Module2 Econ

MODULE 2 – Money-Time Relationship and Equivalence 1
Engr. Caesar P. Llapitan
Topics
I. Introduction
II. The Concept of Equivalence
III. Simple and Compound Interest
IV. Nominal and effective Interest
V. Notations and Cash-Flow Diagrams
VI. Single-Payment Formulas (F/P And P/F)
VII. Uniform Series Formulas (P/A, A/P, A/F, F/A)
VIII. Gradient Formulas
IX. Calculations for Cash Flows That Are Shifted
Learning Objectives
At the end of this module, the students should be able to
1. Identify what is needed to successfully perform an engineering economy study.
2. Explain what equivalence means in economic terms.
3. Calculate simple interest and compound interest for one or more interest periods.
4. Explain nominal and effective interest rate statements.
5. Illustrate the meaning of flows, their estimation, and how to graphically represent them.
6. Use the compound amount factor and present worth factor for single payments to
account for the time value of money.
7. Use the uniform series factors to account for the time value of money.
8. Use the arithmetic gradient factors and the geometric gradient formula to account for
the time value of money.
9. Use uniform series and gradient factors when cash flows are shifted to account for the
time value of money.
I. INTRODUCTION
Most engineering economy studies involve commitment of capital for extended periods of time,
so the effect of time must be considered. In this regard, it is recognized that a money today is
worth more than its present amount one or more years from now because of the interest (or
profit) it can earn. Therefore, money has a time value.
Why consider return to capital?

▪ First, interest and profit pay the providers of capital for forgoing its use during the time
the capital is being used.
- The fact that the supplier can realize a return on capital acts as an incentive to
accumulate capital by savings, thus postponing immediate consumption in favor of
creating wealth in the future.
▪ Second, interest and profit are payments for the risk the investor takes in permitting
another person, or an organization, to use his or her capital.
Whenever capital is required in engineering and other business projects and ventures, it is
essential that proper consideration be given to its cost (i.e., time value).
II. THE CONCEPT OF EQUIVALENCE
This principle states that funds placed in a secure investment will increase in value in a way that
depends on the elapsed time and the interest rate.
▪ the time value of money and the interest rate help develop the concept of economic
equivalence
Economic equivalence exists between cash flows that have the same economic effect and
could therefore be traded for one another in the financial marketplace, which we assume to
exist. Economic equivalence refers to the fact that a cash flow, whether a single payment or a
series of payments, can be converted to an equivalent cash flow at any point in time.
Example:
AC-Delco makes auto batteries available to General Motors dealers through privately owned
distributorships. In general, batteries are stored throughout the year, and a 5% cost increase
is added each year to cover the inventory carrying charge for the distributorship owner.
Assume you own the City Center Delco facility. Make the calculations necessary to show
which of the following statements are true and which are false about battery costs.
a. The amount of $98 now is equivalent to a cost of $105.60 one year from now.
b. A truck battery cost of $200 one year ago is equivalent to $205 now.
c. A $38 cost now is equivalent to $39.90 one year from now.
d. A $3000 cost now is equivalent to $2887.14 one year ago.
e. The carrying charge accumulated in 1 year on an investment of $2000 worth of
batteries is $100.
Solution
a. Total amount accrued = 98(1.05) = $102.90  $105.60; therefore, it is false. Another way
to solve this is as follows: Required original cost is 105.60/1.05 = $100.57  $98.
b. Required old cost is 205.00/1.05 = $195.24  $200; therefore, it is false.
c. The cost 1 year from now is $38(1.05) = $39.90; true.
d. Cost now is 2887.14(1.05) = $3031.50  $3000; false.
e. The charge is 5% per year interest, or $2000(0.05) = $100; true.
III. SIMPLE AND COMPOUND INTEREST
Rate of Interest
Interest is the manifestation of the time value of money, and it essentially represents “rent” paid
for use of the money. Computationally, interest is the difference between an ending amount of
money and the beginning amount.
Two perspectives to an amount of interest

1. interest paid
- Interest is paid when a person or organization borrows money (obtains a loan) and
repays a larger amount.
2. interest earned
- Interest is earned when a person or organization saves, invests, or lends money and
obtains a return of a larger amount.
Computationally, this is the ratio of the amount of interest payment to the principal per unit of
the interest period.
i=
(total interest paid ) × 100
( Principal )( Number of interest periods )
The time unit of the interest rate is called the interest period.
When interest over a specific time unit is expressed as a percentage of the original amount
(principal), the result is called the interest rate or rate of return (ROR).
interest accrued per time unit

Interest rate or rate of return = × 100%
original amount
The term interest rate paid is more appropriate for the borrower’s perspective, while rate of
return earned is better from the investor’s perspective.
Minimum Attractive Rate of Return (MARR)

- A reasonable rate that must be established to accept/reject a decision made.
- It must be higher than the cost of money used to finance the alternative, as well as higher
than the rate that would be expected from a bank or safe (minimal risk) investment.
For a corporation, the MARR is always set above its cost of capital, that is, the interest rates a
company must pay for capital funds needed to finance projects.
The MARR is also referred to as the hurdle rate; that is, a financially viable project’s expected
ROR must meet or exceed the hurdle rate.
Note that the MARR is not a rate calculated like the ROR; MARR is established by financial
managers and is used as a criterion for accept/reject decisions.
ROR  MARR  cost of capital
Rate of return, %
Expected rate of return

on a new project
Range on the rate of

return on pending
projects
All proposal must offer at least MARR

MARR to be considered
Range of cost of capital
Rate of return on “safe investment”
Example: If a corporation can borrow capital funds at an average of 5% per year and expects to
clear at least 6% per year on a project, the minimum MARR will be 11% per year.
An additional economic consideration for any engineering economy study is inflation. In simple
terms, bank interest rates reflect two things: a so-called real rate of return plus the expected
inflation rate.
For instance, the safest investments typically have a 3% to 4% real rate of return built into their
overall interest rates. Thus, an interest rate of, say, 9% per year means that investors expect the
inflation rate to be in the range of 5% to 6% per year.
Simple Interest
▪ When the interest earned on an investment is not reinvested with the original
investment to form new interest-earning capital, the interest is called simple interest.
▪ Simple interest is calculated using the principal only, ignoring any interest accrued in
preceding interest periods.
▪ Simple interest is not used frequently in modern commercial practice.
If P is the principal, the loan amount or the original capital, n is the number of interest periods,
and i is then interest rate for the period, the amount of simple interest i earned for n periods is
Interest = (principal)  (number of periods)  (interest rate)
I = P i  n (1)
Ultimately, the principal must be paid plus the simple interest for n periods at a future time, F;
therefore,
F =P + I = P + Pin = P(1 + in) (2)
where: n = no. of interest periods

I = interest
i = interest rate as fraction per interest period
F = future worth
o The interest is charged on the original loan and not on the unpaid balance.
o Simple interest is paid at the end of each time interval.
Note:
▪ Ordinary – based on twelve 30-day months or 360 days
▪ Exact – based on 365 days for 1 yr.
▪ Ordinary Simple interest = Pi (d/360)
▪ Exact simple interest = Pi (d/365)
Example:
1. If you borrow money from your friend with simple interest of 12%, find the present worth of
P20,000 which is due at the end of 9 months.
Solution:
F = P (1 + in)
P = F / ( 1 + in )
i = 12% ( per year )
n = 9/12 year
Therefore:
P = 20,000 /[1 + 0.12 (9 / 12)]
P = P 18, 348.00
Compound Interest
▪ When the interest earned on an investment is reinvested along with the original
investment to earn interest, the interest earned is called compound interest.
For compound interest, the interest accrued for each interest period is calculated on the
principal plus the total amount of interest accumulated in all previous periods.
Interest = (principal + all accrued interest) (interest rate)
To calculate the total amount due after a number of years:
Total due after a number of years = principal (1 + interest rate)number of years
In equation format, the future amount for each year is

Year 1: P = P + Pi + P(1 + i) = F1
Year 2: P = P + Pi(1 + i) = P(1 + i)2 = F2
Year n: P = P (1 + i)n = Fn
In general:
F = P ( 1 + i)
n
(3)
An interest rate is quoted on an annual basis and is referred to as nominal interest. However,
interest may be payable on a semiannual, quarterly, monthly, or daily basis. In order to
determine the amount compounded, the following equation applies:
mn
  i 
F = P  1+    (4)
  m 
where: m = the number of interest periods per year

n = the number of years
i = the nominal interest
Example:
How many years will it take to double an investment if the interest is 10% per year?
Solution:
F = 2P
P ( F / P , 10%, n ) = 2 P
F / P , 10%, n = 2
(1 + 0.10)n = 2
(1.10)n = 2
n = 7.3 years
Classroom Activity 1
1. What will be the future worth of money after 14 months if a sum of $10,000 is invested today
at a simple interest rate of 12% per year?
2. If $2500 were invested for 5 years at 10% nominal interest compounded quarterly, what
would be the future amount?
3. Suppose you deposit $1,000 in a bank savings account that pays interest at a rate of 8% per
year. Assume that you don't withdraw the interest earned at the end of each period (year),
but instead let it accumulate. (a) How much would you have at the end of year three with
simple interest? (b) How much would you have at the end of year three with compound
interest?
Exercises 1
1. Explain the difference between simple and compound interest. Which is more common?
2. A $5000 loan was to be repaid with 8% simple annual interest. A total of $5350 was paid.
How long had the loan been outstanding?
3. How long will it take for an investment to double at a 4% per year simple interest rate?
4. In your own words explain the time value of money. From your own life (either now or
in a situation that might occur in your future), provide an example in which the time
value of money would be important.
5. A man borrowed $750 from a bank. He agreed to repay the sum at the end of 3 years,
together with the interest at 8% per year. How much will he owe the bank at the end of
3 years? (Answer: $945)
6. In 1995 an anonymous private collector purchased a painting by Picasso entitled Angel
Fernandez de Soto for $29,152,000. The picture depicts Picasso’s friend de Soto seated in
a Barcelona cafe drinking absinthe. The painting was done in 1903 and was valued then
at $600. If the painting was owned by the same family until its sale in 1995, what rate of
return did they receive on the $600 investment?
7. A sum of money invested at 2% per 6-month period (semiannually), will double in
amount in approximately how many years? (Answer: 171/2 years)
8. One thousand dollars is borrowed for one year at an interest rate of 1% per month. If the
same sum of money could be borrowed for the same period at an interest rate of 12% per
year, how much could be saved in interest charges?
9. The local bank offers to pay 5% interest on savings deposits. In a nearby town, the bank
pays 1.25% per 3-month period (quarterly). A man who has $3000 to put in a savings
account wonders whether the higher interest paid in the nearby town justifies driving
there to make the deposit. Assuming he will leave all money in the account for 2 years,
how much additional interest would he obtain from the out-of-town bank over the local
bank?
10. A sum of money Q will be received 6 years from now. At 5% annual interest, the present
worth of Q is $60. At the same interest rate, what would be the value of Q in 10 years?
IV. NOMINAL AND EFFECTIVE INTEREST RATES
Nominal Interest Rates

▪ A Nominal Interest Rate, r, is an interest Rate that does not include any consideration
of compounding
▪ Nominal means, “in name only”, not the real rate in this case.
r = (interest rate per period) (No. of Periods)
▪ A nominal rate (so quoted) do not reference the frequency of compounding. They all
have the format “r% per time period”
Examples:
a. 1.5% per month for 24 months
 Same as: (1.5%) (24) = 36% per 24 months
b. 1.5% per month for 12 months

 Same as: (1.5%) (12 months) = 18%/year
c. 1.5% per month for 6 months

 Same as: (1.5%) (6 months) = 9%/6 months or semiannual period
d. 1% per week for 1 year

 Same as: (1%) (52 weeks) = 52% per year
e. 8% compounded semiannually
 Means 4% interest is paid on the original investment at the end of the six months
and it is then added to the investment to earn interest for the next six months
These nominal rates are calculated in the same way that simple rates are calculated, that is,
interest rate times number of periods.
Effective Interest Rates

An effective interest rate i is a rate wherein the compounding of interest is taken into
account. Effective rates are commonly expressed on an annual basis as an effective annual rate;
however, any time basis may be used.
▪ The EIR is often referred to as the Effective Annual Interest Rate (EAIR)
▪ Format: “r% per time period, compounded ‘m’ times a year.

