Me443 CH3 PDF

Content
•Introduction
•Interest Calculations
•Single Sums of Money
•Series of Cash Flows
•Multiple Compounding
•Continuous Compounding
•Equivalence
•Changing Interest Rates
•Inflationary Effects
•Bond Problems
Engineering Economy and ME 443 3.1

Production Management Chapter 3: Time Value of Money
METU, Mech. Eng. Dept. 2009 Fall
Introduction
•Two groups of criteria for comparing design alternatives:
a) System performance- characteristics such as quality,
safety, customer service, etc.
b) Economic performance- characteristics such as initial
investment requirements, return on
investment and CF profile
•CF profiles are different for each alternative, hence differences
in timings of CF’s must be compensated
•Fundamental concept: Money has a time value, its value depends
on when it is received.
•Here, effect of inflation (purchasing power) will be neglected, only
time value of money (earning power) will be considered.

Introduction
Example 3.1
Consider two investment alternatives with the following cash flow
profiles:
EOY Alt. A Alt. B
0 -10MTL -10MTL
Which one
1 +7MTL +1MTL is better?
2 +5MTL +3MTL
3 +3MTL +5MTL

Introduction
Example 3.2
Given two alternatives with the following CF profiles:
Alt. C
Which one
Alt. D is better?

Introduction
Example 3.3
Given two alternatives with the following CF profiles:
Alt. E
Alt. F Which one

is better?
E-F

Interest Calculations
•If a single sum of money has a current (present) value of P, its value
in n-years will become:
Fn = P + In
Fn: accumulated value of P over n-years, or future value of P
In: increase in the value of P over n-years, also referred to as the
accumulated interest in borrowing and lending transactions, and a
function of P, n and annual interest rate, i.
i: annual interest rate, change in value for 1TL over a 1- year period
•Two approaches for computing value of In:
1. Simple interest approach 2. Compound interest approach

1. Simple interest approach: In is a linear function of time.
In= P i n
Fn= P(1 + in)
2. Compound interest approach: In is obtained using i as the rate of
change in the accumulated value of money.
In= iFn-1
Fn=Fn-1(1+i)
•Whenever the interest charge for any time period is based only on
the unpaid principal amount, not on any accumulated interest charges,
simple interest calculations apply.
Example 3.4
A debt of 2500 TL is incurred at t=2. An annual simple interest rate
of 8% on the unpaid balance is agreed on. Two equal payments of
1000TL are made at t=4 and t=5 and a final payment at t=6 to pay off
the debt, including interest payments. Find the size of the final
payment at t=6.
Solution:
Unpaid balance at the end of t=4:
2500 (1+2x0.08)-1000=1900TL
1900(1+0.08)-1000=1052TL
1052(1+0.08)=1136.16TL
Effect of Compound Interest
End of (A) (B) (C)=(A)+(B)
Period Amount Interest for Amount Owed
Owed Next Period for Next Period
0 P Pi P+Pi=P(1+i)
1 P(1+i) P(1+i)i P(1+i)+P(1+i)i=P(1+i)2
2 P(1+i)2 P(1+i)2i P(1+i)2+ P(1+i)2i=P(1+i)3
.. .. .. ..
. . . .
n-1 P(1+i)n-1 P(1+i)n-1i P(1+i)n-1+ P(1+i)n-1i= P(1+i)n
n P(1+i)n
Single Sums of Money
(1+i)n = (F/P i, n) : single sum, future worth factor
hence,
F = P(1+i)n = P(F/P i, n)
Example 3.5
How much money one should pay 3 years hence, if he/she gets a loan
of 100,000TL at 10% compounded annually now?
(F/P 10,3)=1.3310 (from Table A.16)
F = 100,000(1+0.1)3 = 133,100TL
•Similarly P can be found from the given values of F, i, n:
P = F( 1+i)-n
where
( 1+i)-n = (P/F i, n) : single sum, present worth factor
Example 3.6
How much money is required today to accumulate to a sum of
$10,000 in 10 years, earning interest at 8% compounded annually?
P = F(P/F 8,10) (P/F 8,10) = 0.4632 (from Table A.14)
= 10,000(0.4632)
= $4,632
Series of Cash Flows

