Engineering Economics & Management

(MS490)
Chapter 2
Time Value of Money

Muhammad Ullah
Assistant Professor
School of Management Sciences GIKI
Recap
• Single-Payment
𝐹 =𝑃 1+𝑖 𝑛 [Compounding]
−𝑛
𝑃 =𝐹 1+𝑖 [Discounting]

• Uniform Series /Annuities

1+𝑖 𝑛 −1 𝑖 1+𝑖 𝑛
𝑃=𝐴 and A = 𝑃
𝑖 1+𝑖 𝑛 1+𝑖 𝑛 −1

𝑖
𝐴=𝐹  sinking fund factor
1+𝑖 𝑛 −1

1+𝑖 𝑛 −1
𝐹=𝐴  Uniform Series Compound Amount Factor
𝑖
Factor Values for Untabulated i or n
• There are three ways to find factor values for untabulated 𝑖 or 𝑛 values
1. Formula Method - calculator
2. Spreadsheet Method
3. Linear Interpolation
• Formula or spreadsheet method is fast and accurate.
• Interpolation is only approximate.
Linear Interpolation
Formula of Linear Interpolation is

Determine the value for (F/P, 8.3%,10)

Formula: F = (1 + 0.083)10 = 2.2197
Spreadsheet: = FV(8.3%,10,1) = 2.2197

Interpolation: x f(x)
8% (X1) ------ 2.1589 (f1)
8.3% (x) ------ Unknown (f)
9% (X2) ------ 2.3674 (f2)
8.3 − 8
f = 2.1589 + 2.3674 − 2.1589
9 −8
f = 2.2215

Absolute Error = 2.2215 – 2.2197 = 0.0018

Interpolation

8% 2.1589
0.3% 𝑥
1% 8.3% f 0.2085
9% 2.3674

𝑓 − 2.1589 0.3%
=
0.2085 1% 𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝐸𝑟𝑟𝑜𝑟 = 2.2215 − 2.2197
= 0.0018
𝑓 = 2.22145
Moving from Uniform Series to Gradient
• We started with single amount payments.
• We moved to “uniform series (Annuities)” and its present or future values.
• Now its time to tackle “Arithmetic” or “Geometric” Gradient Series
Arithmetic Gradient
• An arithmetic gradient series is a cash flow series that either increase or decrease by a
constant amount each period.
• The amount of change (increase or decrease) is called the gradient.
• Gradient series can be both: cash inflows or cash outflows.
• Let suppose that an engineer predicts that the cost of operating the plant will increase by
Rs. 50,000 each year until the plant become obsolete. The cash flow series of operating
the plant involves a constant gradient, which is Rs. 50,000 per year.
Example: Arithmetic Gradient
• Let suppose,You bought a used bike with one year warranty.
• The cost of using bike during first year is only the petrol expense that is estimated to be
$2,500.
• From second year, you have to pay $200 per year for repair and maintenance. This cost
will increase by $200 each year.
• What will be the amount in 2nd year?
Arithmetic Gradient
Typical Arithmetic Gradient Cash Flow
PT = ?

i = 10%
0 1 2 3 4 5

400
450
Amount in year 1 500
is base amount 550
600

This diagram = this base amount plus this gradient

PA = ? PG = ?
i = 10% i = 10%
0 1 2 3 4 5
+ 0 1 2 3 4 5

Amount 400 400 400 400 400

50
in year 1 100
PA = 400(P/A,10%,5) PG = 50(P/G,10%,5) 150
is base 200
amount 𝑷𝑻 = 𝑷𝑨 + 𝑷𝑮 = 𝟒𝟎𝟎(𝑷/𝑨, 𝟏𝟎%, 𝟓) + 𝟓𝟎(𝑷/𝑮, 𝟏𝟎%, 𝟓)
Converting Arithmetic Gradient to A
Arithmetic gradient can be converted into equivalent A value using 𝐺(𝐴/𝐺, 𝑖, 𝑛)
i = 10% i = 10%
0 1 2 3 4 5 0 1 2 3 4 5

G
2G A=?
3G
4G

General equation when base amount is involved is

A = base amount + G(A/G,i,n)

For decreasing gradients,

0 1 2 3 4 5
change plus sign to minus
4G
3G
2G A = base amount - 𝑮(𝑨/𝑮, 𝒊, 𝒏)
G
Summation of Arithmetic Gradient
𝑃𝑇 = 𝑃𝐴 ± 𝑃𝐺
𝑃𝐴 can be easily calculated from 𝑃/𝐴 factor. 𝑃𝐺 is something that we should take care of.
[Next slide]