 ‘m’ denotes or infers the number of times per year that interest is compounded
Example:
“12 per cent compounded monthly”
 12% is the nominal rate
 “compounded monthly” conveys the frequency of the compounding throughout
the year
 This example: 12 compounding periods within a year.
The effective rate of interest is useful for describing the compounding effect of interest earned
on interest during one year. The EAIR adds to a nominal rate by informing the user of the
frequency of compounding within a year.
Note:
An effective rate may not always include the compounding period in the statement. If the
compounding period (CP) is not mentioned, it is understood to be the same as the time
period mentioned with the interest rate.
For example, an interest rate of “1.5% per month” means that interest is compounded each
month; that is, CP is 1 month. An equivalent effective rate statement, therefore, is 1.5% per
month, compounded monthly.
Based on these descriptions, there are always three time-based units associated with an interest
rate statement.
▪ Interest period (t) – The period of time over which the interest is expressed.
o This is the t in the statement of r % per time period t, for example, 1% per month.
The time unit of 1 year is by far the most common. It is assumed when not stated
otherwise.
▪ Compounding period (CP) – The shortest time unit over which interest is charged or
earned.
o This is defined by the compounding term in the interest rate statement, for
example, 8% per year, compounded monthly. If CP is not stated, it is assumed to
be the same as the interest period.
▪ Compounding frequency (m) – The number of times that compounding occurs within
the interest period t.
o If the compounding period CP and the time period t are the same, the
compounding frequency is 1, for example, 1% per month, compounded monthly.
Table 2.1 Various Ways to Express Nominal and Effective Interest Rates
Format of Rate Statement Example of Statement What about the Effective Rate?
Nominal rate stated, 8% per year, compounded Find effective rate for any time
compounding period stated quarterly Period
Effective 8.243% per year, Use effective rate of 8.243% per year
Effective rate stated
compounded quarterly directly for annual cash flows
Rate is effective for CP equal to stated
Interest rate stated, no
8% per year interest period of 1 year; find effective
compounding period stated
rate for all other time periods
The equation for converting a nominal interest rate into an effective annual interest rate is
m
 r 
ieff = EAIR =  1 +  − 1 (5)
 m
To determine the effective interest rate per compounding period
( )
1 /m
i = 1 + ieff −1 (5-a)
where: r = nominal interest rate, fraction per period

m = number of the interest periods or compounding per year
Examples
1. Given: interest is 8% per year compounded quarterly
Required: the true annual interest rate
ieff = (1 + 0.08/4)4 – 1 = (1.02)4 – 1 = 0.0824 = 8.24%/year
2. Janice is an engineer with Southwest Airlines. She purchased Southwest stock for $6.90
per share and sold it exactly 1 year later for $13.14 per share. She was very pleased with
her investment earnings. Help Janice understand exactly what she earned in terms of (a)
effective annual rate and (b) effective rate for quarterly compounding, and for monthly
compounding. Neglect any commission fees for purchase and selling of stock and any
quarterly dividends paid to stockholders.
Solution:
a) The effective annual rate of return ieff has a compounding period of 1 year, since the
stock purchase and sales dates are exactly 1 year apart. Based on the purchase price
of $6.90 per share and using the definition of interest rate
amount of increase per 1 year

ieff =  100 %
original price
6.24
=  100% = 90.34 % per year
6.90
b) For the effective annual rates of 90.43% per year, compounded quarterly, and
90.43%, compounded monthly, apply Equation [5] to find corresponding effective
rates on the basis of each compounding period.
Quarter: m = 4 times per year

i = (1 + 0.9034)1/4 – 1 = 0.17472
 This is 17.472% per quarter, compounded quarterly
Month: m = 12 times per year

i = (1 + 0.9034)1/12 – 1 = 0.05514
 This is 5.514% per month, compounded monthly
Note that the term r/m in Equation [5] is always the effective interest rate per compounding
period.
3. If a savings bank pays 11/2% interest every 3 months, what are the nominal and effective
interest rates per year?
Solution:
1
Nominal interest rate per year: r = 4 1 % =6 %
2
m 4
 r   0.06 
Effective annual interest rate: ieff =  1 +  − 1 =  1 +  − 1 = 0.061 = 6.1 %
 m  4 
Alternately, the effective annual interest rate:
ieff = ( 1 + i ) − 1 = ( 1 + 0.015 ) − 1 = 0.061 = 6.1 %

m 4
Spreadsheet function for effective annual interest:

=EFFECT(nominal rate per year, compounding frequency)
=EFFECT( r %, m )
 The thing to remember about using the EFFECT function is that the nominal rate r
entered must be expressed over the same period of time as that of the effective rate
required, which is 1 year here
Spreadsheet function for nominal annual rate r:

=NOMINAL(effective rate, compounding frequency per year)
=NOMINAL( ieff%, m )
Treatment for nominal and effective interest rates parallels that of simple and compound
interest. Like compound interest, an effective interest rate at any point during the year includes
(compounds) the interest rate for all previous compounding periods during the year.
Therefore, for the future amount:
mn
 r 
F =P1+  (6)
 m
Note:
▪ Every nominal interest rate must be converted into an effective rate before it can be used
in formulas, factor tables, or spreadsheet functions because they are all derived using
effective rates.
Examples
1. a) A Visa credit card issued through Chase Bank carries an interest rate of 1% per month on
the unpaid balance. Calculate the effective rate per semiannual period.
b) If the card’s interest rate is stated as 3.5% per quarter, find the effective semiannual and
annual rates.
Solution:
a. The compounding period is monthly. Since the effective interest rate per semiannual period
is desired, the r in Equation [5] must be the nominal rate per 6 months.
r = 1% per month  6 months per semiannual period

= 6% per semiannual period
The m in Equation [5] is equal to 6, since interest is compounded 6 times in 6 months. The
effective semiannual rate is
6
 0.06 
i per 6 months =  1 +  − 1 = 0.0615 or 6.15 %
 6 
b. For an interest rate of 3.5% per quarter, the compounding period is quarterly. In a
semiannual period, m = 2 and r = 7%.
2
 0.07 
i per 6 months =  1 +  − 1 = 0.0712 or 7.12 %
 2 
The effective interest rate per year is determined using r = 14 % and m = 4:
4
 0.14 
i per year =  1 +  − 1 = 0.1475 or 14.75 %
 4 
2. A person is quoted an 8.33% interest rate on a 4-year loan and the interest is compounded
monthly. What is the effective interest rate on this purchase?
Solution:
121
  0.0833  
− 1 = ( 1.006941 ) − 1 = 0.0865 or 8.65 %
12
ieff = 1 +  
  12  
3. A savings bank offers loans on two choices of interest a) 10 % compounded every month and
b) 12% semiannually. Which option would give a lower debt?
Solution:
a. r = 0.1, m = 12
12
 0.1 
ieff =  1 +  − 1 = 10.47% per year
 12 
b. r = 0.12, m = 2
2
 0.12 
ieff =  1 +  - 1 = 12.36% per year
 2 
Therefore:
Option (a) would give a lower debt since effective to be paid would be smaller
4. What will be the equivalent amount after 10 years, if P 2000 is deposited today at an interest
rate of 10% compounded semiannually?
Solution:
a) First, calculate the effective interest rate
i = (1 + r / m )m - 1
= ( 1 + 0.1 / 2) 2
- 1 = 0.1025
F = P (1 + i )n = 2000 (1.1025)10 = P 5306.60
b) Future amount
F = (1 + r / m )mn
= 2000 (1 + 0.1 / 2) ( ) = P 5306.60
2 20
5. A loan shark lends money on the following terms: “If I give you $50 on Monday, you owe me
$60 on the following Monday.”
a) What nominal interest rate per year (r) is the loan shark charging?
b) What effective interest rate per year (ieff) is he charging?
c) If the loan shark started with $50 and was able to keep it, as well as all the money he
received, loaned out at all times, how much money did he have at the end of one year?
Solution:
a) nominal interest rate per year
F = P ( F / P , i, n )
60 = 50 ( F / P , i,1 )
( F / P , i,1 ) = 1.2
Therefore, i = 20% per week
Nominal interest rate per year = 52 weeks × 0.20 = 10.40 = 1040%
b) effective interest rate per year

m 52
 r   10.40 
ieff =  1 +  −1 = 1 +  −1
 m   52 
=13,104 = 1,310,400 % per year
Alternately,
ieff = ( 1 + i ) − 1
m
= (1 + 0.20 ) − 1 =13,104 = 1,310,400 % per year

