Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Chapter 2

2.1. Single-Amount Factors (F/P and P/F)

Determines the amount of money F accumulated after n years (or periods) from a single

present worth P, with compounded interest one time per year (or period).

F1 = P + Pi = P (1 + i)

F2 = F1 + F1i = P (1 + i) + P (1 + i) i = P (1 + i)2
.
.
.

F = P(1 + i)n

P = F(1 + i)-n

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.1

Sandy, a manufacturing engineer, just received a year-end bonus of $10,000 that will be

invested immediately. With the expectation of earning at the rate of 8% per year, Sandy

hopes to take the entire amount out in exactly 20 years to pay for a family vacation when

the oldest daughter is due to graduate from college. Find the amount of funds that will be

available in 20 years.

Solution

P = $10,000, F = ?, i = 8% per year, n = 20 years

F = P(1 + i)n = 10,000(1.08)20 = 10,000(4.6610) = $46,610

Also by using the compound interest tables we can solve this example as follows:

F = P(F/P,8%,20) = 10,000(4.6610) = $46,610

Example 2.2

The Houston American Cement factory will require an investment of $200 million to

construct. Delays beyond the anticipated implementation year of 2012 will require

additional money to construct the factory. Assuming that the cost of money is 10% per

year, compound interest, determine the following for the board of directors of the

Brazilian company that plans to develop the plant.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

(a) The equivalent investment needed if the plant is built in 2015.

(b) The equivalent investment needed had the plant been constructed in the year 2008.

Solution

F3 = P(F/P,i,n) = 200(F/P,10%,3) = 200(1.3310) = $266.2 million = $266,200,000

P-4 = F(P/F,i,n) = 200(P/F,10%,4) = 200(0.6830) $136.6 million = $136,600,000

2.2. Uniform Series Present Worth Factor and Capital Recovery

Factor (P/A and A/P)

Finding equivalent present worth P of a uniform series A in predefined interest rate

(1 + 𝑖𝑖)𝑛𝑛 − 1
𝑃𝑃 = 𝐴𝐴 � � 𝑖𝑖 ≠ 0
𝑖𝑖(1 + 𝑖𝑖)𝑛𝑛

𝑖𝑖(1 + 𝑖𝑖)𝑛𝑛
𝐴𝐴 = 𝑃𝑃 � �
(1 + 𝑖𝑖)𝑛𝑛 − 1

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.3

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.

Example 2.4

Houston American Cement plant may generate a revenue base of $50 million per year.

The president of the Brazilian parent company Votorantim Cimentos may have reason to

be quite pleased with this projection for the simple reason that over the 5-year planning

horizon, the expected revenue would total $250 million, which is $50 million more than

the initial investment. With money worth 10% per year, address the following question

from the president: Will the initial investment be recovered over the 5-year horizon with

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

the time value of money considered? If so, by how much extra in present worth funds? If

not, what is the equivalent annual revenue base required for the recovery plus the 10%

return on money?

Solution

P = 50(P/A,10%,5) = 50(3.7908) = $189.54 million = $189,540,000

The present worth value is less than the investment plus a 10% per year return, so the

president should not be satisfied with the projected annual revenue.

A = 200(A/P,10%,5) = 200(0.26380) = $52.76 per year

The plant needs to generate $52,760,000 per year to realize a 10% per year return over 5

years.

2.3. Uniform Series Compound Amount Factor (A / F and F / A )

The simplest way to find a future value of a given uniform series of money at given

interest rate is to substitute into factors already developed.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.5

The president of Ford Motor Company wants to know the equivalent future worth of a $1

million capital investment each year for 8 years, starting 1 year from now. Ford capital

earns at a rate of 14% per year.

Solution

2.4. Factor Values for Untabulated i or n Values

Linear interpolation can be used for an untabulated interest rate i or number of years n.

Example 2.6

Determine the P/A factor value for i = 7.75% and n = 10 years, using the linear

interpolation.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

F1 = (P/A,7%,10) = 7.0236 and F2 = (P/A,8%,10) = 6.7101.

7 7.0236 7.75 − 7 𝑥𝑥 − 7.0236

2.5. Arithmetic Gradient Factors (P/G and A/G)

An arithmetic gradient series is a cash flow series that either increases or decreases by a

constant amount each period. The amount of change is called the gradient.

G = Constant arithmetic change in cash flows from one time period to the next; G may be

positive or negative.

Example 2.7

A local university has initiated a logo-licensing program. Estimated fees (revenues) are

$80,000 for the first year with uniform increases to a total of $200,000 by the end of year

9. Determine the gradient and construct a cash flow diagram that identifies the base

amount and the gradient series.

Solution

CF9 - CF1 = 200,000 – 80,000 = $120,000

(𝐶𝐶𝐶𝐶9 − 𝐶𝐶𝐶𝐶1) 12000

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Converting an arithmetic gradient G (not including the base amount) for n years into a

present worth at year 0.

Remember: The conventional arithmetic gradient starts in year 2, and P is located in year

0.

The equivalent uniform annual series A/G for an arithmetic gradient G.

1 𝑛𝑛
𝐴𝐴𝐺𝐺 = 𝐺𝐺 � − �
𝑖𝑖 (1 + 𝑖𝑖)𝑛𝑛 − 1

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.8

Neighboring parishes in Louisiana have agreed to pool road tax resources already

designated for bridge refurbishment. At a recent meeting, the engineers estimated that a

total of $500,000 will be deposited at the end of next year into an account for the repair of

old and safety-questionable bridges throughout the area. Further, they estimate that the

deposits will increase by $100,000 per year for only 9 years thereafter, then cease.

