ENGINEERING ECONOMICS

(BPK 30902)

CHAPTER 4 PART II:

TIME VALUE OF MONEY

DR. NOR HAZREN ABDUL HAMID

FAKULTI TEKNOLOGI KEJURUTERAAN
Applications of future and present values

❖ Relating Present and Future Equivalent

Values of Single Cash Flows

❖ Relating a Uniform Series (Annuity) to Its

Present and Future Equivalent Values
 UNIFORM SERIES FORMULAS
(ANNUITY)

There are 4 uniform series formula that involve A,

where A means:

1.The cash flow occurs in consecutive interest periods;

and

2.The cash flow amount is the same in each period.

 UNIFORM SERIES FORMULAS (ANNUITY)
REMEMBER:

1. P (present equivalent value) occurs one interest period before the first A (uniform
amount)
2. F (future equivalent value) occurs at the same time as the last A, and N periods
after P,
3. A (annual equivalent value) occurs at the end of periods 1 through N, inclusive.
UNIFORM SERIES FORMULAS (ANNUITY)
(CONT.)

F = A (F/A, i%, N) Functional

symbol

▶ The quantity in brackets is called the uniform series

compound amount factor.
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

P = A (P/A,i%,N) Functional
symbol

▶ The quantity in brackets is called the uniform series present

worth factor.
 UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Functional
A = F(A/F,i%,N) symbol

▶ The quantity in brackets is called the sinking fund factor.

 UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Functional
A = P(A/P,i%,N) symbol

▶ The quantity in brackets is called capital recovery factor

UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Example 4.1:

How much money should you be willing to pay now for a

guaranteed RM600 per year for 9 years starting next year, at a
rate of return of 15% per year?
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Solution 4.1:

▪ A = RM600, i = 15%, N = 9, P = ?
P = A (P/A, i%, N)
= 600 (P/A, 15%, 15)
= 600 (4.7716) P = RM2,862.95
= RM2,862.96
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)
Example 4.2:

Formasa Plastics has major fabrication plants in Texas and Hong

Kong. The president wants to know the equivalent future worth
of RM1 million capital investment each year for 8 years, starting
1 year from now with annual cash flow of RM1,000 per year.
Formasa capital earns at a rate of 15% per year.
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)
Solution 4.2:

▪ F = ?, N = 8, A = RM1,000, i = 15%
F = A (F/A, i%, N)
= 1,000 (F/A, 15%, 8)
= 1,000 (13.7268)
= RM13,726.80 F = RM13,726.82
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)
Example 4.3:

How much money must an electrical contractor deposit every

year in her saving account starting 1 year from now at 5% per
year in order to accumulate RM6,000 seven years from now?
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Solution 4.3:

▪ i = 5%, F = RM6,000, N = 7, A = ?
A = F (A/F, i%, N)
= 6,000 (A/F, 5%, 7)
= 6,000 (0.1228)
= RM736.00 A = RM736.92
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Example 4.4:

How large of a repayment must an engineer make each year starting

next year if he borrows RM60,000 to start up his new consulting
office and promises to make equal annual payments for 5 years.
Assume the interest rate is 8% per year.
UNIFORM SERIES FORMULAS
(ANNUITY) (CONT.)

Solution 4.4:

▪ P = RM60,000, N = 5, i = 8%, A = ?
A = P (A/P, i%, N)
= 60, 000 (A/P, 8%, 5)
= 60, 000 (0.2505) A = RM15,022.37
= RM15,030
 DEFERRED ANNUITIES (UNIFORM
SERIES)

▶ We need to be able to handle cash flows that do not occur until

some time in the future.

▶ Deferred annuities are uniform series that do not begin until some
time in the future.

▶ If the annuity is deferred J periods then the first payment (cash

flow) begins at the end of period J+1.
 DEFERRED ANNUITIES (UNIFORM
SERIES) (CONT.)
Finding the value at time 0 of a deferred annuity is a two-step process.

1.Use (P/A, i%, N - J) find the value of the deferred annuity at the end of
period J (where there are N - J cash flows in the annuity).
2.Use (P/F, i%, J) to find the value of the deferred annuity at time zero.
 DEFERRED ANNUITIES (UNIFORM
SERIES) (CONT.)
Example 4.5:

A father, on the day his son is born, wishes to determine what lump
amount would have to be paid into an account bearing interest 12% per
year to provide withdrawals of RM2,000 on each of the son’s 18th, 19th,
20th and 21st birthdays.
 DEFERRED ANNUITIES (UNIFORM SERIES)
(CONT.)
Solution 4.5:
A = RM2,000

0 1 2 17 18 19 20 21

i = 12% per year

P0=? P17=F17

▪P17 = A (P/A, 12%, 4) = RM2,000(3.0373) = RM6,074.60

▪P0 = F17 (P/F, 12%, 17) = RM6,074.60(0.1456) = RM884.46
 DEFERRED ANNUITIES (UNIFORM
SERIES) (CONT.)