52
c) amount of money after one year

F = P ( 1 + i ) = 50 ( 1 + 0.20 )
n 52
= $ 655,200
With a nominal interest rate of 1040% per year and effective interest rate of 1,310,400%
per year, the loan shark who started with $50 had $655,200 at the end of one year.
Continuous Interest
If we allow compounding to occur more and more frequently, the compounding period becomes
shorter and shorter. Then m, the number of compounding periods per payment period,
increases. This situation occurs in businesses that have a very large number of cash- flows every
day, so it is correct to consider interest as compounded continuously.
From F = P (1 + r/m)mn:
as m → , r/m → 0 and F = P lim ( 1 + r / m) = Pern

mn
m→
The effective interest rate in Equation [5] reduces to
ieff = er − 1 (7)
Equation [7] is used to compute the effective continuous interest rate. The time periods on i and
r must be the same.
Examples:
a. For an interest rate of 18% per year compounded continuously, calculate the effective
monthly and annual interest rates.
b. An investor requires an effective return of at least 15%. What is the minimum annual
nominal rate that is acceptable for continuous compounding?
Solution:
a. The nominal monthly rate is r = 18%/12 = 1.5%, or 0.015 per month. By Equation [7], the
effective monthly rate is
i% per month = er – 1 = e0.015 – 1 = 1.511%
Similarly, the effective annual rate using r = 0.18 per year is

i% per year = er – 1 = e0.18 – 1 = 19.72%
b. Solve Equation [7] for r by taking the natural logarithm

er – 1 = 0.15
er = 1.15
r = ln 1.15 = 13.976 %
Therefore, a nominal rate of 13.976% per year compounded continuously will generate an
effective 15% per year return.
The general formula to find the nominal rate, given the effective continuous rate i, is
r = ln ( 1 + i ) (8)
It should be noted that when a nominal interest rate is compounded annually, the nominal
interest rate equals the effective interest rate. Also, it will be noted that increasing the frequency
of compounding (for example, from monthly to continuously) has only a small impact on the
effective interest rate. But if the amount of money is large, even small differences in the effective
interest rate can be significant.
To find compound amount and present worth for continuous compounding and a single
payment, we write:
Compound Amount: ( )
F = P ern = P  F / P , r , n (9)
Present Worth: ( )
P = F e − rn = F  P / F , r , n (10)
Examples:
1. If you were to deposit $2000 in a bank that pays 5% nominal interest, compounded
continuously, how much would be in the account at the end of 2 years?
Solution:
The single payment compound amount equation for continuous compounding is
F = Pern
where r =nominal interest rate = 0.05

n =number of years = 2
F = 2000e(
0.05 )( 2 )
= $2210.40
There would be $2210.40 in the account at the end of 2 years.
2. A bank offers to sell savings certificates that will pay the purchaser $5000 at the end of
10 years but will pay nothing to the purchaser in the meantime. If interest is computed
at 6%, compounded continuously, at what price is the bank selling the certificates?
Solution:
P = Fe−rn F = $5000 r = 0.06 n = 10 years
P = 5000e ( )( ) = $2744
− 0.06 10
Therefore, the bank is selling the $5000 certificates for $2744.
3. How long will it take for money to double at 10% nominal interest, compounded
continuously?
Solution:
F = Pern
2 = 1  e0.10n
0.10n = ln 2
n = 6.93 years
It will take 6.93 years for money to double at 10% nominal interest, compounded
continuously.
4. If the savings bank in Example 3 changes its interest policy to 6% interest, compounded
continuously, what are the nominal and the effective interest rates?
Solution:
The nominal interest rate remains at 6% per year.
Effective interest rate = er – 1 = e0.06 − 1 = 0.0618 = 6.18%
1. Mary’s credit card situation is out of control because she cannot afford to make her
monthly payments. She has three credit cards with the following loan balances and
APRs: Card 1, $4,500, 21%; Card 2, $5,700, 24%; and Card 3, $3,200, 18%. Interest
compounds monthly on all loan balances. A credit card loan consolidation company has
captured Mary’s attention by stating they can save Mary 25% per month on her credit
card payments. This company charges 16.5% APR. Is the company’s claim correct?
Note: The annual percentage rate (APR) is a nominal interest rate and does not account
for compounding that may occur, or be appropriate, during a year.
2. a. What is the effective annual interest rate when a nominal rate of 12% per year is
compounded monthly?
b. How many months does it take for a present sum of money to double if the nominal
interest rate is 12% per year and compounding is monthly?
c. How many months does it take for a present sum of money to triple if the nominal
interest rate is 12% per year and compounding is monthly?
3. An APR of 3.75% produces an effective annual interest rate of 3.82% What is the
compounding frequency (m) in this situation?
4. Compute the effective annual interest rate in each of the following situations.
a. 5.75% nominal interest, compounded quarterly.
b. 5.75% nominal interest, compounded daily.
5. A department store charges 13/4%interest per month, compounded continuously, on its
customer’s charge accounts. What is the nominal annual interest rate? What is the
effective interest rate? (Answers: 21%; 23.4%)
Exercises 2
1. A thousand dollars is invested for 7 months at an interest rate of 1% per month. What is
the nominal interest rate? What is the effective interest rate? (Answers: 12%; 12.68%)
2. A firm charges its credit customers 13/4%interest per month. What is the effective
interest rate?
3. A local store charges 11/2%eachmonth on the unpaid balance for its charge account.
What nominal annual interest rate is being charged? What is the effective interest rate?
4. What interest rate, compounded quarterly, is equivalent to a 9.31% effective interest
rate?
5. A bank advertises it pays 7% annual interest, compounded daily, on savings accounts,

provided the money is left in the account for 4 years. What is the effective annual
interest rate?
6. At the Central Furniture Company, customers who buy on credit pay an effective annual
interest rate of 16.1%, based on monthly compounding. What is the nominal annual
interest rate that they pay?
7. A student bought a $75 used guitar and agreed to pay for it with a single $85 payment at
the end of 6 months. Assuming semiannual (every 6 months) compounding, what is the
nominal annual interest rate? What is the effective interest rate?
8. Mr. Sansomewithdrew$1000 from a savings account and invested it in common stock.
At the end of 5 years, he sold the stock and received a check for $1307. If Mr. Sansome
had left his $1000 in the savings account, he would have received an interest rate of 5%,
compounded quarterly. Mr. Sansome would like to compute a comparable interest rate
on his common stock investment. Based on quarterly compounding, what nominal
annual interest rate did Mr. Sansome receive on his investment in stock? What effective
annual interest rate did he receive?
9. The treasurer of a firm noted that many invoices were received with the following terms
of payment: “2%-10 days, net 30 days.” Thus, if he were to pay the bill within 10 days of
its date, he could deduct 2%. On the other hand, if he did not promptly pay the bill, the
full amount would be due 30 days from the date of the invoice. Assuming a 20-day
compounding period, the 2%deduction for prompt payment is equivalent to what
effective annual interest rate?
10. First Bank is sending alumni of universities an invitation to obtain a credit card, with
the name of their university written on it, for a nominal 9.9% interest per year after 6
months of 0% interest. These interest rates apply to the outstanding debt if not paid by
a specified date each month, and hence interest is compounded monthly. If you fail to
make the minimum payment in any month, your interest rate could increase (without
notice) to a nominal 19.99% per year. Calculate the effective annual interest rates the
credit company is charging in both cases
11. A forklift truck costs $29,000. A company agrees to purchase such a truck with the
understanding that it will make a single payment for the balance due in 3 years. The
vendor agrees to the deal and offers two different interest schedules. The first schedule
uses an annual effective interest rate of 13%. The second schedule uses 12.75%
compounded continuously.
a) Which schedule should the company accept?
b) What would be the size of the single payment?
12. How long will it take for $10,000, invested at 5% per year, compounded continuously, to
triple in value?
13. A friend was left $50,000 by his uncle. He has decided to put it into a savings account
for the next year or so. He finds there are varying interest rates at savings institutions: 4
3/8% compounded annually, 41/4% compounded quarterly, and 41/8% compounded
continuously. He wishes to select the savings institution that will give him the highest
return on his money. What interest rate should he select?
14. Jack deposited $500,000 into a bank for 6 months. At the end of that time, he withdrew
the money and received $520,000. If the bank paid interest based on continuous
compounding:
a) What was the effective annual interest rate?
b) What was the nominal annual interest rate?
15. Ace Zenovia Bank and Trust deposits $2,567,223 of excess capital in the Federal Reserve
Bank. If the Fed pays 4% interest compounded daily, how much interest will Zenovia
earn by leaving the money on deposit for two years? By how much does assuming
continuous compounding change the answer?
V. NOTATION AND CASH-FLOW DIAGRAMS
The use of cash-flow (time) diagrams or tables is strongly recommended for situations in which
the analyst needs to clarify or visualize what is involved when flows of money occur at various
times. In addition, viewpoint is an essential feature of cash-flow diagrams.
Cash flows are inflows and outflows of money. These cash flows may be estimates or observed
values. Every person or company has cash receipts − revenue and income (inflows); and cash
disbursements − expenses, and costs (outflows).
Cash flows occur during specified period of time, such as 1 month or 1 year.
Notation: (+) plus sign → cash inflows

(−) minus sign → cash outflows
Samples of Cash Inflow Estimates

- Revenues (from sales and contracts)
- Operating cost reductions (resulting from an alternative)
- Salvage value
- Construction and facility cost savings
- Receipt of loan principal
- Income tax savings
- Receipts from stock and bond sales
Samples of Cash Outflow Estimates

- First cost of assets
- Engineering design costs
- Operating costs (annual and incremental)
- Periodic maintenance and rebuild costs
- Loan interest and principal payments
- Major expected/unexpected upgrade costs
- Income taxes
Net cash flow = receipts − disbursements

= cash inflows − cash outflows
The end-of-period convention means that all cash flows are assumed to occur at the end of an
interest period. When several receipts and disbursements occur within a given interest period,
the net cash flow is assumed to occur at the end of the interest period.
Cash-Flow Diagram
The cash-flow diagram employs several conventions:
1. The horizontal line is a time scale, with progression of time moving from left to right.
2. The arrows signify cash flows and are placed at the end of the period. If a distinction
needs to be made, downward arrows represent expenses (negative cash flows or cash
outflows) and upward arrows represent receipts (positive cash flows or cash inflows).
3. The cash-flow diagram is dependent on the point of view.
a. cash flow as seen by the lender
b. cash flow as seen by the borrower
A = $4.357.10
0
1 2 3 4=n
End of Month i = 1 % per month
P = $17,000 Lender’s Viewpoint
o If the directions of all arrows had been reversed, the problem would have been
diagrammed from the borrower’s viewpoint.
Examples
1. Before evaluating the economic merits of a proposed investment, the XYZ Corporation
insists that its engineers develop a cash-flow diagram of the proposal. An investment of
$10,000 can be made that will produce uniform annual revenue of $5,310 for five years and
then have a market (recovery) value of $2,000 at the end of year (EOY) five. Annual expenses
will be $3,000 at the end of each year for operating and maintaining the project. Draw a
cash-flow diagram for the five-year life of the project. Use the corporation’s viewpoint.
Solution
As shown in the figure below, the initial investment of $10,000 and annual expenses of $3,000
are cash outflows, while annual revenues and the market value are cash inflows.
$2,000
0 $5,310 $5,310
$5,310 $5,310 $5,310
1 2 3 4 5
$3,000 $3,000 $3,000 $3,000 $3,000

