Global Engineering Economics

Chapter 3
Cash Flow Analysis

3-1
 Outline

3.1 Introduction
3.2 Timing of Cash Flows and Modelling
3.3 Compound Interest Factors for Discrete Compounding
3.4 Compound Interest Factors for Single Disbursements or
Receipts
3.5 Compound Interest Factors for Annuities
3.6 Compound Interest Factors for Arithmetic Gradient Series
3.7 Compound Interest Factors for Geometric Gradient Series
3.8 Non-standard Annuities and Gradients
3.9 Present Worth Computations when N → 

3-2
 Practice Problem 3-1

• How much money will be in a bank account at the

end of 2 years if £5000 is deposited today? The
interest rate is 12% compounded monthly.

Answer
F = P(F/P, i, N)
= 5000(F/P, 12%/12, 24) = 5000(F/P, 0.01, 24)
= 5000(1 + 0.01)24
= £6348.67

3-3
 Practice Problem 3-2(a)

• What amount deposited today into an account

bearing 12% nominal interest will give £5000 at the
end of two years? Interest is compounded monthly.

Answer
1
P  F (P / F ,1%,24)  5000  3937.83
24
(1  0.01)

3-4
 Practice Problem 3-2(b)

• (With interest tables) What amount deposited today into an

account bearing 12% nominal interest will yield £5000 at the
end of two years? Interest is compounded monthly.

Answer
From table: (P/F,1%,24) = 0.78757
P = F (P/F, 1%, 24)
= £5000(0.78757)
= £3937.85

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 Practice Problem 3-3

• You want to save £20 000 for a new car over the time
you are at university (5 years) by saving the same
amount A each month. You can get 7% compounded
monthly. What should you save each month?

Answer
i = 0.07/12 (= 0.00583 or 0.583%), N = 5  12 = 60
A = F(A/F, 0.583%, 60) = £20 000(0.01397) =
£279.40

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 Practice Problem 3-4

• A Ford Mustang costs £17 000. It can be financed at

5.9% for 48 months, with monthly compounding. How
much will the monthly payments be?

Answer
i = 0.059/12 = 0.00492 per month
A = P(A/P, i, N) = £17 000(A/P, 0.00492, 48) =
£398.50

3-7
 Practice Problem 3-5

• What is the present worth of a series of 15 annual

payments of £1000 each, when the first payment is
now and the interest rate is 5%, compounded yearly?
• This is an example of an annuity due  the
payments of an annuity are made at the start of each
period rather than at the end.

3-8
 Practice Problem 3-5

• Method 1: Count the first payment as a present

worth and the next 14 payments as a regular
annuity:
P = 1000 + A(P/A, i, N) where
A = 1000, i = 5% and N = 14
P = 1000 + 1000(P/A, 5%, 14)
= 1000 + 1000(9.8986) = 1000 + 9898.6
= £10,898.60

3-9
 Practice Problem 3-5

• Method 2: Determine the

present worth of a standard P1  A( P / A, i, N ) = 1000(P/A,5%,15)
annuity at time 1 and then = 1000(10.380)
find its worth at time 0
(now). The worth at time 1 = 10,380
is:

P0  P1 (F/P, i, N )
• Then the present worth now
(time 0) is:  10 380(F/P,5%,1)  10 380 (1.05)
 10, 899

3 - 10
 Practice Problem 3-6

• What is the present worth of a series of 15 annual

payments of £1000 each, when the first payment is
now and the interest rate is 5%, compounded
monthly?

Answer
The method is as in the previous example, except an effective
annual interest rate must be calculated (Method 2):
i e  (1  0.05 / 12)12  1 = 0.05116
P = 1000 + 1000(P/A, 5.116%, 14)
= 1000 + 1000 (9.82563) = £10,826

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 Practice Problem 3-7

• A new machine costing £8000 will reduce

annual production costs by £2100. The
machine will operate for 5 years, at which
time it will have no resale value. What rate
of return is being earned on this investment?
Restated: For what interest rate will a cash
flow of £2100 per year for 5 years be
equivalent to a present amount of £8000?

3 - 12
 Practice Problem 3-7, cont’d

Answer
Find i in: 2100(P/A, i, 5) = 8000
(P/A, i, 5) = P/A = 8000/2100 = 3.8095
where:
(1  i )N  1
(P / A, i , N ) 
i (1  i )N

which is not easy to solve for i.

3 - 13
 Practice Problem 3-7, cont’d

Answer (cont’d)
Compound interest factor tables may not be available
for all combinations of i and N
From before: (P/A, i, 5) = 3.8095
From tables: (P/A, 10%, 5) = 3.7908
(P/A, 9%, 5) = 3.8897
The interest rate we are looking for must be between
9% and 10%.

