ES 301: Engineering Economy Topic 2: Interest-Money-Time Relationships

INTEREST AND MONEY – TIME RELATIONSHIPS

ANNUITIES
Annuity – a series of equal payments made at equal intervals of time.

TYPES OF ANNUITY
1. Ordinary annuity – one where equal payments are made at the end of each payment period
starting from the first period.

0 1 2 3 4 n
A

A A A A A
P

 (1 + i )n − 1
P =A 
 (1 + i )n i 

The quantity brackets is called the “uniform series present worth factor” and is designated by
the functional symbol P/A, i%, n, read as “ P given A at i percent in n interest periods.”The
equation can be expressed as

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

0 1 2 3 4 n
A

A A A A A
F

 (1 + i )n − 1
F =A 
 i 
The quantity brackets is called the “uniform series compound amount factor” and is
designated by the functional symbol F/A, i%, n, read as “ F given A at i percent in n interest
periods.”The equation can be expressed as

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

Sample Problems
1.1 For having been loyal, trusthworthy and efficient, the company has offered a supervisor a
yearly gratuity pay of P20,000.00 for 10 years with the first payment to be made one year
after his retirement. The supervisor, instead, requested that he be paid a lump sum on the

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ES 301: Engineering Economy Topic 2: Interest-Money-Time Relationships

date of his retirement less interest that the company would have earned if the gratuity is to
be paid on yearly basis. If interest is 15%, what is the equivalent lump sum that he could get?
1.2 Rianer Wandrew borrowed P 50,000 from a Social Security System, in the form of calamity
loan, with interest at 8%, compounded quarterly, payable in equal quarterly installments for
10 years. Find the quarterly payments.
1.3 In anticipation of a much bigger volume of business after 10 years, a fabrication company
purchased an adjacent lot for its expansion program where it hopes to put up a building
projected to cost P4,000,000.00 when it will be constructed 10 years after. To provided for
the required capital expenses, it plans to put up a sinking fund for the purpose.How much
must the company deposit each year if interest to be earned is computed at 15%.

2. Deferred annuity – it is also an ordinary annuity but the payment of the first amount is
deferred a certain number periods after the first.

m periods n periods

0 1 2 n-1 n
0 1 2 m

A A A A
P
A(P/A,i%,n)(P/F,ib%,m A(P/A,i%,n)
)
P = A(P/A, i%, n)(P/F,i%,m)

 (1 + i )n − 1
 (1 + i )
−m
P =A
 (1 + i ) i 
n

Sample Problems
2.1 A new generator has just been installed. It is expected that there will be no maintenance
charges until the end of the sixth year, when P300 will be spent on the generator and P300
will be spent at the end of each successive years until the generator is scrapped at the end of
its fourteenth year of service. What sum of money set aside at the time of installation of the
generator at 6% interest will take care of all maintenance expenses?
2.2 A man invests P10,000 now for the college education of his 2-year old son. If the fund earns
14% effective, how much will the son get each year starting from his 18 th to the 22nd
birthday?
2.3 The purchaser of a tractor paid P10,000 cash and agreed to pay P3000 at the end of 6
months for 10 years. He failed to make the first 5 payments of P3000 each. At the end of 3
years he desires to pay the tractor by a single payment which will cancel both his
accumulated liabilities and his future liabilities. What must he pay if money is worth 6% per
annum compounded semi-annually?
2.4 A man wishes to provide a fund for his retirement such that from his 60th to 70th birthdays he
will be able to withdraw equal sums of P18,000 each for his yearly expenses. He invests equal

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ES 301: Engineering Economy Topic 2: Interest-Money-Time Relationships

amounts from his 41st to 59th birthdays in a fund earning 10% compounded annually. How
much should each of these amounts be?

3. Annuity due – is one where payments are made at the start of each period, beginning from
the first period.
0 1 2 3 4 n
A

A A A A A A
P

 (1 + i )n − 1
P =A + A 
 (1 + i )n i 
 (1 + i )n − 1
F = A (1 + i )n + A  
 i 

Sample Problems
3.1 A farmer bought a tractor costing P25,000 payable in 10 semi-annual payments, each
installment at the beginning of each period. If the rate of interest is 26% compounded semi-
annually, determine the amount of each installment.
3.2 A farmer bought a tractor costing P12,000 if paid in cash. The tractor may also be purchased
by installment to be paid within 5 years. Money is worth 8% compounded annually.
Determine the amount of each annual payment if all payments are made
a. at the end of each of the 5 years
b. at the beginning of each of the 5 years.
3.3 a. Juan bought a car with a cash value of P14,000 on the installment plan under the
following terms:
P4,000 cash upon delivery and the balance payable in 12 equal monthly payments, each
payment combining an amortization installment and 6% on the previously unpaid
balance.Solve for his monthly payment.
b. At the end of 8 months, he was forced to sell the car in order to pay a P7,000 debt. At
what price must he sell his car so that he can completely pay the car and also pay his
P7,000 debt?