End of Year
$10,000
2. Each year Exxon-Mobil expends large amounts of funds for mechanical safety features
throughout its worldwide operations. Carla Ramos, a lead engineer for Mexico and Central
American operations, plans expenditures of $1 million now and each of the next 4 years just
for the improvement of field-based pressure release valves. Construct the cash flow diagram
to find the equivalent value of these expenditures at the end of year 4, using a cost of capital
estimate for safety-related funds of 12% per year.
Solution
Since the expenditures start immediately, the first $1 million is shown at time 0, not time 1.
Therefore, the last negative cash flow occurs at the end of the fourth year, when F also occurs.
F=?
i = 12%
-1 0 1 2 3 4 Year
A = $1,000,000
3. A father wants to deposit an unknown lump-sum amount into an investment opportunity 2

years from now that is large enough to withdraw $4000 per year for state university tuition
for 5 years starting 3 years from now. If the rate of return is estimated to be 15.5% per year,
construct the cash flow diagram.
Solution
Cash flows from the father’s perspective:
The present value P is a cash outflow 2 years hence and is to be determined (P = ?).. Note
that this present value does not occur at time (t = 0), but it does occur one period prior to
the first A value of $4000, which is the cash inflow to the father.
A = $4,000
i = 15 ½ %
0 1 2 3 4 5 6 7 Year
P=?
1. Construct a cash flow diagram for the following: $10,000 outflow at time zero, $3000 per
year inflow in years 1 through 5 at an interest rate of 10% per year, and an unknown
future amount in year 5.
2. Kennywood Amusement Park spends $75,000 each year in consulting services for ride
inspection and maintenance recommendations. New actuator element technology
enables engineers to simulate complex computer-controlled movements in any
direction. Construct a cash flow diagram to determine how much the park could afford
to spend now on the new technology, if the cost of annual consulting services will be
reduced to $30,000 per year. Assume the park uses an interest rate of 15% per year and
it wants to recover its investment in 5 years.
Exercises 3
1. Draw the cash flow diagram if Strong Metalworking borrows $100K to be repaid in 5
years. The interest rate is 11%, and the only payment is at the end of year 5.
2. A computer system will be leased for his last 2 years of school by Richard Husky. Disks,
paper, and printer cartridges will cost him $120 per year. The lease payments are $80 per
month, and there is a security deposit of $500. Draw the monthly cash flow diagram.
3. Grand Junction expects the cost of maintaining its sewer lines to be $20K in the first year
after reconstruction and to increase by $2K each year thereafter until another major
reconstruction after 8 years. Draw the cash flow diagram for the first 8 years.
4. Mary Tipton is buying an auto that costs $12,000. She will pay $2000 immediately and
the remaining $10,000 in four annual end-of-year principal payments of $2500 each. In
addition to the $2500, she must pay 15% interest on the unpaid balance of the loan each
year. Prepare a cash flow diagram.
5. Geske Sausage Company has just purchased a new meat-grinding machine. The
machine’s purchase price was $22,500. Geske made a 20% down payment and agreed to
make nine monthly principal payments of $2000 each. Geske also agreed to pay 1%
interest on the unpaid principal each month. Prepare a cash flow diagram.
6. Draw the cash flow diagram for City Utilities if it borrows $50K to be repaid over 10 years
at an interest rate of 4% and:
a) One final payment is made.
b) Interest is paid annually, and the principal is paid at the end.
c) $6164.55 is paid annually. What interest is paid in year 3?
d) $5000 plus interest on the unpaid balance is paid each year.
VI. SINGLE-PAYMENT FORMULAS (F/P AND P/F)
▪ used to find the present or future amount when only one payment or receipt is involved
Finding F when Given P
F = P ( 1 + i)
n
(11)
where: F = amount of money accumulated after n years (or periods) from a single present
worth P
(1 + i)n → single payment compound amount factor
→ usually referred to as the F/P factor
This is the conversion factor that yields the future amount F of an initial amount P after n years
at interest rate i.
Using functional symbol:
F = P ( F /P , i%, n ) (11-a)
where the factor in parentheses is read “find F given P at i% interest per period for n interest
periods.”
Finding P when Given F

Reverse the situation to determine the P value for a stated amount F. Simply solve Equation
[9] for P.
 1 
P=F   = F(1 + i)-n (12)
 ( 1+ i ) 
n
 
1
where = single-payment present worth factor (SPPWF), or the P/F factor
(1 + i )
n
Using functional notation:
P = F ( P /F , i%, n ) (12-a)
Cash Flows:
Standard Notation: (X/Y, i, n)

- X represents what is sought
- Y represents what is given
P = given
i = given
0 1 2 n–2 n–1 n
F=?
P=?
i = given
0 1 2 n–2 n–1 n
F = given
Rules for performing arithmetic calculations with cash flows:

Rule A. Cash flows cannot be added or subtracted unless they occur at the same point
in time.
Rule B. To move a cash flow forward in time by one-time unit, multiply the magnitude
of the cash flow by (1 + i), where i is the interest rate that reflects the time value
of money.
Rule C. To move a cash flow backward in time by one-time unit, divide the magnitude
of the cash flow by (1 + i).
To simplify routine engineering economy calculations, tables of factor values have been
prepared for a wide range of interest rates and time periods from 1 to large n values, depending
on the i value.
▪ For a given factor, interest rate, and time, the correct factor value is found at the
intersection of the factor name and n.
Table 2.2 F/P and P/F Factors: Notation and Equation and Spreadsheet Function
Factor Standard Equation
Excel
Find/Given Notation with factor
Notation Name Function
Equation Formula
Single-
payment
(F/P,i,n) F/P F = P(F/P, i, n) F = P(1 + i)n =FV(i%,n,,P)
compound
amount
Single-
payment P = F[1/(1 +
(P/F,i,n) P/F P = F(F/P, i, n) =FV(i%,n,,F)
present i)n]
worth
Examples:
1. An engineer received a bonus of $12,000 that he will invest now. He wants to calculate the
equivalent value after 24 years, when he plans to use all the resulting money as the down
payment on an island vacation home. Assume a rate of return of 8% per year for each of the
24 years. Find the amount he can pay down?
Solution
The symbols and their values are
P = $12,000 F = ? i = 8% per year n = 24 years
F = P(F/P,i,n) = 12,000(F/P,8%,24) = $76,094.40
F = P(1 + i)n = 12,000(1 + 0.08)24 = $76,094.17
 An equivalence interpretation of this result is that $12,000 today is worth $76,094 after
24 years of growth at 8% per year compounded annually.
2. Hewlett-Packard has completed a study indicating that $50,000 in reduced maintenance

this year (i.e., year zero) on one processing line resulted from improved wireless monitoring
technology.
a. If Hewlett-Packard considers these types of savings worth 20% per year, find the
equivalent value of this result after 5 years.
b. If the $50,000 maintenance savings occurs now, find its equivalent value 3 years
earlier with interest at 20% per year.
Solution
The symbols and their values are
P = $50,000 F=? i = 20% per year n = 5 years
a. F = P(F/P, i, n) = $50,000(F/P,20%,5)
b. The cash flow diagram appears with F placed at time t = 0 and the P value placed 3 years
earlier at t = - 3. The symbols and their values are
P=? F = $50,000 i = 20% per year n = 3 years
Use the P/F factor to determine P three years earlier.
P = F(P/F,i,n) = $50,000 (P/F,20%,3)
3. Jamie has become more conscientious about paying off his credit card bill promptly to
reduce the amount of interest paid. He was surprised to learn that he paid $400 in interest
in 2007 and the amounts shown in Figure over the previous several years. If he made his
payments to avoid interest charges, he would have these funds plus earned interest available
in the future. What is the equivalent amount 5 years from now that Jamie could have
available had he not paid the interest penalties? Let i = 5% per year.
F=?
i = 5%
-5 -4 -3 -2 -1 0 1 2 3 4 5
$300
$400
$600
Solution:
Use F/P factors to find F in the year labeled 5, which is 10 years after the first cash flow.
F = 600(F/P,5%,10) + 300(F/P,5%,8) + 400(F/P,5%,5) = $1931.11
Alternate solution:
The problem could also be solved by finding the present worth in year -5 of the $300
and $400 costs using the P/F factors and then finding the future worth of the total in 10
years.
P = 600 + 300(P/F,5%,2) + 400(P/F,5%,5) = $1185.50
F = 1185.50(F/P,5%,10) = $1931.06
4. The average price of gasoline in 2005 was $2.31 per gallon. In 1993, the average price was
$1.07. What was the average annual rate of increase in the price of gasoline over this 12-year
period?
Solution:
With respect to the year 1993, the year 2005 is in the future.
P = $1.07, F =$2.31, and N = 12
i = n F / P − 1 = 12 2.31 / 1.07 − 1 = 0.0662 or 6.62%
5. An enterprising student invests $1 ,000 at an annual interest rate that will grow the original
investment to $2,000 in four years. In four more years, the amount will grow to $4,000, and
this pattern of doubling every four years repeats over a total time span of 36 years. How
much money will the student gain in 36 years? What is the magical annual interest rate the
student is earning?
Solution:
The $1,000 originally invested dollars doubles nine times in 36 years; so, the student will
gain ($1,000) (29) − $1,000 = $511,000 in 36 years.
Alternate solution:
Solve F = (F/P, i′, 4) for i′ = 18.921%.
Then,
F = $1,000 (F/P, 18.921%, 36) = $512,000
Thus, the gain is $512,000 − $1,000 = $511,000

6. In 1972, the maximum earnings of a worker subject to social security tax was $9,000. The
maximum earnings subject to social security tax in 2008 is $102,000. What compounded
annual increase has been experienced over this 36-year period of time? How does it compare
with a 3% annual increase in the consumer price index (CPI) over this same time interval?
Solution:
$102,000 = $9,000 (F/P, i′ %, 36) or i′ = 6.98%.
This is more than double the Consumer Price index
7. At a certain state-supported university, annual tuition and fees have risen dramatically in
recent years as shown in the table below.
Tuition and Consumer Price

Year
Fees Index
1982-1983 $827 96.5
1987-1988 $1,404 113.6
1993-1994 $2,018 144.5
2003-2004 $4,450 184.0
2005-2006 $5,290 198.1 (est.)
a. If all tuition and fees are paid at the beginning of each academic year, what is the
compound annual rate of increase from 1982 to 2005?
b. What is the annual rate of increase from 1993 to 2005?
c. How do the increases in Parts (a) and (b) compare with the CPI for the same period of
time?
Solution:
a) $5,290 = $827 (F/P, i%, 23) i = 8.4% per year
b) $5,290 = $2,018 (F/P, i%, 12) i = 8.36% per year
c) 1982−2005: 198.1 = 96.5 (1 + i)23 i = 3.18% per year
1993−2005: 198.1 = 144.5 (1 + i)12 i = 2.66% per year
The cost of tuition and fees has risen 2.6 times faster than the CPI for the 1982−2005 time-
period. Over the 1993−2005 period, they have risen more than three times as fast.
1. Assuming an interest rate of 8% compounded annually. Answer the following questions:
(a) How much money can be loaned now if $6,000 is to be repaid at the end of five years?
(b) How much money will be required in four years in order to repay a $15,000 loan
borrowed now?
2. You bought 200 shares of Motorola stock at $3,800 on December 31, 2000. Your intention
is to keep the stock until it doubles in value. If you expect 15% annual growth for
Motorola stock, how many years do you expect to hold onto the stock?
Present Values of an Uneven Series by Decomposition into Single Payments

