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MS-291: Engineering Economy

(3 Credit Hours)

Chapter 4
Nominal and Effective
Interest Rates
MS291: Engineering Economy

Course Instructor: Dr. Muhammad Sabir

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Equivalence Relations: Payment

Period(PP) and Compounding Period

It is common that the lengths of the payment period and the

compounding period (CP) do not coincide

To do correct calculation of Economic Equivalence

Interest rate must coincide with compounding period

It is important to determine if PP = CP, PP >CP, or PP<CP

Length of Time

Involves Single
Amount
(P and F Only)

PP = CP
PP > CP
PP < CP

P/F , F/P
P/F, F/P

Involves Gradient
Series (A, G, or g)

P/A, P/G, P/g

F/A etc.
P/A, P/G, F/A etc.

Case I:
When PP>CP for Single
Amount for P/F or F/P
Step 1: Identify the number of compounding
periods (M) per year
Step 2: Compute the effective interest rate per
payment period (i)

i = r/M
Step 3: Determine the total number of payment
periods (n)
Step 4: Use the SPPWF or SPCAF with i and N above

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Example Case I:
When PP>CP for Single Amount
for P/F or F/P
Determine the future value of $100 after 2 years at credit
card stated interest rate of 15% per year, compounded
monthly.
F=?
Solution:
P = $100, r = 15%, m = 12

Alternative Method

i = (1 + r/m)m 1

EIR /month = 15/12 = 1.25%

= (1+0.15/12)12 1

n = 2 years or 24 months

= 16.076%

F = P(F/P, i, n)
F = P(F/P, 0.0125, 24)
F = 100(F/P, 0.0125, 24)
F = 100(1.3474)
F = 100(1.3474)

F = P(F/P, i, n)
F = P(F/P, 16.076%, 2)
F = 100(1.3456)
F = $134.56

Interpolation
needed

The results are slightly different because of the rounding off

16.076% to 16.0%

F = $134.74

Case II: When PP >CP

for Series for P/A or F/A

For series cash flows, first step is to determine relationship

between PP and CP
Determine if PP CP, ( if PP < CP then different procedure)
When PP CP, the only procedure (2 steps) that can be
used is as follows:
First, find effective i per PP
Example: if PP is in quarters, must find effective i/quarter

Second, determine n, the number of A values involved

Example: quarterly payments for 6 years yields n = 46 = 24

You can use then the standard P = A(P/A, i , n) or F = A(F/A, i, n)

etc.

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Case II Example: PP >CP

for Series for P/A or F/A
Solution:

For the 7 years, Excelon

Energy has paid $500
every 6 months for a
software maintenance
contract. What is the
equivalent total amount
after the last payment, if
these funds are taken
from a pool that has been
returning 8% per year,
compounded quarterly?

PP = 6 months

CP = Quarter

r = 8 % per year or 4% per 6 months &

m=2 quarter per semi-annual

PP > CP
Effective rate (i) per 6 months = (1+r/m)m -1
i= (1+0.04/2)2 1 => 4.04%

Because in
each PP
amount get
compounded
twice

Since, total time is 7 years and PP is 6 months

we have total 7x2=14 payments

F = A(F/A, i, n)

F = 500(F/A, 0.0404, 14)

F = 500(18.3422) => $9171.09

Case III: Economic

Equivalence when PP< CP
If a person deposits money each month into a savings account where
interest is compounded quarterly, do all the monthly deposits earn
interest before the next quarterly compounding time?
If a person's credit card payment is due with interest on the 15th of the
month, and if the full payment is made on the 1st, does the financial
institution reduce the interest owed, based on early payment? Anyone ?
The Usual answers are NO!!!! Some time possible for big
cooperation's
CP: 3 months = 1 quarter

10

11

12

Months

PP
1 month

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Case III: Economic

Equivalence when PP< CP
Two policies:
1. Inter-period cash flows
earn no interest (most
common)
positive cash flows are
moved to beginning of the
interest period (no
interest earned) in which
they occur and negative
cash flows are moved to
the end of the interest
period (no interest paid)

