ENGINEERING ECONOMY Sixth Edition

Blank and Tarquin

Chapter 2

Factors:
How Time and Interest Affect Money
 Learning Objectives
1. F/P and P/F Factors (Single Payment Factors)
2. P/A and A/P Factors (Uniform Series Present Worth
Factor and Capital Recovery Factor)

3. F/A and A/F Factors (Sinking Fund Factor and Uniform-

Series Compound Amount Factor)

4. P/G and A/G Factors (Arithmetic Gradient Factors)

5. Geometric Gradient
6. Calculate i (unknown interest rate)
7. Calculate “n” (number of years)

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 Single Payment Factors
(F/P and P/F)
• Objective:
– Derive factors to determine the present or future
worth of a cash flow Fn
• Cash Flow Diagram – basic format
i% / period
0 1 2 3 n-
1 n

P0
 Basic Derivation: F/P factor

Fn = P0(1+i)n →(F/P, i%, n) factor:

Excel: =FV(i%, n, ,P)

P0 = Fn1/(1+i)n →(P/F, i%, n) factor:

Excel: =PV(i%, n, , F)

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 Derivation: F/P factor
• Find F given P
• F1 = P + Pi = P(1+i)
• F2 = F1 + F1i = F1(1+i)…..or
• F2 = P(1+i) + P(1+i)i = P(1+i)(1+i) = P(1+i)2
• F3 = F2+ F2 i = F2(1+i) =P(1+i)2 (1+i)
= P(1+i)3
In general:

FN = P(1+i)n
FN = P (F/P, i%, n)
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 Present Worth Factor from F/P

• Since FN = P(1+i)n
• We solve for P in terms of FN
• P = F{1/ (1+i)n} = F(1+i)-n

P = F(P/F,i%,n) where
(P / F, i%, n) = (1+i)-n

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 P/F factor – discounting back in time

• Discounting back from the future

Fn

………….
N
P/F factor brings a single future
sum back to a specific point in
P
time.

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 Example- F/P Analysis

• Example: P= $1,000;n=3;i=10%
• What is the future value, F?
F = ??

0 1 2 3
P=$1,000
i=10%/year

F3 = $1,000 [F/P,10%,3] = $1,000[1.10]3

= $1,000[1.3310] = $1,331.00

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 Example – P/F Analysis

• Assume F = $100,000, 9 years from now. What is the present

worth of this amount now if i =15%?
F9 = $100,000

i = 15%/yr

0 1 2 3
………… 8 9

P= ??
P0 = $100,000(P/F, 15%,9) = $100,000(1/(1.15)9)
= $100,000(0.2843) = $28,426 at time t = 0

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 Uniform Series Present Worth and Capital Recovery Factors

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 Uniform Series Present Worth

 This expression will convert an annuity cash flow

to an equivalent present worth amount one
period to the left of the first annuity cash flow.

 (1  i ) n  1 
P  A n 
for i  0
 i (1  i ) 

P / A i %, n factor
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 Capital Recovery Factor (CRF) = A/P factor
CRF calculates the equivalent uniform annual worth A over n years for a given P
in year 0, when the interest rate is i.
The present worth point of an annuity cash flow is always one period to the left of the first
A amount.
 Given the P/A factor

 (1  i ) n  1 
P  A n 
for i  0 Solve for A in terms of P
 i (1  i ) 
Yielding….

 i (1  i )  n
A P  A/P, i%,
 (1  i )  1 
n
n

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 Modified HW Problem 2.5
• A maker of microelectromechanical systems [MEMS], believes it can
reduce product recalls if it purchases new software for detecting
faulty parts. The cost of the new software is $225,000.
• How much would the company have to save each year for 4 years to
recover its investment if it uses a minimum attractive rate of return of
15% per year?
(A/P, 15%, 4) p. 745 – Table 19 (interest rate i=15%)  column:
A/P, row: n=4
A/P factor = 0.35027
Company would have to save $225,000 x 0.35027 = $78,810.75 each
year.

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 HW Problem 2.12*

• Comparison of Table with equation:

• V-Tek Systems is a manufacturer of vertical compactors, and it is examining its
cash flow requirements for the next 5 years. The company expects to replace office
machines and computer equipment at various times over the 5-year planning
period. Specifically, the company expects to spend $9000 two years from now,
$8000 three years from now, and $5000 five years from now. What is the present
worth of the planned expenditures at an interest rate of 10% per year?