 One way to deal with an uneven series of cash flows is to calculate the equivalent present
value of each single cash flow and then to sum the present values to find P.
Examples
1. Wilson Technology, a growing machine shop, wishes to set aside money now to invest over
the next four years in automating its customer service department. The company can earn
10% on a lump sum deposited now, and it wishes to withdraw the money in the following
increments:
Year 1: $25,000 to purchase a computer and database software designed for
customer service use;
Year 2: $3,000 to purchase additional hardware to accommodate anticipated
growth in use of the system;
Year 3: No expenses: and
Year 4: $5,000 to purchase software upgrades.
How much money must be deposited now in order to cover the anticipated payments over
the next four years?
2. A local newspaper headline blared, "Bo Smith Signs for $30 Million." The article revealed
that, on April 1,2002, Bo Smith, the former record breaking running back from Football
University, signed a $30 million package with the Nebraska Lions. The terms of the contract
were $3 million immediately, $2.4 million per year for the first five years (with the first
payment after one year), and $3 million per year for the next five years (with the first
payment at the end of year six). If the interest rate is 8% compounded annually, what is Bo's
contract worth at the time of contract signing?
3. You are preparing to buy a vacation home eight years from now. The home will cost $50,000
at that time. You plan on saving three deposits at an interest rate of 10%:
Deposit 1: Deposit $10,000 today.
Deposit 2: Deposit $12,000 two years from now.
Deposit 3: Deposit $X five years from now.
How much do you need to invest in year five to ensure that you have the necessary funds to
buy the vacation home at the end of year eight?
Exercises 4
1. If a company sets aside $1,000,000 now into a contingency fund, how much will the
company have in 2 years, if it does not use any of the money and the account grows at a
rate of 10% per year?
2. A solid waste disposal company borrowed money at 10% per year interest to purchase
new haulers and other equipment needed at the company owned landfill site. If the
company got the loan 2 years ago and paid it off with a single payment of $4,600,000,
what was the principal amount P of the loan?
3. To make CDs look more attractive than they really are, some banks advertise that their
rates are higher than their competitors’ rates; however, the fine print says that the rate
is a simple interest rate. If a person deposits $10,000 at 10% per year simple interest, what
compound interest rate would yield the same amount of money in 3 years?
4. You have just invested a one-time amount of $5,000 in a stock-based mutual fund. This
fund should earn (on average) 9% per year over a long period of time. How much will
your investment be worth in 35 years?
5. You just inherited $10,000. While you plan to squander some of it away, how much
should you deposit in an account earning 5% interest per year if you’d like to have
$10,000 in the account in 10 years?
6. A certain college graduate, Sallie Evans, has $24,000 in student-loan debt at the end of
her college career. The interest rate on this debt is 0.75% per month. If monthly
payments on this loan are $432.61, how many months will it take for Sallie to repay the
entire loan?
7. Suppose you contribute $10 per week ($520 per year) into an interest-bearing account
that earns 6% a year (compounded once per year). That’s probably one less pizza per
week! But if you contribute faithfully each week into this account, how much money
would you have saved through the compounding of interest by the end of 15 years?
8. A lump-sum loan of $5,000 is needed by Chandra to pay for college expenses. She has
obtained small consumer loans with 12% interest per year in the past to help pay for
college. But her father has advised Chandra to apply for a PLUS student loan charging
only 8.5% interest per year. If the loan will be repaid in full in five years, what is the
difference in total interest accumulated by these two types of student loans?
VII. UNIFORM SERIES FORMULAS (P/A, A/P, A/F, F/A)
▪ Involve a series of uniform (equal) receipts, each of amount A, occurring at the end of
each period for n periods with interest at i% per period. Such a uniform series is often
called an annuity.
Annuity
▪ An annuity is a series of uniform end-of period payments, such that each period is equal,
and the first payment is made after the first interest period.
A = Uniform Amounts (Given)

A A A A A
0 N = Number
1 2 3 N–1
of Interest
Periods
There are four uniform series formulas that involve A, where A means that:
1. The cash flow occurs in consecutive interest periods, and
2. The cash flow amount is the same in each period.
The formulas relate a present worth P or a future worth F to a uniform series amount A.
General Cash Flows
A = Uniform Amounts (Given)

A A A A A
0
N = Number
1 2 3 N–1 of Interest
Periods
End of Period
i = Interest Rate per Period

P = Present Equivalent (Find) F = Future Equivalent (Find)
P/A and A/P: Uniform Series Present Worth Factor and Capital Recovery Factor
 ( 1 + i )n − 1 
P = A  (13)
 i ( 1 + i )n 
 
 i ( 1 + i )n 
A=P   (14)
 ( 1 + i )n − 1 
 
Standard factor notation:
P = A(P/A, i, n) (15a)
A = P(A/P, i, n) (15b)
A = an end-of-period cash receipt or disbursement in a uniform series, continuing for n periods
The name capital recovery factor comes from asking the question, How large does the annual
return, A, have to be to “recover” the capital, P, that is invested at Time 0?
P=?
i = given
1 2 n–2 n–1 n
0
A = given
P = given
i = given
1 2 n–2 n–1 n
0
A=?
Table 2.3 P/A and A/P Factors: Notation and Equation and Spreadsheet Function
Factor Standard Equation with
Excel
Find/Given Notation factor
Notation Name Function
Equation Formula
Uniform
 ( 1+i )n - 1 
series P= A  F = P(1 + i)n
(P/A,i,n) A/P =PV(i%,n,A,F)
present  i ( 1+i )n 
 
worth
Capital  i ( 1+i )n 
(A/P,i,n) recovery P/A A= P   P = F[1/(1 + i)n] =PMT(i%,n,P,F)
 ( ) 
n
factor  1+i - 1 
Capital – Recovery Factor

▪ This factor is used to calculate the amount of the end–of–period payment necessary to
accumulate a given present value when the number of interest periods and the interest
rate are known.
Examples:
1. A truck is bought on an installment basis with a monthly installment of P3000 for 36
months. If the effective interest is 12% per year, calculate the cash value of the truck?
Solution:
ieff = ( 1 + i ) - 1
n
0.12 = ( 1 + i ) - 1
12
i = 0.949% per month
1 - (1 + i)
-n
P=A
i
1 - ( 1 + 0.00949 )
-36
= 3000 = P 91,122
0.00949
2. A car costing P53000 is to be purchased through a finance company. If the buyer is required
to pay P10000 as down payment and P2000 each month for 30 months, what is the effective
rate in the diminishing balance?
Solution:
P 53,000
1 2 3 … 30
P 2,000 each
P 10,000
 1 − ( 1 + i )−30 
53000 − 10000 = 2000  
 i 
By trial and error:

ieff = (1 + i )12 - 1
= (1 + 0.023057)12 - 1
ieff = 31.46%
3. A small businessman needs P50000 for his operations. One financial institution is willing to
level him money for one year at 12.5% interest per annum (discounted). Another lender is
charging 14% interest, with the principal and interest payable at the end of one year. A third
financier is willing to lend him P50000 payable in 12 equal monthly installments of P4600
each. a) Which offer is best for him? b) What are the effective rates of each, in terms of
simple interest rates with interest and principal payable at the end of one-year loan period?
Solution:
Compare the effective rate of each offer and select with the lowest effective rate.
First offer:
Rate of discount = 12.5%
=d
Rate of interest = d /(1 - d)
= 0.125/(1 - 0.125)
i = 0.1429
i eff = 14.29%
Alternate:
Discount= 50000 - 0.875(50000)
= P 6250
i = 6250/0.875(50000) = 0.1429
Second offer: ieff = 14 %
Third offer:
1 - (1 + i)
-n
P= A
i
1 - (1 + i)
-12
50000= 3000
i
By trial and error:

i = 0.01556
ieff = (1 + 0.01556)12 - 1 = 0.2036
= 20.36%
Therefore: the second offer is the best offer
4. 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:
A = $600, i = 16%, and n = 9
P = 600( P/A ,16%,9) = 600(4.6065) = $2763.90
The PV function =PV(16%,9,600) entered into a single spreadsheet cell will display the
answer P = ($2763.93).
5. Twelve payments of $10,000 each are to be repaid monthly at the end of each month. The
monthly interest rate is 2%.
a. What is the present equivalent (i.e., Po) of these payments?
b. Repeat Part (a) when the payments are made at the beginning of the month. Note that
the present equivalent will be at the same time as the first monthly payment.
c. Explain why the present equivalent amounts in Parts (a) and (b) are different.
Solution:
a) P = $10,000 (P/A, 2%, 12) = $105,573

b) P = $10,000 + $10,000 (P/A, 2%, 11) = $107,868
c) The present equivalent in part (b) is higher because the cash flows are not as far into the
future, so less discounting occurs.
1. It is estimated that a certain piece of equipment can save $22,000 per year in labor and
materials costs. The equipment has an expected life of five years and no market value. If
the company must earn a 15% annual return on such investments, how much could be
justified now for the purchase of this piece of equipment? Draw a cash-flow diagram
from the company’s viewpoint.
2. A micro-brewery is considering the installation of a newly designed boiler system that
burns the dried, spent malt and barley grains from the brewing process. The boiler will
produce process steam that powers the majority of the brewery’s energy operations,
saving $450,000 per year over the boiler’s expected life of 10 years. If the interest rate is
12% per year, how much money can the brewery afford to invest in the new boiler
system?
A = $450,000
0
1 2 3 ... 10
End of Year
A/F and F/A: Sinking Fund Factor and Uniform Series Compound Amount Factor
 i 
A=F   (16)
 (1 + i ) − 1 
n
 
 ( 1 + i )n − 1 
F = A  (17)
 i 
 
Standard factor notation:
F = A(F/A, i, n) (18a)
A = F(A/F, i, n) (18a)
F = given
i = given
0 1 2 n–2 n–1 n
A=?
F=?
i = given
0 1 2 n–2 n–1 n
A = given
Note:
1. P (present equivalent value) occurs one interest period before the first A (uniform
amount),
2. F (future equivalent value) occurs at the same time as the last A, and n periods after P,
and
3. A (annual equivalent value) occurs at the end of periods 1 through n, inclusive.
Table 2.4 F/A and A/F Factors: Notation and Equation and Spreadsheet Function
Factor Standard Equation
Find/
Notation with factor Excel Function
Notation Name Given
Equation Formula
Uniform
 ( 1 + i )n − 1 
series F = A  F = A(F/A, i, n)
(F/A,i,n) F/A =FV(i%,n,A,P)
compound  i 
 
amount
 ( 1 + i )n − 1 
Sinking F = A  A = F(A/F, i, n)
(A/F,i,n) A/F =PMT(i%,n,P,F)
fund  i 
 
Spreadsheet function for finding n:

=NPER(i, A, P)
Spreadsheet function for finding i:

