Engineering Economics: College of Engineering Pune (COEP)

Engineering Economics
College of Engineering Pune(COEP)

Forerunners in Technical Education
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Engineering Economics
• ECONOMICS
“Economics is the study of how people and society choose
to employ scarce resources that could have alternative uses
in order to produce various commodities and to distribute
them for consumption, now or in the future, …”
(from Paul Samuelson and William Nordhaus, Economics, 12th Ed., McGraw-Hill, New York, 1985. )
• WHAT IS ENGINEERING ECONOMICS?

The application of economic principles to engineering
problems, for example in comparing the comparative costs
of two alternative capital projects or in determining the
optimum engineering course from the cost aspect.
College of Engineering Pune (COEP)

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Why Engineering Economy is Important to Engineers
•Decisions made by engineers, managers, corporation presidents, and

individuals are commonly the result of choosing one alternative over
another.
•Decisions often reflect a person’s educated choice of how to best invest
funds (capital).
•The amount of capital is usually restricted, just as the cash available to an
individual is usually limited. The decision of how to invest capital will
invariably change the future, hopefully for the better; that is, it will be value
adding.
•Engineers play a major role in capital investment decisions based on their
analysis, synthesis, and design efforts.
•The factors considered in making the decision are a combination of
economic and noneconomic factors.
•Fundamentally, engineering economy involves formulating, estimating,
and evaluating the economic outcomes when alternatives to accomplish a
defined purpose are available.

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Law of supply and demand
The law of demand holds that other things equal, as
the price of a good or service rises, its quantity
demanded falls.
Equilibrium
point The reverse is also true: as the price of a good or
service falls, its quantity demanded increases
• The law of supply holds that other things equal,
as the price of a good rises, its quantity supplied
will rise, and vice versa.
• Why do producers produce more output when
prices rise?
• This means that demand – They seek higher profits
curves slope downward.
– They can cover higher marginal costs of
production

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Factors influencing Supply
The shape of supply curve is affected by following
• cost of inputs
• Technology
• Weather
• Price related goods
Quantity Demanded
• Quantity demanded is the amount (number of units) of a product
that a household would buy in a given time period if it could buy all
it wanted at the current market price.
2002 Prentice Hall Business publishing Principles of Economics, 6/e Kari Case, Ray Fair

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Supply in Output Markets
• A supply schedule is a table showing how much of a product firms will supply at
different prices.
• Quantity supplied represents the number of units of a product that a firm would be
willing and able to offer for sale at a particular price during a given time period.

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Market Equilibrium
• Only in equilibrium
is quantity supplied
equal to quantity
demanded.
• At any price level
other than P0, the
wishes of buyers
and sellers do not
coincide.

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Shortages and Surpluses
• A shortage occurs when
quantity demanded exceeds
quantity supplied.
– A shortage implies the market
price is too low.
• A surplus occurs when
quantity supplied exceeds
quantity demanded.
– A surplus implies the market
price is too high.

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• Lower demand leads to • Lower supply leads to
lower price and lower higher price and lower
quantity exchanged. quantity exchanged.
• When supply and demand both increase, quantity will increase, but
price may go up or down.

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Defining Costs
There are different ways of defining costs:
By type: By function:
• Development costs
• Capital costs
• Operational costs
• Operating costs
• Maintenance costs
By behaviour: By time:
 Fixed costs  Recurring costs
 Variable costs  Non-recurring costs

Life cycle costs
• Life cycle costs: is the sum of all expenditure
associated with the item during its entire service life
• May include engineering design and development
costs, fabrication, testing, operating and
maintenance cost as well as disposal cost
– First or Initial investment
– Operating and maintenance
– Disposal cost

• Past and sunk costs
– Past costs are Historical costs that have occurred
– Sunk costs are past costs that are unrecoverable
• Future and opportunity costs
• Direct, indirect and overhead cost
a. Costs directly attributable to production of good (raw
material, labor, machine time)
b. Fuel, electricity, office, adm expenses, depreciation of
plant etc
c. For an Accountant: a are prime or direct and b are
indirect or overhead.
d. For an Economists: average variable costs, Marginal cost
 Fixed and variable costs