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 Sinking Fund and Series Compound Amount Factors
(A/F and F/A)

 Take advantage of what we already have

 Recall:

 1 
PF n 
 Also:  (1  i ) 

 i (1  i ) n 
A P 
 (1  i )  1 
n

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 Modern context of a Sinking Fund

• In modern finance, a sinking fund is a method enabling an organization to set aside

money over time to retire its indebtedness. More specifically, it is a fund into which
money can be deposited, so that over time its preferred stock, debentures or stocks
can be retired. For the organization that is retiring debt, it has the benefit that the
principal of the debt or at least part of it, will be available when due. For the
creditors, the fund reduces the risk the organization will default when the principal is
due.
• In some US states, Michigan for example, school districts may ask the voters to
approve a taxation for the purpose of establishing a Sinking Fund. The State
Treasury Department has strict guidelines for expenditure of fund dollars with the
penalty for misuse being an eternal ban on ever seeking the tax levy again.

• Historical Context: A Sinking Fund was a device used in Great Britain in the 18th
century to reduce national debt.

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 HW Problem 2.23

 Southwestern Moving and Storage wants to have enough

money to purchase a new tractor-trailer in 3 years. If the
unit will cost $250,000, how much should the company
set aside each year if the account earns 9% per year?
 (A/F, 9%, 3) or n = 3, F = $250,000, i = 9%
 Using Table 14 (pg 740), the A/F = 0.30505
A= $250,000 x 0.30505 = $76262.50

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 Interpolation (Estimation Process)

• At times, a set of interest tables may not have the exact interest
factor needed for an analysis
• One may be forced to interpolate between two tabulated values
• Linear Interpolation is not exact because:
• The functional relationships of the interest factors are non-
linear functions
• From 2-5% error may be present with interpolation.

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 Example 2.7

• Assume you need the value of the A/P factor for i = 7.3% and n =
10 years.
• 7.3% is likely not a tabulated value in most interest tables
• So, one must work with i = 7% and i = 8% for n fixed at 10
• Proceed as follows:

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 Basic Setup for Interpolation

•Work with the following basic relationships

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 Arithmetic Gradient Factors

• An arithmetic (linear) Gradient is a cash flow series that either

increases or decreases by a constant amount over n time periods.
•A linear gradient always has TWO components:
•The gradient component
•The base annuity component
•The objective is to find a closed form expression for the Present Worth
of an arithmetic gradient

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 Linear Gradient Example
A1+n-1G

A1+n-2G
• Assume the following:

A1+2G

A1+G

0 1 2 3 n-1 N

This represents a positive, increasing arithmetic gradient

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 Example: Linear Gradient

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 Arithmetic Gradient Factors

• The “G” amount is the constant arithmetic change from

one time period to the next.
•The “G” amount may be positive or negative.
•The present worth point is always one time period to the
left of the first cash flow in the series or,
•Two periods to the left of the first gradient cash (G) flow.

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 Present Worth Point…

$700
$600
$500
$400
$300
$200
$100

X0 1 2 3 4 5 6 7

The Present Worth Point of the

Gradient

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 Present Worth: Linear Gradient

• The present worth of a linear gradient is the present

worth of the two components:
– 1. The Present Worth of the Gradient Component
and,
– 2. The Present Worth of the Base Annuity flow

– Requires 2 separate calculations.

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 Present Worth: Gradient Component
(Example 2.10*)
• Three contiguous counties in Florida have agreed to pool tax
resources already designated for county-maintained bridge
refurbishment. At a recent meeting, the county engineers estimated
that a total of $500,000 will be deposited at the end of next year into
an account for the repair of old and safety-questionable bridges
throughout the three-county area. Further, they estimate that the
deposits will increase by $100,000 per year for only 9 years
thereafter, then cease.

• Determine the equivalent (a) present worth and (b) annual series
amounts if county funds earn interest at a rate of 5% per year.

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 Example 2.10 (b)*
Determine the equivalent annual series amounts if
county funds earn interest at a rate of 5% per year.