Determine the equivalent (a) present worth and (b) annual series amounts, if public funds

earn at a rate of 5% per year.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

PT = 500(P/A,5%,10) + 100(P/G,5%,10) = 500(7.7217) + 100(31.6520) = $7026.05 in

thousand dollars = $7,026,050

AT = 500 + 100(A/G,5%,10) = 500 + 100(4.0991) = $909.91 in thousand dollars per year

= $909,910

Example 2.9

The announcement of the HAC cement factory states that the $200 million (M)

investment is planned for 2012. Most large investment commitments are actually spread

out over several years as the plant is constructed and production is initiated. Further

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

investigation may determine, for example, that the $200 M is a present worth in the year

2012 of anticipated investments during the next 4 years (2013 through 2016). Assume the

amount planned for 2013 is $100 M with constant decreases of $25 M each year

thereafter. As before, assume the time value of money for investment capital is 10% per

year to answer the following questions.

(a) In equivalent present worth values, does the planned decreasing investment series

equal the announced $200 M in 2012?

(b) Given the planned investment series, what is the equivalent annual amount that will be

invested from 2013 to 2016?

Solution

PT = PA + PG = 100(P/A,10%,4) = 25(P/G,10%,4) = 100(3.1699) – 25(4.3781) = $207.537

in million dollars = $207,537,000

Use G: AT = 100 – 25(A/G,10%,4) = 100 - 25(1.3812) = $65.471 ($65,471,000 per year)

Use PT: AT = 207.537(A/P,10%,4) = 207.537(0.31547) = $65.471 per year

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

2.6. Gradient Factors (P/G and A/G)

A geometric gradient series is a cash flow series that either increases or decreases by a

constant percentage each period. The uniform change is called the rate of change.

g = constant rate of change, in decimal form, by which cash flow values increase or

decrease from one period to the next. The gradient g can be + or -.

A1 = initial cash flow in year 1 of the geometric series.

Pg = present worth of the entire geometric gradient series, including the initial amount

A1

Note that the initial cash flow A1 is not considered separately when working with

geometric gradients.

The (P/A,g,i,n) factor calculates Pg in period t = 0 for a geometric gradient series starting

in period 1 in the amount A1 and increasing by a constant rate of g each period.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.10

A coal-fired power plant has upgraded an emission control valve. The modification costs

only $8000 and is expected to last 6 years with a $200 salvage value. The maintenance

cost is expected to be high at $1700 the first year, increasing by 11% per year thereafter.

Determine the equivalent present worth of the modification and maintenance cost at 8%

per year.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

1−(1.11/1.08)6
PT = -8000 - Pg + 200(P/F,8%,6) = -8000 - 1700 � 0.08−0.11
� + 200(P/F,8%,6)

= -8000 - 1700(5.9559) + 126 = $-17,999

Example 2.11

Now let’s go back to the proposed Houston American Cement plant in Georgia. The

revenue series estimate of $50 million annually is quite optimistic, especially since there

are many other cement product plants operating in Florida and Georgia on the same

limestone deposit. Therefore, it is important to be sensitive in our analysis to possibly

declining and increasing revenue series, depending upon the longer-term success of the

plant’s marketing, quality, and reputation. Assume that revenue may start at $50 million

by the end of the first year, but then decreases geometrically by 12% per year through

year 5. Determine the present worth and future worth equivalents of all revenues during

this 5-year time frame at the rate of 10% per year.

Solution

0.88 5
1−� �
1.10
Pg = 50 �0.10−(−0.12)� = 50[3.0560] = $152.80

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

F = 152.80(F/P,10%,5) = 152.80(1.6105) = $246.08

2.7. Determining i or n for Known Cash Flow Values

When all the cash flow values are known or have been estimated, the i value (interest rate

or rate of return) or n value (number of years) is often the unknown.

Example 2.12

If Laurel made a $30,000 investment in a friend’s business and received $50,000 5 years

later, determine the rate of return.

Solution

1
P = F(𝑃𝑃/𝐹𝐹, 𝑖𝑖, 𝑛𝑛) = 𝐹𝐹
(1 + 𝑖𝑖)𝑛𝑛

1
30,000 = 50,000 (1+𝑖𝑖)5

1
0.6 =
(1 + 𝑖𝑖)5

1 0.2
i = � � − 1 = 0.1076 = 10.76%
0.6

Another solution by using interpolation:

P = F (P/F,i,n)

30,000 = 50,000(P/F,i,5)

(P/F,i,5) = 0.60

From the interest tables, a P/F factor of 0.6 for n = 5 lies between 10% and 11%.

Interpolate between these two values to obtain i = 10.76%.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 2.13

Pyramid Energy requires that for each of its offshore wind power generators $5000 per

year be placed into a capital reserve fund to cover unexpected major rework on field

equipment. In one case, $5000 was deposited for 15 years and covered a rework costing

$100,000 in year 15. What rate of return did this practice provide to the company? Solve

by hand and spreadsheet.

Solution

Example 2.14

From the introductory comments about the HAC plant, the annual revenue is planned to

be $50 million. All analysis thus far has taken place at 10% per year; however, the parent

company has made it clear that its other international plants are able to show a 20% per

year return on the initial investment. Determine the number of years required to generate

10%, 15%, and 20% per year returns on the $200 million investment at the Georgia site.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution

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