=RATE(n, A, P, F)
Examples
1. Formasa Plastics has major fabrication plants in Texas and Hong Kong. The president wants
to know the equivalent future worth of $1 million capital investments each year for 8 years,
starting 1 year from now. Formasa capital earns at a rate of 14% per year.
Solution:
F = 1000(F/A,14%,8) = $13,232.80
2. How much money must an electrical contractor deposit every year in her savings account
starting 1 year from now at 51⁄2% per year in order to accumulate $6000 seven years from
now? A recent government study reported that a college degree is worth an extra $23,000
per year in income (A) compared to what a high-school graduate makes. If the interest rate
(i) is 6% per year and you work for 40 years (N), what is the future compound amount (F)
of this extra income?
Solution:
A = $6000(A/F,5.5%,7) = $725.76 per year
3. After years of being a poor, debt-encumbered college student, you decide that you want to
pay for your dream car in cash. Not having enough money now, you decide to specifically
put money away each year in a “dream car” fund. The car you want to buy will cost $60,000
in eight years. You are going to put aside $6,000 each year (for eight years) to save for this.
At what interest rate must you invest your money to achieve your goal of having enough to
purchase the car after eight years?
Solution:
$60,000 = $6,000 (F/A, i%, 8)
4. One of life's great lessons is to start early and save all the money you can! If you save two
dollars today and two dollars each and every day thereafter until you are 60 years old, how
much money will you accumulate (say, $730 per year for 35 years) if the annual interest rate
is 7%?
Solution:
F = $730 (F/A, 7%, 35) = $730 (138.2369) = $100,913.
Of this amount, $730 × 35 = $25,550 is money you paid in and $75,363 is accumulated interest.
1. A large electronic retailer is considering the purchase of software that will minimize
shipping expenses in its supply chain network. This software, including installation and
training, would be a $10-million investment for the retailer. If the firm’s effective interest
rate is 15% per year and the life of the software is four years, what annual savings in shipping
expenses must there be to justify the purchase of the software?
2. Suppose that your rich uncle has $1,000,000 that he wishes to distribute to his heirs at the
rate of $100,000 per year. If the $1,000,000 is deposited in a bank account that earns 6%
interest per year, how many years will it take to completely deplete the account? How long
will it take if the account earns 8% interest per year instead of 6%?
3. You have just inherited $100,000 as a lump-sum amount from your distant aunt. After
depositing the money in a practically risk-free certificate of deposit (CD) earning 5% per
year, you plan to withdraw $10,000 per year for your living expenses. How many years will
your $100,000 last in view of these withdrawals? (Hint: It is longer than 10 years!)
4. An outright purchase of $20,000 now (a lumpsum payment) can be traded for 24 equal
payments of $941.47 per month, starting one month from now. What is the monthly interest
rate that establishes equivalence between these two payment plans?
Sinking – Fund Factor

▪ A sinking fund is an interest–earning fund established to accumulate a desired amount
for withdrawal in the future through deposition of a uniform series of payments.
▪ The sinking-fund factor is needed to calculate the number of the end–of–period uniform
payments necessary to accumulate the desired sinking fund.
Sinking Fund with Beginning–of–Period Deposit

▪ In the case of certain sinking funds, a fund is established at the beginning of an interest
period and the first deposit is made at the same time. The second payment is then made
at the beginning of the second interest period. For n deposits in the fund and n interest
periods, the deposits of the sinking fund can be represented on the time scale as follows:
A A A A A A A A A A
A1 A1 A1 A1 A1 A1 A1 A1 A1 A1
0 1 2 3 4 5 6 7 n–2 n–1 n
The series of uniform beginning–of–period deposits can be converted into a series of

uniform end–of–period deposits by the following relations:
A ' = F ( A / F , i , n ) ( P / F , i , 1)
F = A1 ( F / A, i , n ) ( F / P , i , 1) (19)
P = A1 ( F / P , i , 1) ( P / A, i, n )
where: A1 = beginning–of–period uniform payment

A = end–of–period uniform payment
Example:
Given: n = 10 i = 10% A1 = P1000
( 1 + 0.10 )5 - 1
F = 1000 ( F / A,10%,10 )( F / P ,10%,1 ) = 1000 ( 1 + 0.10 )
0.10
= P 17530.70
Deferred Annuities (Uniform Series)

All annuities (uniform series) discussed to this point involve the first cash flow being made at
the end of the first period, and they are called ordinary annuities. If the cash flow does not begin
until some later date, the annuity is known as a deferred annuity.
Time present
… …
0 1 J–1 J J+1 J+2 J+3 N–1 N

End of Period
i%
The present equivalent at the end of period J of an annuity with cash flows of amount A is
A(P/A, i%,N − J)
The present equivalent of the single amount A(P/A, i%,N − J) as of time zero will then be
P0 = A(P/A, i%,N − J)(P/F, i%, J) (20)
Examples
1. Suppose that a father, on the day his son is born, wishes to determine what lump amount
would have to be paid into an account bearing interest of 12% per year to provide
withdrawals of $2,000 on each of the son’s 18th, 19th, 20th, and 21st birthdays.
Solution:
A(P/A, 12%, 4)
(P/F, 12%, 17)

A = $2,000
End of year
0
1 2 17 18 19 20 21
i = 12% per year
P0 = ? P17 = F17
P17 = A(P/A, 12%, 4) = $6,074.60 = F17
P0 = F17(P/F, 12%, 17) = $884.46
2. When you take your first job, you decide to start saving right away for your retirement. You
put $5,000 per year into the company’s 401(k) plan, which averages 8% interest per year.
Five years later, you move to another job and start a new 401(k) plan. You never get around
to merging the funds in the two plans. If the first plan continued to earn interest at the rate
of 8% per year for 35 years after you stopped making contributions, how much is the account
worth?
Solution:
First find the future equivalent of the annuity as of time 5:
F5 = $5,000 (F/A, 8%, 5) = $5,000 (5.8666) = $29,33
To determine F40, F5 can now be denoted P5, and
F40 = P5 (F/P, 8%, 35) = $29,333 (14.7853) = $433,697
Amount of Sinking Fund at Intermediate Period

▪ Sometimes the amount of a sinking fund at an intermediate period is required. If n is
the number of the total annuities, r the number of payments already made, P the
principal, and Fn the future worth of the n payments, the following relationships apply:
Value of n payments at the end of rth year:

Pr = Fn [P / F, i, (n - r) ]
Value of r payments made at the end of rth year:
Fr = A (F / A, i, r)
Value of (n – r) deposits to be made at the end of rth year:
Ur = Fn (P / F , i, n) - A ( F / A, i, r)
= A ( F / A, i, n) [( P / F , i, n) - A ( F / A, i, r )]

U r = P ( A / P , i, n ) ( F / A, i, n ) ( P / F , i, n - r ) - ( F / A, i, r )   (21)
Example:
A P20000 mortgage is being amortized by means of 20 uniform annual payments at an
interest rate of 8%. The mortgage can be paid off at any time by a lump sum equaling the
unpaid balance and a prepayment charge (a penalty for paying off the loans before the due
date) on the unpaid balance at 2%. What amount must be paid after 8 payments have been
made?
Solution:
N = 20 i = 8% r=8 n – r = 12 P = 20,000
U r = U 8 = P ( A / P , i, n) {( F / P , i, n ) [( P / F , i, n - r ) - ( F / A, i, r )]}
U r = 20000 ( A / P , 8%, 20) {( F / A, 8%, 20) ( P / F , 8%, 12) - ( F / A, 8%, 8)}
U r = P 15348.98
Total payment = 1.02(P15 348.98) = P 15 655.96
Equivalence Calculations Involving Multiple Interest Formulas

▪ examples involving two or more equivalence calculations to solve for an unknown
quantity
▪ the end-of-year cash-flow convention is used
▪ the interest rate is constant over the n time periods.
Example:
1. Two receipts of $1,000 each are desired at the EOYs 10 and 11. To make these receipts
possible, four EOY annuity amounts will be deposited in a bank at EOYs 2, 3, 4, and 5. The
bank’s interest rate (i) is 12% per year.
a) Draw a cash-flow diagram for this situation.
b) Determine the value of A that establishes equivalence in your cash-flow diagram.
c) Determine the lump-sum value at the end of year 11 of the completed cashflow diagram
based on your answers to Parts (a) and (b).
Solution
(a) Cash-flow diagrams can make a seemingly complex problem much clearer. The cash-flow
diagram for this example is shown below.
$1,000 $1,000
End of year
1 2 3 4 5 10 11
A= ?
(b) Because the unknown annuity, A, begins at EOY two, it makes sense to establish our
reference year for the equivalence calculations at EOY one (remember that the first annuity
amount follows its P-equivalent amount by one year). So the P-equivalent at EOY 1 of the
four A amounts is
P1 = A(P/A, 12%, 4).
Next, we calculate the EOY one P-equivalent of $1,000 at EOY 10 and $1,000 at EOY 11 as
follows:
P′1 = $1,000 (P/A, 12%, 2) (P/F, 12%, 8).
The (P/F, 12%, 8) factor is needed to discount the equivalent value of the A amounts at EOY
nine to EOY one. By equating both P-equivalents at EOY one, we can solve for the unknown
amount, A.
P1 = P′1
A(P/A, 12%, 4) = $1,000 (P/A, 12%, 2) (P/F, 12%, 8),
Or
3.0373A = $682.63
And
A = $224.75.
Therefore, we conclude that deposits of $224.75 at EOYs two, three, four, and five are
equivalent to $1,000 at EOYs 10 and 11 if the interest rate is 12% per year.
(c) Now we need to calculate the F-equivalent at time 11 of the −$224.75 annuity in years 2
through 5 and the $1,000 annuity in years 10 and 11.
− $224.75 (F/A, 12%, 4) (F/P, 12%, 6) + $1,000 (F/A, 12%, 2)

= −$0.15
This value should be zero, but round-off error in the interest factors causes a small difference
of $0.15.
2. How much would I accumulate in a bank at the instant of the last payment if I made 10
annual payments of P1000 each with the first deposit made today at an interest rate of 10%
per year?
Solution:
F = 1000 ( F / A,10%,9 ) + 1000 ( F / P ,10%,9 )

( 1 + 0.10 )9 - 1 + 1000
= 1000 ( 1 + 0.10 )9 = P15,937
0.10
3. If I start saving in a bank at the rate of P1000 per year with the first savings deposit made
today, how much will I accumulate at the end of 10 years if I make a total of 10 equal
payments (including the first one) and the interest rate is 10% per year?
Solution:
1000 1000 1000 1000 1000 1000 1000 1000 1000 1000
0 1 2 3 4 5 6 7 8 9 10
F = 1000 ( F / A,10%,9 )( F / A,10%,1 ) + 1000 ( F / P ,10%,10 )

