Developed By:

Dr. Don Smith, P.E.

Department of Industrial
Engineering
Texas A&M University
College Station, Texas

Executive Summary Version

Chapter 2
Factors: How Time
and Interest Affect
Money

Slide Sets to

2-1

2005 by McGraw-Hill,

LEARNING OBJECTIVES
1. F/P and P/F
factors

5. Geometric
gradient

2. P/A and A/P

factors

6. Calculate i
7. Calculate n

3. Interpolate for
factor values

8. Spreadsheets

4. P/G and A/G

factors

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2-2

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Sct 2.1 Single-Payment Factors

(F/P and P/F)
Objective:
Derive factors to determine the present or future

worth of a cash flow

Fn

Cash Flow Diagram basic format

0

i% / period
3

n-1

P0 P0 = Fn1/(1+i)n (P/F,i%,n) factor: Excel: =PV(i%,n,,F)

Fn = P0(1+i)n (F/P,i%,n) factor: Excel: =FV(i%,n,,P)

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2-3

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Sct 2.2 Uniform-Series: Present Worth

Factor (P/A) and
Capital Recovery Factor(A/P)
Cash flow profile for P/A factor
i% per interest period

....
0

$A per interest period

n-2

n-1

Find P

Required: To find P given A

Cash flows are equal, uninterrupted and flow at the end of
each interest period
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2-4

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(P/A) Factor Derivation

Setup the following:

1
1
1
1
P A

..

1
2
n 1
n
(1

i
)
(1

i
)
(1

i
)
(1

i
)

Multiply by

(1)

1
to obtain a second equation
(1+i)

P
1
1
1
1
A

..

2
3
n
n 1
1 i
(1

i
)
(1

i
)
(1

i
)
(1

i
)

(2)

Subtract (1) from (2) to yield

i
1
1
P A

n 1
1 i
(1

i
)
(1

i
)

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2-5

(3)
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(P/A) and (A/P) Factor Formulas

Simplify (3) to yield
(1 i ) n 1
P A
for i 0
n
i (1 i )

(4)

(P/A,i%,n) factor
Excel: =PV(i%,n,A)

Solve (4) for A to get

(A/P) factor

i (1 i ) n
A P

n
(1

i
)

Slide Sets to

(5)

2-6

(A/P,i%,n) factor
Excel: =PMT(i%,n,P)

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ANSI Standard Notation for

Interest Factors
Standard notation has been adopted to
represent the various interest factors
Consists of two cash flow symbols, the
interest rate, and the number of time periods
General form: (X/Y,i%,n)
X represents what is unknown
Y represents what is known
i and n represent input parameters; can be known or

unknown depending upon the problem

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Notation - continued
Example: (F/P,6%,20) is read as:
To find F, given P when the interest rate is 6% and

the number of time periods equals 20.

In problem formulation, the standard notation

is often used in place of the closed-form
equivalent relations (factor)
Tables at the back of the text provide
tabulations of common values for i% and n
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2-8

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Sct 2.3 Sinking Fund Factor and Uniform

Series Compound Amount Factor
(A/F and F/A)
F = given

Cash flow diagram for (A/F) factor

i% per interest period

....
0

A=? per interest period

Find A, given F

n-2

n-1

Start with what has already been developed

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

i
)

Slide Sets to

i
A F

n
(1

i
)

2-9

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(F/A) factor from (A/F)

Given: A F

n
(1 i ) 1

(A/F,i%,n) factor
Excel: =PMT(i%,n,,F)

Solve for F in terms of A to yield

(1 i ) n 1
F A

Slide Sets to

2-10

(F/A,i%,n) factor
Excel: =FV(i%,n,A)

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Sct 2.4 Interpolation in Interest Tables

When using tabulated interest tables one
might be forced to approximate a factor that is
not tabulated
Can apply linear interpolation to approximate
See Table 2-4
Factors are nonlinear functions, hence linear

interpolation will yield errors in the 2-4% range

Use a spreadsheet model to calculate the factor
precisely

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2-11

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Sct 2.5 Arithmetic Gradient Factors

(P/G) and (A/G)
A1+(n-1)G

Cash flow profile

A1+(n-

2)G

Find P, given gradient cash flow G

A1+2G

Base amount
= A1

0
n-1

1
n

Slide Sets to

A1+G

CFn = A1 (n-1)G

2-12

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Gradient Example

$20
0

$10
0

0
6

$30
0

1
7

$40
0

$50
0

$70
0

$60
0

Gradients have two components:

1. The base amount and the gradient
2. The base amount (above) = $100/time period

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2-13

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Gradient Components
Find P of gradient series
1G

(n-3)G

(n-2)G

(n-1)G

n-1

2G

0G
Base amount = A / period

..
0

n-2

Present worth point is 1 period to the left of the 0G cash flow

For present worth of the base amount, use the P/A factor (already known)

For present worth of the gradient series, use the P/G factor (to be derived)