Let At denote magnitude of a cash flow at the end of t:
P = A1(1+i)-1+ A2(1+i)
t
-2+ … + A (1+i)-(n-1)+ A (1+i)-n
n-1 n
n n
P   A t 1  i  or, P   A t P/F i, t 
t 1 t 1
Example 3.7
Consider the cash flow diagram below. Using an interest rate of
12% per interest period, find the present worth equivalent.
$3,500
$3,000 $4,000
$2,000
$2,500
$5,000
Solution
0.7972 0.5674
P  -5000  3000 (P/F 12,2)  2500 (P/F 12,5)
0.4523 0.3606
 4000 (P/F 12,7)  2000 (P/F 12,9)
0.3220
 3500 (P/F 12,10)  -$369.50
And,
n
F   A t F/P i, n - t 
t 1
Example 3.8
Given the previous series of CF’s, determine FW at EOP 10
using an interest rate of 12% per compounding period.
3.1058 2.4760
F  -5000 (F/P 12, 10) 3000 (F/P 12, 8)
1.7623 1.4049
 2500 (F/P 12, 5) 4000 (F/P 12, 3)
1.1200
 2000 (F/P 12,1) 3500  - $1147.15
Possible Series of Cash Flows:
a) Uniform Series of CF
At=A t=1, 2, 3, …, n
b) Gradient Series of CF
 0 t 1
At  
A t 1  G t  2, ..., n
c) Geometric Series of CF
 A1 t 1
At  
A t 1 1  j t  2, 3, ..., n
Uniform Series of CF:
• All CF’s in the series are equal
n
 P   A1  i  P  AP/A i, n 
t
t 1
 1  i n  1 uniform series
P/A i, n    n 
Example 3.9
 i1  i   PW factor
Somebody plans to make single deposit P into a fund paying

15% per year such that 150MTL payments are received at the
end of each of the succeeding 5 years. What single deposit is
needed?
3.3522
P  A P/A 15, 5)   150Mx3 .3522  502 ,800 ,000 TL
Suppose that the first withdrawal of the previous example will
not occur until 4 years after the deposit:
3.3522 0.6575
P  150M P/A 15,5) P/F 15,3  330,610,725TL
• deferring the first withdrawal for 3 years hence reduces the
deposit to about its half
• Similarly,
 i1  i n 
A  P 
 1  i  n
 1 
 i1  i n 
   A/P i, n  Capital Recovery Factor
 1  i   1
n
Example 3.10
A debt of 1BTL is incurred at t=0. What is the amount of
three equal payments at t=1, 2, and 3 that will repay the debt
if money is worth 10% compounded per period?
0.4021
A  PA/P i, n   1B A/P 10,3  402,100,000TL

• If the first payment is delayed for 3 years, how much should be
paid each of the three years?
1.3310
V3  PF/P i, n   1B F/P 10, 3  1,331,000,000TL
0.4020
A  V3 A/P 10,3  1,331,000,000 x0.4021  535,195,000TL
• Delaying the first payment for three years has increased the size of
each payment more than 33%.
• Also,
 n
F  A
 1  i  1

 i 
 1  i n  1
   F/A i, n  Uniform Series Future Worth Factor
 i 
Example 3.11
Five deposits of 500MTL each are made at t=1, 2, 3, 4, and 5
into a fund paying 8% compounded per period. How much will
be accumulated in the fund at (a) t=5 and (b) t=10?
5.8666
F5  500 M F/A 8, 5 
 2,933,300, 000TL
1.4693
F10  2 ,933 ,300 ,000 F/P 8, 5 
 4,309,898, 000TL

And  
i
A  F 
 1  i   1
n
 
  A/F i, n  Sinking Fund Factor
i

 1  i   1
n
Example 3.12
What equal annual deposits
must be made at t=2, 3, 4, 5
and 6in order to accumulate
15BTL at t=8 if money is worth
10% compounded annually?

0.8264 0.1638
A  15B P/F 10, 2A/F 10, 5  2,030,465,000TL
Gradient Series of CF:
 0 t 1
At  
A t -1  G t  2, 3, ..., n
• First positive cash flow occurs at the end of 2nd time period.
• Size of CF in gradient series occurring at the end of period t is
given by:
At = (t-1)G t = 1, …, n
PW equivalent of a gradient series is obtained:
n n n
P   A t 1  i   t  1 G 1  i   G  t  11  i 
t t t
t 1 t 1 t 1
1 - 1  ni 1  i  n 
P  G 2 
 i 
 P/A i, n   n P/F i, n  
P  G 
 i
 P/A i, n   n P/F i, n  
   P/G i, n  Gradient Series, PW Factor
 i 
1 n 
A  G   A/F i, n   G A/G i, n  Gradient to Uniform Series
i i  Conversion Factor
Example 3.13
An individual deposits an annual bonus into a savings account
that pays 8% compounded annually. The size of the bonus
increases by 500MTL/year; the initial bonus was 1.5BTL.
Determine how much will be in the fund immediately after the
fifth deposit?

Example 3.13 (continued)
5.8666
F1  1.5B F/A 8, 5  8,799,900,000TL
1.8465 5.8666
F2  500M A/G 8, 5F/A 8, 5  5,416,338,000TL
F  F1  F2  8,799,900,000  5,416,338,000  14,216,238,000TL
Example 3.14
Land is purchased for 25BTL. It is agreed that this amount will
be paid for over a 5-year period with annual payments, using a
12% annual compound interest rate. Each payment is to be
2BTL less than the previous payment. Determine the size of the
last payment.
 -

3.6048 6.3970
25B  A 1 P/A 12, 5 2B P/G 12, 5
25B  2B  6.3970
A1 
3.6048
 10,484,354,000TL
A 5  A 1  4G
 10,484,354,000 - 4  2,000,000,000
 2,484,354,000TL
Geometric Series of Cash Flows:
CF at time t can be given by:
A t  A t -1 1  j t  2, 3, ..., n
j = %change in
or the size of CF
A t  A 1 1  j t  1, 2, ..., n
t -1
Geometric series is used to represent

the growth (+ve j) or decay (-ve j) of
costs and revenues undergoing
annual percentage changes.

