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ENGINEERING ECONOMY, Sixth


Edition
by Blank and
Tarquin

CHAPTER 2

Factors: How Time and


Interest Affect Money
M c
Gra
Hill
w Authored by Don Smith, Texas A&M University 2004

1
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1. Foundations: Overview
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Interpolate Factor Values
5. P/G and A/G Factors
6. Geometric Gradient
7. Calculate i
8. Calculate “n”
9. Spreadsheets
2
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CHAPTER 2: Section 1

F/P and P/F Factors

3
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2.1 Basic Derivations: F/P factor

F/P Factor To find F given P


Fn
To Find F given P

…………
. n

Compound forward in time


P0

4
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2.1 Derivation by Recursion: F/P


factor
F1 = P(1+i)
F2 = F1(1+i)…..but:
F2 = P(1+i)(1+i) = P(1+i)2
F3 =F2(1+i) =P(1+i)2 (1+i)
= P(1+i)3
In general:
Fn = P(1+i)n
Fn = P(F/P,i%,n)

5
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2.1 Present Worth Factor from F/P

Since Fn = P(1+i)n
We solve for P in terms of FN
P = F{ 1/ (1+i)n} = F(1+i)-n
Thus:
P = F(P/F,i%,n) where
(P/F,i%,n) = (1+i)-n
Thus, the two factors are:
1. F = P(1+i)n finds the future worth of P;
2. P = F(1+i)-n finds the present worth from
F 6
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2.1 P/F factor – discounting back in


time

Discounting back from the


future
Fn

…………
.
n
P/F factor brings a single
future sum back to a
P
specific point in time.

7
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CHAPTER 2: Section 2

P/A and A/P Factors

8
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2.2 Example- F/P Analysis

Example: P=
$1,000;n=3;i=10%
What is the future value,
F = ?? F?

0 1 2
P=$1,000 3
i=10%/year

F3 = $1,000[F/P,10%,3] = $1,000[1.10]3
= $1,000[1.3310] = $1,331.00

9
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2.2 Example – P/F Analysis

Assume F = $100,000, 9 years from now.


What is the present worth of this amount
now if i =15%? F9 =
$100,000
i = 15%/yr

0 1 2 3
………… 8
9

P= ??
P0 = $100,000(P/F, 15%,9) = $100,000(1/(1.15)9)
= $100,000(0.2843) = $28,430 at time t = 0

10
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

Annuity Cash Flow


P
= ??

………….
1 2 3 .. .. n
0 n-1 .

$A per period

11
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

Desire an expression for the


present worth – P of a stream
of equal, end of period cash
flows
P -A
= ??

0 1 2 3 n-1
n

A=
given
12
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

Write a Present worth expression

 1 1 1 1 
P = A + + .. + n −1
+ n 
[1]
 (1 + i ) (1 + i ) (1 + i ) (1 + i ) 
1 2

Term inside the brackets is a geometric


progression.
Mult. This equation by 1/(1+i) to yield a second
equation
13
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

The second equation


P  1 1 1 1 
= A + + .. + + n +1  [2]
1+ i  (1 + i) (1 + i)
2 3
(1 + i) (1 + i) 
n

To isolate an expression for P in terms of A,


subtract Eq [1] from Eq. [2]. Note that
numerous terms will drop out.

14
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

Setting up the subtraction


P  1 1 1 1 1 
= A + + ... n +1 
[2]
(1 + i )  (1 + i ) (1 + i ) (1 + i )
2 3 4
(1 + i ) (1 + i ) 
n

 1 1 1 1 
- P = A  (1 + i)1 + (1 + i)2 + .. + (1 + i)n−1 + (1 + i)n  [1]

−i  1 1 
= P = A n +1
−  [3]
1+ i  (1 + i ) (1 + i ) 
15
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

Simplifying Eq. [3] further

−i  1 1 
P = A n +1
− 
1+ i  (1 + i ) (1 + i ) 

A 1   (1 + i ) n − 1 
P=  n +1
− 1 P = A n 
for i ≠ 0
−i  (1 + i )   i (1 + i ) 

16
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2.2 Uniform Series Present Worth


and Capital Recovery Factors

This expression will convert an annuity


cash flow to an equivalent present worth
amount one period to the left of the first
annuity cash flow.

