Engineering Economics

501. Engineering Economics

501.1. Types of Cash Flow
The primary objective of engineering economic analyses is to evaluate
various economic alternatives based on cost. The four types of idealized
"cash ow" discussed in this chapter are
1. Present value (P )a one-time cash ow that occurs now (i.e., at t = 0)
2. Future value (F )a one-time cash ow that occurs after a nite duration (t
= n)
3. Annuity ( A )a constant value cash ow that starts at t = 1 and recurs for

n time periods
4. Gradient series (G )a uniformly increasing (arithmetic) nite cash ow
series that has value zero at t = 1, value G at t = 2, 2G at t = 3, etc.,
ending at a value (n 1)G at t = n.
These cash ows are shown graphically in Fig. 501.1. The analytical
relationships to transform one type of cash ow to another are summarized
in Eqs. (501.1) through (501.9).

Figure 501.1. Types of cash ow.

501.2. The Year-End Accounting Convention

Equations and tables in this chapter are based on the year-end convention of
accounting, in which all expenses incurred in a particular year are
represented as cash ows at the end of that year.
Equations in this section are based on the concept of time value of money ,
which is the anticipated or expected growth of an investment, due to being
compounded at the prevalent or expected rate of return. This rate of return
is called the MARRthe minimum attractive rate of return. In the
formulations in this chapter, this rate of return is represented by the variable

i . MARR is one of the most important concepts in economic analysis. It is the

lowest rate of return that investors will accept by balancing the investment
risk or the opportunity to invest elsewhere for possibly greater returns.
Two sets of formulas are presentedone for discrete compounding (where
the compounding interval is a nite length of time) and the other for
continuous compounding (the limit as the number of compounding intervals

n ). Note that the gradient series loses meaning for continuous

compounding, hence those factors are missing.
The equations representing the various conversions for the time value of
money are given below. In these equations, the following variables are used:

P present worth (single lump sum).

A an annuity (constant installment at the end of every period).

F future worth (single lump sum).
G gradient series starting at zero for the rst period and increasing by
constant increment G every period.

i nominal interest rate per period (MARR). This is often expressed as a

percentage, but must be used as a decimal value in the equations.

n the number of compounding intervals.

Single Payment CompoundedSymbol (F/P, i%, n)Converts to F, Given P

(501.1a )

(501.1b )

Single Payment Present WorthSymbol (P/F, i%, n)Converts to P, Given F

(501.2a )

(501.2b )

Uniform Series Sinking FundSymbol (A/F, i%, n)Converts to A, Given F

(501.3a )

(501.3b )

Capital RecoverySymbol (A/P, i%, n)Converts to A, Given P

(501.4a )

(501.4b )

Uniform Series CompoundedSymbol (F/A, i%, n)Converts to F, Given A

(501.5a )

(501.5b )

Uniform Series Present WorthSymbol (P/A, i%, n)Converts to P, Given A

(501.6a )

(501.6b )

Uniform Gradient Present WorthSymbol (P/G, i%, n)Converts to P, Given

G

(501.7)

Uniform Gradient Future WorthSymbol (F/G, i%, n)Converts to F, Given

G

(501.8)

Uniform Gradient Uniform SeriesSymbol (A/G, i%, n)Converts to A,

Given G

(501.9)
Based on these relations, Tables 501.1 to 501.12 are presented in the section
"Engineering Economics Factors" for interest rates ranging from i = 1% to i
= 12%.