2. inter-period cash flows

earn compound interest

cash flows are not

moved and equivalent
P, F, and A values are
determined using the
effective interest rate
per payment period

Example 4.11: Example: Clean

Air Now (CAN) Company
Last year AllStar Venture Capital agreed to invest funds in Clean
Air Now (CAN), a start-up company in Las Vegas that is an
outgrowth of research conducted in mechanical engineering at
the University of NevadaLas Vegas. The product is a new
filtration system used in the process of carbon capture and
sequestration (CCS) for coal-fired power plants. The venture
fund manager generated the cash flow diagram in Figure in
$1000 units from AllStars perspective. Included are
payments (outflows) to CAN made over the first year and
receipts (inflows) from CAN to AllStar. The receipts were
unexpected this first year; however, the product has great
promise, and advance orders have come from eastern U.S.
plants anxious to become zero-emission coal-fueled plants. The
interest rate is 12% per year, compounded quarterly, and AllStar
uses the no-inter period-interest policy. How much is AllStar in
the red at the end of the year?

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Example 4.11: Example: Clean Air

Now (CAN) Company
The venture fund manager generated the cash flow diagram in $1000
units from AllStars perspective as given below. Included are payments
(outflows) to CAN made over the first year and receipts (inflows)
from CAN to AllStar. The receipts were unexpected this first year;
however, the product has great promise, and advance orders have
come from eastern U.S. plants anxious to become zero-emission coalfueled plants. The interest rate is 12% per year, compounded quarterly,
and AllStar uses the no-inter period-interest policy. How much is
AllStar in the red at the end of the year (Future Value)?

Example: Clean Air Now

(CAN) Company

Given cash flows

Positive Cash flows (inflows) at the start

of CP period

Negative Cash flows (outflows) at the

end of CP period

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Example: Clean Air Now (CAN)

Company
12% per year, compounded quarterly

Solution:
Effective rate per quarter = 12/4 = 3%
Now
F = 1000[-150(F/P, 3%, 4)-200(F/P, 3%, 3) +(180-175 )(F/P, 3%, 2)+ 165(F/P, 3%, 1)-50]
F = $ (-262111) Investment after one year

Continuous Compounding
If we allow compounding to occur more and more frequently, the
compounding period becomes shorter and shorter and m , the
number of compounding periods per payment period, increases.
Continuous compounding is present when the duration of the
compounding period (CP), becomes infinitely small and, the
number of times interest is compounded per period (m), becomes
infinite.
Businesses with large numbers of cash flows each day consider
the interest to be continuously compounded for all transactions.
As m approaches infinity, the effective interest rate
i = (1 + r/m)m 1 must be written and use as; i = er 1

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Example: Continuous
Compounding
Example: If a person deposits $500 into an account every 3 months
at an interest rate of 6% per year, compounded continuously, how
much will be in the account at the end of 5 years?
Solution:

Payment Period: PP = 3 months

Nominal rate per three months: r = 6%/4 = 1.50%
Effective rate per 3 months: i = e0.015 1 = 1.51%
F = 500(F/A,1.51%,20) = $11,573
Practice:
Example 4.12 & 4.13

Varying Interest Rates

Interest rate does not remain constant full life time of a

project

In order to do incorporate varying interest rates in our

calculations, normally, engineering studies do consider
average values that do care of these variations.

But sometimes variation can be large and having significant

effects on Present or future values calculated via using
average values

Mathematically, varying interest rates can be

accommodated in engineering studies

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Example: Varying Interest Rates

Given below the cash flow calculate the Present value.
$70,000
i=7%

$35,000

i=7%
i=9%

$25,000
i=10%

Year
0

P=?

