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Chapter 9 - Engineering Economics
Chapter 9 - Engineering Economics
Definitions
Interest
Simple Interest Annual Basis
Interest paid in any year = Pis
Pis Fraction of investment paid as interest per
year
After n years total interest paid = Pisn
Total investment is worth = P + Pisn
Total investment after 1 year (n = 1) = P (1+is)
What is the drawback of simple interest?
Interest
Compound Interest
At time 0 we have P
At the end of Year 1, we have F1 = P (1 + i )
At the end of Year 2, we have F2 = P (1 + i )2
At the end of Year n, we have Fn = P (1 + i )n
or P = Fn / (1 + i )n
Example
How much would I need to invest at 8
% p.a. to yield $5000 in 10 years?
i 0.08
n 10
F10 5000
P
5000
1 0.08
10
$2315.97
Fn P (1 i j ) P 1 i1 1 i2 ....... 1 in
j 1
Eq. (7.7)
inom
r
m
m
inom
ieff 1
1
m
Example
I invest $1000 at 10 % p.a. compounded
monthly. How much do I have in 1 year, 10
years?
m
12
0.10
inom
F1 P 1
1000 1
m
12
$1104.71
12
ieff
0.10
12
F10 P 1 ieff
10
1 0.1047
$2707.04
Example cont.
As m decreases ieff increases
Is there a limit as m goes to infinity
Yes continuously compounded interest
Derivation pp. 265-266
ieff (continuous) = e inom 1
10
11
12
Example
I borrow $20 K for a car and repay as a $400
monthly payment for 5 years.
$20,000
For Bank
For Me
$400
123
12 3
60
60
$400
$20,000
Copyright R.Turton and J. Shaeiwitz - 2012
13
Cumulative CFD
Cumulative CFD
14
Annuities
1 2
15
Annuities
What is future value Fn?
Fn A 1 i
n 1
A 1 i
n 2
..... A
Geometric progression
1 i n 1
Fn Sn A
i
16
Discount Factors
Just a shorthand symbol for a formula in i and
n
P
1 i
1
P
, i, n
F
1 i n
1
P
P F , i, n F
n
1 i
F
P
1 i 1
A P , i, n
A
i 1 i n
n
17
Discount Factors
n
F
1
i
1
, i, n
i
A
1
P
, i, n
n
F
1 i
therefore
P
1 i 1
, i, n
A
i 1 i n
18
$2,000
4
0
$3,000
Invest 5K, 1K, 2K at end of Years 0, 1, 3, and take 3K at end of
Year 4
Note that annuity payments are all at the end of the year
Copyright R.Turton and J. Shaeiwitz - 2012
19
Example 1
How much in account at end of Year 7 if i = 8%
p.a.?
F7 5,000 1 0.08 1000 1 0.08 2000 1 0.08
7
3000 1 0.08
F7 $9097.84
9097.84
1.08
5308.50
Copyright R.Turton and J. Shaeiwitz - 2012
20
Example 2
What should my annual monthly car payment
be if interest rate is 8% p.a. compounded
monthly?
A
$20,000
Copyright R.Turton and J. Shaeiwitz - 2012
21
Example 2 (contd)
Compare at n = 60
0.08 60
1
1
12
73.47 A
F60 A
0.08
12
0.08 60
F60 20,000 1
29,796.90
12
73.47 A 29,796.90 0
A $405.53
22
Example 2 (contd)
Another method
i
i
1
m m
mn
0.08 0.08
1
12
12
60
,
0
.
08
,
60
0.020276
mn
60
P
i
0.08
1
1
1
12
m
23
Example 3
You buy a house where you finance $200 K
at 6% p.a. interest, compounded monthly.
What is your monthly payment, and how
much interest do you pay over the lifetime
of the loan for a 15-year and a 30-year
mortgage in current dollars?
24
Example 3 (contd)
mn
i
i
1
n
A
i (1 i )
m m
mn
n
P (1 i ) 1
i
1 1
m
15 - year mortgage m 12, n 15
30 - year mortgage m 12, n 30
Copyright R.Turton and J. Shaeiwitz - 2012
25
Example 3 (contd)
For 15-year mortgage
$1687.71/month
total of $303,788 paid
$103,788 interest
26
Example 4
You invest $5000/year (the maximum, for
now) in a Roth IRA, starting at age 25 for 40
years. Assuming a return of 8% p.a., how
much will you have at age 65 in future
dollars?
27
Example 4 (contd)
F (1 i ) 1
A
i
n
F (1 0.08) 1
A
0.08
F
259.06
A
A 5000
40
F $1,295,283
Copyright R.Turton and J. Shaeiwitz - 2012
28
Example 5
Repeat the previous calculation, assuming that you
do not start investing until age 35 or age 45.
F (1 i ) n 1
A
i
F (1 0.08) n 1
A
0.08
A 5000
if n 30
if n 20
F
113.28
A
F
45.76
A
F $566,400
F $228,800
29
Depreciation
Total Capital Investment = Fixed Capital +
Working Capital
Fixed Capital All costs associated with new
construction, but Land cannot be depreciated
Working Capital Float of material to start
operations cannot depreciate
30
Definitions
Salvage Value, S
Value of FCIL at end of project
Often = 0
Life of Equipment
n set by IRS
Not related to actual equipment life
31
Straight Line
Sum of Years Digits (SOYD)
Double Declining Balance (DDB)
Modified Accelerated Cost Recovery System
(MACRS)
32
Straight Line
d kSL
FCI L S
33
d kSOYD
n 1 k FCI L S
1
n n 1
2
SOYD
34
DDB
dk
k 1
2
FCI L
d j
n
35
MACRS
Current IRS-approved method
Year
Depreciation Percentage
1
2
3
4
5
6
20.00
32.00
19.20
11.52
11.52
5.76
See Chapter 9
Based on combination
of DDB and SL
36
Example 9.21
FCI L $150 10
S $10 10
n7
1st Year d SL ?
150 10
d SL
20
7
Same for Years 1-7
Copyright R.Turton and J. Shaeiwitz - 2012
37
7 1 1
7
d SOYD ,1
150 10 150 10 35
1
28
7 8
d SOYD ,2
2
7 1 2
150 10 150 10 30
1
28
7 8
2
38
2
d DDB,1 150 42.9
7
2
d DDB,2 150 42.9 30.6
7
39
40
41
Inflation
$ Net Worth Now vs. $ Next Year
CEPCI j n 1 f CEPCI j
n
42
Inflation
Example
CEPCI 1993 359
CEPCI 2003 402
1 f
10
402
359
402
f
359
0.1
1 0.0114 or 1.14%
Copyright R.Turton and J. Shaeiwitz - 2012
43
Inflation
What is inflation rate since 2003? The current
CEPCI is 600 (2011).
600
(1 f )
1.4925
402
8
f 1.49250.125 1 0.0513
5.13%
44
Inflation
Effect of inflation on interest rate
f affects the purchasing power of the $
Look at the purchasing power of future worth, then
F'
F
(1 f )n
1 i
F
(1 i )
' n
P
(1
i
)
1 f
n
n
(1 f )
(1 f )
i'
1 i
1 i f
1 f
45