Engineering Economy

Is the analysis and evaluation of the factors that will affect the economic
success of engineering projects to the end that a recommendation can be
made which will insure the best of capital.

• SIMPLE INTEREST • AMORTIZATION

• COMPOUND INTEREST • DEPRECIATION
• EFFECTIVE RATE OF INTEREST • CAPITAL FINANCING
• DISCOUNT • RATE OF RETURN
• ANNUITY • BREAK EVEN ANALYSIS
• CAPITALIZED COST • BENEFIT/COST RATIO
SIMPLE INTEREST
• ORDINARY SIMPLE INTEREST
- 12 months of 30 days
- 360 days in a year

• EXACT SIMPLE INTEREST

- 365 days in a year ORDINARY YEAR
- 360 days in a year LEAP YEAR (except for century years and not divisible by 400)

EXAMPLE:
1900 ÷ 4 = 475 (LEAP YEAR)
1900 ÷ 100 = 19 (CENTURY YEAR)
Therefore 1900 have 365 days

2004 ÷ 4 = 501 (LEAP YEAR)

2004 ÷ 100 = 20.04 (NOT A CENTURY YEAR)
Therefore 2004 have 366 days
CASH-FLOW DIAGRAM
Is simply a graphical representation of cash flows on a time scale. Cash-flow diagram for economic analysis
problem is analogous to the of free-body diagrams for mechanics problems.

RECEIPT – positive cash flow or inflow

DISBURSEMENT – negative cashflow or cash outflow

EXAMPLE:
A loan of ₱100 at a simple interest of 10% will become ₱150 after 5 years

₱150 ₱100

0 1 2 3 4 5 0 1 2 3 4 5

₱100 ₱150
(VIEWPOINT OF LENDER)
(VIEWPOINT OF BORROWER)
SIMPLE INTEREST
Interest directly proportional to the length of time and the amount of principal borrowed.

DERIVATION OF FORMULA: Where: F = Future worth

Pin=I (INTEREST) P = Present worth
i = Simple interest rate (per year)
P + Pin n = Number of interest period (in years)
F = P + Pin
F = P(1+in)
P = F(1+in)
EXAMPLE # 1
If a man borrowed money from his girlfriend with simple rate of 12%, determine the present worth of ₱74,900.00, which is
due at the end of 7 months.

Unknown: Present worth Solution: F = P(1+in)

Given: i = 0.12 74,900 = P(1+(0.12)(7/12))
F = 74,900.00 P = ₱70,000
n = 7/12

EXAMPLE # 2
Clara has invested ₱10,000, part at 5% and the remainder at 10% simple interest. How much is invested at higher rate of the
annual interest from this investment is ₱950.00?

Unknown: Investment at the higher rate Given: I = ₱950.00 Solution: I = Pin

• Let x be the first investment with P1 = x I=P1in + P2in
0.05 rate and 10,000-x is the second P2 = 10,000-x 950 = (x)(0.05)(1) + (10,000-x)(0.1)(1)
investment with 0.1 rate n = 1 (annual) x = 1,000
i = 0.05, 0.1 10,000-x = 9,000
10,000 P = ₱9,000.00

x 10,000-x
EXAMPLE # 3
Determine the accumulated amount using exact simple interest on ₱10,000 for the period from January 20, 1990 to
November 28 of the same year at 15% interest rate.

1990 is not a leap year but is a century year Unknown: Future worth Solution: F = P(1+in)
therefore 1990 have 365 days Given: P = ₱10,000 F = 10,000(1+(0.15)(312/365))
i = 0.15 F = ₱11,282.19
• Solve for n: n = 312/365
365-20-2-31 = 312 days

ASSIGNMENT # 1
1.) You got a student loan from the New Mexico Educational Assistance Foundation to pay for your educational expenses this
year. Find the interest on the loan if you borrowed $2,000.00 at 8% for 1 year,

Unknown: Interest CASH-FLOW DIAGRAM Solution: I = Pin

Given: P = $2,000 I = (2,000)(0.08)(1)
i = 0.08 $2,000.00 I = $160.00
n=1
0 1

I
2.) You are starting your small own business in Albuquerque. You borrow $10,000 from the bank at a 9% rate for 5 years. Find
the interest you will pay on this loan.
Unknown: Interest Solution: I = Pin
CASH-FLOW DIAGRAM I = (10,000)(0.09)(5)
Given: P = $10,000
i = 0.09 $10,000 I = $4,500.00
n=5
0 1 2 3 4 5

I
3.) You are tired at the end of the term and decide to borrow $500 to go on a trip to whatever land. You go to the bank and
borrow the money at 11% for 2 years. A) find the interest you will pay on the loan. B) how much will you have to pay the bank
at the end of the two years ?

a.) CASH-FLOW DIAGRAM b.)