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 Equations for P/G and A/G

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 Geometric Gradients

• An arithmetic (linear) gradient changes by a fixed

dollar amount each time period.
•A GEOMETRIC gradient changes by a fixed percentage
each time period.
•We define a UNIFORM RATE OF CHANGE (%) for each
time period
•Define “g” as the constant rate of change in decimal
form by which amounts increase or decrease from one
period to the next

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cash flow diagrams for geometric gradient series

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 Geometric Gradients: Increasing

• Typical Geometric Gradient Profile

•Let A1 = the first cash flow in the series
The series starts in year 1 at an initial amount A1, not considered a base
amount as in the arithmetic gradient.

0 1 2 3 4 …….. n-1 n

A1 A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1
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 Geometric Gradients

For a Geometric Gradient the following parameters are

required:
•The interest rate per period – i
•The constant rate of change – g
•No. of time periods – n

•The starting cash flow – A1

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 Pg /A Equation
• In summary, the engineering economy relation and factor formulas to
calculate Pg in period t = 0 for a geometric gradient series starting in period
1 in the amount A1 and increasing by a constant rate of g each period are

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• Engineers at SeaWorld, a division of Busch Gardens, Inc., have
completed an innovation on an existing water sports ride to
make it more exciting. The modification costs only $8000 and
is expected to last 6 years with a $1300 salvage value for the
solenoid mechanisms. The maintenance cost is expected to
be high at $1700 the first year, increasing by 11% per year
thereafter. Determine the equivalent present worth of the
modification and maintenance cost. The interest rate is 8%
per year.

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 continued
•Assume maintenance costs will be $1700 one year from now.
•Assume an annual increase of 11% per year over a 6-year time period.
•If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0.
•First, draw a cash flow diagram to represent the model.

0 1 2 3 4 5 6

$1700
$1700(1.11)1
$1700(1.11)2
$1700(1.11)3

PW(8%) = ?? $1700(1.11)5

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 continued
Cash flow diagram
Solution: The cash flow diagram shows the salvage value as a
positive cash flow and all costs as negative.
Use Equation [2.24] for g ≠ i to calculate Pg. The total PT is

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 continued *

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 i – rate is unknown
• A class of problems may deal with all of the parameters know
except the interest rate.
•For many application-type problems, this can become a difficult task
•Termed, “rate of return analysis”
•In some cases:
•i can easily be determined
•In others, trial and error must be used

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 Example: i unknown

• Assume one can invest $3000 now in a venture in anticipation of

gaining $5,000 in five (5) years.
•If these amounts are accurate, what interest rate equates these two
cash flows?
$5,000

0 1 2 3 4 5

•F = P(1+i)n
$3,000 •(1+i)5 = 5,000/3000 = 1.6667
•(1+i) = 1.66670.20
•i = 1.1076 – 1 = 0.1076 = 10.76%
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 Unknown Number of Years

• Some problems require knowing the number of time periods

required given the other parameters
•Example:
•How long will it take for $1,000 to double in value if the discount rate
is 5% per year?
Fn = $2000
•Draw the cash flow diagram as….
i = 5%/year; n is unknown!

0 1 2 ... . . . ……. n

P = $1,000
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 Unknown Number of Years
Fn = $2000

• Solving we have…..

0 1 2 ... . . . ……. n

P = $1,000

•(1.05)x = 2000/1000
•X ln(1.05) =ln(2.000)
•X = ln(1.05)/ln(2.000)
•X = 0.6931/0.0488 = 14.2057 yrs
•With discrete compounding it will take 15 years
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• Formulas and factors derived and applied in this chapter perform
equivalence calculations for present, future, annual, and gradient cash
flows. Capability in using these formulas and their standard notation
manually and with spreadsheets is critical to complete an engineering
economy study.
• Using these formulas and spreadsheet functions, you can convert
single cash flows into uniform cash flows, gradients into present worths,
and much more.
• You can solve for rate of return i or time n.
• A thorough understanding of how to manipulate cash flows using the
material in this chapter will help you address financial questions in
professional practice as well as in everyday living.
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 WHAT A DIFFERENCE THE YEARS AND
COMPOUND INTEREST CAN MAKE

Real World Situation - Manhattan Island purchase.

It is reported that Manhattan Island in New York
was purchased for the equivalent of $24 in the year
1626. In the year 2001, the 375th anniversary of the
purchase of Manhattan was recognized.

F = P (1+i)n = 24 (1+ 0.06)382 = 111,443,000,000 (2008)

F = P + Pin = 24 + 24(0.06)382 = $550.08 (simple interest)
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