Alternatively;
𝐴 𝑇 = 𝐴𝐴 ± 𝐴𝐺
Conversion of 𝑃𝐺 in 𝐴/𝐺
Future Value of Arithmetic Gradient
• Multiply 𝑃/𝐺 by 𝐹/𝑃 factor;

𝐺 1+𝑖 𝑛−1 𝑛 𝑛
𝐹𝐺 = − × 1+𝑖
𝑖 𝑖 1+𝑖 𝑛 1+𝑖 𝑛

1 1+𝑖 𝑛−1
𝐹𝐺 = 𝐺 −𝑛
𝑖 𝑖
Example: Arithmetic Gradient
The present worth of $400 in year 1 and amounts increasing by
$30 per year through year 5 at an interest rate of 12% per year is
closest to:
(A) $1532 (B) $1,634 (C) $1,744 (D) $1,829

Solution:
PT = ? PT = 400(P/A,12%,5) + 30(P/G,12%,5)
i = 12% = 400(3.6048) + 30(6.3970)
0 1 2 3 4 5 Year = $1,633.83
Answer is (B)
400
430 The cash flow could also be converted into an A
460
490 (uniform series) value as follows:
G = $30 520
A = 400 + 30(A/G,12%,5)
= 400 + 30(1.7746)
= $453.24
 Solution: (a)

In present worth terms, the planned series will exceed the equivalent of $200 M in
2012 by approximately $7.5 M.
Solution: (b)
 Geometric Gradients
Geometric gradients change by the same percentage each period
Cash flow diagram for present worth
of geometric gradient There are no tables for geometric factors

Use following equation for 𝑔 ≠ 𝑖:

𝒏
𝟏+𝒈
𝟏− 𝟏+𝒊
𝑷𝒈 = 𝑨𝟏
𝒊−𝒈
where: A1 = cash flow in period 1
g = rate of increase
𝑨𝟏𝒏
If 𝒈 = 𝒊, 𝑷𝒈 =
𝟏+𝒊

Note: If g is negative, change signs in front of both g values

Geometric Gradient
If 𝑖 = 𝑔, Eq. 2.31 implies;
Example: Geometric Gradient

Find the present worth of $1,000 in year 1 and amounts

increasing by 7% per year through year 10. Use an interest rate
of 12% per year.
(a) $5,670 (b) $7,333 (c) $12,670 (d) $13,550

Pg = ? Solution:
i = 12%
1 2 3 4 10 𝑃𝑔 = 1000[1 − (1 + 0.07/1 + 0.12)10]/(0.12 − 0.07)
= $7,333
0
1000
1070 Answer is (b)
1145
g = 7%

1838 To find A, multiply Pg by (A/P,12%,10)

Example 2.11
Calculating 𝑛 and 𝑖 for know Cash Flows

 Calculator

 Excel

 Linear Interpolation
Problem # 2.45
Acme Bricks, a masonry products company, wants to have $600,000 on hand before it
invests in new conveyors, trucks, and other equipment. If the company sets aside $80,000
per year in an account that increases in value at a rate of 15% per year, how many years will
it be before Acme can purchase the equipment?

Solution
600,000 = 80,000(F/A,15%,n) 1+𝑖 𝑛−1
=
(F/A,15%,n) = 7.50 𝑖

Interpolate in the 15% interest table or use a spreadsheet function. By spreadsheet, n = 5.4

years.

26
 Interpolation

𝑥 0.7576
5 6.7424 =
1 2.0113
x 0.7576
1 n 7.500 2.0113 𝑥 = 0.3767

6 8.7537 𝑛 = 𝑥 + 5 = 5.3767 years

27
28
 Thank You

Any Questions?
Email: Muhammad.ullah@giki.edu.pk
Engineering Economics & Management
(MS490)
Time Value of Money
Dr. Muhammad Ullah
Assistant Professor
GIKI School of Management Sciences
Single-Payment Compound Amount Factor
If an amount “𝑃” is invested at time 𝑡 = 0 the amount 𝐹1 accumulated after a year is given as;
𝐹1 = 𝑃 + 𝑃 × 𝑖 = 𝑃 1 + 𝑖
At the end of 2nd year, the accumulated amount 𝐹2 is given by;
𝐹2 = 𝐹1 + 𝐹1 × 𝑖
𝐹2 = 𝑃 1 + 𝑖 + 𝑃 1 + 𝑖 𝑖
𝐹2 = 𝑃 1 + 𝑖 2
Similarly;
𝐹3 = 𝑃 1 + 𝑖 3

