Chapter 4 More Interest Formulas

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7, 8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other techniques

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Components of Engineering Economic Analysis

Calculation of P and F are fundamental. Some problems are more complex and require an understanding of added components:
Uniform series. Arithmetic or geometric gradients. Nominal and effective interest rates (covered in presentation #5 on Chapter 3). Continuous compounding.
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Uniform Payment Series Capital Recovery Factor

The series of uniform payments that will recover an initial investment.

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

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Uniform Payment Series Compound Amount Factor F

The future value of an investment based on periodic, constant payments and a constant interest rate.

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

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Example 4-1
At 5%/year
Year Cash in Cash out

1000 0 0 0 -1000 -2000 -2763 -3000 Year Cash In

-$2763

500 1 1

500 2 2

500 3 3

500 4 4

500 5 5

1
2 3 4 5

$500
$500 $500 $500 $500

Cash Out

F = $500(F/A, 5%, 5) = $500(5.526) = $2763

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Uniform Payment Series Sinking Fund Factor

The constant periodic amount, at a constant interest rate that must be deposited to accumulate a future value.

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

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Uniform Payment Series Present Worth Factor

The present value of a series of uniform future payments. P = A(P/A, i, n)

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Example 4-6
F = $100(F/A, 15%, 3) = $347.25 F = $347.25(F/P, 15%, 2) = $459.24
Year 1 2 3 4 5 Cash flow $100 $100 $100 $0 F

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Example 4-7 Finding the Present Value (P) for each cash flow is sometimes the easiest way to find the equivalent P.

Year 0 1 2 3 4

Cash flow P 0 $ 20 $ 30 $ 20

P = $20(P/F, 15%, 2) + $30(P/F, 15%, 3) + $20(P/F, 15%, 4) = $46.28

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Arithmetic Gradient
A uniform increasing amount. The first cash flow is always equal to zero. G = the difference between each cash amount.

G = $10
11

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Arithmetic Gradient combined with a Uniform Series

Decompose the cash flows into a uniform series and a pure gradient. Then add or subtract the Present Value of the gradient to the Present Value of the Uniform series

Example 4-8: Use P/G factor to find present value of the pure gradient portion of the cash flow
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Arithmetic Gradient Uniform Series Factor

A pure gradient (uniformly increasing amount) can also be converted into the equivalent present value of uniform series:

AG = G(A/G, i, n)
See Example 4-9: Notice that the uniform series portion of the cash flow was subtracted to separate the pure gradient.
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Geometric Series Present Worth Factor

Sometimes cash flows increase at a constant rate rather than a constant amount. Inflation, for example, could be reflected in a cash flow diagram that way. The equivalent present value of a geometrically increasing amount. g = the rate of increase (e.g., .05)

P = A(P/A, g, i, n) where (P/A, g, i, n) must be

computed from equation 4-30 or 4-31

Example 4-12 uses g = .10 and i = .08

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