Unknown: Interest $500 Solution: F=P(1+in)
Given: P = $500 F = 500(1+(0.11)(2))
i = 0.11 F = $610.00
n=2 0 1 2

Solution: I = Pin F
I = (500)(0.11)(2)
I = $110.00
COMPOUND INTEREST
Interest is computed every end of each interest period and the interest earned for that period is added to the
principal
Fn Let:
F = accumulated future worth m = number of interest period
n, period
0 1 2 3 4 n P = principal or present worth n = total number of interest period
i = interest rate per interest period = m(t)
P F1 F2 F3 F4 F = r/m t = number of years of investment
r = nominal interest rate

DERIVATION OF FORMULA: COMPOUNDED: EXAMPLE:

ANNUALLY = 1 6% compounded monthly for 10 years
F1 = P(1+i) SEMI-ANNUALLY = 2
QUARTERLY = 4
F2 = P(1+i) (1+i) = P(1+i)2 r m = 12 t = 10
BI-MONTHLY = 6
F3 = P(1+i)2 (1+i) = P(1+i)3 MONTHLY = 12 i = 0.06/12
Fn = P(1+i)n n = 12(10)
F = P(1+r/m)mt
CONTINUOUS COMPOUND
Compound interest where the number of interest period (m) approaches infinity
FORMULA: F = Pert

EFFECTIVE RATE OF INTEREST

The actual rate of interest on the principal for one year

FORMULA:

E.R. = interest earned in one year

principal at the beginning of the year

E.R = [1+ r/m]m – 1

EXAMPLE # 1
If the sum of ₱12,000 is deposited in an account earning interest rate of 9% per year compounded quarterly, what will it
become after 1 year?

Unknown: Number of years (t) Solution: F = P(1+i)n

Given: P = 12000 F = 12,000(1 + 0.0225)4
i = 0.09/4 F = ₱13,117
n=4

EXAMPLE # 2
In the previous problem, what is the effective rate?

Unknown: Effective Rate Solution 1: Solution 2:

Given: F = 13,117 E.R. = F-P (100%) E.R. = [1+ r/m]m – 1
Given: F = 13,117
P
E.R. = 13117-12000 (100%) E.R. = [1+ 0.09/4]4 – 1
12000
E.R. = 0.0931 or 9.31%
E.R. = 9.31%
EXAMPLE # 3
How many years are required for ₱1,000 to increase to ₱2,000 if invested at 9% per year compounded continuously?

Unknown: Number of years (t) Solution: F = Pert

Given: P = 1000 2000 = 1000e0.09t
F = 2000 t = 7.7 years
r = 0.09

EXAMPLE # 4
When compounded bi-monthly, ₱150,000 becomes ₱223,138 after 5 years. What is the nominal rate of interest?

Unknown: Rate of interest (r) Solution: F = P(1 + i)n

Given: P = 150000 223138 = 150000(1 + r/6)6(5)
F = 223138 r = 0.08 or 8%
t=5
m=6
EXAMPLE # 5
What payment X ten years from now is equivalent to a payment of ₱1,000 six years from now, if interest is 15% compounded
monthly?

1 Unknown: Present worth

Given: F = 1000
r = 0.15
CASH-FLOW DIAGRAM m = 12
t=6
X
Solution: P = F(1 + i)-n
P = 1000(1 + 0.15/12)-12(6)
0 1 2 3 4 5 6 7 8 9 10 P = 408.84
1000 2 Unknown: Payment X (Future worth)
P Given: P = 408.84
r = 0.15
m = 12
t=6
Solution: F = P(1 + i)n
F = 408.84(1 + 0.15/12)12(10)
F = ₱1,815.35
EXAMPLE # 5
What payment X ten years from now is equivalent to a payment of ₱1,000 six years from now, if interest is 15% compounded
monthly?
ALTERNATE SOLUTION:

Unknown: Payment X (Future worth)

