BASIC PRINCIPLES IN ENGINEERING ECONOMICS

Chapter-I

'Engineering is the profession in which a knowledge of the mathematical and natural sciences
gained by study, experience, and practice is applied with judgment to develop ways to utilize,
economically, the materials and forces of nature for the benefit of mankind'

1. Basic Principles in Engineering Economics

1.1. Quantifying alternatives for easier decision making

We are routinely faced with the challenge of making significant decision when selecting an
alternative over another. These are decisions of how to best invest the funds or capital of the
company. The usual factor may be once again economic and non-economic or tangible or
intangible.

Engineering economy, quite simply, is about determining the economic factors and the economic
criteria utilized when one or more alternatives are considered for selection. Another way to define
engineering economy is a collection of mathematical techniques which simplify economic
comparisons. With these techniques, a rational, meaningful approach to evaluating the economic
aspects of different methods (alternatives) of accomplishing a given objective can be developed.
The role of engineering economics is to assess the appropriateness of a given project, estimate its
value, and justify it from an engineering standpoint.

Quite often we ask:

Is this particular project (or investment plan) worth implementing, given the possibility of
other investment alternatives?

Individuals, small-business owners, large-corporation presidents, and government agency heads

are routinely faced with the challenge of making significant decisions, when selecting an
alternative over another. These are decisions of how to invest the funds, capital, of the company
and its owners. The amount of capital is always limited, just as the cash available to an individual
is usually limited. These business decisions will invariably change the future, hopefully for the
better. The usual factors considered may be once again economic or non-economic, as well as
tangible and intangible. However, when corporations and public agencies select one alternative
over the other, the financial aspects, return on invested capital, social considerations, and time
frames often increase substantially over those for an individual selection.

Alternatives usually involve information that as first cost (including purchase price, construction,
installation and delivery cost), expected life, estimated annual incomes and expenses of the
alternatives (including annual maintenance and upkeep costs), projected salvage value (resale or
trade-in value), an appropriate interest rate (rate of return), and possibly income tax effects.
Alternatives may be compared directly if they are converted to a common measure. The common
denominator applicable in economic comparisons is value expressed in terms of money. Most
other activities that appear in various activities, such as time, distance, and quantity may often be
converted to monetary terms. This is because of the pervasive nature of the economic system in
which we live in.

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In order to quantify and compare as many aspects a proposal as possible, a common denominator
for most purpose is the birr/dollar value. For this reason most of the significant attributes of a
project are reduced to a birr value wherever possible.
It is essential to convert the prospective output and input items enumerated in the definition step
into receipts and disbursements at specified dates. This phase consists of appraising the unit value
of each item of output or input and determining their total amounts by computation. On
completion, each alternative should be expressed in terms of definite cash flows occurring at
specified dates in the future, plus an enumeration of qualitative considerations that are impossible
to reduce to monetary terms. For such items, the term irreducible is often employed.

Role of Engineering Economy in Decision Making

People make decision, computers, methodologies, and others tools do not. The techniques and
models of engineering economy assist people in making decision. Since decision affect what will
be done, the time frame of engineering economy is the future. Therefore, numbers used in an
engineering economy analysis is best estimate of what is expected to occur.
There is a popular procedure used to address the development and selection of alternatives.
Common name for this procedure are the problem solving approach, or the decision making
process. Typically the steps in the approach are as follows:

Steps to problem solving

1. Understand the problem and goal
2. Collect relevant information
3. Define the alternative solution
4. Evaluate each alternative
5. Select the best alternative using certain criteria
6. Implement the solution and monitor the result.

Engineering economy has a major role in steps 2,3, and 5, and it is the primary technique in step 4
to perform the economic-based analysis of each alternatives. Steps 2 and 3 set up the alternatives,
and engineering economy help structure the estimates of each one. Step 4 utilizes one or more
engineering economy model discussed in this course to complete the economic analysis upon
which a decision is made.

1.2. Project Concept

We call an investment plan a project. A project is undertaken for a particular goal or objective to
be achieved within a limited period of time and with limited resources (manpower, money, etc.). A
project is framework for organizing the use of certain amount of resource in a specific way in order
to achieve concrete result in a period of time. A project is characterized by:
A construction period
An operational period
(expected) life time
Specific desired output (benefits)
Use of scarce and valuable resources and/or undesired outputs (costs).
Sometimes a well defined target.

