Solving Typical FE Problems

What to do:

Find P or F from Single Amounts

How to do it:
The simplest problems to solve in engineering
economic analysis are those which involve finding
the value of a single amount of money at an earlier
or later date than that which is given. Such
problems involve finding the future worth (F) of a
specified present amount (P), or vice versa. These
problems involve using the equations:
F = P(1 + i)n or P = F[1/ (1 + i)n]
In terms of standard factor notation, the equation
on the left is represented as F=P(F/P,i,n) and the
equation on the right is represented as P =
F(P/F,i,n).

Example: #1: A person deposits $5,000 into a

money market account which pays interest at a rate
of 8% per year. The amount that would be in the
account at the end of ten years is most nearly:
a.

$2,792

b.

$9,000

c.

$10,795

d.

$12,165

Solution: The $5,000 represents a present amount,

P. The future amount, F, is

Example #2: A small company wants to deposit a

single amount of money now so that it will have
enough to purchase a new truck costing $50,000
five years from now. If the money can be deposited
into an account which earns interest at 10% per
year, the amount that must be deposited is most

nearly
a.

$10,000

b.

$31,050

c.

$33,250

d.

$319,160

Solution: The $50,000 is a future amount in year

five that must be moved to the present.

Solving Typical FE Problems

What to do:

Find P from a Uniform Series (A) and Vice

Versa

How to do it:
Uniform series cash flows are represented by the
symbol A. A uniform series refers to cash flows
which: (1) occur in consecutive interest periods, and
(2) are the same amount each time. To solve for P
for these types of problems, the following equation
is used:

P=A
In standard factor notation, the equation is P =
A(P/A,i,n). It is important to note in using this
equation that the present worth, P, is located one
interest period ahead of the first A. It is also
important to remember that n must be equal to the
number of A values and the interest rate, i, must be
expressed in the same time units as n. For example,
if n is in months, i must be an effective interest rate
per month.
This standard equation can be used in reverse to
convert a present worth into a uniform series
amount using the form A = P(A/P,i,n). This, for
example, is used to determine the monthly payment

associated with a car purchase or house loan for a

compound interest rate of i%.

Example #3: A company expects the material cost

of a certain manufacturing operation to be $20,000
per year. At an interest rate of 8% per year, the
present worth of this cost over a five year project
period is closest to:
a.

$29,386

b.

$56,220

c.

$79,854

d.

$117,332

Solution:

Example #4: A piece of machinery has a first cost

of $31,000 with a monthly operating cost of
$10,000. If the company wants to recover its
investment in five years at an interest rate of 1%
per month, the monthly income must be closest to:
a.

$5,498

b.

$6,386

c.

$8,295

d.

$10,688

Solution: The A value is per month.

Solving Typical FE Problems

What to do:

Find F from a Uniform Series (A) and Vice

Versa

How to do it:
In the previous problem type, the procedure for
converting a uniform series into an
equivalent presentamount was discussed. Here a
uniform series is converted into a future amount
instead of a present one. The equation for doing so
is:

F=A
The standard notation form is F= A(F/A,i,n). It is
important to remember that the F occurs in
the sameperiod as the last A. As before, the n is
equal to the number of A values and the i used in
the calculation must be expressed over the same
time units as n.

Example #5: If a person deposits $100 per month

into an account which pays interest at a rate of 6%
per year compounded monthly, the amount in the
account at the end of five years would be nearest
to:
a.

$564

b.

$3,69

c.

$6,977

d.

$7,992

Solution: Since the cash flow (i.e., A values) occurs

over monthly interest periods, the n and i must
have monthly time units.

As in the previous problem type, the standard

equation can be set up and solved in reverse to find
an A value from a given future worth, F, using A =
F(A/F,i,n).
Example #6: A small company wants to have
enough money saved to purchase a new $200,000
warehouse in five years. If the company can invest
money at 18% per year, the amount that must be
invested each year is closest to:
a.