• As an illustration, if labour costs increase 10% a year, resulting
series representation of labour costs will be a geometric series.
1 j 
n n t
P   A 1 1  j 1  i   A 1 1  j 
t 1 t 1
 
t 1 t 1  1  i 
 1  1  jn 1  i  n 
A 1   i j
  1- j 
P
 nA 1
 i j
1 i
P  A 1 P/A i, j, n 
1  F/P j, n P/F i, n  
P  A1   i j j0
 i- j 
Example 3.15
A professional sports team has negotiated a 5-year contract with
one of its super stars. The contract calls for a salary of
$1,125,000 the first year followed by 10% annual increases.
The salary will be paid out over a 20-year period, with the
amount paid each year being 10% greater than the previous
year. The general manager of the team and the athlete’s agent
agree that the present worth of the contract will be equated to
the PW of the payments using an annual compounding rate of
10%.
a) General manager wishes to compute the PW equivalent cost to the
team. They have been able to invest money and earn a 15% annual
return.
Example 3.15 (continued):
b) The athlete wants to know how much will be paid each of the first 5
years, how much will be paid the 20th year and PW equivalent of
contract if money is worth i) 5%, ii) 8%,
iii) 10% over 20 years.
Solution:
a) PW equivalent of contract for the general manager:
3.9858
P  A 1 P/A 1 15, 10, 5  1,125,000  3.9858  $4,484,025
b) General manager and agent agreed that the amount to be paid to
the athlete the first year can be determined by setting PW
equivalent of payments=PW equivalent of contract at 10%.
Solution (continued):
18.1818 4.5455
A 1 P/A 1 10, 10, 20   1,125,000 P/A 1 10, 10, 5
 A 1  $281,253
k' th year payment :
A k  281,253F/P 10, k - 1
A 2  $309,378
A 3  $340,316

A 20  $1,720,116
Solution (continued):
PW equivalent of the contract :
P  281,253P/A 1 i, 10, 20 
for i  5% : P  281,253  30.7105  $8,637,423
for i  8% : P  281,253  22.1686  $6,234,988
for i  10% : P  281,253  18.1818  $5,113,687
• Note that PW equivalent of the agreed payment plan is even less
than that of the original contract for the general manager:
11.7790
P  281,253 P/A 1 15, 10, 20   $3,312,880
• FW equivalent of the geometric series is obtained by multiplying
the value of the geometric series PW factor and (F/P i, n) to obtain:
  1  i n  1  jn 
A 1   i j
F  i- j 

 nA 1 1  i  i j
n -1
F/A1 i, j, n   Geometric Series FW Factor

and note that
F/A1 i, j, n   F/A1 j, i, n 

Example 3.16
Zeynep works for a company that pays an annual bonus, the size
of which is based on experience with the company. At the end of
her first year, bonus equals 600MTL. The size of the bonus
compounds at an annual rate of 6%. Zeynep decides to place 2/3
of her annual bonus in a fund that pays 10% per year. How much
will be in the fund immediately after the 30th deposit?
Solution:
292.6478
F  400M F/A 10, 6, 30
 117,059,120,000TL

Multiple Compounding
Example 3.17
Suppose interest is stated as 8% compounded quarterly. If you
borrow 1BTL for one year, how much must be repaid?
8%
i  2% per quarter
4
1.0824
F  P F/P 2, 4   1,082,400,000TL
• Note that if interest were stated as 8.24% compounded annually,
the same amount would be owed.
Effective interest rate: annual compounding rate that is
equivalent to the stated interest rate
• Let r denote nominal interest rate, m=no. of comp./year, i=int.
rate/comp. period and ieff=effective int. rate/year
m
 r   
i eff  1    1  1  i   1   F/P
r
, m 1
m
 m  m 
• 8% compounded semiannually:
0.08
r  0.08, m  2  i   0.04
2
i eff  F/P 4, 2   1  0.0816
• 18% compounded monthly:
0.18
r  0.18, m  12  i   0.015
12
i eff  F/P 1.5, 12   1  0.1956  19.56%
Example 3.18
Somebody borrows $50,000 and pays the loan with interest after
27 months. He pays back $65,000. What is the interest rate for
this transaction?
Let interest period be a quarter (3-month period):
F  PF/P i, 9   1  i  
65,000
 1.3
9
50,000
1  i   1.0296  i  0.0296  2.96%
i eff  1  i   1  1  0.0296   1  0.1237  12.37%
4 4
• Effective annual interest rate is a very good basis for comparing