• Manufacturing Costs
Direct materials
Direct labour
Mfg. Overhead
• Non-manufacturing Costs
Overhead
Marketing
Administrative

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Fixed Costs
• Def: The costs of
providing a company’s
basic operating
capacity
• Cost behavior: Remain
constant over the
relevant range

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Variable Costs
• Def: Costs that vary
depending on the
level of production or
sales
• Cost behavior:
Increase or decrease
proportionally
according to the level
of volume

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Differential (Incremental) Costs
• Def: Costs that
represent the
differences in total
costs, which results
from selecting one
alternative instead of
other

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Sunk Costs
• Def: Cost that has already
been incurred by past
actions
• Economic Implications:
Not relevant to future
decisions
• Example: $500 spent to
replace tires last year—
not relevant in making
selling decision in the
future

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Salvage Value
We are attempting to estimate the total

cost of doing a project. Cost is reduced if
we can sell the equipment at end of
project.
Salvage value is the money that can be
obtained at the end of the project by
selling equipment. Salvage value is a
benefit rather than a cost.
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Time Value of Money
• An important concept in engineering economy
• Money can “make” money if invested.
• The change in the amount of money over a
given time period is called the time value of
money.

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Parameters and Cash Flows
• Parameters
• First cost (investment amounts)

• Estimates of useful or project life
• Estimated future cash flows (revenues and expenses and
salvage values)
Interest rate
• Cash Flows
• Estimate flows of money coming into the firm – revenues,

salvage values, etc. – positive cash flows--cash inflows
• Estimates of investment costs, operating costs, taxes paid –
negative cash flows -- cash outflows
22
The Cash Flow Diagram: CFD
23
Net Cash Flows
• A NET CASH FLOW is
• Cash Inflows – Cash Outflows
•(for a given time period)
• We normally assume that all cash flows occur:
•At the END of a given time period
•End-of-Period Assumption
24
Interest Rate
• INTEREST - THE AMOUNT PAID TO USE MONEY.
– INVESTMENT
• INTEREST = VALUE NOW - ORIGINAL AMOUNT
– LOAN
• INTEREST = TOTAL OWED NOW - ORIGINAL AMOUNT
• INTEREST RATE - INTEREST PER TIME UNIT
INTEREST PER TIME UNIT

INTEREST RATE 
ORIGINAL AMOUNT
25
Interest – Lending Example
•Example 1.3
•You borrow $10,000 for one full year
•Must pay back $10,700 at the end of one year
•Interest Amount (I) = $10,700 - $10,000
•Interest Amount = $700 for the year
•Interest rate (i) = 700/$10,000 = 7%/Yr
26
Interest Rate - Notation
•Notation
•I = the interest amount is $
•i = the interest rate (%/interest period)
•N = No. of interest periods (1 for this problem)
•Interest – Borrowing
•The interest rate (i) is 7% per year
•The interest amount is $700 over one year
•The $700 represents the return to the lender for the use of funds
for one year
•7% is the interest rate charged to the borrower
27
Interest – Example
•Borrow $20,000 for 1 year at 9% interest per year
•i = 0.09 per year and N = 1 Year
•Pay $20,000 + (0.09)($20,000) at end of 1 year
•Interest (I) = (0.09)($20,000) = $1,800
•Total Amt Paid in one year:
$20,000 + $1,800 = $21,800
28
Economic Equivalence
•Two sums of money at different points in time can be made
economically equivalent if:
• We consider an interest rate and,
• number of Time periods between the two sums
$20,000 is
received here
T=0 t = 1 Yr
$21,800 paid
back here
$20,000 now is economically equivalent to $21,800 one year from now IF the interest rate is set to equal
9%/year 29
Equivalence Illustrated
•$20,000 now is not equal in magnitude to $21,800 1 year from now
•But, $20,000 now is economically equivalent to $21,800 one year from now
if the interest rate in 9% per year.
•To have economic equivalence you must specify:
•timing of the cash flows
•interest rate (i% per interest period)
•Number of interest periods (N)
30
Simple and Compound Interest
•Two “types” of interest calculations
•Simple Interest
•Compound Interest
•Compound Interest is more common worldwide
and applies to most analysis situations
31
Simple and Compound Interest
• Simple Interest is calculated on the principal amount only
•Easy (simple) to calculate
•Simple Interest is:
•(principal)(interest rate)(time); $I = (P)(i)(n)
• Borrow $1000 for 3 years at 5% per year
• Let “P” = the principal sum
• i = the interest rate (5%/year)
• Let N = number of years (3)
•Total Interest over 3 Years...
32
For One Year
•$50.00 interest accrues but not paid
•“Accrued” means “owed but not yet paid”
•First Year:
P=$1,000
1 2 3
I1=$50.00
33
End of 3 Years
•$150 of interest has accrued
P=$1,000
1 2 3
I1=$50.00 I2=$50.00 I3=$50.00
Pay back $1000