$27,960

b.

$36,920

c.

$49,650

d.

$63,960

Solution:

Solving Typical FE Problems

What to do:

Find P, A, or F from Uniform Gradient Cash

Flows

How to do it:
A uniform gradient cash flow is one wherein the
cash flow changes (increases or decreases) by
the same amount in each payment period. For
example, if the cash flow in period 1 is $800, and in
period two it is $900, with amounts increasing by
$100 in each subsequent period, this is a uniform
gradient cash flow series with the gradient, G, equal
to $100. The standard factor equation to find the
present worth of the gradient is represented as P =
G(P/G,i,n). This equation finds the value of only the
gradient, not the amount of money that the
gradient was "built on" (i.e., the base amount) in
period one. The base amount in period one must be
handled separately as a uniform series cash flow.
Thus, the general equation to find the present worth
of a uniform gradient cash flow series is:
P = A(P/A,i,n) + G(P/G,i,n)

If the gradient is negative, the total cash flow

decreases from one period to the next. The only
difference is that the plus sign becomes a minus
sign in the equation above.

Example #7: A company expects the cost of

equipment maintenance to be $5,000 in year one,
$5,500 in year two, and amounts increasing by
$500 per year through year 10. At an interest rate
of 10% per year, the present worth of the
maintenance cost is nearest to
a.

$38,220

b.

$42,170

c.

$46,660

d.

$51,790

Solution: This is an increasing gradient (use +

sign) with G = $500 and base amount A = $5,000:

More to do: Find A from Uniform Gradient Cash

Flows
Convert a gradient cash flow into an equivalent
uniform series, A, in one of two ways:
1.

Find the present worth, P, of the cash flows

as discussed above and then convert the P
value to an A value using the A =P(A/P,i,n)
factor, or

2.

Use the uniform gradient annual worth

factor, (A/G,i,n), directly in A= G(A/G,i,n).

When using (A/G,i,n), it is important to remember

that this factor converts only the gradient into an A

value, just like the P/G factor affects only the

gradient. The base amount in year one is simply
added to the A value obtained from A= G(A/G,i,n).
The general equation for the total A value, AT, is
AT = A1 + AG

The future worth, F, of a gradient cash flow is found

by either first finding P and then using the F/P
factor, or first finding A and then using the F/A
factor.

Example #8: The cash flow associated with a

stripper oil well is expected to be $3,000 in month
one, $2,950 in month two, and amounts decreasing
by $50 each month through year five. At an interest
rate of 12% per year compounded monthly, the
equivalent uniform monthly cash flow is closest to:
a.

$1,327

b.

$1,673

c.

$2,794

d.

$4,327

Solution: The negative gradient is G = -$50. The

total equivalent monthly cash flow, AT, is:

olving Typical FE Problems

What to do:

Identify Nominal and Effective Interest

Rates

How to do it:
Nominal and effective interest rates are similar to
simple and compound interest rates, with a
nominal rate being equivalent to a simple interest
rate. All of the equations expressing time value of
money are based on compound (i.e., effective)
rates, so if the interest rate that is provided is a
nominal interest rate, it must be converted into
an effective rate before it can be used in any of
the formulas. The first step in the process of
insuring that only effective interest rates are used
is to recognize whether an interest rate is
nominal or effective. Table 1 shows the three
ways interest rates may be stated.
Table 1- Various interest statements and
their interpretation

(1)
Interest Rate
Statement

i = 12% per
year

i = 1% per
month

i = 3-1/2%
per quarter

(2)
Interpretation

(3)
Comment

i = effective
12% per year
compounded
yearly

When no
compounding
period is
given, interest
rate is an
i = effective
effective rate,
1% per month with
compounded
compounding
monthly
period
i = effective 3- assumed to be
equal to stated
1/2% per
time period
quarter
compounded
quarterly

i = 8% per
year,
compounded
monthly

i = nominal
8% per year
compounded
monthly

i = 4% per
quarter
compounded
monthly

i = nominal
4% per
quarter
compounded
monthly

i = 14% per
year
compounded
semiannually

i = nominal
14% per year
compounded
semiannually

When
compounding
period is given
without stating
whether the
interest rate is
nominal or
effective, it is
assumed to be
nominal.
Compounding
period is as
stated.