CASH-FLOW DIAGRAM
Given: P = 1000
r = 0.15
X m = 12
t=4
0 1 2 3 4 5 6 7 8 9 10 Solution: F = P(1 + i)n
F = 1000(1 + 0.15/12)12(4)
1000
F = ₱1,815.35
EXAMPLE # 6
A bank is advertising 9.5% accounts that yields 9.84% annually. How often is the interest compounded?
Solution:
(1+r/m)m – 1 = (1+r/m)m – 1
(1+0.0984/1)1 = (1+0.095/m)m
m = 3.87 ≈ 4 (compounded quarterly)

EXAMPLE # 7
You borrow ₱3,500 for one year from a friend at an interest of 1.5% compounded monthly instead of taking a loan from a
bank at a rate of 18% per year. Compare how much money you will save or lose on the transaction.
FRIEND: BANK
3500 3500
DIFF = ₱578
0 1 0 1 You will save ₱578.00
F if you borrow from
F
your friend
Solution: Solution:
F = P(1 + r/m)mt F = P(1 + r/m)mt
F = 3500(1 + 0.015/12)12(1) F = 3500(1 + 0.18/1)1(1)
F = ₱3,552 F = ₱4,130
EXAMPLE # 8
What is the present worth of two ₱100 payment at the end of third year and fourth year if the annual interest rate is 8%?

100 100 Solution:

P = 100(1+0.08)-3 + 100(1+0.08)-4
0 1 2 3 4 P = ₱152.89
P

EXAMPLE # 9
Compute the equivalent rate of 6% compounded semi-annually to a rate compounded quarterly.

Solution:
(1+r/m)m – 1 = (1+r/m)m – 1
(1+0.06/2)2 = (1+r/4)4
r = 6%
EXAMPLE # 10
You need ₱4,000 per year for four years to go to college. Your father invested ₱5,000 in 7% account for your education when
you were born. If you withdraw ₱4,000 at the end of your 17 th, 18th, 19th and 20th birthday, how much money will be left in the
account at the end of 21st year?
CASH-FLOW DIAGRAM Solution:
5000 5000(1+0.07)21 = 4000(1+0.07)4 + 4000(1+0.07)3
+ 4000(1+0.07)2 + 4000(1+0.07)1 + x
X = ₱1,700 Solution:
0 17 18 19 20 21
(1+r/m)m – 1 = (1+r/m)m – 1
4K 4K 4K 4K X (1+0.06/2)2 = (1+r/4)4
EXAMPLE # 11 r = 6%
A rich man put up a trust in the bank with instructions to give his son the earnings of ₱400,000 at the end of every 4 years and
to continue until the 20th year of the deposit when the son could get the ₱400,000 earning the principal. What is the amount
of money placed in the trust fund if guaranteed interest of 16% per year?
CASH-FLOW DIAGRAM Solution:
P P = 400k(1+0.16)-4 +…+ 400k(1+0.16)-20
P = ₱468,082.1538

0 4 8 12 16 20
400K 400K 400K 400K400K
EXAMPLE # 12
The present worth of several cash payments may be defined as the sum of the values of the future payments discounts at a
given rate for the corresponding period to the present. Find the present value of installment payments ₱1,000 now, ₱2,000 at
the end of first year, ₱3,000 at the end of 2nd year if money is worth 10% compounded annually.
CASH-FLOW DIAGRAM Solution:
P P = 1000 + 2000(1+0.1)-1 + 3000(1+0.1)-2
P = ₱5,297

0 1 2
1000 2000 3000
EXAMPLE # 13
A student plan to deposit ₱1,500 in the bank now and another ₱3,000 for the next 2 years. If he plans to withdraw ₱5,000 3
years after his last deposit for the purpose of buying shoes, what will be the amount of money left in the bank one year of
withdrawal r=10%
CASH-FLOW DIAGRAM Solution:
Bes wala akong solution dito sa notebook ko
5000 X
Solution:
0 1 2 3 4 5 6 (1+r/m)m – 1 = (1+r/m)m – 1
(1+0.06/2)2 = (1+r/4)4
1500 3000 r = 6%
ASSIGNMENT # 2
Derive the Continuous Compound Formula
COMPOUND INTEREST: F = P(1+r/m)mt Let m/r = x
e = lim (1+1/x)x F = P[(1 + 1/x)x]rt
x ∞
F = P(1+r/m)mt e
F = P[1+1/(m/r)]mt F = Pert
F = P[[1 + 1/(mr)]m/r]rt