P = 70,000(P/A, 7%, 2) + 35,000 (P/F, 9%, 1) (P/F, 7%, 2)

+ 25000(P/F, 10%, 1) (P/F, 9%, 1) (P/F, 7%, 2)
= 70,000 (1.8080) + 35,000 (0.9174)(0.8734) + 25,000(0.9091)(0.8734)(0.0.9174)
= $172,816

Varying Interest Rates

When interest rates vary over time, use the interest
rates associated with their respective time periods to
find P
The general formula for varying interest rate is given as:
P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + ..
+ Fn (P/F, i1, 1)(P/F, i2, 1) (P/F, in, 1)

For single F or P only the last term of the equation can

be used.
For uniform series replace F with A

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Example: Varying Interest Rates

Calculate the Present value of the following Cash flow
series
P=?
i=10%

i=14%

Year

0
$100 $100 $100 $100 $100
$160 $160

$160

P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + ..

+ Fn (P/F, i1, 1)(P/F, i2, 1) (P/F, in, 1)

P = 100(P/A, 10%, 5) + 160 (P/A, 14%, 3) (P/F, 10%, 5)

= 100(3.7908) + 160(2.3216)(0.6209)
= $609.72

Chapter 5
Present Worth
Analysis
Engineering Economy

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Background

An engineering project or alternative is formulated to make or purchase a

product, to develop a process, or to provide a service with specified
results

An engineering economic analysis evaluates cash flow estimates for

parameters such as initial cost, annual costs and revenues, etc., over an
estimated useful life of the product; process, or service

We have learned some basic tools in pervious chapters

In this chapter (and next few chapters.Stage 2) we are going to use the
basic tools (we learnt already) with some more techniques to evaluate one
or more alternatives using the factors and formulas learned in Stage 1

After completing these chapters, you will be able to evaluate most

engineering project proposals using a well-accepted economic analysis
technique, such as present worth, future worth, capitalized cost, lifecycle costing, annual worth, rate of return, or benefit /cost analysis

Background
A future amount of money converted to its equivalent value now has
a present worth (PW) that is always less than that of the future cash
flow, because all P/F factors have a value less than 1.0 for any interest
rate greater than zero
For this reason, present worth values are often referred to as
discounted cash flows (DCF) , and the interest rate is referred to as
the discount rate
Up to this point, present worth computations have been made for
one project or alternative
In this chapter, techniques for comparing two or more mutually
exclusive alternatives by the present worth method. Full details of
contents of the chapter is on next slide

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Content of the
Chapter
1.

Formulate Alternatives

2.

Present Worth of equal-life alternatives

3.

Present Worth of different-life alternatives

4.

Future Worth analysis

5.

Capitalized Cost analysis

From Chapter 1:
Steps in an Engineering Economy Study
Step 1 in
Study

Problem description
Objective statement

Step 2

Available data
Alternatives for solution

Step 3

Cash flows and other

estimates

Step 4

Measure of worth
criterion
(PW, B/C, IRR etc)

Step 5

Engineering Economic
Analysis

Step 6

Best alternative
Selection

Step 7

Implementation and
Monitoring

One or more approaches

to meet objectives

Expected life
Revenues
Costs
Taxes
Project Financing

Tools u will be learning

in this course are used
here

Time Passes

Step 1 in
Study

New Problem
description

New engineering
economic study begins

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Two types of the Events:

basic concept from probability
theory
Mutually Exclusive events Independent Events
If two events cannot occur at
One event is independent
the same time, it is called
of the other event
mutually exclusive events

Mutually exclusive means two

outcomes cannot happen
simultaneously

An example is tossing a coin

once, which can result in
either heads or tails, but not
both.

In this case the

occurrence of one event
is totally independent of
another event
E.g., it rained today. And
a chair broke down in
office today. These are
two independent events

Formulating
Alternatives
Two types of economic proposals:
1. Mutually Exclusive (ME) Alternatives: Only one proposal
can be selected; Compete against each other and are
compared pairwise. These proposals are normally called
alternatives
e.g., A selection of Best diesel powered engine among the
available models

2.

Independent Projects: More than one can be selected , these

proposals are called projects; it competes only against DN

Do Nothing (DN) An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
In this chapter, we will learn Present Worth Method to evaluate either type
of proposal ..in next chapters we will learn some more such techniques.