 (1 + i ) n − 1 
P = A n 
for i ≠ 0
 i (1 + i ) 

P / A i %, n factor
17
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2.2 Capital Recovery Factor


A/P, i%, n
The present worth
point of an annuity
cash flow is always one
Given the P/A factorperiod to the left of the
first A amount
 (1 + i )n − 1 
P = A n 
for i ≠ 0 Solve for A in terms of
 i (1 + i )  P

Yielding….

 i (1 + i )  n
A= P  A/P,i%,n factor
 (1 + i ) − 1 
n

18
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CHAPTER 2: Section 3

F/A and A/F Factors

19
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2.3 F/A and A/F Derivations $F

Annuity Cash Flow

………….
. N
0

Find $A given the


$A per period Future amt. - $F

20
2.3 Sinking Fund and Series
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Compound amount factors (A/F and


F/A)

Take advantage of what we already


have
Recall:
Substitute “P”
 1  and simplify!
P=F n 
 (1 + i ) 
Also:
 i (1 + i ) n 
A= P 
 (1 + i ) − 1 
n

21
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2.3 A/F Factor

By substitutionA = F  1   i (1 + i ) n

 (1 + i ) n   (1 + i ) n − 1 
we see:   

Simplifying we
have:  i 
Which is the A =F 
 (1 + i ) − 1 
n
(A/F,i%,n) factor

22
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2.3 F/A factor from the A/F Factor

 i 
Given: A= F 
 (1 + i ) − 1 
n

Solve for F in
terms of A  (1 + i ) − 1  n
F=A  
 i 
23
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2.3 F/A and A/F Derivations $F

Annuity Cash Flow

………….
. N
0

Find $F given the


$A per period $A amounts

24
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2.3 Example 2.5

Formosa Plastics has major fabrication


plants in Texas and Hong Kong.
It is desired to know the future worth of
$1,000,000 invested at the end of each
year for 8 years, starting one year from
now.
The interest rate is assumed to be 14%
per year.

25
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2.3 Example 2.5

•A = $1,000,000/yr; n = 8 yrs, i = 14%/yr

•F8 = ??

26
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2.3 Example 2.5

Solution:
The cash flow diagram shows the annual
payments starting at the end of year 1
and ending in the year the future worth is
desired. Cash flows are indicated in $1000
units. The F value in 8 years is

F = l000(F/A,14%,8) =
1000( 13.23218) = $13,232.80 =
13.232 million 8 years from now.

27
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2.3 Example 2.6

How much money must Carol deposit


every year starting, l year from now at
5.5% per year in order to accumulate
$6000 seven years from now?

28
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2.3 Example 2.6

Solution
The cash How diagram from Carol's
perspective fits the A/F factor.
A= $6000 (A/F,5.5%,7) =
6000(0.12096) = $725.76 per year
The A/F factor Value 0f 0.12096 was
computed using the A/F factor formula

29
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CHAPTER 2: Section 4

Interpolation in Interest
Tables

30
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2.4 Interpolation of Factors


• All texts on Engineering economy will
provide tabulated values of the various
interest factors usually at the end of the
text in an appendix
• Refer to the back of your text for those
tables.

31
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2.4 Interpolation of Factors


• Typical Format for Tabulated Interest
Tables

32
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2.4 Interpolation (Estimation


Process)
• At times, a set of interest tables may not
have the exact interest factor needed for
an analysis
• One may be forced to interpolate
between two tabulated values
• Linear Interpolation is not exact because:
• The functional relationships of the
interest factors are non-linear
functions
• Hence from 2-5% error may be present
with interpolation.
33
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2.4 An Example
• Assume you need the value of the A/P
factor for i = 7.3% and n = 10 years.
• 7.3% is most likely not a tabulated value
in most interest tables
• So, one must work with i = 7% and i = 8%
for n fixed at 10
• Proceed as follows:

34
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2.4 Basic Setup for Interpolation

•Work with the following basic


relationships

35
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2. 4 i = 7.3% using the A/P


factor
• For 7% we would observe:

COMPOUND PRESENT SINKING COMPOUND CAPITAL


N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 1.9672 0.5083 0.0724 13.8164 0.14238

A/P,7%,10) = 0.14238

36
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2. 4 i = 7.3% using the A/P


factor
• For i = 8% we observe:

COMPOUND PRESENT SINKING COMPOUND CAPITAL


N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 2.1589 0.4632 0.0690 14.4866 0.14903