alternative financing plans.
• A number of situations involve CF’s occurring at intervals that are
not the same as the compounding intervals.
Example 3.19
Lynn makes monthly deposits of $500 in a savings account that
pays interest at a rate equivalent to 8% compounded quarterly.
How much money should be in the account immediately after
the sixtieth deposit? If no interest is earned on money deposited
during a quarter and the first deposit coincides with the
beginning of a quarter, what will be the account balance
immediately after the sixtieth deposit?
Solution:
In the first part it is assumed that monthly deposits earn interest
equivalent to 8% compounded quarterly, hence; if i designates
monthly rate: 4
 
i eff  1  i   1  1 
0.08
  1  i  0.6623% per month
12
 4 
Solution(continued):
 1  0.0066 60  1
 F  500F/A 0.66%, 60  500    $36,688
 0.0066 
In the second part however it is assumed that money deposited
during a quarter can not earn any interest.
iq= 2%
1st quarter 2nd quarter 3rd quarter ... 20th quarter

0 1 2 19 20
0 1 2 3 4 5 6 7 8 9 56 57 58 59 60
...
...
500
500/month
1000
1.4568 22.8406
F  500 F/P 2,19  1500 F/A 2, 19  1000  $ 35 ,989 1500 1500 1500
Example 3.20
Somebody makes semi-annual deposits of 1.5BTL into an account that
pays interest equivalent to 12% compounded monthly. Determine the
account balance immediately before the tenth deposit.
i eff  1  i s.a.   1  1  0.01  1

2 12
1  i s.a.  1.016  i s.a.  0.06152 / semi  annum

 1  0.06152 9  1
F  1.5B  1  0.0615
 0.06152 
 18,412,893,000TL

Example 3.20
i eff  1  i s.a.   1  1  0.01  1

2 12

 1  0.06152 9  1
F  1.5B  1  0.0615
 0.06152 
 18,412,893,000TL

Example 3.20
i eff  1  i s.a.   1  1  0.01  1

2 12

 1  0.06152 9  1
F  1.5B  1  0.0615
 0.06152 
 18,412,893,000TL

Continuous Compounding
• As the frequency of comp./year  ieff
• For cont. comp. Single Payment Compound
Amount Factor will then become:
mn
 r
lim 1    e rn
m   m
hence, F = Pern
cont. comp. single sum
F = P(F/P r,n) F.W. factor

Example 3.21
Somebody borrows 2B TL from a bank at 15%
compounded continuously. How much should he
pay after 5 years in order to pay off the loan?
 2.1170 
F  P  F/P 15%,5 
 
 2B  2.117
 4,234,000, 000TL
Effective interest rate:
i eff  e r  1
i eff  (F/P r,1)  1
if 15% comp. cont.,
 1.1618 
i eff   F/P 15,1   1  0 . 1618  16 . 18 %
 
also,
P  Fe - rn
and P  P/F r, n 

Discrete Flows
Example 3.22
Four equal, quarterly deposits of 1.5BTL each are
made at t=0,1,2 and 3 into a fund that pays 8%
compounded continuously. Then at t=7 and t=10,
withdrawals of size A(TL) are made so that the
fund is depleted at t=10. What is the size of
withdrawals A?
Example 3.22 (Solution) A A
CF diagram: r=8%
0 1 2 3 4 5 6 7 8 9 10
1.5BTL/year
4.1228

1.503 1.0618

F  1.5B( F/A 2,4 )  ( F/P 2,7 )   A 1  ( F/P 2,3 ) 
 
1.5B  4.1228  1.1503
A  3, 450 , 231,000 TL
2.0618
In the case of the geometric series, the size of the
tth CF will be assumed to be given by:
At=At-1ec t=2, …, n
or,
At=A1e(t-1)c t=1, …, n
c=nominal comp. rate of increase in the size of CF
(P/A1 r,c,n): cont. comp. geo. series P.W. factor
(F/A1 r,c,n): cont. comp. geo. series F.W. factor
Example 3.23
Somebody receives an annual bonus from his employer. He
wishes to deposit the bonus in a fund that pays interest at a
rate of 8% compounded continuously. His first bonus is
1BTL. The size of his bonus is expected to increase at a rate
of 4% a year. How much money will be in the fund
immediately before the tenth deposit?
A1  1BTL r  8% c  4% n  10
14.6224 1.0833
F  1BTL(F/A1 8,4,9)  (F/P 8,1)   15,840,446,000TL
Equivalence
Two CF series or profiles are said to be equivalent at some
specified interest rate k%, if their PW (or any other worth)
are equal using that interest rate k%.
Example 3.24
What single sum of money at t=4 is equivalent to the CF
profile shown below. Use a 12% interest rate in analysis.
2B 2B
0 1 2 3 4 5 6  4
3B 2B X=?
5B 4B
Equivalence
Example 3.24 (solution)
4.7793 4.1273 1.5735 1.6901
X  5B(F/A12,4) -1B(P/G12,4)(F/P12,4) - 2B(P/A12,2)
 14,021,993,000TL
Example 3.25
Given the two CF profiles shown below, for what value of X
are the two series equivalent using an interest rate of 10%?
inc. by $X/year
inc. by $8,000/year $16,000+6X
$80,000 from year3