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Different scholars classify project period into different phases:

I. Project identification
II. Project formation and preparation
III. Project appraisal
IV. Project implementation
V. Project monitoring and evaluation
Project appraisal or investment analysis is about the comparison of different investment
alternatives or projects say: A0, A1, A2… Aj, An
One of these alternatives say A0 is the without case i.e. the alternative of doing none of the projects
A1, A2,…, Aj, An. sometimes there may be only one project without any alternatives. But in project
appraisal there are at least two alternatives: doing the project or not doing it.
The objective of economic analysis of such projects is three fold:
J The evaluation as to whether a specific project is economically desirable.
J The identification of the most desirable project among several desirable alternatives.
J The placement of the more economically desirable projects in rank order.
Projects are classified into:
J Private owned
J Public or state owned
This distinction is closely related to the nature of goods and services in terms of excludability and
subtractibility.
o Excludability: the degree to which users can be excluded. It is the capacity to prevent
consumers who do not meet the conditions set out by the supplier from using the
resource. Example: flood protection offered by the construction of dikes has low
excludability. People living in a flood protected area cannot easily be excluded from the
benefit of flood protection.
o Subtractibility: the degree to which consumption by one user reduces the possibility for
consumption by the others.
Example: -Fisheries have high subtractibility
-Flood control has low subtractibility
-Navigation has low subtractibility.
Public goods have low subtractibility and low excludability. Eg. Service of flood protection.
Private goods have high subtractibility and high excludability. Eg. Individual pit (waste water).
The following are important criteria for public sector decisions;
 Economic efficiency: deals with efficiency of resource allocation. A project is
economically feasible if the total benefits which result from the project exceed those which
could accrue without the project by an amount in excess of the project cost. The concepts
of opportunity cost and willingness to pay have to be addressed while economic prices,
representing real scarce values which often differ from real market prices are introduced in
the analysis. According to established economic theory if a market is competitive, then the
forces within that market will ensure that resources are allocated in an efficient (economic)
manner.
However where there are:
o Economics of scale: i.e. fixed costs are higher than variable costs as in any large
capital investment.
o Economics of scope: I.e. the unit costs of producing several products
simultaneously are lower than producing them separately.

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Such activities tend to become natural monopolies. Monopolies both tend to produce less and
charge more for goods and services than they would under competitive conditions. Market
mechanism may be deficient in generating competition. Many water infrastructure projects such as
large dams, sewerage systems, water supply systems and canal head works provide ready examples
of such natural monopolies.
 Equity: distribution of costs and benefits over different social classes and different regions.
Eg. Block tariffing in public water supply.
 Inter-generation effects or long term aspects: distribution of costs and benefits over
time. Distribution of natural resources may be beneficial to actual generation but hampers
future development potential. Level of national debt may become a burden to future
generation.
 Feasibility of implementation: should be evaluated in technical, financial, social, and
administrative senses. Socially in the sense that reluctance of social groups to accept
certain effects of the project may be there. Administrative wise compatibility with other
development plans of the government has to be considered.

CLASSIFICATION OF COST
A key objective in engineering applications is the satisfaction of human needs, which will nearly
always imply a cost.
Economic analyses may be based on a number of cost classifications:
1. First (or Initial) Cost : Cost to get activity started such as property improvement,
transportation, installation, and initial expenditures.
2. Operation and Maintenance Cost : They are experienced continually over the useful life
of the activity.
3. Fixed Cost : Fixed costs arise from making preparations for the future, and includes costs
associated with ongoing activities throughout the operational life-time of that concern.
Fixed costs are relatively constant; they are decoupled from the system input/output, for
example.
4. Variable Cost : Variable costs are related to the level of operational activity (e.g. the cost
of fuel for construction equipment will be a function of the number of days of use).
5. Incremental or Marginal Cost : Incremental (or marginal) cost is the additional expense
that will be incurred from increased output in one or more system units (i.e. production
increase). It is determined from the variable cost.
6. Sunk Cost : It cannot be recovered or altered by future actions. Usually this cost is not a
part of engineering economic analysis.
7. Life-Cycle Cost : This is cost for the entire life-cycle of a product, and includes feasibility,
design, construction, operation and disposal costs.
1.3. Time value of money
It is clearly explained in quote;
A bird in hand is more than two in a bush!
The way interest operates reflects the fact that money has a time value. This is why amounts of
interest depend on the length of time; interest rates, for instance, are typically given in terms of
percentages per year. Because money can earn at a certain interest rate through out its investment
period, it is recognized that a dollar received at some future date is not worth as much as a dollar at
hand in the present so long as money has earning power over time. Thus, the fact that money has

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value means that equal dollar amounts at different points have different value when the interest
rate that can be earned exceeds zero.

‘The time-value of money is the relationship between interest and time'

It could also be argued that money has a time value because the purchasing power of a dollar
changes through time. During periods of inflation, the amount of goods that can be bought for a
particular amount of money decreases as the time of purchase occurs further out in the future.
The concept of time value of money is vitally important for alternative aspects which can be
quantified in terms of dollar or birr. It is often said that money for if we makes money. The
statement is indeed true, for if we elect to invest money today (for example, in a bank, a business
or a stock mutual fund), we inherently expect to have more money in the future. This change in the
amount of money in a given time period is called the time value of money; it is the most important
concept in engineering economy. You should also realize that if a person or a company finds it
necessary to borrow money today, by tomorrow more than the original loan principal will be owed.
This fact is also explained by the time value of money.

1.4. Interest Formula and Equivalence

The manifestation of the time value of money is called interest, which is the increase between an
original sum of money borrowed and the final amount owed, or the original amount owned (or
invested) and the final amount accrued. In simple terms interest is the price or cost of the use of
money.
When interest is expressed as a percentage of the original amount per time
unit, the result is an interest rate. This rate is calculated as:
Percent interest rate=interest accrued per time unit *100%
Original amount

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By far the most common time period in which to express an interest rate is 1 year. However, since
interest rate may be expressed over periods of time shorter than 1 year, for example 1% per month,
the time unit used in expressing an interest rate must also be identified. This period is called
interest period.

Examples
With an interest rate of 6%, show that $94.34 last year, $100 now, and $106 one year from
now are equivalent. This is the concept of equivalence; READ more about it.
For more than one interest period, the terms simple interest and compound interest are used.

Compound or Composite interest (The interest of the interest)

If the interest is not paid but added to the outstanding sum at the end of each period then in the
future interest will, of course, have to be paid also over the non-paid interest of the previous
period, etc. Finally, the principal sum P plus all accrued interest will have to be paid to the owner
of the money. It simply means interest on top of interest. Compound interest reflects the effect of
the time value of money on the interest also.

Example:
Compute the compound interest and loan balance for each year for the $1000 a certain person
borrowed at 5% per year. Graphically compare the result for compound interest and simple
interest.

Solution:
End of
Year Amount Interest    
  borrowed Rate interest Balance
0 $1,000.00 5%   $1,000.00
1     $50.00 $1,050.00
2     $52.50 $1,102.50
3     $55.13 $1,157.63

Interest= (principal + all accrued interest)X(interest) ------ for compound Interest

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End of simple Compound

Year Amount Interest interest   interest  
  borrowed Rate interest Balance interest Balance
0 $1,000.00 5%   $1,000.00   $1,000
1     $50.00 $1,050.00 $50 $1,050
2     $50.00 $1,100.00 $52.50 $1,102.50
3     $50.00 $1,150.00 55.13 1157.63

Interest=(principal)x(number of periods)x(interest rate)---- for Simple interest

a m o u n t o w e d ($ )

$1,200.00
1157.63
$1,150.00 $1,150.00
$1,102.50
$1,100.00 $1,100.00
s imple interest
$1,050
c ompound interes t
$1,050.00 $1,050.00
$1,000
$1,000.00 $1,000.00

$950.00
0 1 2 3
End of interest Period

Exercise:
A loan of $1,000 is made at an interest of 12% for 5 years. The interest is due at the end of
each year with the principal is due at the end of the fifth year. Compute the compound interest
and loan balance for each year.

Note!
The word interest rate is used for the borrower’s vantage, when money has been borrowed, or
when a fixed interest is established. There is another term known as rate of return (ROR) which is
equivalent to the term interest rate but it is commonly used when estimating the profitability of a
proposed alternative or when evaluating the results of a completed project or investment. However,
both are represented by the later i.
Investment alternatives are evaluated upon the prognosis that a reasonable ROR can be expected.
Some reasonable rate must therefore be selected and utilized in the selection criteria phase of the
engineering economy study approach. The reasonable rate is called the minimum attractive rate of
return (MARR).

Nominal and Effective Interest Rates

In economic analysis a year is usually used as the interest period. In financial transactions,
however the interest period may be of any duration. We use the terms nominal interest rate and
effective interest rates to describe more precisely the nature of compounding schemes.

Even though financial institutions may use more than one interest period per year in compounding
the interest, they usually quote the interest on an annual basis. For example, a year’s rate at 1.5%
compounded monthly is typically quoted as “18% compounded monthly”. When stated in this

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fashion, the 18% is called a nominal interest rate or annual percentage rate. The effective interest
rate represents the actual interest earned or charged for a specified time period. The effective
interest rate based on a year is referred to as the effective annual interest rate ia. The effective
interest rate based on the payment period is called the effective interest rate per payment period
ie. In genera
m
 r 
i e  1    1
 m
Where, r = nominal interest rate (per year)
i= actual (effective interest rate) per year
m= number of interest periods per year
ie= effective annual interest rate

Example: Suppose a bank charges a rate of 12% compounded quarterly (four times per year). This
means that 3% is charged every quarter. The interest per dollar accrued at the end of the year is
(1.03)4 − 1 = 0.1255. Thus the effective annual interest rate is ia = 12.55%. If the interest is
compounded monthly (12 times per year) then the effective annual interest rate is ia = (1.01)12−1 =
0.1268 = 12.68%.

Two types of operation are used:

1. Compounding – future value of money
2. Discounting- present value of money
In the practice of analysis, it is customary to express benefits interns of present value by applying
the proper discount factors.
Point in time: a discrete point for accounting:
o Beginning of the year
o Middle of the year
o End of the year- Generally used as a matter of convention
This means that flows of money that may occur more or less continuously during the year are
assumed to occur at one particular point-of-time during that year and that interest will be
calculated only at the end of the year.
The analysis of the financial, economical and social benefits and costs requires expressing them in
comparable terms. In order to make them comparable, it is customary to express both in terms of
their present value. Only then application of criteria proceeds.

Continues compounding:
As a limit interest may be considered to be compounded an infinite number of times per year, i.e.
continuously.
The concept of continues compounding is useful as an approximation to compound increases of
income, expenditures, population, traffic count or similar events, which are spread over the year
instead of concentrated at years end.
In this case:
m
 r 
i e  1    1
 m 
r
m  m

 r m
 r r   r 
ie  lim 1    1 , but  1  m    1  m 
m   m     
 

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m
Let, y 
r
y
 1
lim 1    e
y 
 y

m
 r 
i e  lim 1   1  er 1
y 
 m
… For continuous compounding

Example: calculate and show the validity of the tabular values

================================================================
Compounding Number of Effective interest Effective annual
frequency Periods rate per period interest rate
================================================================

Annually 1.0 18% 18.00%

Semiannually 2.0 9% 18.81$
Quarterly 4.0 4.5% 19.25%
Monthly 12.0 1.5% 19.56%
Weekly 52.0 0.3642% 19.68%
Daily 365.0 0.0493% 19.74%
Continuously infinity 0.0000% 19.72%