(A/P,8%,10) = 0.14903

37
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2. 4 Estimating for i = 7.3%


• Form the following relationships

38
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2.4 Final Estimated Factor Value

• Observe for i increasing from 7% to 8%


the A/P factors also increases.
• One then adds the estimated increment
to the 7% known value to yield:

39
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2.4. The Exact Value for 7.3%


• Using a previously programmed
spreadsheet model the exact value for
7.3% is:

40
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CHAPTER 2 Section 5

P/G and A/G Factors

41
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2.5 Arithmetic Gradient Factors

• In applications, the annuity cash flow


pattern is not the only type of pattern
encountered
•Two other types of end of period patterns
are common
•The Linear or arithmetic gradient
•The geometric (% per period) gradient

•This section presents the Arithmetic


Gradient
42
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2.5 Arithmetic Gradient Factors


• An arithmetic (linear) Gradient is a
cash flow series that either increases
or decreases by a constant amount
over n time periods.
•A linear gradient is always comprised
of TWO components:

43
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2.5 Arithmetic Gradient Factors


•The Two Components are:
•The Gradient component
•The base annuity component
•The objective is to find a closed form
expression for the Present Worth of an
arithmetic gradient

44
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2.5 Linear Gradient Example


A1+(n-1)G

A1+(n-2)G

Assume the following:

A1+2G

A1+G

0 1 2 3 n-1
N
This represents a positive, increasing arithmetic
gradient

45
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2.5 Example: Linear Gradient

• Typical Negative, Increasing


Gradient: G=$50

The Base Annuity


= $1500

46
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2.5 Example: Linear Gradient

• Desire to find the Present Worth of this


cash flow

The Base Annuity


= $1500

47
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2.5 Arithmetic Gradient Factors

• The “G” amount is the constant


arithmetic change from one time
period to the next.
•The “G” amount may be positive or
negative!
•The present worth point is always one
time period to the left of the first cash
flow in the series or,
•Two periods to the left of the first
gradient cash flow! 48
2.5 Derivation: Gradient Component
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Only

Focus Only on the gradient Component


(n-1)G

(n-2)G
“0” G

+2G

Removed Base annuity


0 1 2 3 n-1
N 49
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2.5 Present Worth Point…

The Present worth point of a linear


gradient is always:
 2 periods to the left of the
“1G” point or,
 1 period to the left of the

very first cash flow in the


gradient series.
DO NOT FORGET THIS!
50
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2.5 Present Worth Point…

$700
$600
$500
$400
$300
$200
$100

X0 1 2 3 4 5 6
7
The Present Worth Point of the
Gradient

51
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2.5 Gradient Component

•The Gradient $600

Component $400
$500

$300
$200
$100

$0

X0 1 2 3 4 5 6
7
The Present Worth Point of the
Gradient

52
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2.5 Present Worth Point…

•PW of the Base Annuity is at t = 0

•PWBASEAnnuity =$100(P/A,i%,7)

Base Annuity – A =
$100

X0 1 2 3 4 5 6
7
The Present Worth Point of the
Gradient

53
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2.5 Present Worth: Linear Gradient

The present worth of a linear


gradient is the present worth of the
two components:
 1. The Present Worth of the Gradient

Component and,
 2. The Present Worth of the Base

Annuity flow
 Requires 2 separate calculations!

54
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2.5 Present Worth: Gradient


Component

The PW of the Base Annuity is simply


the Base Annuity –A{P/A, i%, n} factor
What is needed is a present worth
expression for the gradient
component cash flow.
We need to derive a closed form
expression for the gradient
component.

55
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2.5 Present Worth: Gradient


Component

General CF Diagram – Gradient Part Only

(n-
(n- 1)G
3G 2)G
2G
1G

0G

We want the PW at time t = 0 (2 periods to the left of


1G)
0 1 2 3 4 ……….. n-1
n

56
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2.5 To Begin- Derivation of P/G,i%,n

P = G ( P / F , i %, 2) + 2G ( P / F , i %,3) + ...
[(n-2)G](P/F,i%,n-1) + [(n-1)G](P/F,i%,n)

Next Step:
Factor out G and re-write as …..

57
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2.5 Factoring G out…. P/G factor

P=G { (P/F,i%,2)+2(P/F,i%,3) +...(n-1)(P/F,i%,n)}

What is inside of the { }’s?