i = effective
10% per year
compounded
monthly

i = effective
10% per year
compounded
monthly

i = effective
6% per
quarter

i = effective
6% per
quarter
compounded
quarterly

i = effective
1% per month
compounded
daily

i = effective
1% per month
compounded
daily

If interest rate
is stated as an
effective rate,
then it is an
effective rate.
If
compounding
period is not
given,
compounding
period is
assumed to
coincide with
stated time
period.

The three statements in the top part of the table

show that an interest rate can be stated over
some designated time period without specifying
the compounding period. Such interest rates are
assumed to be effective rates with
the compounding period (CP) assumed to be the
same as that of the stated interest rate.
For the interest statements presented in the
middle of Table 1, three conditions prevail:
1.

the compounding period is identified,

2.

this compounding period is shorter than

the time period over which the interest is
stated, and

3.

the interest rate is not designated as

either nominal or effective.

In such cases, the interest rate is assumed to be

nominal and the compounding period is equal to
that which is stated. (We show how to get
effective interest rates from these in the next
section.)
For the third group of interest-rate statements in
Table 1, the word effective precedes or follows
the specified interest rate and the compounding
period is also stated. These interest rates are
obviously effective rates over the respective time
periods stated. Likewise, the compounding
periods are equal to those stated. Similarly, if the
word nominal had preceded any of the interest
statements, the interest rate would be a nominal
rate. Table 2 contains a listing of several interest

statements (column 1) along with their

interpretations (columns 2 and 3).
Table 2- Specific examples of interest
statements and interpretations

(1)
Interest
Statement

(2)
Nominal or
Effective
Interest

(3)
Compounding
Period

15% per year

compounded
monthly

Nominal

Monthly

15% per year

Effective

Yearly

Effective 15%
per year
compounded
monthly

Effective

Monthly

20% per year

compounded
quarterly

Nominal

Quarterly

Nominal 2%
per month
compounded
weekly

Nominal

Weekly

2% per month

Effective

Monthly

2% per month
compounded
monthly

Effective

Monthly

Effective 6%
per quarter

Effective

Quarterly

Effective 2%
per month
compounded
daily

Effective

Daily

1% per week
compounded
continuously

Nominal

Continuously

0.1% per day

compounded
continuously

Nominal

Continuously

Solving Typical FE Problems

What to do:

Find an Effective Interest Rate from a Nominal Rate

and Vice Versa

How to do it:
All of the formulas used in making time value calculations
are based on effective interest rates. Therefore, whenever
the interest rate that is provided is a nominal rate, it is
necessary to convert it to an effective interest rate. As
shown below, an effective interest rate, i, can be calculated
for any time period longer than the compounding period.
The most common way that nominal interest rates are
stated is in the form 'x% per year compounded y' where x
= interest rate and y = compounding period. An example is
18% per year compounded monthly. When interest rates
are stated this way, the simplest effective rate to get is the
one over the compounding period because all that is
required is a simple division. For example, from the
interest rate of 18% per year compounded monthly, a
monthly interest rate of 1.5% is obtained (i.e., 18% per
year/12 compounding periods per year) and this is an
effective rate because it is the rate per compounding
period. To get an effective rate for any period longer than
the compounding period use the effective interest rate
formula.
i = (1+r/m)m - 1

This effective interest rate formula can be solved for r or

r/m as needed to determine a nominal interest rate from

an effective rate.
For continuous compounding, the effective rate formula is
the mathematical limit as m increases without bounds, and
the formula reduces to i = er - 1.