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Project or alternatives types

based on Cash flows
There are two types of alternatives based on Cash flows
1. Revenue each alternative project being evaluated generate
costs and revenues over life period of alternative.
E.g., new systems, products/services that involve capital costs
Criteria of selection is to maximize the economic measure (e.g.,
profit in case of introducing new product).
2. Cost ( or service based) Each alternative has only cost cash
flow estimates (revenues are same for all alternatives)
E.g., which 100-seat plane to buy?
Criteria of selection is to minimize the economic measures (e.g.,
in this case cost of buying 100-seat plane)

Mandates, Ideas, identifications,

experience, Plans, Estimates

Not viable

B
C

Formulatin
g
Alternative
s

Not viable

1
3

Mutually
Exclusive
Alternatives

Select
only
one

viable

1
2
3
.
.
.
m

Either of
these

E
Independent
projects

Select
all
justifi
ed

1
2
3
.
.
.
DN

Type of Cash flow Estimates

- Revenue Alternatives
- Cost Alternatives
Revenues and costs
Costs only

Performance evaluation and make

selection

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Example 1: Selection of Alternatives

by Present Worth Criteria

For the alternatives shown below, which should be selected if they

are (a) mutually exclusive; (b) independent?
Project ID

Solution:

Present Worth

A
B

$ 30,000
$ 12,500

$ 4,000

2,000

(a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

Present Worth (PW)

analysis
This is the process of obtaining the equivalent worth of future
cash flows at present time

That is, finding PW of cash flows

We say that future cash flows are discounted to time 0

The higher the PW, the better PW is evaluate based on an

interest rate, which is equal to the organizations MARR

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Present Worth Analysis

Evaluation
Mutually exclusive projects
For one project, it is financially viable if PW 0.
For 2 or more alternatives, select the one with the
(numerically) largest PW value.

Independent Projects

Select all projects with PW 0

However, in practice a budget limit exists (details in chapter 12)

REMEMBER: This Evaluation is for the case when

alternatives have equal life

PW Analysis Procedure
The present worth method is quite popular in industry
because all future costs and revenues are transformed
to equivalent monetary units NOW
This Criteria work as follows;
Convert all cash flows to Present Worth (same as
present value) using MARR
Precede costs by minus sign; receipts by plus sign

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Example 2: PW evaluation of equal-life

Mutually Exclusive alternatives
Alternative X has a first cost of $20,000, an operating cost of $9,000 per year, and a $5,000
salvage value after 5 years.
Alternative Y will cost $35,000 with an operating cost of $4,000 per year and a salvage
value of $7,000 after 5 years.
At an MARR of 12% per year, which should be selected?

Solution: Cash flow diagram ? Any one ?

Find PW at MARR and select numerically larger PW value

PWX = 20,000 9000(P/A,12%,5) + 5000(P/F,12%,5)

Convert all cash

flows to Present
Worth (same as
present value) using
MARR

Precede costs by
minus sign;
receipts by plus
sign

= $49,606
PWY = 35,000 4000(P/A,12%,5) + 7000(P/F,12%,5)
= $45,447
Select alternative Y

Practice: Example
5.1

Example 2: PW evaluation of equal-life

Mutually Exclusive alternatives
Alternative X has a first cost of $20,000, an operating cost of $9,000 per year, and a $5,000
salvage value after 5 years.
Alternative Y will cost $35,000 with an operating cost of $4,000 per year and a salvage
value of $7,000 after 5 years.
At an MARR of 12% per year, which should be selected?

Solution: Cash flow diagram ? Any one ?

Find PW at MARR and select numerically larger PW value

Convert all cash flows

to Present Worth
(same as present
value) using MARR

Precede costs by
minus sign; receipts
by plus sign

PWX = 20,000 9000(P/A,12%,5) + 5000(P/F,12%,5)

= $49,606
PWY = 35,000 4000(P/A,12%,5) + 7000(P/F,12%,5)
= $45,447
Select alternative Y

Practice: Example
5.1

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THANK YOU

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