58
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2.5 Replace (P/F’s) with closed-form

 1 2 n-2 n-1 
P=G  2
+ 3
+ ... + n-1
+ n [1]
 (1+i) (1+i) (1+i) (1+i) 

Multiply both sides by (1+i)

59
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2.5 Mult. Both Sides By (n+1)…..

 1 2 n-2 n-1 
1
P(1+i) =G  1
+ 2
+ ... + n-2
+ n-1  [2]
 (1+i) (1+i) (1+i) (1+i) 

•We have 2 equations [1] and [2].


•Next, subtract [1] from [2] and
work with the resultant equation.

60
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2.5 Subtracting [1] from [2]…..

 1 2 n-2 n-1 
1
P(1+i) =G  1
+ 2
+ ... + n-2
+ n-1 
 (1+i) (1+i) (1+i) (1+i) 
-  1 2 n-2 n-1 
P=G  2
+ 3
+ ... + n-1
+ n 
 (1+i) (1+i) (1+i) (1+i) 

G  (1 + i ) − 1 n  n
P=  − n 
i  i (1 + i ) n
(1 + i ) 
61
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2.5 The P/G factor for i and N


G (1 + i ) − 1
n
n 
P=  − n 
i  i (1 + i ) n
(1 + i ) 

( P / G, i %, N ) factor
62
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2.5 Further Simplification on P/G

(1 + i ) − iN − 1 N
( P / G, i %, N ) =
i (1 + i )
2 N

Remember, the present worth point of any


linear gradient is 2 periods to the left of the
1-G cash flow or, 1 period to the left of the
“0-G” cash flow.
P=G(P/G,i,n)
63
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2.5 Extension – The A/G factor

Some authors also include the derivation of the A/G factor.


A/G converts a linear gradient to an equivalent annuity cash flow.
Remember, at this point one is only working with gradient component
There still remains the annuity component that you must also handle separately!

64
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2.5 The A/G Factor

Convert G to an equivalent A

A = G ( P / G , i, n)( A / P, i, n)
How to do it…………

65
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2.5 A/G factor using A/P with P/G


G (1 + i ) − 1
n
n   i (1 + i ) 
n
P=  − n   
i  i (1 + i ) n
(1 + i )   (1 + i ) − 1 
n

(A/P,i,n)

The results follow…..

66
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2.5 Resultant A/G factor

G  (1 + i ) n − 1 n   i (1 + i ) n 
P=  − n  
i  i (1 + i ) n
(1 + i )   (1 + i ) n − 1 
(A/P,i,n)

1 n 
(A/G,i,n) = A=G − 
 i (1 + i ) − 1 
n

67
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2.5 Gradient Example

• Consider the following cash flow


$500
$400
$300
$200
$100

0 1 2 3 4
5
Present Worth Point is here!
And the G amt. = $100/period

Find the present worth if i = 10%/yr; n = 5


yrs
68
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2.5 Gradient Example- Base


Annuity

• First, The Base Annuity of $100/period


A = +$100

0 1 2 3 4
5

•PW(10%) of the base annuity = $100(P/A,10%,5)


•PWBase = $100(3.7908)= $379.08
•Not Finished: We need the PW of the gradient
component and then add that value to the $379.08
amount

69
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2.5 Focus on the Gradient


Component
$400
$300
$200
$100
$0

0 1 2 3 4
5

We desire the PW of the Gradient


Component at t = 0

PG@t=0 = G( P/G,10%,5 ) = $100( P/G,10%,5 )

70
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2.5 The Set Up


$400
$300
$200
$100
$0

0 1 2 3 4
5

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

Could substitute n=5,


G  (1 + i ) − 1 N
N  i=10% and G = $100 into
P=  −  the P/G closed form to get
i  i (1 + i ) N
(1 + i ) N  the value of the factor.

71
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2.5 PW of the Gradient


Component

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

P/G,10%,5) Sub. G=$100;i=0.10;n=5

G  (1 + i) N − 1 N 
P=  −  6.861
i  i (1 + i ) N (1 + i) N 
8
Calculating or looking up the
P/G,10%,5 factor yields the
following:
Pt=0 = $100(6.8618) = $686.18 for
the gradient PW
72
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2.5 Gradient Example: Final


Result

• PW(10%)BaseAnnuity = $379.08

•PW(10%)GradientComponent = $686.18

•Total PW(10%) = $379.08 + $686.18

•Equals $1065.26

•Note: The two sums occur at t =0 and


can be added together – concept of
equivalence
73
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2.5 Example Summarized

This Cash Flow… $500


$400
$300
$200
$100

0 1 2 3 4
5

Is equivalent to $1065.26 at time 0 if the


interest rate is 10% per year!

74
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2.5 Shifted Gradient Example: i =


10%

• Consider the following Cash


Flow
0 1 2 3 4 5 6 7

$450
$500
$550
$600

1. This is a “shifted” negative, decreasing


gradient.
2. The PW point in time is at t = 3 (not t = o)

75
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2.5 Shifted Gradient Example

• Consider the following Cash


Flow
0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The PW @ t = 0 requires getting the PW @ t


=3;
•Then using the P/F factor move PW3 back to
t=0 76
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2.5 Shifted Gradient Example

• Consider the following Cash


Flow
0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The base annuity is a $600 cash flow for 3


time periods

77
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2.5 Shifted Gradient Example: Base


Annuity

• PW of the Base Annuity: 2


Steps
0 1 2 3 4 5 6 7

P3=-600(P/A,10%,4)
P0=P3(P/F,10%,3)
P3

P0 A = -$600
3.1699 0.7513
P0= [-600(P/A,10%,4)](P/F,10%,3)
P 0-baseannuity = -$1428.93

78
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2.5 Shifted Gradient Example:


Gradient
• PW of Gradient Component: G = -
$50
0 1 2 3 4 5 6 7

P3-Grad = +50(P/G,10%,4)

P0=P3(P/F,10%,3)
P3

P0 0G 3G
1G 2G
4.3781 0.7513
=-$164.46
P0-grad = {+50(P/G,10%,4)}(P/F,10%,3)

79
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CHAPTER 2: Section 6

Geometric Gradient

80
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2.6 Geometric Gradients

• An arithmetic (linear) gradient changes by


a fixed dollar amount each time period.
•A GEOMETRIC gradient changes by a fixed
percentage each time period.
•We define a UNIFORM RATE OF CHANGE
(%) for each time period
•Define “g” as the constant rate of change
in decimal form by which amounts increase
or decrease from one period to the next

81
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2.6 Geometric Gradients:


Increasing

• Typical Geometric Gradient Profile


•Let A1 = the first cash flow in the series

0 1 2 3 4 …….. n-1
n

A1 A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1
82
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2.6 Geometric Gradients:


Decreasing

• Typical Geometric Gradient Profile


•Let A1 = the first cash flow in the series

0 1 2 3 4 …….. n-1
n
A1(1-g)n-1
A1(1-g)3
A1(1-g)2

A1(1-g)

A1
83
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2.6 Geometric Gradients:


Derivation

• First Major Point to Remember:

•A1 does NOT define a Base Annuity;


•There is no BASE ANNUITY for a
Geometric Gradient!
•The objective is to determine the Present
Worth one period to the left of the A1 cash
flow point in time
•Remember: The PW point in time is one
period to the left of the first cash flow – A1!

84
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2.6 Geometric Gradients:


Derivation

• For a Geometric Gradient the


following parameters are required:
•The interest rate per period – i
•The constant rate of change – g
•No. of time periods – n

•The starting cash flow – A1

85
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2.6 Geometric Gradients:


Starting

• Pg = The Aj’s time the respective


(P/F,i,j) factor
•Write a general present worth
relationship to find Pg….
A1 A1 (1 + g ) A1 (1 + g ) 2 A1 (1 + g ) n −1
Pg = + + + ... +
(1 + i )1
(1 + i ) 2
(1 + i ) 3
(1 + i ) n

Now, factor out the A1 value and rewrite


as..

86
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2.6 Geometric Gradients

 1 (1 + g )1 (1 + g )2 (1 + g ) n −1 
Pg = A1  + + + ... + n  (1)
 (1 + i ) (1 + i ) 2
(1 + i ) 3
(1 + i ) 
(1+g)
Multuply both sides by to create another equation
(1+i)
(1+g) (1+g)  1 (1 + g )1 (1 + g )2 (1 + g )n −1  (2)
Pg = A1  + + + ... + 
(1+i) (1+i)  (1 + i ) (1 + i ) 2
(1 + i )3
(1 + i )n 

Subtract (1) from (2) and the result is…..