Generalized formula for calculating future values is given by;

𝐹𝑛 = 𝑃 1 + 𝑖 𝑛
In book, the notation is; Single Payment Compound Amount
𝒏 Factor (SPCAF), also 𝑭/𝑷 factor
𝑭 = 𝑷 𝟏+𝒊
𝑭
𝑷= Single Payment Present
(𝟏 + 𝒊)𝒏
𝑷 = 𝑭 𝟏 + 𝒊 −𝒏
Worth Factor, 𝐏/𝑭 factor
Example
• After graduation, Mr. Saad Hassan, an Electrical Engineer is planning to go
on vacation to London in five years time. This trip will cost him Rs.
500,000. How much, does he need to deposit today at the rate of 10% in a
saving account to have Rs. 500,000 at the end of five years?

Cash Flow Diagram

Solution Using Formula 𝑭 =500,000

−𝑛
𝑃 =𝐹 1+𝑖 𝒊 = 𝟏𝟎 %

−5
= 500,000 1 + 0.10 0 1 2 3 4 5

= 310,450
P= ?
Factor Notation
• This notations includes two cash flows symbols, interest rate and number of periods
• General form is: (X/Y, i, n) which means calculating “X” from “Y”. i.e. X is required and Y
is given, “i” is interest rate and “n” is number of periods.
A Typical Uniform Series and its Present Worth
Present Worth of Uniform Series
 Example: P/A Factor

An engineer believes that by modifying the structure of a certain water treatment plant, his
company would save Rs. 50,000 per year. At an interest rate of 10% per year, how much
could the company afford to spend now to just break even over a 6 year project period?

P = A(P/A, i, n)
P = Rs. 50,000(P/A,10%,6)
P = Rs. 50,000 (4.3553)
P = Rs. 217,765
Example: Calculating A from P
Q:You borrow $15,000 from a bank to purchase a used car. The interest rate on your loan
is 0.25% per month and you will make a total of 36 monthly payments. What is your
monthly payment?
Sinking Fund Factor
𝑃/𝐴 factor relationship is given by;
1+𝑖 𝑛 −1
𝑃=𝐴
𝑖 1+𝑖 𝑛

𝑖 1+𝑖 𝑛
𝐴=𝑃
1+𝑖 𝑛 −1

𝐹
Since 𝑃 =
1+𝑖 𝑛
𝐹 𝑖 1+𝑖 𝑛
𝐴=
1+𝑖 𝑛 1+𝑖 𝑛 −1

𝑖 Sinking Fund Factor

𝐴=𝐹
1+𝑖 𝑛 −1

1+𝑖 𝑛 −1
𝐹=𝐴 Uniform Series Compound Amount Factor
𝑖
Example: Sinking Fund Factor
An engineering firm has to pay Rs. 1,000,000 for the replacement of production plant by
the end of fifth year from now. The market rate of interest is 10% per year. How much the
company should deposit annually in a saving account to have exactly Rs. 1,000,000 by the
end of fifth year?
Solution:
𝐴 = 𝐹 (𝐴/𝐹, 𝑖, 𝑛)
𝐴 = 𝑅𝑠. 1,000,000(𝐴/𝐹, 10%, 5)
𝐴 = 𝑅𝑠. 1,000,000 (0.16380)
𝐴 = 𝑅𝑠. 163,800
Arithmetic Gradient
• An arithmetic gradient series is a cash flow series that either increase or decrease by a
constant amount each period.
• The amount of change (increase or decrease) is called the gradient.
• Gradient series can be both: cash inflows or cash outflows.
• Let suppose that an engineer predicts that the cost of operating the plant will increase by
Rs. 50,000 each year until the plant become obsolete. The cash flow series of operating
the plant involves a constant gradient, which is Rs. 50,000 per year.
Example: Arithmetic Gradient
• Let suppose,You bought a used bike with one year warranty.
• The cost of using bike during first year is only the petrol expense that is estimated to be
$2,500.
• From second year, you have to pay $200 per year for repair and maintenance. This cost
will increase by $200 each year.
• What will be the amount in 2nd year?
Arithmetic Gradient
Typical Arithmetic Gradient Cash Flow
PT = ?