Table 501.1. Economics Factors for i = 1%

Table 501.2. Economics Factors for i = 2%

Table 501.3. Economics Factors for i = 3%

Table 501.4. Economics Factors for i = 4%

Table 501.5. Economics Factors for i = 5%

Table 501.6. Economics Factors for i = 6%

Table 501.7. Economics Factors for i = 7%

Table 501.8. Economics Factors for i = 8%

Table 501.9. Economics Factors for i = 9%

Table 501.10. Economics Factors for i = 10%

Table 501.11. Economics Factors for i = 11%

Table 501.12. Economics Factors for i = 12%

501.3. Nonannual Compounding

Note that these interest rates are per period. For example, if the duration is

n = 3 years, and the eective annual interest rate is 6%, then the table yields

(P /F , i = 6%, n = 3) = 0.8396. However, if the time period is measured in

months (e.g., n = 36 months) and the interest rate is still given as an
eective annual interest rate of 6%, then the tables cannot be used directly.
This becomes a case of nonannual compounding. The equivalent monthly
interest rate i M is that rate of increase (monthly) which, compounded over a
year (12 periods) will yield 6%. Thus, the value of i M can be solved from

Noting the absence of tables for this interest rate, the formula for ( P /F , i =
0.00487, n = 36) yields the value 0.8396. This value is identical to that
obtained using three 1-year periods. This is because the 6% is designated as
the eective annual rate.
However, if the annual interest rate of 6% were quoted as a nominal rate
(instead of an eective rate), then the equivalent monthly interest rate would
be 6%/12 = 0.5% = 0.005. This would have yielded a dierent P /F factor (P /F ,

i = 0.005, n = 36) = 0.8356.

501.4. Engineering Economics Factors

In this section, conversion factors are tabulated for interest rate i = 1% to i =
12%.
The following sections present various types of engineering economics
problems.

501.5. Present Worth

Example 501.1
What amount must be invested in a fund with a 10% eective annual interest
rate to yield $2000.00 at the end of 3 years, assuming that interest is
compounded half yearly?
Solution Let the half yearly interest rate be i .
Then
3 years = 6 half-year periods

Note that since the interest rate is 10% eective annual rate, we can also do
the following:
From the tables: (P /F , 3 years, 10%) = 0.7513
Therefore, P = $2000 3 0.7513 = $1502.60.
If the rate had been specied as a 10% nominal annual interest rate, the rst
approach would have been correct, but the second approach would have
yielded a dierent and incorrect answer.
Example 501.2
Investment A costs $45,000 up-front investment and pays back $58,000 after 3
years. Investment B costs $25,000 up front and pays back $12,000 each year
for 3 years. If the MARR is 6%, which investment is superior?
Solution Converting all cash ows to present worthcosts as negative cash
ow and revenues as positive.
Therefore, investment B is superior.

501.6. Principal in a Sinking Fund

Example 501.3
To create a capital fund for future expenditures, a company invests $125,000
annually into a fund accumulating interest rate of 5% (compounded
annually). What is the value of the fund immediately after the 5th payment?
Solution The future worth of the rst 5 payments is

501.7. Nonannual Compounding

Example 501.4
A bank oers a 6% nominal interest rate per annum, compounded daily. What
is the eective annual rate?
Solution Nominal daily rate = 6% 365 = 0.0164% =1.6438 3 10 4

The F /P factor is given by

Therefore, eective annual interest rate = 6.18%.

501.8. Capitalized Cost

Example 501.5
What is the capitalized cost of a project that has an initial cost of $50 million
and requires annual maintenance cost of $2.5 million? Assume that the
eective interest rate is 10%.
Solution The capitalization cost of an annuity is the principal that generates
the annuity to perpetuity. Therefore, the capitalization cost factor is given by
(P /A ) as n and is given by

Therefore, the capitalization cost for the project is $75 million.

501.9. Equivalent Uniform Annual Cost

When two alternatives are being compared and they have unequal time lines,
i.e., unequal useful life, they cannot be compared based on present worth or
future worth. They must be compared in terms of annual cost. All costs must
then be converted to annuities using the appropriate length of time. This
cost is called the equivalent uniform annual cost (EUAC).
Example 501.6
A sidewalk construction project has two design alternativesbrick and
concrete.
Brick will last 12 years, have an initial cost of $600,000 and annual
maintenance cost of $2000. Concrete will last 20 years, have an initial cost of

$1,000,000 and annual maintenance cost of $1000. Which option is superior

from an economy point of view? The interest rate is 6%.
Solution

Therefore, the annual cost of constructing in brick is 17% cheaper than

concrete.

