
P1
P1  $25, 000( P / F ,10%,1) P2  $3, 000( P / F ,10%, 2) P4  $5, 000( P / F ,10%, 4)
 $22, 727  $2, 479  $3, 415

P  P1  P2  P3  $28, 622
49
Review of Interpolation

50
Typical format for look-up table

51
 Interpolation gives an estimate!
• The unknown interest rate that you want will typically not be
included in those tables:
• But you can interpolate between two tabulated values to
estimate it
• Linear interpolation is not exact:
• The exact conversion factors are non-linear!
• Therefore, interpolation can cause errors:
• Typically from 2-5%
• Errors will be smaller when interpolating between values that
are closer to each other
52
 Interpolation example
• You are considering a project that costs $1000 in year 0,
and pays $144 annually for 10 years i=?

• You want the interest rate such that P = $1000 is

equivalent to A = $144/year for n = 10 years

• Dividing tells us that A/P = .144

• Use the look-up tables in the back of the book to find

interest rates that give values near .144

53
 Interpolation example

• For i = 7%, 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 1.9672 0.5083 0.0724 13.8164 0.14238

(A/P, 7%, 10) = 0.14238

54
 Interpolation example

• 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

55
 Interpolation example
• Using the look-up tables, we found that:

– At i = 7%, (A/P, 7%, 10) = .14238 (< .144)

– At i = 8%, (A/P, 8%, 10) = .14903 (> .144)

• Therefore, we know that the IRR must be between 7% and

8%:

– Could interpolate between 5% and 10%, but this would

give bigger errors!

56
 Interpolation example
• Reading across at A/P = .144 lets us “eyeball” how close
the IRR is to 7%
• Interpolation just lets us do that more exactly!

8.5
Interest rate, i

8
7.5
7
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)

57
 Interpolation example
8.5

Interest rate, i
8
7.5
7
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)

• As the factor A/P increases, the interest rate i also

increases
• Use the slope of this line to figure out how much to add to
7% to get A/P = .144
58
 Interpolation example
8.5 0.14903

Interest rate, i
8
7.5
7 0.14238
6.5
0.142 0.144 0.146 0.148 0.15
(A/P, i, 10)

• The formula for interpolation tells us:

• i  7%
+ [(8%-7%))/(.14903-.14238)] (.144-.14238)
• i  7.24%
59
 Interpolation example
• The formula for interpolation tells us:
• i  7%
+ [(8%-7%))/(.14903-.14238)] (.144-.14238)
• i  7.24%

• Using trial and error, the exact value of the IRR is 7.2459%

60
 Interpolation Review
• Interpolation is approximate, not exact!
• It requires:
– One interest rate that gives a smaller ratio
– One interest rate that gives a larger ratio
• The answer must lie between the two.

61
 Types of Annuities

 An Annuity represents a series of equal payments (or

receipts) occurring over a specified number of
equidistant periods.

• Ordinary Annuity: Payments or receipts occur at the end of

each period.
• Annuity Due: Payments or receipts occur at the beginning of
each period.

62
 Parts of an Annuity

(Ordinary Annuity)
End of End of End of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
63
 Parts of an Annuity

(Annuity Due)
Beginning of Beginning of Beginning of
Period 1 Period 2 Period 3

0 1 2 3

$100 $100 $100

Today Equal Cash Flows

Each 1 Period Apart
64
 Deferred Annuities
• A deferred annuity is the same as any other
annuity, except that its payments do not
begin until some later period
• The timeline shows a five-period deferred
annuity

100 100 100 100 100

0 1 2 3 4 5 6 7

65
 Deferred Annuities

• Find P given A for an ordinary annuity if the

annuity is deferred j periods, where j < N
• P = A ( P/A, i%, N-j )
• P = A ( P/A, i%, N-j ) ( P/F, i%, j )

66
 PV of a Deferred Annuity (cont.)
• To find the PV of a deferred annuity, we first
find use the PVA equation, and then discount
that result back to period 0
• Here we are using a 10% discount rate

PV2 = 379.08
PV0 = 313.29
0 0 100 100 100 100 100

0 1 2 3 4 5 6 7
67
 FV of a Deferred Annuity

• Future value of a deferred annuity is

calculated in exactly the same way as any
other annuity
• There are no extra steps at all

68