ENGINEERING

ECONOMICS [IE 551]

Tutorial Sheet 1

DEPARTMENT OF INDUSTRIAL ENGINEERING

 Tutorial Sheet 1

1 Methods of Calculating Interest

1.1 Compare the interest earned by $1,000 for five years at 8% simple interest with that
earned by the same amount for five years at 8% compounded annually.
1.2 You are considering investing $3,000 at an interest rate of 8% compounded annually
for five years or investing the $3,000 at 9% per year simple interest for five years.
Which option is better?
1.3 You are about to borrow $10,000 from a bank at an interest rate of 9% compounded
annually. You are required to make five equal annual repayments in the amount of
$2,571 per year, with the first repayment occurring at the end of year 1. Show the
interest payment and principal payment in each year.

2 Equivalence Concept
2.1 Suppose you have the alternative of receiving either $12,000 at the end of five years or
P dollars today. Currently you have no need for money, so you would deposit the P
dollars in a bank that pays 5% interest. What value of P would make you indifferent in
your choice between P dollars today and the promise of $12,000 at the end of five
years?
2.2 Suppose that you are obtaining a personal loan from your uncle in the amount of
$20,000 (now) to be repaid in two years to cover some of your college expenses. If
your uncle usually earns 8% interest (annually) on his money, which is invested in
various sources, what minimum lump-sum payment two years from now would make
your uncle happy?

3 Single Payments (Use of F/P or P/F Factors)

3.1 What is the present worth of these future payments?
(a) $5,500 6 years from now at 10% compounded annually
(b) $8,000 15 years from now at 6% compounded annually
(c) $30,000 5 years from now at 8% compounded annually
(d) $15,000 8 years from now at 12% compounded annually
3.2 For an interest rate of 13% compounded annually, find
(a) How much can be lent now if $10,000 will be repaid at the end of five years?
(b) How much will be required in four years to repay a $25,000 loan received now?
3.3 How many ye51ars will it take an investment to triple itself if the interest rate is 12%
compounded annually?

4 Uneven Payment Series

4.1 If you desire to withdraw the following amounts over the
next five years from a savings account that earns 8%
interest compounded annually, how much do you need to
deposit now?

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4.2 A local newspaper headline blared, “Bo Smith Signed for $30 Million.” A reading of
the article revealed that on April 1, 2005, Bo Smith, the former record-breaking
running back from Football University, signed a $30 million package with the Dallas
Rangers. The terms of the contract were $3 million immediately, $2.4 million per year
for the first five years (with the first payment after 1 year) and $3 million per year for
the next five years (with the first payment at year 6). If Bo’s interest rate is 8% per
year, what would his contract be worth at the time he signs it?

5 Equal Payment Series

5.1 What is the future worth of a series of equal year-end deposits of $1,000 for 10 years in
a savings account that earns 7%, annual interest if
(a) all deposits are made at the end of each year?
(b) All deposits are made at the beginning of each year?
5.2 What is the future worth of the following series of payments?
(a) $3,000 at the end of each year for 5 years at 7% compounded annually
(b) $4,000 at the end of each year for 12 years at 8.25% compounded annually
(c) $5,000 at the end of each year for 20 years at 9.4% compounded annually
(d) $6,000 at the end of each year for 12 years at 10.75% compounded annually
5.3 Part of the income that a machine generates is put into a sinking fund to replace the
machine when it wears out. If $1,500 is deposited annually at 7% interest, how many
years must the machine be kept before a new machine costing $30,000 can be
purchased?
5.4 What equal annual payment series is required to repay the following present amounts?
(a) $10,000 in 5 years at 5% interest compounded annually
(b) $5,500 in 4 years at 9.7% interest compounded annually
(c) $8,500 in 3 years at 2.5% interest compounded annually
(d) $30,000 in 20 years at 8.5% interest compounded annually
5.5 What is the present worth of the following series of payments?
(a) $800 at the end of each year for 12 years at 5.8% compounded annually
(b) $2,500 at the end of each year for 10 years at 8.5% compounded annually
(c) $900 at the end of each year for 5 years at 7.25% compounded annually
(d) $5,500 at the end of each year for 8 years at 8.75% compounded annually
5.6 You have borrowed $25,000 at an interest rate of 16%. Equal payments will be made
over a three-year period. (The first payment will be made at the end of the first year.)
What will the annual payment be, and what will the interest payment be for the second
year?

6 Linear Gradient Series

6.1 An individual deposits an annual bonus into a savings account that pays 8% interest
compounded annually. The size of the bonus increases by $2,000 each year, and the
initial bonus amount was $5,000. Determine how much will be in the account
immediately after the fifth deposit.
6.2 An individual deposits an annual bonus into a savings account that pays 8% interest
compounded annually. The size of the bonus increases by $2,000 each year, and the
initial bonus amount was $5,000. Determine how much will be in the account
immediately after the fifth deposit.