 ( 1 + 0.10 )9 - 1 
 ( 1 + 0.1 )  + 1000 ( 1 + 0.10 ) = P17530.90
1 10
= 1000 
 0.10   
Exercises 5
1. If I start saving in a bank at a rate of P1000 per year at the end of each year from now, how
much will I accumulate at the end of 10 yrs. if the interest rate is 10% per year?
2. A man wants to deposit in a savings bank a certain amount of money annually by the end of
the current year and for a total of 30 years. How much should be deposit annually so that
he will have P 30000 by the end of 30 years if the interest rate is 10%? (A = P 182.38)
3. A savings bank is offering house mortgage loans at 8.5% interest compounded monthly.
What will be the monthly payment for a loan of P43000 for a 30-year mortgage if the first
installment is due after one month from the date of signing the deed? What will be the
effective annual interest rate? (ieff = 8.84% per yr.; A = P330.62 / mo.)
4. You borrow $15,000 from your credit union to purchase a used car. The interest rate on your
loan is 0.25% per month and you will make a total of 36 monthly payments. What is your
monthly payment?
5. Your company has a $100,000 loan for a new security system it just bought. The annual
payment is $8,880 and the interest rate is 8% per year for 30 years. Your company decides
that it can afford to pay $10,000 per year. After how many payments (years) will the loan be
paid off?
6. What is the future worth of a series of equal year-end deposits of $5,000 for 10 years in a
savings account that earns 8% annual compound interest if (a) all deposits are made at the
end of each year? (b) all deposits are made at the beginning of each year?
7. What equal annual series of payments must be paid into a sinking fund in order to
accumulate the following amounts?
a) $12,000 in 13 years at 4% compounded annually.
b) $25,000 in eight years at 7% compounded annually.
c) $15,000 in 25 years at 9% compounded annually.
d) $8,000 in eight years at 8.85% compounded annually.
Equivalent Groups of Money Values

▪ The principal of the equivalence of money based on a given interest rate on the time
scale applies not only to the individual sums of the money but also to the groups of
money sums. Sometimes it is required to translate a group of the money sums to a single
equivalent sum of to another group of money sums at another date.
Example:
A owes B the sum of P5000 due Dec. 31, 1984, P3000 due Dec. 31, 1986. By mutual consent A
would discharge the debt by making a payment of P7000 on Dec. 31, 1987 and a balance
payment on Dec. 31, 1988 with interest at 8%. What is the amount of the final payment?
Solution:
Let x be the final payment
First Plan Agreed Revised Plan

P5000 on 12/31/84 P7000 on 12/31/87
P3000 on 12/31/86 x on 12/31/88
Choose a convenient standard date for the evaluation of the two groups of money sums:
(Dec. 31, 1988)
7000 (F / P , 8%, 1) + x = 5000 (F / P , 8%, 4) + 3000 (F / P , 8%, 2)

x = P 2741.70
Calculation of Interest or Investment Rate

▪ When equivalent money sums are known, and it is required to calculate the interest rate
on which their equivalence is based, the calculations involve trial & error and, in
addition, an approximate interpolation.
Example
1. A person purchased a plot of land for P20000 in January 1972. Taxes on the property were
as follows: P300 in 1973, P300 in 1974, P350 in 1975, 1976 each, P400 in 1977 and 1978 each,
and P500 in 1979. The owner paid the charges up to the and including 1976 but not
subsequently. The owner sold the lot at the end of 1979 for P40,000, paid the back taxes at
9% interest compounded annually, and paid a commission of 5% to the real estate broker.
What rate of return did the owner realize on the investment?
Solution:
Net receipt of the investor at the end of 1979
1977 taxes = 400 (F/P, 9%, 2) P475.24

1978 taxes = 400 (F / P, 9%, 1) 436.00
1979 taxes = 500 500.00
Total equivalent taxes P1411.24
Commission: 5% of P40,000 2000.00
Total disbursement at end of 1979 P3411.24
Selling price 40,000.00
Net receipt at the end of 1979 P36,588.76
Disbursements Date Net receipts 12/31/79

20,000 1/1/73 36,588.76
300 12/1/73
300 12/31/74
350 12/31/75
350 12/31/76
Let i % be the return on investment

20,000 (F / P , i, 7) + 300 ( F / P, i, 6) + 300 ( F / P, i, 5) + 350 ( F / P, i, 4) + 350 (F / P , i, 3) = 36,588.76
By trial & error:

Trial 1: assume 9% Trial 2: assume 8%
LHS = 38,472.02 LHS = 36,109.93
Thus, by straight – line interpolation:

i = 8.2%
Interest Rates That Vary over Time

Real-world interest rates for a corporation vary from year to year, depending upon the financial
health of the corporation, its market sector, the national and international economies, forces of
inflation, and many other elements. Loan rates may increase from one year to another.
When P, F, and A values are calculated using a constant or average interest rate over the life of
a project, rises and falls in i are neglected. If the variation in i is large, the equivalent values will
vary considerably from those calculated using the constant rate. Although an engineering
economy study can accommodate varying i values mathematically, it is more involved
computationally to do so.
To determine the P value for future cash flow values (Ft) at different i values (it) for each year t,
we will assume annual compounding. Define
it = effective annual interest rate for year t (t = years 1 to n)
To determine the present worth, calculate the P of each Ft value, using the applicable it, and sum
the results. Using standard notation and the P/F factor,
P = F1 (P/F , i1 ,1) + F2 (P/F , i1 ,1)( P/F , i2 ,1) + . . . (22)

+ Fn (P/F , i1 ,1)(P/F , i2 ,1) . . . (P/F , in ,1)
VIII. UNIFORM (ARITHMETIC) GRADIENT OF CASH FLOWS
Some problems involve receipts or expenses that are projected to increase or decrease by a
uniform amount each period, thus constituting an arithmetic sequence of cash flows. For
example, because of leasing a certain type of equipment, maintenance and repair savings relative
to purchasing the equipment may increase by a roughly constant amount each period. This
situation can be modeled as a uniform gradient of cash flows.
Arithmetic–Gradient Conversion Factor

▪ If successive payments made at equal intervals of time differ by a constant amount, the
series of payments is termed uniform–gradient series.
As the time scale shows, the annual payment increases uniformly by G. This is converted to the
uniform annuity by the following formula:
A = A' + G ( A / G,i,n ) where G = equivalent uniform annuity payment
If the payment decreases by a constant gradient

A = A' - G ( A / G,i,n )
Note that whereas the annuity counts after the first year, the gradient starts at the end of the
second year.
Present Worth:
P = Present worth of base amount + present worth of gradient amount
P = A ' (P / A ', i, n) + G (P / G, i, n) (23)
where: A = amount in period 1

G = amount of change in cash flow between periods 1 and 2
n = number of periods from 1 through n of gradient cash flow
i = interest rate per period
If the gradient cash flow decreases from one period to the next, the only change in the general
equation is that the plus sign becomes a minus sign. Since the gradient G begins between years
1 and 2, this is called a conventional gradient.
Note:
▪ Arithmetic gradients consist of two parts: a uniform series that has an A value equal to
the amount of money in period 1, and a gradient that has a value equal to the change in
cash flow between periods 1 and 2.
▪ For arithmetic gradients, the gradient factor is preceded by a plus sign for increasing
gradients and a minus sign for decreasing gradients.
Finding P when Given G
 1  ( 1 + i )n - 1 n  

PG = G   -  
 i  i ( 1 + i ) ( 1 + i )  
n n
(24)
= ( 1 / i ) ( P / A, i%, n ) - n ( P / F , i%, n ) 

= G(P/G, i%, N)
The term in braces is called the gradient to present equivalent conversion factor
Examples
1. The Highway Department expects the cost of maintenance for a piece of heavy construction
equipment to be $5000 in year 1, to be $5500 in year 2, and to increase annually by $500
through year 10. At an interest rate of 10% per year, determine the present worth of 10 years
of maintenance costs.
2. As an example of the straightforward use of the gradient conversion factors, suppose that
certain EOY cash flows are expected to be $1,000 for the second year, $2,000 for the third
year, and $3,000 for the fourth year and that, if interest is 15% per year, it is desired to find
a) present equivalent value at the beginning of the first year,
b) uniform annual equivalent value at the end of each of the four years.
3. The heat loss through the exterior walls of a certain poultry processing plant is estimated to
cost the owner $3,000 next year. A salesperson from Superfiber Insulation, Inc., has told you,
the plant engineer, that he can reduce the heat loss by 80% with the installation of $18,000
worth of Superfiber now. If the cost of heat loss rises by $200 per year (uniform gradient)
after the next year and the owner plans to keep the present building for 15 more years, what
would you recommend if the interest rate is 10% per year?
Solution
Savings in heat loss: $3,000(0.8) = $2,400
Savings next year will increase by: $200(0.8) = $160 each year (gradient)
P0(savings) = $2,400(P/A,10%,15) + $160 (P/G,10%,15)

= $2,400 (7.6061) + 160 (40.15)
= $24,678.64
The present equivalent value of the savings is greater than the installation cost of $18,000.
Therefore, recommend installing the insulation.
Finding A when Given G
1 n 
AG = G  - 
 i ( 1 + i ) - 1 
n
(25)
= G ( A / G, i, n )
The term in brackets is called the gradient to uniform series conversion factor.
Example
For my new car purchased today, I have to pay five year–end installments of $1000 each for the
next 5 years. For the first year, the maintenance will be covered by the dealer. For the second
year, the maintenance will cost me $100. For the remaining year, the maintenance will be $200,
$300 & $400. How much should I set aside in a bank to meet the installments and maintenance
expresses for the next 5 yrs. if the interest is 8%.
Solution:
P = A ( P/A,8% )
=  A' + G ( A/G,8%,5 )  ( P/A,8%,5 )
 100  ( 1 +0.08 ) -1  
5
   1- ( 1+0.08 )-5 
 0.08
= 1000 +  -5     
 0.08 

0.08 
 ( 1+0.08 ) 5
-1   

0.08 
= ( 1000+ 184.65 )( 3.993 )
= P 4730.30
Finding F when Given G
 1  ( 1 + i )n - 1  
 