$24,000 $16,000
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
$200,000 $140,000
Equivalence
Example 3.25 (solution) 5.3349 16.0287
PW(10)  -200,000  24,000(P/A 10,8)  8,000(P/G 10,8)
5.3349 12.7631 0.9091
 -140,000  16,000(P/A 10,8)  X(P/G 10,7)(P/F 10,1)
110,909
X  $9,559
12.7631 0.9091
Example 3.26
Assume payments of 2B, 3B and 5B TL are received at t=3,4,
and 5 respectively. For what interest rate, five equal payments
of 1,756M TL occurring at t=1,2,3,4 and 5 respectively
are equivalent to the previous payments?
Equivalence
5BTL 1,756M TL/year
2BTL 3BTL
0 1 2 3 4 5
0 1 2 3 4 5
FW(i)  2(F/P i,2)  3(F/P 1)  5
 1.756(F/A i,5)
Let i  8%,
2  1.1664  3  1.08  5  10,572,800 ,000TL
1.756  5.8666  10,301,750 ,000TL 10,572,800 ,000TL
Equivalence
Example 3.26 (solution cont.’d)
Let i  10%
2 1.21 31.1 5  10,720,555,000TL
1.756 6.1051 10,720,555,000TL  10,720,000,000TL
i  10%

Principal Amount and Interest
Amount in Loan Payments
•Income taxes are affected by the amount of interest paid
on the borrowed funds. It is therefore important to know
how much of each payment is interest and how much is
reducing the principal amount borrowed initially.
Example 3.27
Suppose an individual borrows 10BTL and pays it back
using four equal instalments, with interest computed at
10% compounded annually. The payment size is
computed to be: A=P(A/P 10,4)=10Bx0.3155=3.155BTL
EOY Total Interest Payment Principal Payment Balance (BTL)
Payment (BTL) (BTL)
(BTL)
1 3.155 10x0.1=1 2.155 10-2.155=7.845
2 3.155 7.845x0.1=0.7845 3.155-0.7845=2.3705 7.845-2.3705=5.474
3 3.155 5.474x0.1=0.5474 3.155-0.5474=2.60755 5.474-2.60755=2.86695
4 3.155 2.86695x0.1=0.2867 3.155-0.2867=2.8663 0

•The amount of principal remaining to be repaid immediately after
making payment (t-1) can be found by stripping off the interest on
the remaining (n-t+1) payments; letting Ut-1 denote the unpaid
principal after making payment t-1, we know that:
Ut -1  A(P/Ai, n - t  1)
n - t 1 … ...
Ut -1  A  (1 i)- j 0 1 2 … t-1 t ... n
j1
•The amount by which payment t reduces the unpaid will be

designated Et and given by:
Et= Ut-1-Ut
 n t  n-t
E t  A (1  i)- j  (1  i)-(n-t 1)   A (1 i)- j
 j1  j1
-(n-t 1)
E t  A(1 i)
E t  A(P/Fi, n - t  1)
E t  P(A/Pi, n)(P/Fi, n - t  1)
It  A - Et
I t  A1- (P/Fi, n - t  1)
Example 3.28
An individual purchases a 130BTL house and makes a down payment
of 30BTL. The remaining 100BTL is financed over a 25 year period at
12% compounded monthly. The individual keeps the house for 5 years
and decides to sell it. How much equity (paid principal) is there in the
house?
Solution:
Monthly house payment:
A=100B(A/P 1, 300) = 1.053BTL
Amount of principal remaining=PW of remaining 240 monthly paym.
P = 1.053B(P/A 1,240) = 95.66633BTL
Individuals equity:
100B-95.66633B+30B = 34.367BTL
Total payment in 5 years:
60x1.053B = 63.18BTL
Hence total interest payment in 5 years:
63.18B-4.367B = 58,813,000,000TL

Changing Interest Rates
F=P (1+i1) (1+i2) ... (1+in-1) (1+in)
P=F (1+in)-1 (1+in-1)-1 … (1+i2)-1 (1+i1)-1
Example 3.29
Somebody deposits 5BTL in an account that pays interest at a rate
of 7% compounded annually. Two years after the deposit, the
savings account begins paying interest at a rate of 8% compounded
continuously. Five years after the deposit, the savings account
begins paying interest at a rate of 9% compounded semiannually.
How much money should be in the savings account 10 years after
the initial deposit?
F=?
i1=9% comp. semi-annually
i1=7% i1=8% comp. cont.
1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8 9 10
5BTL
1.1449 1.2712 1.5530
F  5B(F/P 7,2)(F/P 8,3)  (1  0.045)10  11,300,934,000TL