87
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2.6 Geometric Gradients

 1+g   (1 + g ) n
1 
Pg  − 1 = A1  n +1
− 
 1+i   (1 + i ) 1+ i 
Solve for Pg and simplify to yield….

  1 + g n 
1 −   
  1+ i  
Pg = A1 g≠i
 i−g 
 
 
88
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2.6 Geometric Gradient P/A


factor

  1+ g  n

1 −   
  1+ i   g≠i
Pg = A1
 i−g 
 
 
• This is the (P/A,g,i,n) factor and is valid if
g is not equal to i.

89
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2.6 Geometric Gradient P/A


factor

•Note: If g = i we have a division by “0” –


undefined.
•For g = i we can derive the closed form PW
factor for this special case.
•We substitute i for g into the Pg
relationship to yield:

90
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2.6 Geometric Gradient: i = g


Case

 1 1 1 1 
Pg =A1  + + + ... + 
 (1+i) (1+i) (1+i) (1+i) 

nA1
Pg = For the case i =

(1 + i )
g

91
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2.6 Geometric Gradients:


Summary

•Pg = A1(P/A,g,i,n)
  1 + g n 
1 −    nA1
Pg = A1  

1+ i  
i−g 
g≠i Pg =



 (1 + i )
g not = to Case: g =
i i

92
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2.6 Geometric Gradient: Notes

•The geometric gradient requires


knowledge of:
•A1, i, n, and g
•There exist an infinite number of
combinations for i, n, and g: Hence
one will not find tabulated tables for
the (P/A, g,i,n) factor.

93
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2.6 Geometric Gradient: Notes

•You have to calculated either from


the closed form for each problem or
apply a pre-programmed spreadsheet
model to find the needed factor value
•No spreadsheet built-in function for
this factor!

94
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2.6 Geometric Gradient:


Example

•Assume maintenance costs for a


particular activity will be $1700 one
year from now.
•Assume an annual increase of 11%
per year over a 6-year time period.

95
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2.6 Geometric Gradient:


Example

•If the interest rate is 8% per year,


determine the present worth of the
future expenses at time t = 0.
•First, draw a cash flow diagram to
represent the model.

96
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2.6 Geometric Gradient Example (+g)

•g = +11% per period; A1 = $1700; i =


8%/yr

0 1 2 3 4 5 6
7
$1700 $1700(1.11)1

$1700(1.11)2
$1700(1.11)3

PW(8%) = ??
$1700(1.11)5

97
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2.6 Solution
• P = $1700(P/A,11%,8%,7)
•Need to calculate the P/A factor from
the closed-form expression for a
geometric gradient.
•From a spreadsheet we see:
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = 11%
i= 8%   1 + g n 
N= 7 1 −   
1+ i  
7.04732 Pg = A1   g≠i
P/A,g,i,n factor is……
 i−g 
 
First Amt= $ 1,700.00  
P. Value = $ 11,980.44
98
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2.6 Geometric Gradient ( -g )

• Consider the following problem with


a negative growth rate – g.
A1 =
$1000 $900
$810
$729

0 1 2 3 4
P0=??
g = -10%/yr; i = 8%; n = 4

We simply apply a “g” value = -0.10

99
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2.6 Geometric Gradient (-g


value)

• Evaluate:   1+ g n
 
1−   
For a negative g 1+ i
value = -0.10 Pg = 1A  g i ≠
 i− g 
 
 
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = -10%
i= 8%
N= 4
P/A,g,i,n factor is…… 2.87637

First Amt= $ 1,000.00


P. Value = $ 2,876.37
100
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CHAPTER 2: Section 7

Determination of an
Unknown Interest Rate

101
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2.7 When the i – rate is unknown

• A class of problems may deal with


all of the parameters know except the
interest rate.
•For many application-type problems,
this can become a difficult task
•Termed, “rate of return analysis”
•In some cases:
•i can easily be determined
•In others, trial and error must be
used
102
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2.7 Example: i unknown

• Assume on can invest $3000 now in


a venture in anticipation of gaining
$5,000 in five (5) years.
•If these amounts are accurate, what
interest rate equates these two cash
flows?