4. Perpetuity – is one where the payments periods extend forever or in which periodic
payments continue indefinitely.
0 1 2 3 4 n
A

A A A A A A
P

1 − (1 + i )−  
P = A(P/A, i%, n) = A  
 i 

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ES 301: Engineering Economy Topic 2: Interest-Money-Time Relationships

P
P=
A
Where: P is called the capitalized value or cost of A.

Sample Problems
1. An endowment fund is to provide an annual scholarship of P4,000 for the first 5 years;
P6,000 for the next 5 years and P9,000 thereafter.The fund will be established 1 year
before the first scholarship is awarded. If the fund earns 12% interest, what sum must be
deposit?
2. To maintain a bridge, P5,000 will be required at the end of 3 years and annually
thereafter.If money is worth 8%, determine the capitalized cost of all future
maintenance.

Capitalized Cost
As a natural extension and application of perpetuity we have capitalized cost of any
structure or property ( equipment, machinery, building, etc.) is the sum of its first cost and the
present worth of all costs for replacement, operation, and maintenance for a long time or
forever, that is,
Capitalized cost = First cost + Cost of Perpetual Maintenance.
To derive the formulas for capitalized cost, let
FC = first cost of the structure,
S = the amount needed to replace or maintain the property every k periods,
X = the amount of principal invested at i% per period, the interest on which will amount to S
every k periods.
 S 
Capitalized cost = FC + X = FC +  
 (1 + i ) − 1
k

Sample Problems
1. A manufacturing plant installed a new boiler at a total cost of P150,000 and is estimated to
have a useful life for 10 years. It is estimated to have a scrap value at the end of its useful
life of P5,000. If interest is 12% compounded annually, determine its capitalized cost.
2. A heat exchanger is needed in a chemical process. If interest is 9% compounded annually,
determine which of the following heat exchanger is cheaper by comparing the capitalized
costs:
Exchanger A costs P22,000 with a scap value of P1,000 and a useful life for 7 years;
Exchanger B costs P28,000 with a scap value of P1,500 and a useful life of 10 years.
3. A research foundation wishes to set up a trust fund earning 10% compounded annually to
(a). provide P2,000,000 for the lot and building and P1,000,000 for the initial
equipment of a structural Engineering and materials laboratory ;
(b). pay P400,000 for the annual operating cost every year;and
(c). pay P500,000 for the purchase of new equipment and replacement of some
equipment every 5 years beginning 5 years from now.

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ES 301: Engineering Economy Topic 2: Interest-Money-Time Relationships

How much money is needed to be put in the fund for the building and equipment
replacement?

Amortization
Amortization is any method of repaying a debt, the principal and interest included,
usually by a series of equal payments at equal interval of time.

Sample Problem
Construct the amortization schedule for a debt of P10,000 with interest at the rate of
19%, payable semi-annually, which is paid for, principal and interest included, by payments for
P2,000 at the end of each 6 months for as long as necessary.

Uniform Arithmetic Gradient

In certain cases, engineering economy problems involve disbursement or receipts that
increase or decrease each year by varying amounts. As time goes by, the maintainance expense
for mechanical equipment usually increase. If this increase is constant then it is known as a
uniform arithmetic gradient. Present worth
P
of gradient
0 1 2 3 4 5 n-1 n No. of periods

G  (1 + i )n − 1 n  0
G
P=  − 
i  i(1 + i )n (1 + i )n 
2
G 3
= G(P/G, i%, n) G 4
G (n-2)G
(n-1)G
Sample Problems
1. A contract has been signed to lease a building at P20,000 per year with annual increase
of P1,500 for 8 years. Payments are to be made at the end of each year, starting one year
from now. The prevailing rate is 7%. What lump sum paid today would be equivalent to
the 8-year lease-payment plan?
2. Suppose a man receives an initial annual salary of P12,000 increasing at the rate of
P1,000 a year. If money is worth 10%, determine his equivalent uniform salary for a
period of 8 years.

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