Example #9: For an interest rate of 12% per year

compounded quarterly, the effective interest rate per year
is closest to:
a.

4%

b.

12%

c.

12.55%

d.

12.68%

Solution: An effective interest rate per year is sought.

Therefore, r must be expressed per year and m is the
number of times interest is compounded per year.

Example #10: For an interest rate of 2% per month, the

effective semiannual rate is closest to:
a.

11.55%

b.

12%

c.

12.62%

d.

26.82%

Solution: In this example, the i on the left-hand side of

the effective interest rate equation will have units of
semiannual periods. Therefore, the r must have units of
semiannual periods (i.e., 12% per six months) and m must
be the number of times interest is compounded per
semiannual period, 6 in this example.

The types of calculations used to obtain effective interest

rates are summarized in Table 3.
Table 3- Summary of Calculations Involved in
Finding Effective Rates

Interest
Statement

To Find i for
Compounding
Period

To Find i for any

Period Longer than
Compounding
Period

i = 1% per
month

i is already
expressed over
compounding
period

Use effective
interest rate
equation

i = 12% per
year
compounded
quarterly

Divide 12% by 4

Use effective
interestrate
equation

i = nominal 16%
per year
compounded
semiannually

Divide 16% by 2

Use effective
interest rate
equation

i = effective
14% per year
compounded
monthly

Use effective
interest rate
equation and
solve for r/m

For effective i
values other than
yearly, solve for r in
effective interest
rate equation and
then proceed as in
previous two
examples

Solving Typical FE Problems

What to do:

Find P or F for Single Payments and Nominal Interest

Rates

How to do it:
For problems involving single payment amounts, that is, P
and F, there are essentially an infinite number of ways to
solve the problems. This is because any effective interest rate
can be used in the P/F or F/P factors as long as the n has the
same units as the i. That is, if an effective interest rate per

month is used, then n must be the number of months

between the P and F. If i is an effective interest rate per year,
then n must be the number of years.

Example #11: If you deposit $1,000 now at an interest rate

of 12% per year compounded monthly, the amount that will
be in the savings account five years from now is closest to:
a.

$1,600

b.

$1,762

c.

$1,817

d.

$1,905

Solution: The 12% rate is a nominal rate and cannot be used

directly. The simplest way to work the problem is to use an
interest rate of 1% per month (an effective rate) because the
F/P factor can be looked up directly in the 1% table. Any
other effective interest rate would involve a fraction. (For
example, the effective yearly rate is 12.68%, which is not in
a factor table.)

If the effective interest rate of 12.68% per year is used in the

example above, it is necessary to use the F/P formula to
calculate F, since there is no 12.68% interest table. If done
correctly, however, the answer is the same.

Solving Typical FE Problems

What to do:

Calculations Involving Uniform Series and Nominal

Interest Rates

How to do it:
When using the uniform series cash flow equations, there are
two necessary conditions:
1.

the n must always be equal to the number of payments

involved, and
2.

the effective interest rate must have the same time

units as the payments.

For example, if uniform cash flow values (A or G) occur over

quarterly time periods, the interest rate must be an effective
quarterly rate. Similarly, if the cash flow values occur monthly
or yearly, the interest rate must be an effective monthly or
yearly rate, respectively.

Example #12: An individual deposits $100 per month into an

account which pays interest at a rate of 6% per year
compounded monthly. The value of the account after five years
is closest to:
a.

$5,630

b.

$6,210

c.

$6,764

d.

$6,977

Solution: Since cash flow occurs over monthly time periods,

the interest rate must be an effective monthly rate, which in
this case is 0.5%.

Solving Typical FE Problems

What to do:

Find P, A, or F from Non-conventional Uniform Series Cash

Flows

How to do it:
When a uniform series cash flow begins at a time other than period
one, it is called a non-conventionaluniform series. It is nonconventional since determining the present worth requires at least
two different factors. This is because the uniform series present
worth equation is derived with the P one interest period ahead of the
first A value. If the first A value does not occur in period one, the P
will not occur at time zero; another factor, usually the P/F factor,

must be utilized to obtain the P value at time zero.