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6.3 Compute the value of P in the accompanying

cash flow diagram, assuming that i=9%

6.4 What is the equal payment series for 12 years that is equivalent to a payment series of
$15,000 at the end of the first year, decreasing by $1,000 each year over 12 years?
Interest is 8% compounded annually.

7 Geometric Gradient Series

7.1 Suppose that an oil well is expected to produce 100,000 barrels of oil during its first
year in production. However, its subsequent production (yield) is expected to decrease
by 10% over the previous year’s production. The oil well has a proven reserve of
1,000,000 barrels.
(a) Suppose that the price of oil is expected to be $60 per barrel for the next several
years. What would be the present worth of the anticipated revenue stream at an interest
rate of 12% compounded annually over the next seven years?
(b) Suppose that the price of oil is expected to start at $60 per barrel during the first
year, but to increase at the rate of 5% over the previous year’s price. What would be the
present worth of the anticipated revenue stream at an interest rate of 12% compounded
annually over the next seven years?
(c) Consider part (b) again. After three years’ production, you decide to sell the oil
well. What would be a fair price?
7.2 What is the amount of 10 equal annual deposits that can provide five annual
withdrawals when a first withdrawal of $5,000 is made at the end of year 11 and
subsequent withdrawals increase at the rate of 8% per year over the previous year’s
withdrawal if
(a) The interest rate is 9% compounded annually?
(b) The interest rate is 6% compounded annually?

8 Equivalence Calculations
8.1 Find the present worth of the cash receipts
were compounded annually.

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8.2 Find the equivalent present worth of the cash

receipts where In other words, how much do you
have to deposit now (with the second deposit in
the amount of $200 at the end of the first year) so
that you will be able to withdraw $200 at the end
of second year, $120 at the end of third year, and
so forth if the bank pays you a 8% annual interest
on your balance?
8.3 What value of A makes two annual cash flows equivalent at 13% interest compounded
annually?

8.4 From the accompanying cash flow diagram, find the value of C that will establish the
economic equivalence between the deposit
series and the withdrawal series at an interest
rate of 8% compounded annually

9 Solving for an Unknown Interest Rate or Unknown Interest Periods

9.1 At what rate of interest compounded annually will an investment double itself in five
years?
9.2 Determine the interest rate (i) that makes the pairs of cash flows shown economically
equivalent.

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9.3 You have $10,000 available for investment in stock. You are looking for a growth
stock whose value can grow to $35,000 over five years. What kind of growth rate are
you looking for?
9.4 How long will it take to save $1 million if you invest $2,000 each year at 6%?

10 Short Case Studies

10.1 Fairmont Textile has a plant in which employees have been having trouble with carpal
tunnel syndrome (CTS, an inflammation of the nerves that pass through the carpal
tunnel, a tight space at the base of the palm), resulting from long-term repetitive
activities, such as years of sewing. It seems as if 15 of the employees working in this
facility developed signs of CTS over the last five years. DeepSouth, the company’s
insurance firm, has been increasing Fairmont’s liability insurance steadily because of
this problem. DeepSouth is willing to lower the insurance premiums to $16,000 a year
(from the current $30,000 a year) for the next five years if Fairmont implements an
acceptable CTS-prevention program that includes making the employees aware of CTS
and how to reduce the chances of it developing. What would be the maximum amount
that Fairmont should invest in the program to make it worthwhile? The firm’s interest
rate is 12% compounded annually.
10.2 Adidas will put on sale what it bills as the world’s first computerized “smart shoe.” But
consumers will decide whether to accept the bionic running shoe’s $250 price tag—
four times the average shoe price at stores such as Foot Locker. Adidas uses a sensor, a
microprocessor, and a motorized cable system to automatically adjust the shoe’s
cushioning. The sensor under the heel measures compression and decides whether the
shoe is too soft or firm. That information is sent to the microprocessor and, while the
shoe is in the air, the cable adjusts the heel cushion. The whole system weighs less than
40 grams. Adidas’s computer-driven shoe—three years in the making—is the latest
innovation in the $16.4 billion U.S. sneaker industry. The top-end running shoe from
New Balance lists for $199.99. With runners typically replacing shoes by 500 miles,
the $250 Adidas could push costs to 50 cents per mile. Adidas is spending an estimated
$20 million on the rollout. The investment required to develop a full-scale commercial
rollout cost Adidas $70 million (including the $20 million ad campaign), which will be
financed at an interest rate of 10%. With a price tag of $250, Adidas will have about
$100 net cash profit from each sale. The product will have a five-year market life.
Assuming that the annual demand for the product remains constant over the market life,
how many units does Adidas have to sell each year to pay off the initial investment and
interest?

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