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2-14

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Gradient Decomposition
As we know, arithmetic gradients are
comprised of two components
1. Gradient component

2. Base amount

When working with a cash flow containing a

gradient, the (P/G) factor is only for the
gradient component
Apply the (P/A) factor to work on the base
amount component
P = PW(gradient) + PW(base amount)
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2-15

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Derivation Summary for (P/G)

Start with:

P G ( P / F , i, 2) 2G ( P / F , i,3) 3G ( P / F , i, 4) ...
(1)
+[(n-2)G](P/F,i,n-1)+[(n-1)G](P/F,i,n)
Multiply (1) by (1+i)1 to create a second equation
Subtract (1) from the second equation and simplify
Yields
G (1 i ) n 1
n
P=

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

Slide Sets to

(1 i ) n in 1
(P/G,i,n) factor

2
n
i (1 i )

No Excel relation exists

2-16

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Use of the (A/G) Factor

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

(n-1)G

(n-

2)G

Find A, given gradient cash flow G

A

...

2G

Equivalent A of
gradient series

0
n-1

1
n

CFn = (n-1)G

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2-17

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Sct 2.6 Geometric Gradient Series Factor

Geometric Gradient
Cash flow series that starts with a base amount A1
Increases or decreases from period to period by a

constant percentage amount

This uniform rate of change defines
A GEOMETRIC GRADIENT
Notation:

g = the constant rate of change, in decimal form, by which

future amounts increase or decrease from one time
period to the next

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2-18

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Typical Geometric Gradient

A1(1+g)n-1

Given A1, i%, and g%

A1

A1(1+g)

A1(1+g)2

....
0

n-2

n-1

Required: Find a factor (P/A,g%,i%,n) that will convert future

cash flows to a single present worth value at time t = 0
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2-19

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Basic Derivation: Geometric Gradient

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

Start with:

(1)

Factor out A1 out and re-write

1
(1 g )1 (1 g ) 2
(1 g ) n 1
Pg A1

...

2
3
(1

i
)
(1

i
)
(1

i
)
(1 i) n

(2)

Multiply by (1+g)/(1+i) to obtain Eq. (3 )

Pg

(1+g)
(1+g)
1
(1 g )1
(1 g ) 2
(1 g ) n 1
A1

...

(1+i)
(1+i) (1 i )
(1 i ) 2
(1 i ) 3
(1 i) n

(3)

Subtract Eq. (2 ) from Eq. (3 ) to yield

(1 g ) n
1
1+g

n 1
1 i
1+i

(1 i )

Pg

1 g
1

1 i
ig

Solve for Pg and simplify to

yield.

Slide Sets to

2-20

Pg A1

gi

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Two Forms to Consider

1 g
1

1 i
ig

Pg A1

nA1
Pg
(1 i )

gi

Case: g = i

Case: g = i

To use the (P/A,g%,i%,n) factor

A1 is the starting cash flow
There is NO base amount associated with a geometric gradient
The remaining cash flows are generated from the A1 starting value
No tables available to tabulate this factortoo many combinations of i% and g
% to support tables

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2-21

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Sct 2.7 Determination of

Unknown Interest Rate
Class of problems where the interest rate, i%,
is the unknown value
For simple, single payment problems (i.e., P
and F only), solving for i% given the other
parameters is not difficult
For annuity and gradient type problems,
solving for i% can be tedious
Trial and error method
Apply spreadsheet models

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2-22

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The IRR Spreadsheet Function

Define the total cash flow as a column of
values within Excel
Apply the IRR function:
=IRR(first_cell:last_cell, guess value)

If the cash flow series is an A value then apply

the RATE function:
=RATE(number_years, A,P,F)

See examples 2.12 and 2.13

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2-23

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Sct 2.8 Determination of

Unknown Number of Years
Class of problems where the number of time
periods (years) is the unknown
In single payment type problems, solving for
n is straight forward
In other types of cash flow profiles, solving
for n requires trial and error or spreadsheet
In Excel, given A, P, and/or F, and i% values
apply:
=NPER(i%,A,P,F) to return the value of n

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2-24

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Sct 2.9 Spreadsheet Application Basic

Sensitivity Analysis
Sensitivity Analysis is a process of
determining what input variables really matter
in a given problem formulation
Sensitivity analysis aids in evaluating certain
what-If scenarios
Spreadsheet modeling is the best approach to
formulate sensitivity analysis for a given
problem
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2-25

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Sensitivity Analysis
See Example 2.15
Illustratesa what-if situation for receiving money in

three different time periods

Tabulates the associated rate of returns for the
three situations

See Example 2.16

The evaluation of non-sequential cash flows

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2-26

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Summary
Interest factors exist to aid in determining
economic equivalence of various cash flow
patterns
Notation is introduced that is applied
throughout the remainder of the text
Introduction of important Excel spreadsheet
financial functions to aid in evaluation of
engineering economy problems

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End of Slide Set

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