501.10. Depreciation
Depreciation is an accounting device that is used to reduce the book value of
capital assets. The reduction in book value represents the wear and tear on
the equipment. The primary reason for using the device of depreciation is to
lower the value of capital assets on the balance sheet in order to lower tax
liabilities.
Of the various models for depreciation, the four most commonly used for
equipment placed in service before 1981 are (1) straight line method, (2)
declining balance method, (3) sum of years digits method, and (4) units of
production method. For property placed in service after 1986, the MACRS
(modied accelerated cost recovery system) is to be used.

501.11. Straight Line Method

Using the straight line method, the annual depreciation claimed on a
property is given by

(501.10)
where C = initial value of the property

S = salvage value at the end of design life

n = design life

501.12. Declining Balance Method

Under the declining balance method, the annual depreciation claimed on a

property is calculated as
Annual depreciation = depreciation rate book value at the beginning of the
year
The most common depreciation rate used is double the straight-line rate. For
this reason, this technique is also referred to as the double-declining balance
method.
For example, if the initial cost of the property is $1000 and the salvage value
after a 5-year useful life is $100, then the depreciable value is $900. If the
straight line approach were taken, the annual depreciation would be $180
(18%). Let us use a rate of 36% for the declining balance method. The
following numbers are calculated. For comparison, the very last column in the
table gives the end of yearbook value using straight line depreciation.
Book value
Year

at
beginning

Depreciation

Book value

Book value

at end of

(straight

year

line)

of year
1

1000

360

640

820

640

230

410

640

410

148

262

460

262

94

168

280

168

60

108

100

501.13. Sum of Years Digits Method

Under this method, annual depreciation is determined by multiplying the
depreciable cost by a schedule of fractions. If the useful life is n years, the
sum of years' digits represents the sum 1 1 2 1 3 1 1 n = n (n 1 1)/2. The
depreciation fractions are then

For example, if the depreciation period is 5 years, the sum of years' digits is 1
1 2 1 3 1 4 1 5 = 15. The fractions are therefore 5/15 for the 1st year, 4/15 for
the 2nd year, 3/15 for the 3rd year, 2/15 for the 4th year, and 1/15 for the 5th
year.

501.14. Units of Production Method

Under this method, annual depreciation is computed based on the number of
units produced during the year. A depreciation rate per unit of production is
rst computed by dividing the depreciable cost by the total number of units
expected to be produced over the useful life.

501.15. Modied Accelerated Cost Recovery System

Under the MACRS, the owner of the property is allowed to depreciate the
property by published percentages that are given in Table 501.13.

Table 501.13. MACRS Depreciation Schedules

Recovery

3year

5year

7year

10year

15year

20year

year

property

property

property

property

property

property

33.33

20.00

14.29

10.00

5.00

3.75

44.45

32.00

24.49

18.00

9.50

7.219

14.81

19.20

17.49

14.40

8.55

6.677

7.41

11.52

12.49

11.52

7.70

6.177

11.52

8.93

9.22

6.93

5.713

5.76

8.92

7.37

6.23

5.285

8.93

6.55

5.90

4.888

4.46

6.55

5.90

4.522

6.56

5.91

4.462

10

6.55

5.9

4.461

11

3.28

5.91

4.462

12

5.9

4.461

13

5.91

4.462

14

5.9

4.461

15

5.91

4.462

16

2.95

4.461

17

4.462

18

4.461

19

4.462

20

4.461

Example 501.7
An asset has a purchase price of $25,000. It has a 10-year useful life and a
salvage value of $8000. Find the book value at the end of year 3 using
straight line depreciation.
Solution
Annual depreciation D = (25,000 2 8000)/10 = $1700 per year
Book value = 25,000 2 3 3 1700 = $19,900
Example 501.8
What would be the book value at the end of 3 years for the above-named
asset if the MACRS (modied accelerated cost recovery system) method of
depreciation was used?
Solution Depreciation percentages in years 1, 2, and 3 = 10%, 18%, and
14.4%, respectively
Book value = 25,000 3 [1 2 0.1 2 0.18 2 0.144] = 25,000 3 0.576 = $14,400