i = 10%
0 1 2 3 4 5

400
450
Amount in year 1 500
is base amount 550
600

This diagram = this base amount plus this gradient

PA = ? PG = ?
i = 10% i = 10%
0 1 2 3 4 5
+ 0 1 2 3 4 5

Amount 400 400 400 400 400

50
in year 1 100
PA = 400(P/A,10%,5) PG = 50(P/G,10%,5) 150
is base 200
amount 𝑷𝑻 = 𝑷𝑨 + 𝑷𝑮 = 𝟒𝟎𝟎(𝑷/𝑨, 𝟏𝟎%, 𝟓) + 𝟓𝟎(𝑷/𝑮, 𝟏𝟎%, 𝟓)
Converting Arithmetic Gradient to A
Arithmetic gradient can be converted into equivalent A value using 𝐺(𝐴/𝐺, 𝑖, 𝑛)
i = 10% i = 10%
0 1 2 3 4 5 0 1 2 3 4 5

G
2G A=?
3G
4G

General equation when base amount is involved is

A = base amount + G(A/G,i,n)

For decreasing gradients,

0 1 2 3 4 5
change plus sign to minus
4G
3G
2G A = base amount - 𝑮(𝑨/𝑮, 𝒊, 𝒏)
G
Summation of Arithmetic Gradient
𝑃𝑇 = 𝑃𝐴 ± 𝑃𝐺
𝑃𝐴 can be easily calculated from 𝑃/𝐴 factor. 𝑃𝐺 is something that we should take care of.
[Next slide]

Alternatively;
𝐴 𝑇 = 𝐴𝐴 ± 𝐴𝐺
Conversion of 𝑃𝐺 in 𝐴/𝐺
Future Value of Arithmetic Gradient
• Multiply 𝑃/𝐺 by 𝐹/𝑃 factor;

𝐺 1+𝑖 𝑛−1 𝑛 𝑛
𝐹𝐺 = − × 1+𝑖
𝑖 𝑖 1+𝑖 𝑛 1+𝑖 𝑛

1 1+𝑖 𝑛−1
𝐹𝐺 = 𝐺 −𝑛
𝑖 𝑖
Example: Arithmetic Gradient
The present worth of $400 in year 1 and amounts increasing by
$30 per year through year 5 at an interest rate of 12% per year is
closest to:
(A) $1532 (B) $1,634 (C) $1,744 (D) $1,829

Solution:
PT = ? PT = 400(P/A,12%,5) + 30(P/G,12%,5)
i = 12% = 400(3.6048) + 30(6.3970)
0 1 2 3 4 5 Year = $1,633.83
Answer is (B)
400
430 The cash flow could also be converted into an A
460
490 (uniform series) value as follows:
G = $30 520
A = 400 + 30(A/G,12%,5)
= 400 + 30(1.7746)
= $453.24
 Solution: (a)

In present worth terms, the planned series will exceed the equivalent of $200 M in
2012 by approximately $7.5 M.
Solution: (b)
 Geometric Gradients
Geometric gradients change by the same percentage each period
Cash flow diagram for present worth
of geometric gradient There are no tables for geometric factors

Use following equation for 𝑔 ≠ 𝑖:

𝒏
𝟏+𝒈
𝟏− 𝟏+𝒊
𝑷𝒈 = 𝑨𝟏
𝒊−𝒈
where: A1 = cash flow in period 1
g = rate of increase
𝑨𝟏𝒏
If 𝒈 = 𝒊, 𝑷𝒈 =
𝟏+𝒊

Note: If g is negative, change signs in front of both g values

Geometric Gradient
If 𝑖 = 𝑔, Eq. 2.31 implies;
Example: Geometric Gradient

Find the present worth of $1,000 in year 1 and amounts

increasing by 7% per year through year 10. Use an interest rate
of 12% per year.
(a) $5,670 (b) $7,333 (c) $12,670 (d) $13,550

Pg = ? Solution:
i = 12%
1 2 3 4 10 𝑃𝑔 = 1000[1 − (1 + 0.07/1 + 0.12)10]/(0.12 − 0.07)
= $7,333
0
1000
1070 Answer is (b)
1145
g = 7%

1838 To find A, multiply Pg by (A/P,12%,10)

Example 2.11
Calculating 𝑛 and 𝑖 for know Cash Flows

 Calculator

 Excel

 Linear Interpolation
Problem # 2.45
Acme Bricks, a masonry products company, wants to have $600,000 on hand before it
invests in new conveyors, trucks, and other equipment. If the company sets aside $80,000
per year in an account that increases in value at a rate of 15% per year, how many years will
it be before Acme can purchase the equipment?

