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ENGINEERING ECONOMY (GE401) CHAPTER 2 Factors: How Time and Interest Affect Money Foundations: Overview 1. 2. 3. 4. 5. 6. 7. 8.

F/P and P/F Factors P/A and A/P Factors F/A and A/F Factors Interpolate Factor Values P/G and A/G Factors Geometric Gradient Calculate i Calculate n

F/P and P/F Factors Basic Derivations: F/P factor F/P Factor To find F given P

Derivation by Recursion: F/P factor F1 = P(1+i) F2 = F1 (1+i)..but: F2 = P(1+i)(1+i) = P(1+i)2 F3 =F2(1+i) =P(1+i) 2 (1+i) = P(1+i) 3 In general: Fn = P(1+i)n Fn = P(F/P,i%,n) Present Worth Factor from F/P Since Fn = P(1+i)n We solve for P in terms of FN P = F{ 1/ (1+i)n} = F(1+i)-n Thus: P = F(P/F,i%,n) where

(P/F,i%,n) = (1+i)-n Thus, the two factors are: 1. F = P(1+i)n finds the future worth of P; 2. P = F(1+i)-n finds the present worth from F P/F factordiscounting back in time Discounting back from the future

Example- F/P Analysis Example: P= 1,000; n=3; i=10% What is the future value, F?

Example P/F Analysis Assume F = $100,000, 9 years from now. What is the present worth of this amount nowif i =15%?

P/A and A/P Factors Uniform Series Present Worth and Capital Recovery Factors Annuity Cash Flow

Uniform Series Present Worth and Capital Recovery Factors Desire an expression for the present worth P of a stream of equal, end of period cash flows A

Uniform Series Present Worth and Capital Recovery Factors Write a Present worth expression

Uniform Series Present Worth and Capital Recovery Factors The second equation

Uniform Series Present Worth and Capital Recovery Factors Setting up the subtraction

Uniform Series Present Worth and Capital Recovery Factors Simplifying Eq. [3] further

Uniform Series Present Worth and Capital Recovery Factors This expression will convert an annuity cash flow to an equivalent present worth amount one period to the left of the first annuity cash flow.

Capital Recovery Factor A/P, i%, n

F/A and A/F Factors F/A and A/F Derivations

Sinking Fund and Series Compound amount factors (A/F and F/A)

A/F Factor

F/A factor from the A/F Factor

F/A and A/F Derivations

Example: Formosa Plastics has major fabrication plants in Riyadh and in Jaddh. It is desired to know the future worth of $1,000,000 invested at the end of each year for 8 years, starting one year from now. The interest rate is assumed to be 14% per year. Sol. Example: A = $1,000,000/yr; n = 8 yrs, i = 14%/yr F8 = ??

Solution of Example

The cash flow diagram shows the annual payments starting at the end of year 1 and ending in the year the future worth is desired. Cash flows are indicated in $1000 units. The F value in 8 years is F = l000(F/A,14%,8) = 1000(13.23218) = $13,232.80 = 13.232 million 8 years from now.

Example: How much money must Carol deposit every year starting, l year from now at 5.5% per year in order to accumulate $6000 seven years from now?

Solution of Example The cash How diagram from Carol's perspective fits the A/F factor. A= $6000 (A/F,5.5%,7) =6000(0.12096) = $725.76 per year The A/F factor Value 0f 0.12096 was computed using the A/F factor formula

Interpolation in Interest Tables Interpolation of Factors All texts on Engineering economy will provide tabulated values of the various interest factors usually at the end of the text in an appendix Refer to the back of your text for those tables. Interpolation of Factors Typical Format for Tabulated Interest Tables

Interpolation (Estimation Process) At times, a set of interest tables may not have the exact interest factor needed for an analysis One may be forced to interpolate between two tabulated values Linear Interpolation is not exact because: The functional relationships of the interest factors are non-linear functions Hence from 2-5% error may be present with interpolation. An Example Assume you need the value of the A/P factor for i = 7.3% and n = 10 years. 7.3% is most likely not a tabulated value in most interest tables So, one must work with i = 7% and i = 8% for n fixed at 10 Proceed as follows Basic Setup for Interpolation Work with the following basic relationships

i = 7.3% using the A/P factor For 7% we would observe: COMPOUND PRESENT SINKING COMPOUND CAPITAL IN AMT. FACTOR WORTH FUND AMOUNT RECOVERY F/P P/F A/F F/A A/P 10 1.9672 0.5083 0.0724 13.8164 0.14238

i = 7.3% using the A/P factor For i = 8% we observe: COMPOUND PRESENT SINKING COMPOUND CAPITAL N AMT. FACTOR WORTH FUND AMOUNT RECOVERY F/P P/F A/F F/A A/P 10 2.1589 0.4632 0.0690 14.4866 0.14903