501.16. Tax Issues

Example 501.9
A corporation pays 48% in income tax on prots. It purchases an asset that
will produce a revenue stream of $5000 for 10 years. The cost of the asset is
$30,000. Annual expenses are $1500. Salvage value (at the end of year 10) of
the equipment is $1200. Ignore depreciation. Use an MARR of 8%. What is
the after-tax present worth of the asset?
Solution
Annual revenue = $5000
Annual expenses = $1500
Annual prot = $3500
Annual taxes = 0.48 3 $3500 = $1680
NET annual prot = $1820

501.17. Bonds
Example 501.10
What is the maximum an investor should pay for a 25-year bond with a
$20,000 face value and an 8% coupon rate (with interest paid semiannually)?
The bond will be held to maturity. The eective annual rate for comparison is
10%.
Solution If the interest is paid semiannually, the payment is 4% of 20,000 =
$800.
The eective MARR = 10%. This must be converted to an equivalent 6-month
rate using

Bond is held to maturity, which is 25 years, or 50 six-month periods. The

present worth of 50 $800 payments at an interest rate 0.0488

present worth of 50 $800 payments at an interest rate 0.0488

The present worth of a future sum of $20,000 is

The total present worth of all sources of income from the bond, if held to
maturity, is $16,726.46.

501.18. Break-Even Analysis

Example 501.11
A company has a choice between two processes to manufacture a product.
The data for both options (A and B) are given below. How many units must be
produced annually to justify process A? Assume the MARR = 7%.
Process A

Process B

Initial cost ($)

50,000

28,000

Fixed annual cost ($)

2,500

1,300

Annual production cost

20

30

Life (years)

10

Salvage value of

4,000

($/unit)

equipment ($)

Solution Let annual production be x units.

Since length of timeline is dierent for options A and B, use EUAC (equivalent
uniform annual cost).
EUAC of all costs (option A) in thousands of dollars

EUAC of all costs (option B) in thousands of dollars

In order to justify option A, we must have

At least 335 units must be produced annually in order to justify option A.

501.19. Benet-Cost Analysis

A project is considered benecial if benets exceed costs. This may be
expressed mathematically as

(501.11)
If the rst approach is taken, all benets and costs should be converted to
equivalent quantities (i.e., all expressed as present worth, or all converted to
annuities, etc.). For the second approach, it is typical to express the
dierential as the net present worth of all benets and costs.
Example 501.12
For an existing bridge, the costs related to performing repairs are shown in
the table below. All costs are in thousands of dollars. Calculate the benetcost ratio of performing repairs. Use MARR = 8%.
Existing

Repair

Initial cost

120

Salvage value

50

180

Maintenance costs:

Years 110

12

Years 1120

18

Design life

20 years

Solution The added cost of repairing the bridge is $120,000. This is a

present value P . The oset to the cost is the extra $180 2 $50 = $130 in
salvage. This can be considered a negative cost. This is a future value F .
By performing the repairs, the maintenance costs are reduced by $7000
throughout the 20 years plus an additional savings of $4000 in years 11 to 20.
The rst is an annuity A . The second is a shifted annuity A . We can visualize
the shifted annuity (1) as the dierence between two annuities as shown
below: (2) 2 (3). Annuities 2 and 3 are easier to deal with because their origin
is at t = 0, and therefore the tables can be used.

Converting all quantities to present worth (all sums in thousands of dollars)

Benet cost ratio = 0.88

Citation
EXPORT

Indranil Goswami: Civil Engineering All-In-One PE Exam Guide: Breadth and Depth,
Second Edition. Engineering Economics, Chapter (McGraw-Hill Professional, 2012),
AccessEngineering

Copyright McGraw-Hill Education. All rights reserved.

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