Example 4.6:

You put RM5,000 per year into a XYZ saving plan, which averages 8%
interest per year. Five years later, you move to another place and start a
new XYZ saving plan. You never get around to merging the funds in the
two plans. If the first plan continued to earn interest at the rate of 8%
per year for 35 years after you stopped making contributions, how much
is the account worth?
 DEFERRED ANNUITIES (UNIFORM
SERIES) (CONT.)
Solution 4.6:

1. A = RM5,000, i = 8%, N = 5. F = ?
F = 5,000 (F/A, 8%, 5)
= 5,000 (5.8666)
= RM29,333

2. P = RM29,333, i = 8%, N = 35. F = ?

F = 29,333 (F/P, 8%, 35)
= 29,333 (14.7853)
= RM433,697.20
 GRADIENT FORMULAS
▶ Some problems involve receipts or expenses that are projected to increase or
decrease by a uniform amount each period, thus constituting an arithmetic
sequence of cash flows.
▶ This situation can be modeled as a uniform gradient of cash flows. The table
below shows such a gradient.

End of Period Cash Flows

1 0
2 G
3 2G
: :
G is known as the uniform
N (N-1)G gradient amount
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES)

▶ Starts at base amount and increases by constant gradient G in years 2 through n

▶ Cash flows that change by a constant amount each period

Base
Amount
A
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)
▶ The general equation to find the present worth of an arithmetic gradient
cash flow series:

P = Present worth of + Present worth of

base amount gradient amount

= A(P/A, i%,n) + G(P/G, i%.n)

A = amount in period 1
G = amount of change in cash flow between periods 1 and 2
n = number of periods from 1 through n of gradient cash flow
i = interest rate per period
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)
Finding P when given G

Functional
P = G (P/G,i%,N) symbol
▶The term in braces is called the gradient to present equivalent conversion factor.
▶The P/G factor finds the present worth in Year 0 of the gradient only. It does not
include the base amount of money that the gradient was built upon.
 Finding A when given G

Functional
A = G (A/G,i%,N) symbol

▶The term in braces is called the gradient to uniform series conversion factor.
▶The A/G factor converts only the gradient into an A value. The base amount in Year 1 (A1)
must be added to obtain the total annual worth (AT) of the cash flow.

AT = A1 + G (A/G,i%,N)
OR
AT = A 1 + A G
GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)

Example 4.7:

The Highway Department expects the cost of maintenance for a piece of

heavy construction equipment to be RM5,000 in Year 1, to be RM5,500
in Year 2, and to increase annually by RM500 through year 10. At an
interest rate of 10% per year, determine the present worth of 10 years of
maintenance cost.
GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)
Solution 4.7:

= 5,000 (P/A, 10%, 10) + 500 (P/G, 10%, 10)

= 5,000(6.1446) + 500(22.891)
= 30,723 + 11,445.5
= RM42, 168.50
P = A(P/A,i%,n) + G(P/G,i%.n)
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)

Example 4.8:

An EXY cash flows are expected to be RM1,000 for the second year,
RM2,000 for the third year, and RM3,000 for the fourth year and that, if
interest is 15% per year. What is the present equivalent value at the
beginning of the first year?
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)

Solution 4.8:

P = G (P/G,i%,N)

= 1,000 (P/G, 15%, 4)

= 1,000 (3.786)
= RM3,786
 GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)

Example 4.9:

The cash flow associated with a strip mining operation is expected to be

RM200,000 in Year 1, RM180,000 in Year 2, and amounts decreasing by
RM20,000 annually through year 8. At an interest rate of 12% per year,
calculate the equivalent annual cash flow.
GRADIENT FORMULAS (ARITHMETIC
GRADIENT SERIES) (CONT.)