+ $150 of
The unpaid interest did not earn interest over
interest
the 3-year period
34
Compound Interest
•Compound Interest is different
•In this application, compounding means to
compute the interest owed at the end of the
period and then add it to the unpaid balance of
the loan
•Interest “earns interest”
35
Compound Interest Cash Flow
• For compound interest, 3 years, we have:
P=$1,000
Owe at t = 3 years:
$1,000 + 50.00 + 52.50 +
1 2 3 55.13 = $1157.63
I1=$50.00
I2=$52.50
I3=$55.13
36
Compound Interest: Calculated
• For the example:

•P0 = +$1,000
•I1 = $1,000(0.05) = $50.00
•Owe P1 = $1,000 + 50 = $1,050 (but, we don’t pay yet)
•New Principal sum at end of t = 1: = $1,050.00
37
Compound Interest: t = 2
• Principal and end of year 1: $1,050.00

•I1 = $1,050(0.05) = $52.50 (owed but not paid)
•Add to the current unpaid balance yields:
•$1050 + 52.50 = $1102.50
•New unpaid balance or New Principal Amount
•Now, go to year 3…….
38
Compound Interest: t = 3
• New Principal sum: $1,102.50
•I3 = $1102.50 (0.05) = $55.125 = $55.13
•Add to the beginning of year principal yields:
•$1102.50 + 55.13 = $1157.63
•This is the loan payoff at the end of 3 years
•Note how the interest amounts were added to form a new principal sum with
interest calculated on that new amount
39
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Terminology and Symbols
P = value or amount of money at a time designated as
the present or time 0.
F = value or amount of money at some future time.
A = series of consecutive, equal, end-of-period amounts
of money.
n = number of interest periods; years
i = interest rate or rate of return per time period;
percent per year, percent per month
t = time, stated in periods; years, months, days, etc
41
P and F
• The symbols P and F represent one-time occurrences:
•It should be clear that a present value P represents a single sum

of money at some time prior to a future value F
$F
0 1 2 … … n-1 n
$P
42
Annual Amounts
• It is important to note that the symbol A always represents a
uniform amount (i.e., the same amount each period) that extends
through consecutive interest periods.
•Cash Flow diagram for annual amounts might look like the
following:
$A $A $A $A $A
…………
0 1 2 3 .. N-1 n
A = equal, end of period cash flow amounts
43
The MARR
• Firms will set a minimum interest rate that the financial managers of the
firm require that all accepted projects must meet or exceed.
•The rate, once established by the firm is termed the Minimum Attractive
Rate of Return (MARR)
•The MARR is expressed as a per cent per year
•In some circles, the MARR is termed the Hurdle Rate
44
Example 1.17
• A father wants to deposit an unknown lump-sum amount into an
investment opportunity 2 years from now that is large enough to withdraw
$4000 per year for state university tuition for 5 years starting 3 years from
now.
•If the rate of return is estimated to be 15.5% per year, construct the cash
flow diagram.
45
Interest Formulas
A uniform series of payments or receipts represents:
• A collection of end-of-period cash payments or receipts

arranged in a uniform series and continuing for n
periods. Such a series is equivalent to P or F at
interest rate i, given the constant cash payment (or
receipt) designated as A
(based on the term “annuity”, a regular payment).
Consider a 4-yr period:
A A A A
| | | |
F = 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4
| | | |A
| | | A(1+i)1
| | A(1+i)2
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Uniform series (contin.)
F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Now, multiply by (1+i)
(1+i) F = A(1+i)4 + A(1+i)3 + A(1+i)2 + A(1+i)