3 - 14
 Practice Problem 3-7, cont’d

Answer (cont’d)
(P/A, 10%, 5) = 3.7908  (x1, y1) = (0.10, 3.7908)
(P/A, 9%, 5) = 3.8897  (x2, y2) = (0.09, 3.8897)

Want to find i: (x*, y*) = (i, 3.8095)

3 - 15
 Practice Problem 3-7, cont’d

Answer (cont’d)
By interpolation…
 y *  y1 
x*  x1  ( x2  x1 ) 
 y2  y1 
 3.8095  3.7908 
 0.10  (0.09  0.10) 
 3.8897  3.7908 
 0.09811
 9. 8%

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Figure 3.3 Linear Interpolation

3 - 17
 Practice Problem 3-8

• A lottery prize pays £1000 at the end of the first year,

£2000 the second, £3000 the third, etc., for 20
years. If there is only one prize in the lottery, 10 000
tickets are sold, and you can invest your money
elsewhere at 15% interest, how much is each ticket
worth, on average?

3 - 18
 Practice Problem 3-8, cont’d

Answer
Method 1: First find annuity value of prize and
then find present value of annuity.
Method 2: Find P–1 with A' = 0, G = 1000 and N
= 21. Then find P0.

3 - 19
 Practice Problem 3-8, cont’d

Answer
Method 1
A' = 1000, G = 1000, i = 0.15, N = 20
A = A' + G(A/G, i, N) = 1000 + 1000(A/G, 15%, 20)
= 1000 + 1000(5.3651) = 6365.10
Now find present value of annuity:
P = A (P/A, i, N) where A = 6365.10, i = 15%, N = 20
P = 6365.10(P/A, 15, 20)
= 6365.10(6.2593) = 39,841.07

Since 10,000 tickets are to be sold, on average each ticket is worth

(39 841.07)/10,000 = £3.98.

3 - 20
 Practice Problem 3-8, cont’d

Answer
Method 2
Find P1 with A' = 0, G = 1000 and N = 21.

Then find P0.

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 Practice Problem 3-9

• Suppose that the salary of an engineer during the coming year

is expected to be £128 000. It is expected to increase by 12%
per year over the following four years, when she would retire
and receive a pension. She has just been in a bad accident
and will be unable to work again, so a judge is estimating the
lump sum amount that the insurance company must pay to the
engineer now in order to replace her salary. The interest rate
is taken to be 10%, compounded yearly, during this period.
What is the present worth now of the earnings over the next
five years?

3 - 22
 Practice Problem 3-9, cont’d

Answer
N = 5, g = 0.12, i = 0.10, A = 128 000
Find the growth adjusted interest rate:

P = A(P/A, g, i, N) = 128 000(4.7138) = £603,366

The present worth of the next five year’s salary is
£603,366.

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 Practice Problem 3-10

• A £500,000 gift was bequeathed to a city for the

construction and continued maintenance of a small
music hall. Annual maintenance for a hall is
estimated at £15,000.
• In addition, £25,000 will be needed every 10 years
for painting and major repairs.
• How much will be left for the initial construction costs
after funds are allocated for continuous upkeep?
Interest is 6% per annum.

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 Practice Problem 3-10, cont’d

Answer
Amount left = £500 000  (capitalized cost of perpetual
upkeep) = £500 000  A/i
where A = annual disbursement
A = 15,000 + 25,000(A/F, 6%, 10) = 15,000 + 25 000(0.07587)
= 16,896.75
Amount left = 500,000  (16,896.75)/0.06 = £218 387.50
The amount left for constructing the hall is £218 388.

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 Practice Problem 3-11

• A supplier of laboratory equipment is looking at a

mobile demonstration unit which will cost £71 000. It
will have a useful life of 5 years and the salvage
value at that time is estimated at £8000.
a) If the cost of capital is 15% per year, what are the
equivalent annual costs (i.e., the annual capital recovery
costs) of purchasing the equipment?
b) If the mobile demonstration unit is estimated to produce
extra profits of £23 000 per year, is it economically justified?

3 - 26
 Practice Problem 3-11

Answer
a) A = (P − S)(A/P, i, N) + Si
= (71 000 − 8000)(A/P, 15%, 5) + 8000(0.15)
= 63 000(0.29832) + 1200 = £19 994

The equivalent annual costs (capital recovery costs) are £19 994.

b) Since the savings per year exceed the equivalent annual costs,
the purchase is justified.

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