Estimating for i = 7.3% Form the following relationships

Final Estimated Factor Value Observe for i increasing from 7% to 8% the A/P factors also increases. One then adds the estimated increment to the 7% known value to yield:

The Exact Value for 7.3% Using a previously programmed spreadsheet model the exact value for 7.3% is:

P/G and A/G Factors Arithmetic Gradient Factors In applications, the annuity cash flow pattern is not the only type of pattern encountered Two other types of end of period patterns are common The Linear or arithmetic gradient The geometric (% per period) gradient This section presents the Arithmetic Gradient Arithmetic Gradient Factors An arithmetic (linear) Gradient is a cash flow series that either increases or decreases by a constant amount over n time periods. A linear gradient is always comprised of TWO components: Arithmetic Gradient Factors

The The The The

Two Components are: Gradient component base annuity component objective is to find a closed form expression for the

Present Worth of an arithmetic gradient Linear Gradient Example

Example: Linear Gradient Typical Negative, Increasing Gradient: G=$50

Example: Linear Gradient Desire to find the Present Worth of this cash flow

Arithmetic Gradient Factors The G amount is the constant arithmetic change from one time period to the next. The G amount may be positive or negative! The present worth point is always one time period to the left of the first cash flow in the series or, Two periods to the left of the first gradient cash flow!

Derivation: Gradient Component Only Focus Only on the gradient Component

Present Worth Point

The Present worth point of a linear gradient is always: 2 periods to the left of the 1G point or, 1 period to the left of the very first cash flow in the gradient series. DO NOT FORGET THIS! Present Worth Point

Gradient Component

Present Worth Point PW of the Base Annuity is at t = 0 PWBASE Annuity=$100(P/A,i%,7)

Present Worth: Linear Gradient

The present worth of a linear gradient is the present worth of the two components: 1. The Present Worth of the Gradient Component and, 2. The Present Worth of the Base Annuity flow Requires 2 separate calculations! Present Worth: Gradient Component The PW of the Base Annuity is simply the Base Annuity A{P/A, i%, n} factor What is needed is a present worth expression for the gradient component cash flow. We need to derive a closed form expression for the gradient component. Present Worth: Gradient Component General CF Diagram Gradient Part Only

To Begin- Derivation of P/G,i%,n

Next Step: Factor out G and re-write as .. Factoring G out. P/G factor

What is inside of the { }s? Replace (P/Fs) with closed-form

Multiply both sides by (1+i) Mult. Both Sides By (n+1)..

We have 2 equations [1] and [2]. Next, subtract [1] from [2] and work with the resultant equation. Subtracting [1] from [2]..

The P/G factor for i and N

Extension The A/G factor Some authors also include the derivation of the A/G factor. A/G converts a linear gradient to an equivalent annuity cash flow. Remember, at this point one is only working with gradient component There still remains the annuity component that you must also handle separately! The A/G Factor Convert G to an equivalent A

How to do it A/G factor using A/P with P/G

The results follow.. Resultant A/G factor

Gradient Example Consider the following cash flow

Gradient Example- Base Annuity First, The Base Annuity of $100/period

PW(10%) of the base annuity = $100(P/A,10%,5) PWBase = $100(3.7908)= $379.08 Not Finished: We need the PW of the gradient component and then add that value to the $379.08 amount Focus on the Gradient Component

We desire the PW of the Gradient Component at t = 0

The Set Up

PW of the Gradient Component

Calculating or looking up the P/G,10%,5 factor yields the following: Pt=0 = $100(6.8618) = $686.18 for the gradient PW

Gradient Example: Final Result PW(10%)Base Annuity = $379.08 PW(10%)Gradient Component = $686.18 Total PW(10%) = $379.08 + $686.18 Equals $1065.26 Note: The two sums occur at t =0 and can be added together concept of equivalence Example Summarized This Cash Flow

Shifted Gradient Example: i =10% Consider the following Cash Flow

Shifted Gradient Example Consider the following Cash Flow

1. This is a shifted negative, decreasing gradient. 2. The PW point in time is at t = 3 (not t = o) Shifted Gradient Example

Consider the following Cash Flow

The base annuity is a $600 cash flow for 3 time periods Shifted Gradient Example: Base Annuity PW of the Base Annuity: 2 Steps

Shifted Gradient Example: Gradient PW of Gradient Component: G = -$50

Geometric Gradient Geometric Gradients An arithmetic (linear) gradient changes by a fixed dollar amount each time period.