Solution
600,000 = 80,000(F/A,15%,n) 1+𝑖 𝑛−1
=
(F/A,15%,n) = 7.50 𝑖

Interpolate in the 15% interest table or use a spreadsheet function. By spreadsheet, n = 5.4

years.

30
 Interpolation

𝑥 0.7576
5 6.7424 =
1 2.0113
x 0.7576
1 n 7.500 2.0113 𝑥 = 0.3767

6 8.7537 𝑛 = 𝑥 + 5 = 5.3767 years

31
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin [ISBN-10: 0073376302]

• Course Material Link:

https://pern-
my.sharepoint.com/:f:/g/personal/muhammad_ullah_giki_edu_pk/EnRMK3GdevxHnfQ7-
19oJ9MBAgDPRhmfD7vsTV_GZw4-lA?e=34qBJv

32
33
 Engineering Economics & Management
MS490

Chapter 3
Combining Factors and Spreadsheet Functions

Muhammad Ullah
Assistant Professor
School of Management Sciences GIKI
Recap – Chapter 2
• Single-Payment
𝑛
𝐹 =𝑃 1+𝑖 [Compounding]
𝑃 =𝐹 1+𝑖 −𝑛
[Discounting] 1 1+𝑖 𝑛−1
𝐹𝐺 = 𝐺 −𝑛
𝑖 𝑖
• Uniform Series /Annuities
𝟏+𝒈 𝒏
𝟏−
1+𝑖 𝑛 −1 𝑖 1+𝑖 𝑛 𝟏+𝒊
𝑃=𝐴 and A = 𝑃 𝑷𝒈 = 𝑨𝟏
𝑖 1+𝑖 𝑛 1+𝑖 𝑛 −1 𝒊−𝒈
𝑨𝟏 𝒏
𝑖 If 𝒈 = 𝒊, 𝑷𝒈 = 𝟏+𝒊
𝐴=𝐹 1+𝑖 𝑛 −1
----- sinking fund factor

1+𝑖 𝑛 −1
𝐹=𝐴 ----- Uniform Series Compound Amount Factor
𝑖
 Shifted Uniform Series

A shifted uniform series starts at a time other than period 1

The cash flow diagram below is an example of a shifted series
Series starts in period 2, not period 1

A = Given FA = ?
Shifted series usually
require the use of
0 1 2 3 4 5 multiple factors
PA = ?

Remember: When using P/A or A/P factor, PA is always one year ahead of first A
When using F/A or A/F factor, FA is in same year as last A
 Example Using P/A Factor: Shifted Uniform Series
The present worth of the cash flow shown below at i = 10% is:
(a) $25,304 (b) $29,562 (c) $34,462 (d) $37,908

P0 = ?
P1 = ? i = 10%

0 1 2 3 4 5 6
Actual year
0 1 2 3 4 5 Series year

A = $10,000
Solution: (1) Use P/A factor with n = 5 (for 5 arrows) to get P1 in year 1
(2) Use P/F factor with n = 1 to move P1 back for P0 in year 0

P0 = P1(P/F,10%,1) = A(P/A,10%,5)(P/F,10%,1) = 10,000(3.7908)(0.9091) = $34,462

Answer is (c)
Example Using F/A Factor: Shifted Uniform Series

How much money would be available in year 10 if $8000 is deposited each

year in years 3 through 10 at an interest rate of 10% per year?

Cash flow diagram is:

FA = ?
i = 10%
Actual year
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 Series year
A = $8000

Solution: Re-number diagram to determine n = 8 (number of arrows)

FA = 8000(F/A,10%,8)
= 8000(11.4359)
= $91,487
Question:

A charity organization will receive a donation of $1,000 at the end of every

2nd year for the next 20 years, that is, 10 donations in total. The first donation
will be received two years from now.
 How can you covert these cash flows into an annuity? Be creative and show
your cash flow diagram.
 What is the present value of all these donations at 10% compound annual
interest rate? Use of Excel in this exercise is not allowed.
 Solution

1,000 1,000 1,000

0 1 2 3 4 20

Three Problems with this Cash Flow Diagram

1. It is not a conventional Uniform Series i.e. this 1st cash flow is at 𝑡 = 2
2. Although frequency is same, but there are no cash flows at 𝑡 = 1,3,5 … 𝑒𝑡𝑐.
3. Cash flows are after every two years. Interest rate, on the other hand, is quoted
per year.