Example #13: The costs associated with a particular process are

expected to be $6,000 per year for five years, beginning three years
from now. At an interest rate of 10% per year, the present worth of
these costs is closest to:
a.

$17,088

b.

$18,796

c.

$22,745

d.

$29,210

Solution: If the P/A factor is used, the P (call it P2) will be placed in
year two, one period ahead of the first A. The value can then be
moved to year zero with the P/F factor with n = 2.

More to do: Find F for a non-conventional series

To convert a non-conventional uniform series into a future amount,
F, the F/A factor is used with n equal to the number of periods. The F
value is located in the period containing the last payment.

Example #14: For the cash flow in the previous example, the future
worth in year eight at an interest rate of 10% per year is closest to:
a.

$36,631

b.

$47,310

c.

$56,923

d.

$68,615

Solution: Now, the n is equal to five and F is located in year eight,

as requested.

More to do: Find A for a non-conventional series

To convert a non-conventional uniform series cash flow into a
conventional uniform series cash flow (i.e., A in periods one through
n), the simplest method is to initially find P or F (as described above)
and then use the A/P or A/F factor.

Example #15: For the cash flow in Example 13 ($6,000 for 5

years), the equivalent uniform annual worth, A, in years one through
eight at i = 10% per year is closest to:
a.

$2,875

b.

$3,202

c.

$3,522

d.

$4,262

Solution: Either the P (Example #13) or the F (Example #14) can

be used to find A. In either case, n is equal to eight in the A/P or A/F
factor. Calculating P initially (Example #13) to find A:

Solving Typical FE Problems

What to
do:

Compare Alternatives by PW or AW Analysis

How to do
it:

A present worth (PW) comparison of alternatives involves converting all cash flows to
their present worth and then selecting the one alternative with the lowest cost (or
highest profit). An annual worth (AW) analysis, on the other hand, involves converting
all cash flows into equivalent uniform amounts per period (usually years).
Sign Convention: The sign convention of the FE Exam is used in the analysis below.
Costs, such as, first cost and annual operating cost, are given a positive sign,
revenues, such as, salvage value, are assigned a negative sign. This is the opposite of
the text material, however it agrees with the FE Exam sign convention.
PW analysis: When the alternatives under consideration have different lives, it is
necessary to adopt some procedure, which will yield a comparison for equal
service when using the PW method. The reason for the equal service requirement is
obvious, since without it, the alternative with the shortest life is likely to yield the
lowest present cost even if it is not the most economical. One way to satisfy the equal
service requirement is to compare the alternatives over their least common multiple of
years. This will insure that the alternatives under consideration will end at the same
time. Repurchase of each alternative at the same first cost is a common assumption.
AW analysis: In the annual worth procedure, it is not necessary to worry about equal
service because the annual worth of one life cycle will be exactly the same as that for
two, three, or any number of life cycles. Therefore, compare the AW of alternatives
simply by calculating each annual worth over the respective life cycle and select the
one with the lowest cost (or highest profit).

Example #16: A company is considering two alternatives for manufacturing a certain

part. Method R will have a first cost of $40,000, an annual operating cost of $25,000,
and a $10,000 salvage value after its five year life. Method S will have an initial cost
of $100,000, an annual operating cost of $15,000, and a $12,000 salvage value after
its 10 year life. At an interest rate of 12% per year, the present worth values of the
two alternatives are closest to:

Solution: The least common multiple is 10 years. Method R is repurchased after 5

years.

Example #17: For the alternatives in Example 16 above, their annual worth values
are closest to:

Solution: Calculate AW over their respective life cycles of 5 and 10 years,

respectively.