FG = G   - n 
 i  i   (26)
G nG
= ( F / A, i%, n ) -
i i
Example:
1. Calculate the future equivalent at the end of 2012, at 8% per year, of the following series of
cash flows in Figure below: [Use a uniform gradient amount (G) in your solution.]
Solution
F = $1,000 (F/A, 8%, 4) (F/P, 8%, 1) − $200 (P/G, 8%, 4) (F/P, 8%, 5)
= $1,000 (4.5061) (1.08) − $200 (4.65) (1.4693)
= $3,500.14
Miscellaneous Problems
1. Suppose that annual income from a rental property is expected to start at $1,300 per year
and decrease at a uniform amount of $50 each year after the first year for the 15-year expected
life of the property. The investment cost is $8,000, and i is 9% per year. Is this a good
investment? Assume that the investment occurs at time zero (now) and that the annual
income is first received at EOY one.
Solution
P0(rental income) = $1,300(P/A,9%,15) − $50(P/G,9%,15)
= $1,300(8.0607) − $50(43.807)
= $8,288.56
The present equivalent of the rental income is greater than the present equivalent of the
$8,000 investment, so the rental property appears to be a good investment.
2. For a repayment schedule that starts at EOY four at $Z and proceeds for years 4 through 10
at $2Z, $3Z, . . ., what is the value of Z if the principal of this loan is $10,000 and the interest
rate is 7% per year? Use a uniform gradient amount (G) in your solution.
Solution
P0 (loan amount) = P0 (loan repayment) $10,000
= Z(P/G,7%,8)(P/F,7%,2) $10,000
= Z(18.825)(0.8734) $10,000
= 16.4417 Z Z = $608.21
3. Refer to the accompanying cash-flow diagram (see Figure below), and solve for the unknown
quantity in Parts (a) through (d) that makes the equivalent value of cash outflows equal to
the equivalent value of the cash inflow, F.
a. If F = $10,000, G = $600, and N = 6, then i = ?
b. If F = $10,000, G = $600, and i = 5% per period, then N = ?
c. If G = $1,000, N = 12, and i = 10% per period, then F = ?
d. If F = $8,000, N = 6, and i = 10% per period, then G = ?
4. In the accompanying diagram, Figure below, what is the value of K on the left-hand cash-
flow diagram that is equivalent to the right-hand cash-flow diagram? Let i = 12% per year.
Solution
Using time 1 as the reference point, set P1(LHS) = P1(RHS)
K(P/A,12%,2) (P/F,12%,2) = $100(P/A,12%,6) + $110(P/G,12%,6)

K(1.6901) (0.7972) = $100(4.1114) + $110(8.93)
1.3473 K = $1,393.44
K = $1,034.25
5. Suppose that the parents of a young child decide to make annual deposits into a savings
account, with the first deposit being made on the child’s fifth birthday and the last deposit
being made on the 15th birthday. Then, starting on the child’s 18th birthday, the withdrawals
as shown will be made. If the effective annual interest rate is 8% during this period of time,
what are the annual deposits in years 5 through 15? Use a uniform gradient amount (G) in
your solution. (See Figure)
Solution
A = [$2,000 (P/A,8%,4) + $400 (P/G,8%,4)] (P/F,8%,2) (A/F,8%,11)
= [$2,000 (3.3121) + $400 (4.650)] (0.8573) (0.0601)
= $437.14
6. You owe your best friend $2,000. Because you are short on cash, you offer to repay the loan
over 12 months under the following condition. The first payment will be $100 at the end of
month one. The second payment will be $100 + G at the end of month two. At the end of
month three, you’ll repay $100 + 2G. This pattern of increasing G amounts will continue for
all remaining months.
a. What is the value of G if the interest rate is 0.5% per month?
b. What is the equivalent uniform monthly payment?
c. Repeat Part (a) when the first payment is $150 (i.e., determine G).
Solution
(a) $2,000 = $100 (P/A, 0.5%, 12) + G (P/G, 0.5%, 12)
= $100 (11.6189) + G (63.214)
G = $13.26 per month beginning at the end of month 2
(b) A = $2,000 (A/P, 0.5%, 12)

= $2,000 (0.0861)
= $172.20
(c) G = {$6189.11 - (150$$2,000)}/ 63.214

=$4.07 per month beginning at end of month 2
Exercises 6
1. Lisa plans to retire on her 61st birthday. On her 22nd birthday, Lisa will start saving $A
per year for40 years. Starting on her 62nd birthday, Lisa plans on withdrawing $10,000
and will continue these annual withdrawals until the account is exhausted on her 85th
birthday. If Lisa’s bank account pays 3% per year, what annual amount of $A will Lisa
need to invest in her bank account to achieve her retirement goal?
2. Major overhaul expenses of $5,000 each are anticipated for a large piece of earthmoving
equipment. The expenses will occur at EOY four and will continue every three years
thereafter up to and including year 13. The interest rate is 12% per year.
a. Draw a cash-flow diagram.
b. What is the present equivalent of the overhaul expenses at time 0?
c. What is the annual equivalent expense during only years 5–13?
3. It is estimated that you will pay about $80,000 into the Social Security system (FICA)
over your 40-year work span. For simplicity, assume this is an annuity of $2,000 per year,
starting with your 26th birthday and continuing through your 65th birthday.
a. What is the future equivalent worth of your Social Security savings when you
retire at age 65 if the government’s interest rate is 6% per year?
b. What annual withdrawal can you make if you expect to live 20 years in
retirement? Let i = 6% per year.
4. Refer to the accompanying cash-flow diagram (see Figure), and solve for the unknown
quantity in Parts (a) through (d) that makes the equivalent value of cash outflows equal
to the equivalent value of the cash inflow, F.
a. If F = $10,000, G = $600, and N = 6, then i = ?
b. If F = $10,000, G = $600, and i = 5% per period, then N = ?
c. If G = $1,000, N = 12, and i = 10% per period, then F = ?
d. If F = $8,000, N = 6, and i = 10% per period, then G = ?
5. You owe your best friend $2,000. Because you are short on cash, you offer to repay the
loan over 12 months under the following condition. The first payment will be $100 at the
end of month one. The second payment will be $100 + G at the end of month two. At the
end of month three, you’ll repay $100 + 2G. This pattern of increasing G amounts will
continue for all remaining months.
a. What is the value of G if the interest rate is 0.5% per month?
b. What is the equivalent uniform monthly payment?
c. Repeat Part (a) when the first payment is $150 (i.e., determine G).
6. The heat loss through the exterior walls of a certain poultry processing plant is estimated
to cost the owner $3,000 next year. A salesperson from Superfiber Insulation, Inc., has
told you, the plant engineer, that he can reduce the heat loss by 80% with the installation
of $18,000 worth of Superfiber now. If the cost of heat loss rises by $200 per year (uniform
gradient) after the next year and the owner plans to keep the present building for 15
more years, what would you recommend if the interest rate is 10% per year?
7. Start saving for retirement immediately! Even a modest amount will add up in a hurry.
Jay decides to follow this advice and puts away1%of his annual salary of $50,000 per year.
This equates to $500 on his 21st birthday, and his salary will increase by 2% (on average)
every year thereafter until Jay turns 60 years old. What is the worth of Jay’s account at
age 60 when the annual interest rate on Jay’s account is 4% per year?
8. It is likely that your college tuition will increase an average of 8% per year for the next 4
years. The annual cost of tuition at the beginning of your freshman year in college will
be $12,000 (A1). How much money will you and your parents have to deposit in a mutual
fund account one year prior to your freshman year to pay for your tuition for the 4 years
you will spend earning your degree in engineering? The mutual fund will earn an average
of 5% annual interest.
9. A person has made an arrangement to borrow $1,000 now and another $1,000 two years
hence. The entire obligation is to be repaid at the end of four years. If the projected
interest rates in years one, two, three, and four are 10%, 12%, 12%, and 14%, respectively,
how much will be repaid as a lump-sum amount at the end of four years?
10. It is likely that your college tuition will increase an average of 8% per year for the next 4
years. The annual cost of tuition at the beginning of your freshman year in college will
be $12,000 (A1). How much money will you and your parents have to deposit in a mutual
fund account one year prior to your freshman year to pay for your tuition for the 4 years
you will spend earning your degree in engineering? The mutual fund will earn an average
of 5% annual interest.
References
1. Blank, L., Tarquin, A. (2012) Engineering Economy. 7th Edition. McGraw-Hill, Inc.
2. Chan S Park (2004) Contemporary Engineering Economics. 3rd Edition Pearson
Education South Asia, PTE Ltd.
3. Newman, Donald G, Ted G. Eschenbach and Jerome P. Lavelle (2004) Engineering
Economic Analysis, 9th Edition. Oxford University Press, Inc.
4. Sullivan, William G., et al. (2015) Engineering Economy. 16th Edition. Pearson Higher
Education, South Asia, PTE Ltd.
5. Ted G. Eschenbach (2003) Engineering Economy – Applying Theory to Practice, 2nd
Edition. Oxford University Press, Inc.

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MODULE 2 – Money-Time Relationship and Equivalence 1

Engr. Caesar P. Llapitan

Why consider return to capital?

II. THE CONCEPT OF EQUIVALENCE

III. SIMPLE AND COMPOUND INTEREST

Two perspectives to an amount of interest

interest accrued per time unit

Minimum Attractive Rate of Return (MARR)

ROR  MARR  cost of capital

Expected rate of return

Range on the rate of

All proposal must offer at least MARR

Rate of return on “safe investment”

Interest = (principal)  (number of periods)  (interest rate)

F =P + I = P + Pin = P(1 + in) (2)

where: n = no. of interest periods

Interest = (principal + all accrued interest) (interest rate)

To calculate the total amount due after a number of years:

Total due after a number of years = principal (1 + interest rate)number of years

In equation format, the future amount for each year is

where: m = the number of interest periods per year

IV. NOMINAL AND EFFECTIVE INTEREST RATES

Nominal Interest Rates

r = (interest rate per period) (No. of Periods)

b. 1.5% per month for 12 months

c. 1.5% per month for 6 months

d. 1% per week for 1 year

Effective Interest Rates

▪ Format: “r% per time period, compounded ‘m’ times a year.

To determine the effective interest rate per compounding period

where: r = nominal interest rate, fraction per period

ieff = (1 + 0.08/4)4 – 1 = (1.02)4 – 1 = 0.0824 = 8.24%/year

amount of increase per 1 year

Quarter: m = 4 times per year

 This is 17.472% per quarter, compounded quarterly

Month: m = 12 times per year

 This is 5.514% per month, compounded monthly

Alternately, the effective annual interest rate:

ieff = ( 1 + i ) − 1 = ( 1 + 0.015 ) − 1 = 0.061 = 6.1 %

Spreadsheet function for effective annual interest:

Spreadsheet function for nominal annual rate r:

Therefore, for the future amount:

r = 1% per month  6 months per semiannual period

The effective interest rate per year is determined using r = 14 % and m = 4:

F = P (1 + i )n = 2000 (1.1025)10 = P 5306.60

Therefore, i = 20% per week

Nominal interest rate per year = 52 weeks × 0.20 = 10.40 = 1040%

b) effective interest rate per year

= (1 + 0.20 ) − 1 =13,104 = 1,310,400 % per year

c) amount of money after one year

as m → , r/m → 0 and F = P lim ( 1 + r / m) = Pern

The effective interest rate in Equation [5] reduces to

Similarly, the effective annual rate using r = 0.18 per year is

b. Solve Equation [7] for r by taking the natural logarithm

where r =nominal interest rate = 0.05

There would be $2210.40 in the account at the end of 2 years.

Therefore, the bank is selling the $5000 certificates for $2744.

The nominal interest rate remains at 6% per year.

Effective interest rate = er – 1 = e0.06 − 1 = 0.0618 = 6.18%