- F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Solve for the difference
i F = A(1+i)4 - A
= A[(1+i)4 - 1] Thus, F = A[(1+i)4 - 1] / i
 1  i   1
n
In general, F  A 
 i 
\ uniform series
compound-amount factor
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Engr 360 Engineering Econ. 4.3
If we turn this around and solve for A, we obtain:
 i 
A  F 
 1  i   1
n
\ uniform series
sinking-fund factor
Example: Set up a uniform-payment investment (college fund) with the goal

of having $80,000 after 20 years, invested at 6% compounded annually. What
is the required annual payment?
A = $80,000(.06)/[1.0620 –1] = $80,000(.06/2.207135) = $2174.77

OR
A = F (A/F, 6%, 20) = $80,000(.0272) = $2176
( ~ $182/mo.)
If we take the uniform-series compounding equation and replace F

with the single-payment compounding expression, we obtain:
 1  i n  1
P1  i n
 A  uniform series
 i  present-worth factor
 1  i   1n /
P  A n 
 i1  i  
This expression is used to calculate the present worth, given
the regular annuity payment.
If we instead solve for A, we obtain:
 i 1  i n 
A  P 
 1  i   1
n
\ uniform series
capital-recovery factor
This expression is used to calculate the regular annuity

payment, given the present worth.
Important relationships:
The uniform series present-worth factor equals the sum of the n terms of the
single payment, present-worth factor:
[P/A, i, n] = [P/F, i, 1] + [P/F, i, 2] + [P/F, i, 3] +… [P/F, i, n]
Example: Consider a purchase contract at 7% for a copy machine over 4 yr. ,

[P/A, 7%, 4] = 3.387
[P/F, 7%, 1] + [P/F, 7%, 2] + [P/F, 7%, 3] + [P/F, 7%, 4]
= .9346 + .8734 + .8163 + .7629 = 3.3872
The uniform series compound-amount factor equals 1 plus the sum of (n-1)
terms of the single payment, compound-amount factor:
[F/A, i, n] = 1 + [F/P, i, 1] + [F/P, i, 2] + [F/P, i, 3] +… [F/P, i, n-1]

Important relationships (contin.)

The uniform series capital-recovery factor equals the uniform series
sinking-fund factor plus the interest rate i:
[A/P, i, n] = [A/F, i, n] + i
Proof:
 i 1  i n   i 
  i
 1  i   1  1  i   1
n n
multiply both sides by denominator:
i 1  i   i  i 1  i   i  i 1  i 
n n n
Example: Recall the self-finance program for the business purchase,

[A/P, 0.5%, 120] = 0.0111
[A/F, 0.5%, 120] + 0.005 = .0061+.005 = 0.0111
Arithmetic Gradient series
Definition: A collection of end-of-period, increasing cash payments or receipts

arranged in a uniformly increasing series. The uniform increase in
each successive payment is called the gradient amount, G.
Consider a 4-yr period of uniformly increasing cash flows:
3G Note: for n periods, there are (n-1) terms for G

2G |
G | |
0 | | |
0….....1…..…2….....3…..…4
|
F  G
 
 1  i n  ni  1
| 2 
|  i 
| F
Example: For 6% interest rate over 4 yr. and G of $200,

F = $200[(1.06)4 - 1 – 4(.06)] / (.06)2 = $200(6.2436) = $1248.72
Arithmetic Gradient series (contin.)
Recall the single payment present-worth expression:

 1 
P  F n 
 1  i  
Substitute the gradient expression for F:
 1  i n  ni  1 1 
P  G  
 1  i 
2 n
 i 
 1  i n  ni  1
P  G 
 i 1  i 
2 n

\ arithmetic gradient
present-worth factor
Recall the sinking-fund factor expression:  i 

A  F 
 1  i   1
n
 1  i n  ni  1 i 
A  G  
 1  i   1 
2 n
 i
 1  i n  ni  1
A  G

 i 1  i   1 
n 

uniform-series factor
Nominal and Effective Interest Rates
The nominal interest rate (per yr), r, is the annual interest rate
without including effects of any compounding during the year.
(Note: This is what we have considered thus far in the class.)
The effective interest rate (per yr), ia , is the annual interest rate
including effects of any compounding during the year.
The net effect of compounding during subperiods of the year is

to increase the overall return in the given year(s).
When a nominal interest rate is compounded annually, it is

equal to the effective annual interest rate.
Define the following terms:
r = nominal interest rate per interest period (typ. one year);

i = effective interest rate per interest period;
ia = effective interest rate per year;
m = number of compounding subperiods per time period.
Effective interest rate per year, given the nominal interest rate
per year (r) :
ia = [1 + (r/m)]m - 1
Effective interest rate per year, given the effective interest rate
per compounding subperiod (i = r/m) :
ia = (1 + i)m - 1
Continuous Compounding:
Consider single-payment compounding for m compounding

subperiods per year over n years:
F = P[1 + i]n = P[1 + (r/m)]mn
Now, set x = r/m and rewrite the expression as:
F = P[(1 + x)1/x]rn As m gets large, x goes to zero.
Thus, for an infinite no. of subperiods, limx–>0(1 + x)1/x = e

and therefore:
F = P(e rn) and P = F(e -rn)
For continuous compounding, (1+i) = e r

and the effective interest rate per year is: ia = e r – 1
Continuous Compounding Factors for Uniform Series
Contin. compounding  e rn  1
F  A r 
compound amount (future worth)  e  1 
 er  1 
Contin. compounding A  F  rn 
sinking fund  e  1
Contin. compounding  e rn  1 
P  A rn r 
present worth  e (e  1) 
Contin. compounding  e rn (e r  1) 
A  P 
capital recovery  e  1 
rn
Example:
Our consulting firm will need to purchase two new vehicles three years from
now at a total cost expected to be $50,000. We decide to take some of our
cash reserves and purchase a 3-yr. CD to set aside funds now for this future
purchase. The bank is offering two types of CD’s, one that pays 5.2% annual
interest compounded quarterly and the other that pays 5% annual interest
compounded continuously. Which one will require the smaller initial deposit
and thus preserve as much as possible of our current cash reserves?
Effec. interest rate for quar. compounding: ia = (1+.052/4)4 – 1 = 0.05302
P1 = $50,000(1.05302)-3 = $42,821 OR $50,000(1.013)-12 = $42,821
Effec. interest rate for contin. compounding: ia = e.05 – 1 = 0.05127
P2 = $50,000(1.05127)-3 = $43,036
Select the 5.2% compounded quarterly.

Interest Formulas
A uniform series of payments or receipts represents:
A collection of end-of-period cash payments or receipts arranged in a uniform

series and continuing for n periods. Such a series is equivalent to P or F at
interest rate i, given the constant cash payment (or receipt) designated as A
(based on the term “annuity”, a regular payment).
Consider a 4-yr period:
A A A A
| | | |
F = 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4 + 0..1..2..3..4
| | | |A
| | | A(1+i)1
| | A(1+i)2
| A(1+i)3
F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Now, multiply by (1+i)
(1+i) F = A(1+i)4 + A(1+i)3 + A(1+i)2 + A(1+i)

- F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Solve for the difference
i F = A(1+i)4 - A
= A[(1+i)4 - 1] Thus, F = A[(1+i)4 - 1] / i
In general,  1  i n  1
F  A 
 i 
\ uniform series
compound-amount factor
If we turn this around and solve for A, we obtain:
 i 
A  F 
 1  i   1
n
\ uniform series
sinking-fund factor
Example: Set up a uniform-payment investment (college fund) with the goal

of having $80,000 after 20 years, invested at 6% compounded annually. What
is the required annual payment?
A = $80,000(.06)/[1.0620 –1] = $80,000(.06/2.207135) = $2174.77

OR
A = F (A/F, 6%, 20) = $80,000(.0272) = $2176
( ~ $182/mo.)
If we take the uniform-series compounding equation and

replace F with the single-payment compounding expression, we
obtain:
 1  i n  1
P1  i 
n
 A 
 i  uniform series
 1  i   1
P  A
n
/
n 
 i1  i  
This expression is used to calculate the present worth, given

the regular annuity payment.
Example:
Our consulting firm would like to purchase a used testing machine from an
independent testing/inspection lab, and we make two offers: 1) a lump-sum of
$40,000 or 2) monthly payments of $1200 over 3 years at a 6% annual interest
rate. Which option do you think the testing lab would prefer, assuming it has
to replace the sold machine?
Ploan = $1200 [P/A, 0.5%, 36] = $1200(32.871) = $39,445
The lab would prefer the $40k payment now, because it is greater than
the present worth of the proposed loan terms.
Note: Floan = $1200[F/A, 0.5%, 36] = $1200(39.336) = $47,203

If we instead solve for A, we obtain:
 i 1  i n 
A  P 
 1  i   1
n
\ uniform series
capital-recovery factor
This expression is used to calculate the regular annuity

payment, given the present worth.
Example:
Our consulting firm would like to purchase a small, independent

testing/inspection lab consisting of four employees who own equal shares in
the lab. They have offered to sell for either 1) a lump-sum of $280,000 or 2)
self-finance that amount over 10 yrs. at 6% annual interest rate. We could
make the lump-sum payment by using $80k of cash reserves, plus get a bank
loan for the remaining $200k with terms of 5 years at 3% annual interest.
Ignoring any opportunity costs, what should we do to minimize our monthly
payments (to provide minimal impact on our regular cash flows)?
Abank = $200,000 [A/P, 0.25%, 60] = $200,000(.0180) = $3600/mo.
As-fin. = $280,000 [A/P, 0.5%, 120] = $280,000(.0111) = $3108/mo.
Select the self-finance option.

Important relationships:
The uniform series present-worth factor equals the sum of the n terms of the
single payment, present-worth factor:
[P/A, i, n] = [P/F, i, 1] + [P/F, i, 2] + [P/F, i, 3] +… [P/F, i, n]
Example: Consider a purchase contract at 7% for a copy machine over 4 yr. ,

[P/A, 7%, 4] = 3.387
[P/F, 7%, 1] + [P/F, 7%, 2] + [P/F, 7%, 3] + [P/F, 7%, 4]
= .9346 + .8734 + .8163 + .7629 = 3.3872
The uniform series compound-amount factor equals 1 plus the sum of (n-1)
terms of the single payment, compound-amount factor:
[F/A, i, n] = 1 + [F/P, i, 1] + [F/P, i, 2] + [F/P, i, 3] +… [F/P, i, n-1]

Important relationships (contin.)

The uniform series capital-recovery factor equals the uniform series
sinking-fund factor plus the interest rate i:
[A/P, i, n] = [A/F, i, n] + i
Proof:
 i 1  i n   i 
  i
 1  i   1  1  i   1
n n
multiply both sides by denominator:
i 1  i   i  i 1  i   i  i 1  i 
n n n
Example: Recall the self-finance program for the business purchase,

[A/P, 0.5%, 120] = 0.0111
[A/F, 0.5%, 120] + 0.005 = .0061+.005 = 0.0111
Arithmetic Gradient series

arranged in a uniformly increasing series. The uniform increase in
each successive payment is called the gradient amount, G.
Consider a 4-yr period of uniformly increasing cash flows:
3G Note: for n periods, there are (n-1) terms for G

2G |
G | |
0 | | |
0….....1…..…2….....3…..…4
|
F  G
 
 1  i n  ni  1
| 2 
|  i 
| F
Example: For 6% interest rate over 4 yr. and G of $200,