Solving Typical FE Problems

What to do:

Find the Capitalized Cost of Infinite Cash Flow Sequence

How to do it:
Capitalized cost refers to the present worth of cash flows which go
on for an infinite period of time. For example, if someone wanted

to know how much money now (a P value) is needed to fund a

permanent $10,000 per year scholarship in their name, this
involves a capitalized cost calculation. The equation is
P = A/i

Sign Convention: The sign convention of the FE Exam is used in

the following examples; costs are given a positive sign and
revenues are assigned a negative sign.

Example #18: A member of congress wants to know the

capitalized cost of maintaining a proposed national park. The
annual maintenance cost is expected to be $25,000. At an interest
rate of 6% per year, the capitalized cost of the maintenance would
be closest to:
a.

$1,500

b.

$25,000

c.

$150,000

d.

$416,667

Solution: In this problem, A= $25,000 and i = 0.06.

More to do: If the infinite cash flow series occurs in time periods
longer than the stated interest period (for example, every three
years instead of every year), the easiest way to work the problem
is to convert the recurring cash flow into an A value using the A/F
factor and then divide by i.

Example #19: A dam will have a first cost of $5,000,000, an

annual maintenance cost of $25,000 and minor reconstruction
costs of $100,000 every five years. At an interest of 8% per year,
the capitalized cost of the dam is nearest to:

a.

$213,125

b.

$525,625

c.

$5,312,500

d.

$5,525,625

Solution: The $100,000 which occurs every five years can be

converted to an A value using the A/F factor. Dividing the resulting
A values by i will yield the capitalized cost, Pcap.

If one want to find the equivalent uniform annual worth (an A

value) of an infinite cash flow, simply multiply the capitalized cost
by i to obtain A.

Solving Typical FE Problems

What to do:

Find the Capitalized Cost of Finite Cash Flows

How to do it:
As discussed in the previous section, capitalized cost refers to the
present worth of cash flow which goes on for an infinite period of time.
If an asset or alternative has a finite life, its capitalized cost is
determined by first finding the annual worth of the alternative over one
life cycle (which is also its annual worth for infinite service) and then
dividing the resulting A value by i.
Sign Convention: The sign convention of the FE Exam is used in the
following example; costs are given a positive sign and revenues are
assigned a negative sign.

Example #20: An alternative for manufacturing a certain part has a

first cost of $50,000, an annual cost of $10,000, and a salvage value of
$5,000 after its 10 year life. At an interest rate of 10% per year, the
capitalized cost of the alternative is closest to:
a.

$17,822

b.

$145,000

c.

$178,215

d.

$189,355

Solution: Find the equivalent uniform annual worth over one life cycle
(10 years) and then divide by i for the capitalized cost.

Solving Typical FE Problems

What to do:

Find the Benefit/Cost Ratio

How to do it:
The benefit/cost ratio (B/C) is an economic analysis technique used commonly,
especially by governmental agencies. In its purest form, the numerator B consists
of economic consequences to the people (i.e., benefits and disbenefits), while the
denominator C consists of consequences to the government (i.e., costs and
savings). The units in the calculation can be present worth, annual worth, or
future worth dollars, as long as they are the same in the numerator and
denominator. A B/C ratio equal to or greater than 1 indicates that the project is
economically attractive. If disbenefits are involved, they are substracted from the
benefits; if government savings are involved, they are subtracted from the costs.
The general B/C is:

In B/C analysis, costs are not preceded by a minus sign.

Example #21: A federal agency is considering expanding a national park by

adding recreational facilities. The initial cost of the project will be $1.5 million,
with an annual upkeep cost of $50,000. Public benefits have been valued at
$300,000 per year, but disbenefits of $200,000 (initial cost) have also been
recognized. The park is expected to be permanent. At an interest rate of 6% per
year, the B/C ratio is closest to:
a.

0.71

b.

2.06

c.

2.50

d.

3.57

Solution: Annual dollars will be used (arbitrarily chosen over PW or FW) to

determine the B/C ratio. Use A = Pi to convert present worth estimates to annual
worth values.

