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ENGINEERING ECONOMY

SESSION_II

Time Value of Money

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 1
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
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 2
ENGINEERING ECONOMY

SESSION II Section 1

F/P and P/F Factors

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 3
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 4
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)
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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 specific
P
point in time.
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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 3
P=$1,000
i=10%/year

F3 = $1,000[F/P,10%,3] = $1,000[1.10]3
= $1,000[1.3310] = $1,331.00
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 8
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(0.1111) = $11,110 at time t = 0
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 9
ENGINEERING ECONOMY

SESSION Section 2

P/A and A/P Factors

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 10
2.2 Uniform Series Present Worth and
Capital Recovery Factors

Annuity Cash Flow


P = ??

1 2 3
…………..
.. .. n-1 n
0

$A per period

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 11
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 - A
P = ??

0 1 2 3 n-1 n

A = given
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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2.2 Uniform Series Present Worth and
Capital Recovery Factors

Write a Present worth expression

 1 1 1 1  [1]
P  A   ..  n 1
 n 
 (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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.2 Uniform Series Present Worth and
Capital Recovery Factors

Setting up the subtraction


 1 1 1 1 
P  A   ..   n 1  [2]
 (1  i ) 2
(1  i ) 3
(1  i ) n
(1  i ) 

 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) 
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 15
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) 

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 16
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
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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 period to the
Given the P/A factor left of the first A amount

 (1  i)n  1 
P  A n 
for i  0 Solve for A in terms of P
 i(1  i) 
Yielding….

 i(1  i)  n
A P  A/P,i%,n factor

 (1  i)  1
n

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 18
ENGINEERING ECONOMY Fifth Edition

SESSION II Section 3

F/A and A/F Factors

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 19
2.3 F/A and A/F Derivations $F

Annuity Cash Flow

…………..
N
0

Find $A given the


$A per period Future amt. - $F

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 20
2.3 Sinking Fund and Series Compound
amount factors (A/F and F/A)

Take advantage of what we already


have
Recall:
Substitute “P” and
 1  simplify!
PF n 
 (1  i) 
Also:
 i(1  i)n 
A P 
 (1  i)  1
n

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 21
2.3 A/F Factor

By substitution A  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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 22
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 
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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2.3 F/A and A/F Derivations $F

Annuity Cash Flow

…………..
N
0

Find $F given thethe


$A per period $A amounts

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.3 Example 2.5

Formasa 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.
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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2.3 Example 2.5

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


•F8 = ??

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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/
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 27
2.3 Example 2.6

How much money must Carol deposit every


year starting, l year from now at 5% per
year in order to accumulate $6000 seven
years from now?

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 29
ENGINEERING ECONOMY

SESSION II Section 4

Interpolation in Interest
Tables

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 30
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.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.4 Interpolation of Factors
• Typical Format for Tabulated Interest Tables

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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 forces 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.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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:

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 34
2.4 Basic Setup for Interpolation

•Work with the following basic relationships

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2. 4 Estimating for i = 7.3%
• Form the following relationships

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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:

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 39
2.4. The Exact Value for 7.3%
• Using a previously programmed spreadsheet
model the exact value for 7.3% is:

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 40
ENGINEERING ECONOMY

SESSION II Section 5

P/G and A/G Factors

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 41
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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
contestant amount over n time periods.
•A linear gradient is always comprised of TWO
components:
•The Gradient component
•The base annuity component
•The objective is to find a closed form expression
for the Present Worth of an arithmetic gradient
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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2.5 Linear Gradient Example
A1+n-1G

A1+n-2G
Assume the following:

A1+2G

A1+G

0 1 2 3 n-1 N

This represents a positive, increasing arithmetic gradient

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.5 Example: Linear Gradient

• Typical Negative, Increasing Gradient: G=$50

The Base Annuity


= $1500

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.5 Example: Linear Gradient

• Desire to find the Present Worth of this cash flow

The Base Annuity


= $1500

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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!

Blank & Tarquin: 5-th Edition Ch. 1


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2.5 Derivation: Gradient Component Only

Focus Only on the gradient Component


A +n-1G 1

“0” G A1+n-2G

A1+2G

A1+G

Blank & Tarquin: 5-th Edition Ch. 1


0 1 2
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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!
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.5 Gradient Component

•The Gradient Component $600


$500
$400
$300
$200
$100

$0

X0 1 2 3 4 5 6 7

The Present Worth Point of the


Gradient

Blank & Tarquin: 5-th Edition Ch. 1


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2.5 Present Worth Point…

•PW of the Base Annuity is at t = 0


•PWBASE Annuity=$100(P/A,i%,7)

Base Annuity – A = $100

X0 1 2 3 4 5 6 7

The Present Worth Point of the


Gradient

Blank & Tarquin: 5-th Edition Ch. 1


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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!

Blank & Tarquin: 5-th Edition Ch. 1


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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.

Blank & Tarquin: 5-th Edition Ch. 1


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2.5 Present Worth: Gradient Component

General CF Diagram – Gradient Part Only

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

Blank & Tarquin: 5-th Edition Ch. 1


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

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

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

Blank & Tarquin: 5-th Edition Ch. 1


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2.5 Factoring G out…. P/G factor

P  G{( P / F , i%, 2)  2( P / F , i%, 2)  ...


...+ [(n-2)](P/F,i,n-1)+[(n-1)])P/F,i,n)}

Blank & Tarquin: 5-th Edition Ch. 1


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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)

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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.

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2. 5 Subtracting [1] from [2]…..

 1 2 n-2 n-1 
P(1+i) =G  1
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) 
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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
Blank & Tarquin: 5-th Edition Ch. 1
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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)
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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!
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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…………

Blank & Tarquin: 5-th Edition Ch. 1


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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) (1  i)   (1  i)  1 
N N

(A/P,i,n)

The results follow…..

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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 

1 n 
A/G,i,n = G  
 i (1  i )  1 
N

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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


Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 67
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.5 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)

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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2.5 The Gradient Component
$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, i=10%


G  (1  i)  1
N
N  and G = $100 into the P/G
P=    closed form to get the value
i  i(1  i) N
(1  i) N  of the factor.
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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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=    6.8618
i  i(1  i) N (1  i) N 

Calculating or looking up the P/G,10%,5 factor


yields the following:
Pt=0 = $100(6.8618) = $686.18 for the gradient
PW
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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2.5 Gradient Example: Final Result

• PW(10%)Base Annuity = $379.08

•PW(10%)Gradient Component= $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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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!

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 73
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)
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 74
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
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 75
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 76
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-base annuity = -$1428.93
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 77
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
1G 2G 3G
4.3781 0.7513
P0-grad = {+50(P/G,10%,4)}(P/F,10%,3) =-$164.46

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 78
ENGINEERING ECONOMY Mc
Hill

SESSION II Section 6

Geometric Gradient

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 79
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

Blank & Tarquin: 5-th Edition Ch. 1


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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

Blank & Tarquin: 5-th Edition Ch. 1


A1(1+g)n-1
Authored by: Dr. Don Smith Texas A&M
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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 Blank & Tarquin: 5-th Edition Ch. 1


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2.6 Geometric Gradients: Derivation

• First Major Point to Remember:


•A1 does NOT define a Base Annuity/
•There is not 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!
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 83
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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..

Blank & Tarquin: 5-th Edition Ch. 1


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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) (1  i) (1  i) 
2 3

(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…..

Blank & Tarquin: 5-th Edition Ch. 1


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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 
 
 
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 87
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 not
equal to i.
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 88
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:

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 89
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 = g

(1  i)
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 90
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 i Case: g = i

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 91
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.
•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!
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 92
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.
•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.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 93
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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 
1    
N= 7 1 i  
7.04732 Pg  A1   gi
P/A,g,i,n factor is……
 ig 
 
First Amt= $ 1,700.00  
Blank & Tarquin: 5-th Edition Ch. 1
P. Value = $Authored
11,980.44
by: Dr. Don Smith Texas A&M
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2.6 Geometric Gradient ( -g )

• Consider the following problem with a negative


growth rate – g. g = -10%/yr; i = 8%; n = 4
A1 = $1000
$900
$810
$729

0 1 2 3 4
P0=??

We simply apply a “g” value = -0.10

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 96
2.6 Geometric Gradient (-g value)

• Evaluate:   1  g n 
1    
For a negative g 1 i  
value = -0.10 Pg  A1   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. Blank
Value & Tarquin:
= 5-th Edition
$ Ch. 12,876.37
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 97
ENGINEERING ECONOMY

SESSION II Section 7

Determination of an Unknown
Interest Rate

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 98
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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?
$5,000

0 1 2 3 4 5

•F = P(1+i)n

$3,000
•5,000 = 3,000(1+i)5
•(1+i)5 = 5,000/3000 = 1.6667
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 100
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?
$5,000

0 1 2 3 4 5

•(1+i)5 = 5,000/3000 = 1.6667

$3,000
•(1+i) = 1.66670.20
•i = 1.1076 – 1 = 0.1076 = 10.76%
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 101
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.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 102
2.7 Example of the IRR function

=IRR($D7:$D12)
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
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ENGINEERING ECONOMY

SESSION II Section 8

Determination of Unknown
Number of Years

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 104
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?
Fn = $2000
•Draw the cash flow diagram as….
i = 5%/year; n is unknown!

0 1 2 ... . . . ……. n

P = $1,000 Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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……

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 106
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)

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 107
2.8 No. of Years – NPER function

• From Excel one can formulate as:

=NPER(C23,C22,C20,C21)

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 108
ENGINEERING ECONOMY

SESSION II Section 9

Spreadsheet Application –
Basic Sensitivity Analysis

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 109
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 variable.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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 appropriate.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 111
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”

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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
targeted response variable.

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
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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”

Blank & Tarquin: 5-th Edition Ch. 1


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11/6/2018 University 114
ENGINEERING ECONOMY Mc
Graw
Hill

SESSION II Summary

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 115
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

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 116
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!!!

Blank & Tarquin: 5-th Edition Ch. 1


Authored by: Dr. Don Smith Texas A&M
11/6/2018 University 117
ENGINEERING ECONOMY

SESSION II End of Slide Set

Blank & Tarquin: 5-th Edition Ch.


1 Authored by: Dr. Don Smith
11/6/2018 Texas A&M University 118