How do we solve this?

- creatively fill the gaps.

Since 𝐴 = 𝐹 𝐴/𝐹, 10%, 2

𝐴 = 1000 × 0.47619 = 476.19
The resultant cash flow will look like;

476.19 476.19 476.19 476.19 476.19

0 1 2 3 4 20

𝑃 = 𝐴(𝑃/𝐴, 10%, 20)

𝑃 = 476.19 × 8.5136 = 4,054.10
Shifted Series and Random Single Amounts

For cash flows that include uniform series and randomly placed single amounts:

Uniform series procedures are applied to the series amounts

Single amount formulas are applied to the one-time cash flows

The resulting values are then combined per the problem statement

The following slides illustrate the procedure

Example: Series and Random Single Amounts
Find the present worth in year 0 for the cash flows shown using an
interest rate of 10% per year.
PT = ?
i = 10%
0 1 2 3 4 5 6 7 8 9 10

A = $5000
$2000

PT = ?
i = 10%
Actual year
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8
Series year
A = $5000
$2000
Solution:

First, re-number cash flow diagram to get 𝑛 for uniform series: 𝑛 = 8

 Example: Series and Random Single Amounts
PA
PT = ? i = 10%
0 1 2 3 4 5 6 7 8 9 10 Actual year
0 1 2 3 4 5 6 7 8
Series year
A = $5000 $2000

Use P/A to get PA in year 2: PA = 5000(P/A,10%,8) = 5000(5.3349) = $26,675

Move PA back to year 0 using P/F: P0 = 26,675(P/F,10%,2) = 26,675(0.8264) = $22,044

Move $2000 single amount back to year 0: P2000 = 2000(P/F,10%,8) = 2000(0.4665) = $933

Now, add P0 and P2000 to get PT: PT = 22,044 + 933 = $22,977

 Example Worked a Different Way
(Using F/A instead of P/A for uniform series)

The same re-numbered diagram from the previous slide is used

PT = ? FA = ?
i = 10%
0 1 2 3 4 5 6 7 8 9
10
0 1 2 3 4 5 6 7 8

A = $5000
$2000

Solution: Use F/A to get FA in actual year 10: FA = 5000(F/A,10%,8) = 5000(11.4359) = $57,180
Move FA back to year 0 using P/F: P0 = 57,180(P/F,10%,10) = 57,180(0.3855) = $22,043
Move $2000 single amount back to year 0: P2000 = 2000(P/F,10%,8) = 2000(0.4665) = $933
Now, add two P values to get PT: PT = 22,043 + 933 = $22,976 Same as before

As shown, there are usually multiple ways to work equivalency problems

 Example: Series and Random Amounts
Convert the cash flows shown below (black arrows) into
an equivalent annual worth A in years 1 through 8 (red arrows)
at i = 10% per year.
A=?
0 1 2 3 4 5 6 7 i = 10%
8 0 1 2 3 4 5

A = $3000
$1000

1. Find F in year 8 and use A/F with n = 8

Approaches:
2. Convert all cash flows into P in year 0 and use A/P with n = 8

Solution: Solve for F: F = 3000(F/A,10%,5) + 1000(F/P,10%,1)

= 3000(6.1051) + 1000(1.1000)
= $19,415
Find A: A = 19,415(A/F,10%,8)
= 19,415(0.08744)
= $1698
 Shifted Arithmetic Gradients

Shifted gradient begins at a time other than between periods 1 and 2

Present worth PG is located 2 periods before gradient starts

Must use multiple factors to find PT in actual year 0

To find equivalent A series, find PT at actual time 0 and apply (A/P,i,n)

 Example: Shifted Arithmetic Gradient
John Deere expects the cost of a tractor part to increase by $5 per year beginning 4
years from now. If the cost in years 1-3 is $60, determine the present worth in year 0
of the cost through year 10 at an interest rate of 12% per year.
i = 12%
PT = ? Actual years
0 1 2 3 4 5 10
0 1 2 3 8 Gradient years
60 60 60
65
70
G=5 95
Solution: First find P2 for G = $5 and base amount ($60) in actual year 2