For the series of CF:
P  A1(1 i1)1  A2 (1 i1)1(1 i2 )1  A3 (1 i1)1(1 i2 )1(1 i3 )1
...  An (1 i1)1(1 i2 )1 ...(1 in )1
F  A n  A n -1 (1  i n )  A n -1 (1  i n -1 )(1  i n )
 ...  A 1 (1  i 2 )(1  i 3 ) ... (1  i n -1 )(1  i n )
Example 3.30
What is the size of equivalent annual payments for the above
problem?
ieff=(1+0.045)2-1 = 9.2%
5BTL
A
1.8080 2.5619 0.8734  (1 0.092)5 1  0.7866 0.8734
(P/A 7,2)  (P/A 8,3) (P/F 7,2)   5
(P/F 8,3) (P/F 7,2)
 0.092(1  0.092) 
A=745,156,000TL/year
Inflationary Effects
•Inflation is an increase in the amount of currency in circulation,
resulting in a relatively sharp and sudden fall in its value and
therefore a rise in prices.
•One of the most popular indicators of the general inflation rate (j) is
the Consumer Price Index (CPI).
•General inflation rate (j) is an overall measure of the annual decrease
in purchasing power of a unit currency.
•The rate (j) is determined by the price changes of a wide range of
Goods and services. Inflation rate is a weighted average of
commodity escalation rates (g) of many goods and services.
•Negative value of inflation rate (j) is known as deflation.
•Commodity escalation rate (g) is the annual rate of increase in the
price for a particular good or service.
•Value of (g) includes the effects of general inflation (j) and may be
lower or higher than the value of (j).
•(g) may vary considerably from one year to another, but it can be
expressed as a compound annual rate over a longer period of time.
•Then-current value of an amount at EOY “k” (Tk) is the actual no.
of currency units that will change hands.

•Constant worth CF (Ck) represents the purchasing power at time “k”
of an amount relative to some base point in time, usually year zero.
This can be thought of as the then-current CF with the general
inflation content removed.
•When constant worth CF can be represented as a uniform series,
equivalent then-current CF will be represented by a geometric series.
•Let year zero be used to establish the base for constant worth CF
occurring at EOY “k”:
Ck = T0 for k=1, …, n
Then-current equivalent CF:
Tk = T0(F/P j,k) for k=1, …, n

Likewise, if the then-current CF’s increase at a commodity escalation
rate of (g):
Tk = T0(1+g)k = T0(F/P g, k) for k=1, …, n
then,
Ck = Tk(1+j)-k = Tk(P/F j, k) for k=1, …, n
or,
Ck = T0(1+g) k (1+j)-k
= Tk (F/P g, k)(P/F j, k) for k=1, …, n
•Commodity escalation rate is a combined rate, consisting of inflation
and real escalation, the real commodity escalation rate “v”:
v = (1+g)/(1+j) -1
Hence, if constant worth CF’s increase at a real escalation rate of
“v” such that:
Ck = T0(1+v)k = T0(F/P v, k) for k=1, …, n
then,
Tk = T0(1+v) k = T0(F/P g, k)
= Tk (F/P g, k)(P/F j, k) for k=1, …, n
PW equivalent of a constant worth CF is given by:
P = Ck(P/F d,k) d = real interest rate
PW equivalent of a then current CF is given by:
P = Tk(P/F i,k) i = combined interest rate
1+i = (1+d)(1+j), i=
d+j+dj
Example 3.37
Raw materials for use on a 3-year project are expected to increase in
price at an annual commodity escalation rate of 10%. The general
inflation rate (j) is also expected to be 10% per year. A unit of raw
material costs 50 M TL today:
Year Then Current TL Constant Worth TL

1 55,000,000 50,000,000
2 60,500,000 50,000,000
3 66,505,000 50,000,000
Example 3.38
Energy on the 3-year project of the previous example, currently costs
5,500,000 TL per 1000 kW-h. Energy costs will escalate at a rate of
22% and inflation will remain constant at 10% per year:
Year Then Current TL Constant Worth TL
Tk = T0(1+g)k Ck = T0(1+g)k/(1+j)k
1 6,710,000 6,100,000
2 8,180,000 6,760,500
3 9,980,870 7,500,400

Economic Analysis Under Inflation
•In order to properly account for the time value of money, an
appropriate discount or interest rate must be determined.
•Real discount rate “d” does not include an adjustment for the
expected general inflation rate. It represents the earning power of
money, or MARR, in the absence of inflation and is used to move
constant worth mounts of money backward and forward in time.
•Combined discount rate “i” includes an adjustment for the general
inflation rate. It takes into account earning power of money as well as
purchasing power of money (inflation) nd is expected as:
1+i = (1+d)(1+j)
i = d+j+dj