Derive the Effective Rate of Interest formula

• Since the actual rate of interest on the principal is one year, we let t=1 for compound interest and n=1 for simple interest

F = P(1+in)
F = P(1 + r/m)mt

P(1 + in) = P(1 + r/m)mt

1 + i(1) = (1 + r/m)m(1)
i = (1 + rm)m - 1
DISCOUNT
An interest rate that is deducted right away “advance interest”

FORMULA: d = discount =F–P

future worth F

RELATIONSHIP OF DISCOUNT RATE AND INTEREST RATE

D=F–P d = 1+i-1
d=F–P 1+I
F d= i
P= F and D=Fd 1+i
1+in
Fd = F – F
1+in
Considering 1 peso-1year analysis
(1)D = (1) – 1
1+i(1)
EXAMPLE # 1
A CE borrowed ₱50,000 from a bank and promises to pay the loan after 1 year. The CE received ₱45,000 in cash. Determine
the rate of discount and the rate of interest.

Given: P = 45,000 Solution:

F = 50,000 d = F-P i = F-P
n=1 F P
d = 50000-45000 (100) d = 50000-45000 (100)
50000 45000
d = 10% i = 11.11%

EXAMPLE # 2
Engr. Timbreza borrowed ₱1,500 from a bank and promised to pay the amount at the end of 9 months. But he only received
₱1,340 after the bank deducted advance interest. Find the simple interest rate and discount rate.
Given: F = 1,500 Solution:
P = 1,340 F = P(1+in) d= i
n = 9/12 1500 = 1340 (1 + i(9/12)) 1+i
i = 0.1592 or 15.92% d = 0.1592 (100)
1+0.1592
d = 13.73%
EXAMPLE # 3
Engr. Taylor promised to pay ₱36,000 at the end of 90 days. He was offered a 12% discounts if he pays in 30 days. Find the rate
of interest.
CASH-FLOW DIAGRAM
Given: F = 36,000
d = 12% or 0.12 36000
P = 36,000 – (36,000(0.12))
= 31,680 60 days remaining 0 30 60 90
n = 60/360 (Banker’s Year)
31680

Solution:
F = P(1 + in)
36000 = 31680 (1+i(60/360))
i = 81.82%%
INFLATION
Increase in the amount of money needed to purchase same amount of goods or services which results in the
decrease in purchasing power
DERIVATION OF FORMULA: Fprice = Pprice(1 + f)n
F = 5% if = 5%
x x(1+f) x(1+f)2 x(1+f)n
P P(1+if) P(1+if)2 P(1+f)n
100 105 110.25
100 105 110.25

0 1 2 n
0 1 2 n
Let: F = P(1+if) n

f = inflation rate (1+f)n

if = market rate n ir = 1+if – 1
ir = real interest rate F = P 1 + if
1+f
1+f
n F = P(1+ir)n
F = P 1 + 1+if – 1 if = ir + f + irf
1+f
EXAMPLE # 1
In 1960, the average value of a house is ₱300,000. In 2010, the average of the house of the same model is ₱2,132,000. What
was the rate of inflation of the house?

Given: P = 300,000 Solution:

F = 2,132,000 2132000 = 300000(1+f)50
n = 50 f = 4%

EXAMPLE # 2
In year zero, you invest ₱100,000 in a 15% security for 10 years. During that time, the average annual inflation is 6%. How
much in terms of year zero pesos will be in the account of maturity?
n
F = P 1 + if Solution:
1+f 10
F = 100000 1 + 0.15
1 + 0.06
Given: P = 100,000
n = 10 F = ₱225,901.83
if = 0.15
f = 0.06
EXAMPLE # 3
A man invested ₱130,000 at an interest rate of 10% compounded annually. What will be the final amount of his investment, in
terms of today’s peso, after 5 years, if inflation remains the same at the rate of 8%
n
F = P 1 + if Solution:
1+f 5
F = 130000 1 + 0.10
Given: P = 130,000 1 + 0.08
n=5 F = ₱142,491.19
if = 0.10
f = 0.08
EXAMPLE # 4
What is the uninflated present worth of a ₱200,000 future value in two years if the average inflation is 6% and the real interest
rate
Given: P = 200,000 Solution: F = P(1+ir)n
n=2 200000 = P(1+0.1)2
ir = 0.10 P = ₱165,289.27
f = 0.06