F = $200[(1.06)4 - 1 – 4(.06)] / (.06)2 = $200(6.2436) = $1248.72
Recall the single payment present-worth expression:

 1 
P  F n 
 1  i  
 1  i n  ni  1 1 
P  G  
 1  i 
2 n
 i 
 1  i n  ni  1
P  G 
 i 1  i 
2 n

Example:
Our firm has purchased a photocopy machine that will require increasing service/
maintenance costs over the next six years (at which time we will sell it and buy a new
one). Such costs at the end of yr. 1 will be $100 and thereafter increase by $50 each
subsequent year (total is $1350). Our plan is to make these payments by using
amounts based on an initial cash deposit in an investment account in the local credit
union paying 4% annual interest. What is the required initial deposit?
250
|
200
150 | |
100 100 100 100 100 100 100 | | |
| | | | | | 50 | | | |
| | | | | | 0 | | | | |
0....1….2…..3….4…..5….6 + 0....1….2….3…..4….5…..6
| |
| |
| PA | PG
P = PA+PG = $100[P/A, 4%, 6]+$50[P/G, 4%, 6] = $100(5.242)+$50(12.506)

P = $524.20 + $625.30 = $1149.50
Recall the sinking-fund factor expression:  i 

A  F 
 1  i   1
n
 1  i n  ni  1 i 
A  G  
 1  i   1 
2 n
 i
 1  i n  ni  1
A  G

 i 1  i   1 
n 

uniform-series factor
Example:
For the photocopy machine maintenance program previously investigated, let us now
consider what the equivalent uniform annual maintenance cost would be (assume the
same 4% interest rate).
250
200 |
150 | |
100 100 100 100 100 100 100 | | |
| | | | | | 50 | | | |
| | | | | | 0 | | | | |
0....1….2…..3….4…..5….6 + 0....1….2….3…..4….5…..6
A = $100 + $50[A/G, 4%, 6] = $100 + $50(2.386)
A = $100 + $119.30 = $219.30

Geometric series

arranged in a series that increases at a uniform rate. The uniform
rate increase, g, is applied to each successive regular (typ. annual)
payment (or receipt) amount.
Consider a 4-yr period with costs increasing at 5% per year and given an
initial cost in year 1 of $100:
Year Cash Flow (cost in $)
1 $100 = $100.00
2 100+100(5%) = 100(1+.05)1 = 105.00
3 105+105(5%) = 100(1+.05)2 = 110.25
4 110.25+110.25(5%) = 100(1+.05)3 = 115.76
In general, An = A1(1+g)n-1
Geometric series (contin.)
Note the compounding present-worth expression for a given future cash flow:
 1 
Pn  An  n
 1  i  
Substitute in the geometric gradient expression for An and drop n-th notation:
n 1  
P  A1 1  g   1 
 1  i n 
 
 n 
For..i  g ,...P  A1  
 1  i  
 1  1  g n 1  i n 
For..i  g ,...P  A1 

 ig 
 \ geometric series
Nominal and Effective Interest Rates
The nominal interest rate (per yr), r, is the annual interest rate
without including effects of any compounding during the year.
(Note: This is what we have considered thus far in the class.)
The effective interest rate (per yr), ia , is the annual interest rate
including effects of any compounding during the year.
The net effect of compounding during subperiods of the year is

to increase the overall return in the given year(s).
When a nominal interest rate is compounded annually, it is

equal to the effective annual interest rate.
Define the following terms:
r = nominal interest rate per interest period (typ. one year);

i = effective interest rate per interest period;
ia = effective interest rate per year;
m = number of compounding subperiods per time period.
Effective interest rate per year, given the nominal interest rate
per year (r) :
ia = [1 + (r/m)]m - 1
Effective interest rate per year, given the effective interest rate
per compounding subperiod (i = r/m) :
ia = (1 + i)m - 1
Continuous Compounding:
Consider single-payment compounding for m compounding

subperiods per year over n years:
F = P[1 + i]n = P[1 + (r/m)]mn
Now, set x = r/m and rewrite the expression as:
F = P[(1 + x)1/x]rn As m gets large, x goes to zero.
Thus, for an infinite no. of subperiods, limx–>0(1 + x)1/x = e