•Either of the two procedures should be followed:
1. Express all CF’s in terms of their then-current amounts and use an
interest rate that combines the real discount rate and the inflation rate;
i = d + j + dj
2. Express all CF’s in terms of their constant worth amounts and use
the real discount rate alone without n inflation rate component.
•Using the first approach, to account for inflationary effects PW
equivalent of a series of then-current CF’s is computed as follows:
n n
PW(i)   Tt (1  d)-t (1  j)-t   Tt (1  d  j  dj)-t
t 0 t 0
n
  Tt (1  i)-t
t 0
•Second approach computes PW equivalent using constant worth
amounts:
n
PW(d)   Ct (1  d)-t
t 0
Example 3.39
Consider two CF series for a project over a 3-year period. Expenses
are 10 BTL to start, with operating and maintenance costs of 2 BTL in
the first year, increasing at an escalation rate of 15% per year.
Incomes begin in year 1 at 8 BTL and decrease at a rate of 20% per
year. If the general inflation rate is 10% and the real discount rate is
7%, find PW of project using the two methods.

Then-Current Project Analysis
EOY,t Then Current Then Current Net CF,Discount Fact. Discounted net
exp. (g1=0.15), Inc. (g2=0.15), TL (1+d+j+dj)-t CF, TL
TL TL =(1+0.177)-t Tt(1+0.177)-t
0 -10 B - -10 BTL 1.00 -10 BTL
1 -2 B 8B 6B 0.85 5,097,710,000
2 -2.3 BTL 6.4 BTL 4.1 BTL 0.722 2,959,590,000
3 -2.645 BTL 5.12 BTL 2.475 BTL 0.613 1,517,910,000
-424,790,000

Constant Worth Project Analysis
EOY,t Const. Worth Constant Worth Net CF, Discount Fact. Discounted net
-t -t
exp., TL Incomes, TL Ct, TL (1+d) = (1+0.07) CF, TL
Ct(1+0.07)-t
0 -10 B - -10 BTL 1.00 -10 BTL
1 -1,818,180,000 7,272,730,000 5,454,550,000 0.935 5,097,710,000
2 -1,900,830,000 5,289,260,000 3,388,430,000 0.873 2,959,590,000
3 -1,987,230,000 3,846,730,000 1,859,500,000 0.816 1,517,910,000
-424,790,000

•If the effect of inflation were ignored,
PW = 1,208,910,000 TL instead of -424,790,000 TL.
•If the inflation rate tends to change from one time period to the next, PW
can be expressed:
n k
PW(dt , jt )  T0   Tk (1 jt )1 (1  d t )1
t 1 t 1
k
where,  representsproductof the followingtermsfor t
t 1
rangingfrom1 throughk

Bond Problems
• Important financial instruments in the business world as investment
opportunities.
• Additional reasons for considering bond problems are:
1. Issuance and sale of bonds is a mechanism by which capital may
be raised to finance engineering projects.
2. Bond problems illustrate the notion of equivalence, i.e. purchase
price of a bond is equivalent (has same PW) to the returns from
bond at appropriate compound interest rate.
3. Bond problems are convenient investment opportunities which
may be used to illustrate various methods of measuring investment
worth, especially PW and IRR methods.

Bond Problems
• An organisation may issue bonds to raise capital totalling to large
amounts.
• A financial brokerage firm usually handles the issue on a commission
basis and sells smaller amounts to other organisational units or individual
investors.
• Stated value on the individual bond is termed the face or par value.
• Par value is to be repaid by the issuing organisation at the end of a
specified period of time.
• Issuing unit is obligated to redeem the bond at par value at maturity.
• Also the issuing unit is obligated to pay a stipulated bond rate on the face
value during the interim between the date of issuance and date of
redemption.
• Bond rate applies to the par value of bond.
Bond Problems
Example 3.40
A person purchases a 5 BTL, 5-year bond on the date of issuance for
5 BTL. The stated bond rate is 10% semiannually, and the interest
payments are received on schedule until the bond is redeemed at
maturity for 5 BTL.
5 BTL
250 MTL
... Bond rate per semiannual interest
period: 10%/2 = 5%
Bond holder therefore receives:
5 BTL (0.1/2)5B = 250 MTL every 6 months