P2 = 60(P/A,12%,8) + 5(P/G,12%,8) = $370.41

P0 = P2(P/F,12%,2) = $295.29
Next, move P2 back to year 0

Next, find PA for the $60 amounts of years 1 and 2 PA = 60(P/A,12%,2) = $101.41

Finally, add P0 and PA to get PT in year 0 PT = P0 + PA = $396.70

 Shifted Geometric Gradients

Shifted gradient begins at a time other than between periods 1 and 2

Equation yields Pg for all cash flows (base amount A1 is included)

𝒏
𝟏+𝒈
Equation (i ≠ g): 𝑷𝒈 = 𝑨𝟏
𝟏− 𝟏+𝒊
𝒊−𝒈

For negative gradient, change signs on both g values

There are no tables for geometric gradient factors

 Example: Shifted Geometric Gradient
Weirton Steel signed a 5-year contract to purchase water treatment chemicals
from a local distributor for $7000 per year. When the contract ends, the cost of
the chemicals is expected to increase by 12% per year for the next 8 years. If
an initial investment in storage tanks is $35,000, determine the equivalent
present worth in year 0 of all of the cash flows at i = 15% per year.
 Example: Shifted Geometric Gradient

Gradient starts between actual years 5 and 6; these are gradient years 1 and 2.
Pg is located in gradient year 0, which is actual year 4
Pg = 7000{1-[(1+0.12)/(1+0.15)]9/(0.15-0.12)} = $49,401
Move Pg and other cash flows to year 0 to calculate PT
PT = 35,000 + 7000(P/A,15%,4) + 49,401(P/F,15%,4) = $83,232
 Summary of Important Points

P for shifted uniform series is one period ahead of first A;

n is equal to number of A values

F for shifted uniform series is in same period as last A;

n is equal to number of A values

For gradients, first change equal to G or g occurs

between gradient years 1 and 2

For negative arithmetic gradients, change sign on G from + to -

For negative geometric gradients, change sign on g from + to -

 Thank You

Any Questions?
Email: Muhammad.ullah@giki.edu.pk
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin [ISBN-10: 0073376302]
and accompanying PowerPoint slides

• Videos from Dragon’s Den are copy righted. We are using it only for educational
purposes.

21
Engineering Economics & Management
(MS490)
Chapter 4
Nominal and Effective Interest Rates

Muhammad Ullah
Assistant Professor
Department of Management Sciences GIKI
Recap
• Single-Payment
𝑛
𝐹 =𝑃 1+𝑖 [Compounding]
𝑃 =𝐹 1+𝑖 −𝑛
[Discounting] 1 1+𝑖 𝑛−1
𝐹𝐺 = 𝐺 −𝑛
𝑖 𝑖
• Uniform Series /Annuities
𝟏+𝒈 𝒏
𝟏−
1+𝑖 𝑛 −1 𝑖 1+𝑖 𝑛 𝟏+𝒊
𝑃=𝐴 and A = 𝑃 𝑷𝒈 = 𝑨𝟏
𝑖 1+𝑖 𝑛 1+𝑖 𝑛 −1 𝒊−𝒈
𝑨𝟏 𝒏
𝑖 If 𝒈 = 𝒊, 𝑷𝒈 = 𝟏+𝒊
𝐴=𝐹 1+𝑖 𝑛 −1
----- sinking fund factor

1+𝑖 𝑛 −1
𝐹=𝐴 ----- Uniform Series Compound Amount Factor
𝑖
Nominal and effective interest rates
• We learned that the primary difference between simple interest and
compound interest is that compound interest includes interest on the
interest earned in the previous period, while simple interest does not.
• Here we discuss nominal and effective interest rates, which have the
same basic relationship.
• The concepts of nominal and effective must be used when interest is
compounded more than once each year.

3
Nominal interest rates
• A nominal interest rate r is an interest rate that does not
account for compounding.
By definition:
r = interest rate per time period x number of periods

4
 Nominal interest rates
• A nominal rate may be calculated for any time period longer than the time
period stated.
For example, the interest rate of 1.5% per month is the same as each of the
following nominal rates.

These nominal rates are calculated in the same way that simple rates, that is, interest
rate times number of periods. 5
Compounding period (CP)
• After the nominal rate has been calculated, the compounding period
(CP) must be included in the interest rate statement.
• As an illustration, consider the nominal rate of 1.5% per month.
– If we define the CP as 1 month, the nominal rate statement is 18% per year,
compounded monthly, or 4.5% per quarter, compounded monthly.

• Now we can consider an effective interest rate

6
Effective interest rate
• An effective interest rate i is a rate wherein the compounding of
interest is taken into account.
• Effective rates are commonly expressed on an annual basis as an effective
annual rate; however, any time basis may be used.
• Interest rate statement:
– 10% per year, compounded monthly, or 12% per year, compounded weekly.
– If the CP is not mentioned, it is understood to be the same as the time
period mentioned with the interest rate.
o For example, an interest rate of “1.5% per month” means that interest is
compounded each month; that is, CP is 1 month

7
Effective Interest Rate per CP (Periodic Interest Rate)
𝑟 % 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡 𝑟
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝐶𝑃 = =
𝑚 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑝𝑒𝑟 𝑡 𝑚

Example: Assume 𝑟 = 9% per year, compounded monthly. Then;

𝑚 = 12
9%
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒𝑝𝑒𝑟 𝐶𝑃 = = 0.75% per month compounded monthly.
12
 Effective Annual Interest Rate

Suppose 𝒊𝒂 represent the Effective Annual Interest

Rate.
𝐹 = 𝑃 + 𝑃 × 𝑖𝑎 = 𝑃 1 + 𝑖𝑎 -----(1)

Assume 𝑃 = 1
𝐹 = (1 + 𝑖𝑎 )

We also know that;

𝐹 = 1+𝑖 𝑚
 1 + 𝑖𝑎 = 1 + 𝑖 𝑚

𝑖𝑎 = 1 + 𝑖 𝑚 −1

Similarly 𝑖 = 1 + 𝑖𝑎 1/𝑚 −1

Where 𝑖 is the effective interest rate per

compounding period.
 Example # 1
For a nominal interest rate of 12% per year, determine the
nominal and effective rates per year for (a) quarterly, and (b) Nominal rates are converted
monthly compounding into effective annual rates via
Solution: the equation:
(a)
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 12% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 𝑖𝑎 = 1 + 𝑖 𝑚 −1
12
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟 = = 3.0% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
4

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝑖𝑎 = 1 + 𝑖 𝑚

− 1 = 1 + 0.03 4
− 1 = 12.55% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
𝑖𝑎 = effective annual interest
rate
(b) 𝑖 = effective rate for one
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 12% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
compounding period
12 𝑚 = number times interest is
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ = = 1.0% 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ
12 compounded per year
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 𝑖𝑎 = 1 + 𝑖 𝑚 − 1 = 1 + 0.01 12 − 1 = 12.68% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
 Example # 2

For an interest rate of 1.2% per month, determine the Nominal rates can be converted
nominal and effective rates (a) per quarter, and (b) per year into effective rates
Solution: for any time period via the
(a)
following equation:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟 𝑝𝑒𝑟 𝑞𝑢𝑎𝑡𝑒𝑟 = 1.2% × 3 = 3.6% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
𝑚
𝑖 = 1 + 𝑟/𝑚 −1
3
𝑚
0.036
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟 = 1 + 𝑟/𝑚 −1= 1+ −1
3
= 3.64% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
𝑖 = effective annual interest
rate for any period
(b) 𝑟 = nominal rate for the same
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑟 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 1.2% × 12 = 14.4% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 period as 𝑖
𝑚 = number times interest is
12
𝑚
0.144 compounded in period specified
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑖 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟 = 1 + 𝑟/𝑚 −1= 1+ −1
12
for 𝑖
= 15.39% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
Problem # 4.10
The Second National Bank of Fullertum advertises an APR of 14%
compounded monthly for student loans. Determine the APY.
Solution:
APR: Annual Percentage Rate => it is Nominal Rate
APY: Annual Percentage Yield => it is Effective Rate
12
0.14
𝑖 = 1 + − 1 = 14.93% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
12

13
Problem # 4.11
For an effective annual rate 𝑖𝑎 of 15.87% compounded quarterly, determine;
(a) the effective quarterly rate and
(b) the nominal annual rate.
Solution:
(a) Use Equation [4.4]: 𝑖 = 1 + 𝑖𝑎 1/𝑚 −1
1
𝑖 = 1 + 0.1587 4 –1
= 0.0375 𝑜𝑟 3.75% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
(b) 𝑟 = 0.0375 × 4 = 15% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
14
 Thank You

Any Questions?
Email: muhammad.ullah@giki.edu.pk