103
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2.7 Example: i unknown

• The Cash Flow Diagram is…


$5,000

0 1 2 3 4
5

$3,000
•F = P(1+i)n
•5,000 = 3,000(1+i)5
•(1+i)5 = 5,000/3000 =
1.6667
104
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2.7 Example: i unknown

• Solution: $5,000

0 1 2 3 4
5
•(1+i)5 = 5,000/3000 =
$3,000 1.6667
•(1+i) = 1.66670.20
•i = 1.1076 – 1 = 0.1076 =
10.76%

105
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2.7 For “i” unknown

• In general, solving for “i” in a time


value formulation is not straight
forward.
•More often, one will have to resort to
some form of trial and error approach
as will be shown in future sections.
•A sample spreadsheet model for this
problem follows.

106
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2.7 Example of the IRR function

=IRR($D7:$D12)

107
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CHAPTER 2: Section 8

Determination of Unknown
Number of Years

108
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2.8 Unknown Number of Years

• Some problems require knowing the


number of time periods required
given the other parameters
•Example:
•How long will it take for $1,000 to
double in value if the discount rate is
5% per year?
•Draw the cash flow diagram as….

109
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2.8 Unknown Number of Years

Fn = $2000

0 1 2 ... ...
……. n

P = $1,000

i = 5%/year; n is unknown!

110
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2.8 Unknown Number of Years

• Solving we have….. Fn =
$2000

0 1 2 ... ...
……. n

P=
$1,000
•Fn=? = 1000(F/P,5%,x): 2000 =
1000(1.05)x
•Solve for “x” in closed form……
111
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2.8 Unknown Number of Years

• Solving we have…..
•(1.05)x = 2000/1000
•Xln(1.05) =ln(2.000)
•X = ln(1.05)/ln(2.000)
•X = 0.6931/0.0488 = 14.2057 yrs
•With discrete compounding it will
take 15 years to amass $2,000 (have
a little more that $2,000)
112
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2.8 No. of Years – NPER function

• From Excel one can formulate as:

=NPER(C23,C22,C20,C21
)

113
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CHAPTER 2: Section 9

Spreadsheet Application –
Basic Sensitivity Analysis

114
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2.9 Basic Sensitivity Analysis

• Sensitivity analysis is a procedure


applied to a formulated problem
whereby one can assess the impact of
each input parameter relating to the
output variable.
•Sensitivity analysis is best
performed using a spreadsheet
model.
•The procedure is to vary the input
parameters within certain ranges and
observe the change on the output 115
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2.9 Basic Sensitivity Analysis

• By proper modeling, one can


perform “what-if” analysis on one or
more of the input parameters and
observe any changes in a targeted
output (response) variable
•Commercial add-in packages are
available that can be linked to Excel
to perform such an analysis
•Specifically: Palisade Corporation’s
TopRank Excel add-in is most
116
appropriate.
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2.9 Basic Sensitivity Analysis

• When you build your own models,


devise an approach to permit varying
at least one of the input parameters
and store the results of each change
in the output variable…then plot the
results.
•If a small change in one of the input
parameters represents a significant
change in the output variable then…
•That input variable is “sensitive”
117
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2.9 Basic Sensitivity Analysis

• If an input parameter is deemed


“sensitive” then some effort should
go into the estimation of that
parameter
•Because it does influence the
response (output) variable.
•Less sensitive input parameters may
not have as much effort required to
estimate as those input parameters
do not have that much impact on the
118
targeted response variable.
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2.9 Basic Sensitivity Analysis

• When you build your own models,


devise an approach to permit varying
at least one of the input parameters
and store the results of each change
in the output variable…then plot the
results.
•If a small change in one of the input
parameters represents a significant
change in the output variable then…
•That input variable is “sensitive”
119
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Mc
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Hill
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CHAPTER 2:
Summary of Important Points

120
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Chapter Summary

• This chapter presents the


fundamental time value of money
relationships common to most
engineering economic analysis
calculations
•Derivations have been presented for:
•Present and Future Worth- P/F and
F/P
•Annuity Cash flows – P/A, A/P, F/A
and A/F
•Gradients – P/G, A,G and P/A,g,i,n 121
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Chapter Summary

• One must master these basic time


value of money relationships in order
to proceed with more meaningful
analysis that can impact decision
making.
•These relationships are important to
you professionally and in your
personal lives.
•Master these concepts!!!
122
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ENGINEERING ECONOMY, Sixth


Edition
Blank and
Tarquin

End of Slide Set

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Hill
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