Instead of dividing the benefits by the cost to obtain a B/C ratio, the costs could
be substracted from the benefits (B - C) to obtain the difference between them. If
this procedure is followed, a (B - C) difference of zero or greater indicates
economic attractiveness.

Solving Typical FE Problems

What to do:

Find the Present Worth of a Bond

How to do it:
A bond is a long term note (essentially an IOU) issued by a corporation or
governmental entity for the purpose of financing major projects. The borrower
receives money now in return for a promise to pay later, with interest paid in
between. The conditions for repayment of the money obtained by the borrower
are specified at the time the bonds are issued. These conditions include the
bond face value, bond interest rate, and bond maturity date.
The bond face value refers to the denomination of the bond (frequently
$1,000). The face value is important for two reasons: (1) it represents the
lump sum amount the holder will receive on the bond maturity date, and (2) it
is used in conjunction with the bond interest rate and bond interest payment
period to determine the interest per period the bond holder will receive prior to
maturity. This interest received per period by the bond holder is calculated

according to the following equation

I = _______ ( V)(b)___________
No. times interest paid per year

The present worth of a bond represents the amount of money now that is
equivalent to the future income or payment stream associated with the bond:
the interest, I, received each period and the face value. The bond interest
represents a uniform series cash flow while the face value, V, represents a
future single payment amount on the bond maturity date. The present worth of
a bond can be determined by the following general equation:
PWbond = I(P/A,i,n) + V(P/F,i,n)
Example #22: A municipal bond with a face value of $10,000 will mature 15
years from now. The bond interest rate is 6% per year, payable quarterly. At an
interest rate of 16% per year compounded quarterly, the present worth of the
bond is closest to:
a.

$4,173

b.

$4,345

c.

$5,277

d.

$6,135

Solution: The first step is to calculate the bond interest paid per quarter.
Then, use this interest as an A value and the single amount face value to
determine the present worth. The quarterly interest rate is 16%/4 = 4% for
15(4) = 60 quarters.

Solving Typical FE Problems

What to do:

Find the Present Worth When Inflation is Considered

How to do it:
There are two ways to take inflation into account in engineering economic
evaluations:
1.

Use an interest rate that has been corrected for inflation, or

2.

Convert the cash flows into constant value dollars.

Only the first procedure is discussed here. The equation that can be used to adjust
the interest rate to account for inflation is the following:
if = i + f + if

If the inflated interest rate is used in making present worth calculations, all cash
flow amounts are left in "then current" dollars (i.e. inflated or future dollars).

Example #23: A company has the option of building a warehouse now or building
it three years from now. The cost now would be $400,000, but three years from
now the cost will be $500,000. If the company's minimum attractive rate of return
(real i) is 12% per year and the inflation rate is 10% per year, the present worth
cost of the building in three years when inflation is considered is closest to:
a.

$268,700

b.

$355,900

c.

$375,650

d.

$402,700

Solution: First calculate the inflated interest rate, if. Then, use the inflated interest
rate in the P/F formula 1/(1 + if)n.

Solving Typical FE Problems

What to do:

Determine Asset Depreciation by SL or MACRS Methods

How to do it:
Depreciation is an accounting procedure for systematically reducing the
value of an asset. Depreciation isone of the deductions that reduces taxable
income in the general income tax equation for corporations.
Income tax = (income - deductions) (tax rate)
There are several methods for depreciating an asset but only the two
commonly accepted methods are discussed here: Straight Line (SL) and
Modified Accelerated Cost Recovery System (MACRS).
The straight-line method is so named because the depreciation charge is the
same each year, resulting in a straight line when the asset's remaining book
value (i.e., undepreciated amount, which is discussed in next section) is
plotted versus time. The general equation for the annual SL depreciation
charge (D) is:
D = B - SV
n

Example #24: A machine with a first cost of $25,000 is expected to have a

$5,000 salvage value after its five year depreciable life. The depreciation
charge by the straight-line method for year three is closest to:
a.