1.5. Cash Flow Diagram

Cash flow is the stream of monetary (dollar/birr) values— costs (inputs) and benefits (outputs)—
resulting from a project investment.
It is difficult to solve a problem if you can not see it. The easiest way to approach problems in
economic analysis is to draw a picture. The picture should show three things:
1. A time interval divided into an appropriate number of equal periods
2. All cash outflows (deposits, expenditures, etc.) in each period
3. All cash inflows (withdrawals, income, etc.) for each period
A cash flow diagram is simply a graphical representation of cash flows drawn on a time scale.
Cash flows are described by the actual inflow and outflow of money.
Cash inflows:
 Revenues
 Salvage value
Cash outflows:
 First cost of asset
 Operation cost
 Periodic maintenance costs
 Taxes
Unless otherwise indicated, all such cash flows are considered to occur at the end of their
respective periods. Figure below is a cash-flow diagram showing an outflow or disbursement of
$1000 at the beginning of year 1 and an inflow or return of $2000 at the end of year 5.
"end-of-year" convention

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Since there are two parties to every transaction, it is important to not that cash flow directions in
cash flow diagrams depend upon the point of view taken.

Notation
To simplify the subject of economic analysis, symbols are introduced to represent types of cash
flows and interest factor. the following symbols will be used here:
P = Present sum of money ($)
F = Future sum of money ($)
n =Number of interest periods
i = Interest rate per period (%)

INTEREST FACTORS DERIVATION

Derivation Of The Single Payment Factors (F/P And P/F)
A formula is developed which allows determination of the future amount of money F that is
accumulated after n years from a single investment P when interest is compounded one time per
year. If an amount of money P is invested at some time t = 0, the amount of money F1 that will be
accumulated 1 year hence at an interest rate of i percent per year will be:
F1=P + Pi
= P(1+i)
At the end of the second year, the amount of money accumulated F2 is the amount that is
accumulated after year 1 plus the interest from the end of year 1 to the end of year 2. Thus;
F2 = F1 + F1i
= P (1+i) + P (1+i)i
= P(1+i+i+i2)
= P (1+i)2
Similarly,
F3 = P(1+i)3

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From the preceding values, it is evident by mathematical induction that the formula for
compounding can be generalized for n years to:
F  P 1  i  .................1.1
n

The factor (1+i)n is called the single payment compound-amount factor (SPCAF) or the F/P factor.
By rearranging equation (1.) discounting equation can be given as:
 1 
P  F n  ….. (1.2)
 1  i  
The expression in the brackets is known as single-payment present-worth factor (SPPWF), or the
P/F factor.
Derivation of The Uniform Series Present Worth Factor and Capital Recovery Factor (P/A
and A/P)
P
1 2 3 4 5 n

A
The present worth P of the uniform series shown above can be determined by considering each A
value as a future worth F and using equation 1.2 with the P/F factor and then summing the present-
worth values.

 1   1   1   1 
P  A 1 
 A 2 
 A 3 
 ….. + A N 
 1  i    1  i    1  i    1  i  
 1 1 1 
P  A   ....  
 1  i  1  i  1  i  n 
1 2

Multiplying both sides by 1/(1+i);

P  1 1 1 
 A   ....  n 1 
1 i  1  i  1  i  1  i  
2 3

After some simplification of the above equation, we com up with:

 1  i  n  1 
P  A n 
....i  0 …… (1.3)
 i 1  i  
The terms in brackets is called the uniform-series present-worth factor (US-PWF) or the P/A
factor.

 i 1  i  n 
A  P  ….. (1.4)
 1  i   1 
n

In equation 1.4 the terms in the bracket is called capital-recovery factor (CRF), or A/P factor,
yields the equivalent uniform annual worth A over n years of a given investment P when the
interest rate is i.

Derivation Of The Sinking Fund Factor And The Uniform –Series Compound-Amount
Factor (A/F And F/A)

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While the sinking-fund factor (SFF), or A/F factor, and the uniform-series compound-amount
factor (USCAF), or F/A factor, could be derived using the F/P factor, the simplest way to derive
the formula is to substitute into those already developed. Hence,
 i 
A  F  A/F factor ….. (1.5)
 1  i   1 
n

 1  i  n  1 
F  A  F/A factor …… (1.6)
 i 

Points to ponder
i. The end of one year is the beginning of the next year
ii. P is the beginning of a year at a time of recorded as a present
iii. F is the end of the nth year fro a time recorded as being present.
iv. A is occur at the end of each year or the period under consideration. When P and A are
involved the first A of the series occurs one year after P. when F and A are involved the
last A of the series occurs at the same time as F.