A GEOMETRIC gradient changes by a fixed percentage each time period. We define a UNIFORM RATE OF CHANGE (%) for each time period Define g as the constant rate of change in decimal form by which amounts increase or decrease from one period to the next Geometric Gradients: Increasing Typical Geometric Gradient Profile Let A1 = the first cash flow in the series

Geometric Gradients: Decreasing Typical Geometric Gradient Profile Let A1 = the first cash flow in the series

Geometric Gradients: Derivation First Major Point to Remember: A1 does NOT define a Base Annuity; There is no BASE ANNUITY for a Geometric Gradient! The objective is to determine the Present Worth one period to the left of the A1 cash flow point in time Remember: The PW point in time is one period to the left of the first cash flow A1! Geometric Gradients: Derivation For a Geometric Gradient the following parameters are required: The interest rate per period i The constant rate of change g No. of time periods n The starting cash flow A1 Geometric Gradients: Starting

Pg = The Ajs time the respective (P/F,i,j) factor Write a general present worth relationship to find Pg.

Now, factor out the A1 value and rewrite as.. Geometric Gradients

Subtract (1) from (2) and the result is.. Geometric Gradients

Geometric Gradient P/A factor

This is the (P/A,g,i,n) factor and is valid if g is not equal to i. Geometric Gradient P/A factor Note: If g = i we have a division by 0 undefined. For g = i we can derive the closed form PW factor for this special case. We substitute i for g into the Pg relationship to yield: Geometric Gradient: i = g Case

Geometric Gradients: Summary

Geometric Gradient: Notes The geometric gradient requires knowledge of: A1, i, n, and g There exist an infinite number of combinations for i, n, and g: Hence one will not find tabulated tables for the (P/A,g,i,n) factor.

Geometric Gradient: Notes You have to calculated either from the closed form for each problem or apply a pre-programmed spreadsheet model to find the needed factor value No spreadsheet built-in function for this factor! Geometric Gradient: Example Assume maintenance costs for a particular activity will be $1700 one year from now. Assume an annual increase of 11% per year over a 6-year time period. Geometric Gradient: Example If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0. First, draw a cash flow diagram to represent the model. Geometric Gradient Example (+g) g = +11% per period; A1 = $1700; i = 8%/yr

Solution P = $1700(P/A,11%,8%,7) Need to calculate the P/A factor from the closed-form expression for a geometric gradient. From a spreadsheet we see:

Geometric Gradient ( -g ) Consider the following problem with a negative growth rate g.

We simply apply a g value = -0.10 Geometric Gradient (-g value)

Determination of an Unknown Interest Rate When the i rate is unknown A class of problems may deal with all of the parameters know except the interest rate. For many application-type problems, this can become a difficult task Termed, rate of return analysis In some cases: i can easily be determined In others, trial and error must be used

Example: i unknown Assume on can invest $3000 now in a venture in anticipation of gaining $5,000 in five (5) years. If these amounts are accurate, what interest rate equates these two cash flows?

Example: i unknown The Cash Flow Diagram is

Example: i unknown

For i unknown In general, solving for i in a time value formulation is not straight forward. More often, one will have to resort to some form of trial and error approach as will be shown in future sections. A sample spreadsheet model for this problem follows.

Example of the IRR function

Determination of Unknown Number of Years Unknown Number of Years Some problems require knowing the number of time periods required given the other parameters Example: How long will it take for $1,000 to double in value if the discount rate is 5% per year? Draw the cash flow diagram as. Unknown Number of Years

i = 5%/year; n is unknown! Unknown Number of Years Solving we have..

Fn=? = 1000(F/P,5%,x):

2000 = 1000(1.05)x Solve for x in closed form Unknown Number of Years Solving we have.. (1.05)x = 2000/1000 Xln(1.05) =ln(2.000) X = ln(1.05)/ln(2.000) X = 0.6931/0.0488 = 14.2057 yrs With discrete compounding it will take 15 years to a mass $2,000 (have a little more that $2,000) No. of Years NPER function From Excel one can formulate as:

Chapter Summary This chapter presents the fundamental time value of money relationships common to most engineering economic analysis calculations Derivations have been presented for: Present and Future Worth- P/F and F/P Annuity Cash flows P/A, A/P, F/A and A/F Gradients P/G, A,G and P/A,g,i,n One must master these basic time value of money relationships in order to proceed with more meaningful analysis that can impact decision making. These relationships are important to you professionally and in your personal lives.

Master these concepts!!!

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