Solution 4.9:

AT = A1 + G (A/G,i%,N)

= 200,000 – 20,000 (A/G, 12%, 8)

= 200,000 – 20,000(2.9131)
= 200,000 – 58,262
= RM141,738
 GRADIENT FORMULAS (GEOMETRIC
GRADIENT SERIES)

▶ Starts from base amount A1 and increases by constant percentage g in

years 2 through n

▶ Cash flows that change by a constant percentage each period

▶ Geometric gradients yield the present worth of all the cash flows.
GRADIENT FORMULAS (GEOMETRIC
GRADIENT SERIES)
 GRADIENT FORMULAS (GEOMETRIC GRADIENT
SERIES)

A1 = total cash flow in period 1

g = rate of change per period (decimal form)
i = interest rate

▶ Once we know the present equivalent of a geometric gradient series, we can

easily compute the equivalent uniform series or future amount using the basic
interest factors (A/P, i%, N) and (F/P, i%, N).
 GRADIENT FORMULAS (GEOMETRIC
GRADIENT SERIES)

Example 4.10:

A mechanical contractor has four employees whose combined salaries

through the end of this year are RM250,000. If he expects to give an
average raise of 5% each year, calculate the present worth of the
employees‘ salaries over the next 5 years. Let i = 12% per year.
GRADIENT FORMULAS (GEOMETRIC
GRADIENT SERIES)
Solution 4.10:

P = 250,000 1 – (1.05/1.12)5
0.12 – 0.05
= 250,000(3.94005)
= RM985,012.74
 PRESENT WORTH (PW)

▶ The present worth (PW) is found by discounting all cash inflows and
outflows to the present time at an interest rate that is generally the
MARR.

▶ A positive PW for an investment project means that the project is

acceptable (it satisfies the MARR).

PW decision rule: If PW (i=MARR) > 0, the project is

economically justified
 PRESENT WORTH (PW) (CONT.)

Example 4.11:

Consider a project that has an initial investment of $50,000 and that

returns $18,000 per year for the next four years. If the MARR is 12%,
is this a good investment?
 PRESENT WORTH (PW) (CONT.)

Solution 4.11:

PW = PW cash of inflows – PW cash of outflows

= A (P/A, i%, N) - PW cash of outflows
= RM18,000 (P/A, 12%, 4) – RM50,000
= RM18,000(3.0373) – RM50,000
= RM4671.40 ≥ 0

Therefore, this is a good investment.

 FUTURE WORTH (FW)

▶ An alternative to the PW method

▶ FW method is very useful in capital investment decision situations.

▶ FW is based on the equivalent worth of all cash inflows and outflows at the end
of the study period at an interest rate that is generally the MARR.

▶ Decisions made using FW and PW will be the same.

PW decision rule: If FW (i=MARR) > 0, the project is

economically justified
 FUTURE WORTH (FW) (CONT.)

Example 4.12:

A $45,000 investment in a new conveyor system is projected to improve

throughout and increasing revenue by $14,000 per year for five years.
The conveyor will have an estimated market value of $4,000 at the end
of five years. Using FW and a MARR of 12%, is this a good
investment?
 FUTURE WORTH (FW) (CONT.)

Solution 4.12:

FW = RM4,000 + RM14,000 (F/A, 12%, 5) – RM45,000

(F/P, 12%, 5)
= RM4,000 + RM14,000(6.3528) –
RM45,000(1.7623)
= RM13,635.70 ≥ 0

Therefore, this is a good investment.

 ANNUAL WORTH (AW)

▶ Is another way to access projects

▶ Annual worth is an equal periodic series of dollar amounts that is

equivalent to the cash inflows and outflows, at an interest rate that is
generally the MARR.

▶ The AW of a project is annual equivalent revenue or savings minus

annual equivalent expenses, less its annual capital recovery (CR) amount.
ANNUAL WORTH (AW) (CONT.)

Formula:

R = Annual equivalent revenues

E = Annual equivalent expenses
CR = Capital recovery

AW decision rule: If AW (i=MARR) > 0, the project is

economically justified
 ANNUAL WORTH (AW) (CONT.)
▶ Capital Recovery (CR) reflects the capital cost of the asset

▶ CR is the annual equivalent cost of the capital invested.

▶ The CR covers the following items.

▶ Loss in value of the asset
▶ Interest on invested capital (at MARR)

▶ The CR distributes the initial cost (I) and the salvage value (S) across the life
of the asset.
 ANNUAL WORTH (AW) (CONT.)
Example 4.13:

A project requires an initial investment of $45,000, has a salvage value of

$12,000 after six years, incurs annual expenses of $6,000, and provides
an annual revenue of $18,000. Using a MARR of 10%, determine the
AW of this project.
ANNUAL WORTH (AW) (CONT.)
▶ Solution 4.13:

I=RM45,000; S=RM12,000; AE=RM6,000; AR=RM18,000; N=6; MARR=10%

CR(10%) = 45,000(A/P, 10%, 6) – 12,000(A/F, 10%, 6)

= 45,000(0.2296) – 12,000(0.1296)
= RM8,776.80
AW = RM18,000 – RM6,000 – RM8776.80
= RM3,223.20 ≥ 0

Therefore, it is a good investment.