EXERCISE/TUTORIAL INTEREST CALCULATION

1. You put 1000 birr in a bank account at the end of 2000. The interest rate is 7% per year.
What amount will you have in your account at the end of 2015?

2. What deposit should you make on 1st January 2001, in order to obtain an amount of
$100,000 on 31st December 2011? The interest rate is 6%.

3. If you make an annual deposit of 2000 birr with a bank at the beginning of the year, starting
1st January 2001, what will be the value of all deposits on 31 st December 2011, if the
interest rate is 6%?

4. If you place 20,000 birr in a bank at the end of 2000, yielding 7% interest, what equal
amount can you withdraw at the end of every year, starting at the end of the year 2010, and
continuing during 5 more years thereafter, so that the account is depleted at the end of
2015?

5. What deposit at the end of each month should you make, starting 31 st January 2001, in
order to obtain an amount of $25,000 on the 31 st December 2011? Assume an annual
interest rate of 6% and monthly discounting.

6. How much must a family invest now to provide a lump sum of $1000 for school fees at the
end of 6 years, 8 years, and 12 years from now if interest rate is 5%?

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P=?

Year

$10000 $10000 $10000

7. A person buys a site near the fringe of an industrial area in a large city for $1000,000.
Annual outgoings on the site for maintenance, fencing, watching, etc., amount to $45,000.
It is estimated that the site will not be sold for 8 years, at which time the area is due for
development. For which minimum price must the site be sold at that time so as to break
even on the costs if the original purchase price and the annual outgoings could have been
alternatively invested at 12 % per year?
P= $1000,000

F=?
A=$45,000/year

8. A uniform annual investment is to be made into a sinking fund with a view to providing the
capital at the end of 7 years for the replacement of a tractor. An interest rate of 6 per cent is
available. What is the annual investment needed to provide for 50,000 birr?
F=50,000 Birr

A=?/year

9. A unit of mechanical equipment has an initial cost of 100,000 birr and annual maintenance
expenditure to average 12,000 birr for its 8 years of life. If interest is at 10% and the
equipment has no salvage value, what is its equivalent annual cost, excluding labor, fuels,
etc.?
P= 100,000

A=12,000/year

10. If the maintenance cost of a bulldozer amounts to 2000 birr by the end of the first year of
its service, 2500 birr by the end of the second and 3000 birr, 3500 birr, 4000 birr by the end

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of the third, fourth, and fifth year respectively, find the equivalent uniform series cost each
year over a period of 5 yeas, interest is at 5%.

A=2000 Birr
2000
2500
G=500 birr
3000
3500 4000
11. If a mill building is constructed of reinforced concrete (option-1), it will have an estimated
initial cost of $200,000 and no maintenance costs for the first 10 years. A building to serve
a similar purpose but erected in structural steel-work and clad in plastic coated metal sheets
(option-2) has an initial cost of $160,000 but the steel-work needs to be painted every 2
years at a cost of $14,000. With interest at 10%, which is the cheapest investment
considered over the first 10 years of the building life?

12. If a proposal for the installation of equipment in a factory require a capital investment now
of 10,000 birr, what saving per year must be shown over the next 10 years to justify the
expenditure at an interest rate of 5%?

13. A man and wife buy a house and take out a mortgage of $60,000 to meet part of the cost.
They agree to pay of the mortgage over 25 years making monthly payments; interest on the
mortgage is 10.5% per year. To what will the monthly payment amounts? What amount of
the original debt of $60,000 will remain after they made 250 payments?

14. The purchaser of an automobile is paying for it at the rate of 600 birr per half-year, having
agreed to make 10 such payments, but after 2 years, when the fourth payment become due,
decides to make a lump sum payment to settle the account. With an interest rate of 10%,
how much will be needed to do this if there is no rebate of the interest to be changed for the
whole of the 5 years?

15.

A=600birr/year Lump sum payment

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS

Table: present worth factors(changes F to P)

Table: capital recovery factor (changes P to A)

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 BASIC PRINCIPLES IN ENGINEERING ECONOMICS

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