Bond Problems
•Since 5 BTL investment was exactly returned at redemption and
since during the interim an interest rate of 10% semiannual was
received, the yield must be 10% semiannual.
•5 BTL at t=0 is therefore equivalent to the revenue CF if the time
value of money is 10% compounded semiannually.
i.e. P = A(P/A 5,10) + F(P/F 5,10)
5B = 0.05x5Bx7.7217 + 5Bx0.6139
5 BTL = 5 BTL
•If more than the par value is paid at t=0 and if the revenue figures
remained the same, then IRR<bond rate. i.e.:
Bond Problems
5.5 BTL  5 BTL
-5.5B(F/P i,10) + 0.05x5B(F/A i,10) + 5B = 0
IRR can be found by iterative procedure as:
3.772% per semi-annum
Effective yield:
ie= (1+ 0.03772)2 - 1 = 7.686%
•Bonds may be purchased and sold for less than, greater than, or equal
to par value depending the economic environment.
•Once purchased, bonds may be kept for a variable no. of interest
periods before being sold.
Bond Problems
Notation: P = purchase price of bond
F = sales price (redemption value) of a bond
V = par or face value of a bond
r = bond rate/interest period
I = yield rate /interest period
n = no. of interest payments received by the bond holder
A = Vr = interest payment received
•General expression:
P = Vr(P/A i,n) + F(P/F i,n)
•Three types of bond problems:
1. Given P, r, n, V and a desired i, find sales price.
2. Given F, r, n, V and a desired i, find purchasing price.
3. Given P, F, r, n, V and find the yield earned on investment.
Bond Problems
Example 3.41
Somebody wishes to purchase a bond having a face value of 100 MTL and a
bond rate of 12% payable annually. The bond has a remaining life of 8
years. In order to earn an 18% rate of return on the investment, what amount
should be paid for the bond?
02660 4.0776
P  100M(P/F18,8)  100M 0.12(P/A18,8)
 755,312,000TL
Example 3.42
If the bond of the previous example is purchased for 90 MTL at an arbitrary
t=0 and sold after 6 years, what must be the selling price for the bond to be
preferred over investing at a MARR of 15% compounded annually?

Bond Problems
Example 3.42(solution)
3.7845 04323
90M  100M 0.12(P/A15,6)  (P/F15,6)
90M -12M 3.7845
F  103,136,700TL
0.4323
Example 3.43
A person buys a 100 MTL face value bond for 110 MTL. He sells it
for 130 MTL after 5 years. The bond pays 6 MTL semiannually.
Determine the equivalent annual yield rate.

Bond Problems
Example 3.43(solution)
110M(F/Pi,10)  6M(F/Ai,10)  130M
Let i  6%
110M1.7908 6M 13.1808 130M
196,988,000  209,084,800
Let i  8%
110M 2.1589 6M14.4866 130M
237,479,000  216,919,600
 6%  i 8%
(209,084,000 -196,988,000)(8%- 6%)
i  6% 
(209,084,000 -196,988,000)  (237,479,000 - 216,919,600)
i  6.74%per semi- annum
ie  (1  0.0674)2 1  13.93%

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Engineering Economy and ME 443 3.1

Engineering Economy and ME 443 3.2

Engineering Economy and ME 443 3.3

Engineering Economy and ME 443 3.4

Alt. F Which one

Engineering Economy and ME 443 3.5

Engineering Economy and ME 443 3.6

Series of Cash Flows

Somebody plans to make single deposit P into a fund paying

Engineering Economy and ME 443 3.18

Engineering Economy and ME 443 3.20

Engineering Economy and ME 443 3.21

Gradient Series of CF:

Engineering Economy and ME 443 3.24

Engineering Economy and ME 443 3.26

Geometric series is used to represent

Engineering Economy and ME 443 3.28

F/A1 i, j, n   Geometric Series FW Factor

Engineering Economy and ME 443 3.34

Engineering Economy and ME 443 3.35

• Effective annual interest rate is a very good basis for comparing

i eff  1  i s.a.   1  1  0.01  1

1  i s.a.  1.016  i s.a.  0.06152 / semi  annum

Engineering Economy and ME 443 3.41

i eff  1  i s.a.   1  1  0.01  1

1  i s.a.  1.016  i s.a.  0.06152 / semi  annum

Engineering Economy and ME 443 3.42

i eff  1  i s.a.   1  1  0.01  1

1  i s.a.  1.016  i s.a.  0.06152 / semi  annum

Engineering Economy and ME 443 3.43

Engineering Economy and ME 443 3.44

Engineering Economy and ME 443 3.46

Engineering Economy and ME 443 3.55

2 3.155 7.845x0.1=0.7845 3.155-0.7845=2.3705 7.845-2.3705=5.474

3 3.155 5.474x0.1=0.5474 3.155-0.5474=2.60755 5.474-2.60755=2.86695

4 3.155 2.86695x0.1=0.2867 3.155-0.2867=2.8663 0

Engineering Economy and ME 443 3.57

•The amount by which payment t reduces the unpaid will be

Engineering Economy and ME 443 3.61

Engineering Economy and ME 443 3.63

Engineering Economy and ME 443 3.66

Engineering Economy and ME 443 3.67

Year Then Current TL Constant Worth TL

Engineering Economy and ME 443 3.71

Engineering Economy and ME 443 3.72

Engineering Economy and ME 443 3.74

Engineering Economy and ME 443 3.75

Engineering Economy and ME 443 3.76

Engineering Economy and ME 443 3.77

Engineering Economy and ME 443 3.78

Engineering Economy and ME 443 3.80

Engineering Economy and ME 443 3.84

Engineering Economy and ME 443 3.85

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