and therefore:
F = P(e rn) and P = F(e -rn)
For continuous compounding, (1+i) = e r

and the effective interest rate per year is: ia = e r – 1
Continuous Compounding Factors for Uniform Series
Contin. compounding  e rn  1
F  A r 
compound amount (future worth)  e  1 
 er  1 
Contin. compounding A  F  rn 
sinking fund  e  1
Contin. compounding  e rn  1 
P  A rn r 
present worth  e (e  1) 
Contin. compounding  e rn (e r  1) 
A  P 
capital recovery  e  1 
rn
Example:
Our consulting firm will need to purchase two new vehicles three years from
now at a total cost expected to be $50,000. We decide to take some of our
cash reserves and purchase a 3-yr. CD to set aside funds now for this future
purchase. The bank is offering two types of CD’s, one that pays 5.2% annual
interest compounded quarterly and the other that pays 5% annual interest
compounded continuously. Which one will require the smaller initial deposit
and thus preserve as much as possible of our current cash reserves?
Effec. interest rate for quar. compounding: ia = (1+.052/4)4 – 1 = 0.05302
P1 = $50,000(1.05302)-3 = $42,821 OR $50,000(1.013)-12 = $42,821
Effec. interest rate for contin. compounding: ia = e.05 – 1 = 0.05127
P2 = $50,000(1.05127)-3 = $43,036
Select the 5.2% compounded quarterly.

Engineering Economics: College of Engineering Pune (COEP)

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Engineering Economics: College of Engineering Pune (COEP)

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Engineering Economics

College of Engineering Pune(COEP)

• WHAT IS ENGINEERING ECONOMICS?

College of Engineering Pune (COEP)

•Decisions made by engineers, managers, corporation presidents, and

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

There are different ways of defining costs:

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

College of Engineering Pune (COEP)

We are attempting to estimate the total

College of Engineering Pune (COEP)

• First cost (investment amounts)

• Estimate flows of money coming into the firm – revenues,

INTEREST PER TIME UNIT

$20,000 + $1,800 = $21,800

•Number of interest periods (N)

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1000

• For compound interest, 3 years, we have:

• For the example:

• Principal and end of year 1: $1,050.00

•It should be clear that a present value P represents a single sum

A = equal, end of period cash flow amounts

• A collection of end-of-period cash payments or receipts

F = A(1+i)3 + A(1+i)2 + A(1+i)1 + A Now, multiply by (1+i)

(1+i) F = A(1+i)4 + A(1+i)3 + A(1+i)2 + A(1+i)

= A[(1+i)4 - 1] Thus, F = A[(1+i)4 - 1] / i

If we turn this around and solve for A, we obtain:

Example: Set up a uniform-payment investment (college fund) with the goal

A = $80,000(.06)/[1.0620 –1] = $80,000(.06/2.207135) = $2174.77

If we take the uniform-series compounding equation and replace F

If we instead solve for A, we obtain:

This expression is used to calculate the regular annuity

[P/A, i, n] = [P/F, i, 1] + [P/F, i, 2] + [P/F, i, 3] +… [P/F, i, n]

Example: Consider a purchase contract at 7% for a copy machine over 4 yr. ,

[F/A, i, n] = 1 + [F/P, i, 1] + [F/P, i, 2] + [F/P, i, 3] +… [F/P, i, n-1]

Important relationships (contin.)

multiply both sides by denominator:

Example: Recall the self-finance program for the business purchase,

Definition: A collection of end-of-period, increasing cash payments or receipts

Consider a 4-yr period of uniformly increasing cash flows:

3G Note: for n periods, there are (n-1) terms for G

Example: For 6% interest rate over 4 yr. and G of $200,

Recall the single payment present-worth expression:

Recall the sinking-fund factor expression:  i 

Substitute the gradient expression for F:

Nominal and Effective Interest Rates

The net effect of compounding during subperiods of the year is

When a nominal interest rate is compounded annually, it is

r = nominal interest rate per interest period (typ. one year);