$4,000

b.

$5,000

c.

$10,000

d.

$15,000

Solution: According to the straight line method, the depreciation charge is

the same each year of the five years.
D = 25,000 - 5,000
5
= $4,000
Answer is (a)

More to do: MACRS The MACRS method is an accelerated depreciation

method because more depreciation is charged in early years than later
years. The annual depreciation rate is tabulated for each acceptable
depreciable life value. The general equation is

where:

dt

D = dt B
= depreciation rate for year t

= first cost or unadjusted base

The dt value is obtained from tables provided by the U.S. Government. The
dt value is different for each year, decreasing with each year, except between
years one and two. The reason for this is that some of the depreciation in
year one is deferred to year (n +1). For example, dt values for a three-year
depreciable life are 33.33%, 44.45%, 14.81%, and 7.41% for years t = 1, 2,
3, and 4, respectively.
Note that in the MACRS equation for calculating depreciation, the salvage
value is not subtracted from the first cost as it is in the straight line method.

Example #25: A machine with a first cost of $40,000 is to be depreciated

by the MACRS method. The machine has an estimated $10,000 salvage
value after its five year depreciable life. The depreciation charge for year 3 is
closest to:
a.

$5,760

b.

$5,920

c.

$7,680

d.

$10,000

Solution: From the MACRS tables, dt for year 3 for a five year recovery
period is 19.2%.

Solving Typical FE Problems

What to do:

Find Asset Book Value by SL or MACRS

How to do it:
Book value (BV) represents the remaining, undepreciated amount of an asset after

the depreciation charges to date have been subtracted from the first cost. In
general equation form, book value is

For the MACRS method, the depreciation charge is different each year. To find the
total depreciation, Dt, the annual depreciation rates must be summed and then
multiplied by B.

Examples #26: A five-year asset which had a first cost of $20,000 with a $2,000
salvage value was depreciated by the straight line method. The book value at the
end of year four was closest to:
a.

$3,600

b.

$4,000

c.

$5,600

d.

$16,400

Solution: Calculate the annual depreciation charge and use this amount in the book
value equation.

Examples #27: A machine with a first cost of $80,000 is depreciated by the

MACRS method. The machine has a depreciable value of 10 years with a $10,000
estimated salvage value. The book value of the machine after year 6 would be

closest to:
a.

$23,600

b.

$30,650

c.

$49,350

d.

$56,400

Solution: From the MACRS depreciation rate table, the rates (in percent) for the
first six years, respectively, are 10, 18, 14.4, 11.52, 9.22, and 7.37, for a total of
70.51%. The book value after six years is:

Solving Typical FE Problems

What to do:

Find the Breakeven Point

How to do it:
The most common breakeven analysis problems are composed of two parts: a fixed
cost part and a variable cost part. Often the variable cost is related to the number
of units of something produced or consumed, and in many cases, units is common
to all the alternatives under consideration. Other times, only one alternative has a
variable cost. In either case, the procedure for solving the problem involves setting
the costs of two alternatives (in terms of P, A, or F) equal to each other and solving
for the number of units required for breakeven.
Sign Convention: The sign convention of the FE Exam is used in the following
example; costs are given a positive sign and revenues are assigned a negative sign.

Example #28: A company is considering two methods for obtaining a certain part.
Method A will involve purchasing a machine for $50,000 with a life of 5 years, a
$2,000 salvage value and a fixed annual operating cost of $10,000. Additionally,
each part produced by the method will cost $10.
Method B will involve purchasing the part from a subcontractor for $25 per part. At
an interest rate of 10% per year, the number of parts per year required for the two
methods to break even is
a.

1,333

b.

1,524

c.

1,850

d.

2,011

Solution: If x is the number of parts required per year, the breakeven equation in
terms of annual dollars is: