Engineering Economy Umak: Time Value of Money

Engineering Economy
UMAK
Time Value of Money

Arithmetic Gradient Series
1
Arithmetic (Linear) Gradient Series
 An arithmetic gradient is a cash flow series that either
increases or decreases by a constant amount
 The cash flow, whether income or disbursement, changes

by the same arithmetic amount each period
 The amount of the increase or decrease is the gradient (G)
 For example, if an engineer predicts that the cost of

maintaining a machine will increase by $500 per year until
the machine is retired, a gradient series is involved and the
amount of the gradient is $500
2
 The diagram is of an arithmetic gradient series with a base

amount of $1,500 and a gradient of $50
 The origin of the series is at the end of the first period
 G is the constant arithmetic change in the magnitude of receipts

or disbursements from one time period to the next
3
Strict Linear Gradient Series
 The strict linear gradient series has the origin at the end
of the first period with a zero value
 The gradient G can be either positive or negative. If G >

0, the series is referred to as an increasing gradient
series. If G < 0, it is a decreasing gradient series
4
Example
 A company expects a revenue of $80,000 in fees next
year. Fees are expected to increase uniformly to a level
of $200,000 in nine years
 Determine the arithmetic gradient and construct the

cash flow diagram
5
Example
 The cash flow in year n (CFn) may be calculated as:
CFn = base amount + (n-1)G
 The base amount (generally A1) is $80,000 and the total
revenue increase in 9 years = 200,000 – 80,000 = 120,000
 G = increase/(n-1) = 120,000/(9-1) = $15,000
6
Analysis
Three factors will be considered for arithmetic gradient strict
series:
 P/G factor for present worth: G(P/G,i,n)
Convert an arithmetic gradient G (without the base amount)
for n years into a present worth at year 0
 A/G factor for annual series: G(A/G,i,n)

for n years into an equivalent uniform series of A value
 F/G factor for future worth: G(F/G,i,n)

for n years into an equivalent future value at year n
7
Present Worth Factor – P/G Factor
The Present worth factor (P/G) can be expressed in the
following form:
gradient series
P = G(P/G,i,n) present-worth factor
8
Present Worth Factor – Example
 A textile mill has just purchased a lift truck that has a useful
life of five years. The engineer estimates that maintenance
costs for the truck during the first year will be $1,000
 As the truck ages, maintenance costs are expected to

increase at a rate of $250 per year over the remaining life
 Assume that the maintenance costs occur at the end of

each year. The firm wants to set up a maintenance account
that earns 12% annual interest. All future maintenance
expenses will be paid out of this account. How much does
the firm have to deposit in the account now?
9
The idea here is to have

a strict gradient series
10
 We have: A1=$1,000; G=$250; i=12%; and n=5 years.
Find P
 The cash flow can be broken into two components where

the first is an equal uniform payment series (A1) and the
second is a strict linear gradient series (G)
 P = P1 + P2
P = A1(P/A,12%,5) + G(P/G,12%,5) =
$1,000(3.6048) + $250(6.397) = $5,204
11
Annual Series Factor – A/G Factor
The equivalent uniform annual series (A value) for an
arithmetic gradient G is found by the following formula:
A = G(A/G,i,n) 
Arithmetic-gradient
uniform-series factor
12
Annual Series Factor – Example
 You want to deposit $1,000 in your saving account at the
end of the first year and increase this amount by $300
for each of the next five years
 Then what should be the size of an annual uniform

deposit that yields an equal balance with the above by
the end of six years if the interest rate is 10%?
13
14
 We have: A1=$1,000; G=$300; i=10%, and n=6. Find A
 We have to separate the constant portion of $1,000 from

the series leaving the gradient series of 0; 0; 300; 600;
….; 1,500
 To find the equal payment series beginning at the end of

year 1 and ending at year 6 we consider:
A = $1,000 + $300(A/G,10%,6) =
$1,000 + $300(2.2236) = $1,667.08
15
An alternative way
to solve this
question is by finding
the present worth of
all the payments and
then to convert P to
a uniform series of A
16
Future Worth Factor – F/G Factor
The future worth factor (F/G) can be expressed in the
following form:
F = G(F/G,i,n)
Arithmetic-gradient
future worth factor
17
Future Worth Factor – Example
 Suppose that you make a series of annual deposits into a
bank account that pays 10% interest. The initial deposit
at the end of the first year is $1,200
 The deposit amounts decline by $200 in each of the next

four years
 How much would you have immediately after the fifth

deposit?
18
Future Worth Factor – Example
F = F1 – F2
F = A1(F/A,10%,5) – $200(F/G,10%,5) =
$1,200(6.105) – $200(11.051) = $5,115
19
Seatwork:
1. A construction firm is considering the purchase of
an air compressor.
The compressor has the following expected end of

year maintenance costs:
Year 1 $800
Year 2 $800
Year 3 $900
Year 4 $1000
Year 5 $1100
Year 6 $1200
Year 7 $1300
Year 8 $1400
What is the present equivalent maintenance cost if the

interest rate is 12% per year compounded annually?
20
Seatwork:
2. A young couple has decided to make advance plans for financing
their 3 year old daughter’s college education. Money can be
deposited at 8% per year, compounded annually.
What annual deposit on each birthday, from the 4th to the 17th
(inclusive), must be made to provide $7,000 on each birthday from
the 18th to the 21st (inclusive)?
3. You borrowed $10,000 from a local bank w/ the agreement that you
will pay back the loan according to a graduated payment plan. If your
first payment is set at $1,500.What would the remaining payment
look like at a borrowing rate of 10%.
21
Problem 1 – Alt Soln 1
GIVEN:
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
FIND P: P = PA + PG + PF = A(P/A,i,n) + G(P/G,i,n) + F(P/F,i,n)
= $700(P/A,12%,8) + $100(P/G,12%,8) + $100(P/F,12%,1)
DIAGRAM: = $700(4.9676) + $100(14.4715) + $100(0.8929) = $5014
P? PA ?
1 2 3 4 1 2 3 4
n=8 n=8
0 $700 0 PF ?
$700 n=1
PG ?
$100 $100 $200 0
$300 $700 1 2 3 4 $100
n=8
0
$100 $200
NOTE: CAN BREAK INTO 3 CASH FLOWS: $300 $700
ANNUAL, LINEAR GRADIENT, AND FUTURE
22
Problem 1 – Alt Soln 2
GIVEN:
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
FIND P: P = PA + PG(PPG) = A(P/A,i,n) + G(P/G,i,n-1)(P/F,i,1)
= $800(P/A,12%,8) + $100(P/G,12%,7)(P/F,12%,1)
DIAGRAM: = $800(4.9676) + $100(11.6443)(0.8929) = $5014
P? PA ?
1 2 3 4 1 2 3 4
n=8 n=8
0 0
$800 $800
$100 $200 PPG ? PG ?

0 1 2 3
$600 n=7
0 1
NOTE: PG MUST BE OFFSET ONE YEAR – SO PG ? $100 $200
BRING THE OFFSET YEAR BACK TO TIME
$600
ZERO
23
Problem 2
A young couple has decided to make advance plans for
financing their 3 year old daughter’s college education.
Money can be deposited at 8% per year, compounded
annually.
What annual deposit on each birthday, from the 4th to the
17th (inclusive), must be made to provide $7,000 on each
birthday from the 18th to the 21st (inclusive)?
DIAGRAM: GIVEN:
$7 000 WITHDRAWALS18-21 = $7
000
4 17 i = 8%/YR, CPD YEARLY
FIND A4-17:
0 18 21 yrs
P17 = A(F/A,i,n) = A(P/A,i,n)
A?
= A(F/A,8%,14) = 7 000(P/A,8%,4)
STRATEGY: CAN BREAK INTO 2 CASH FLOWS,
SO PICK A CONVENIENT POINT IN TIME AND SET = A(24.2149) = 7 000(3.3121)
DEPOSITS EQUAL TO WITHDRAWALS…
 A = $957
24
Problem 3:
Since the loan payment series consists of two parts –(1) a
$1,500 equal-payment series and (2) a strict gradient series
(unknown,yet to be determined),calculate the present value
of each series and equate them with $10,000
$10,000= $1,500(P/A,10%,5) + G(P/G,10%,5)

= $5,686.18+6.8618G
6.8618G= $4,313.82
G= $628.67
1 2 3 4 5
0
$1,500
G
2G
3G
4G
25
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Engineering Economy

Time Value of Money

 The cash flow, whether income or disbursement, changes

 The amount of the increase or decrease is the gradient (G)

 For example, if an engineer predicts that the cost of

 The diagram is of an arithmetic gradient series with a base

 The origin of the series is at the end of the first period

 G is the constant arithmetic change in the magnitude of receipts

 The gradient G can be either positive or negative. If G >

 Determine the arithmetic gradient and construct the

 G = increase/(n-1) = 120,000/(9-1) = $15,000

 A/G factor for annual series: G(A/G,i,n)

 F/G factor for future worth: G(F/G,i,n)

 As the truck ages, maintenance costs are expected to

 Assume that the maintenance costs occur at the end of

The idea here is to have

 The cash flow can be broken into two components where

 Then what should be the size of an annual uniform

 We have to separate the constant portion of $1,000 from

 To find the equal payment series beginning at the end of

 The deposit amounts decline by $200 in each of the next

 How much would you have immediately after the fifth

The compressor has the following expected end of

What is the present equivalent maintenance cost if the

$100 $200 PPG ? PG ?

$10,000= $1,500(P/A,10%,5) + G(P/G,10%,5)

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