An Engineering Science

ENGINEERING ECONOMY

University of Eastern Philippines

College of Engineering
Agricultural & Biosystems Engineering Department

Engr. Elaido B. Jao Jr.

Instructor

2020
 ES 414a: ENGINEERING ECONOMY

MODULE 1: ENGINEERING ECONOMY ITS TIME VALUE OF MONEY AND

IMPORTANCE

OVERVIEW

Engineering Economy is one of the most essential subjects in the engineering

disciplines. This module is to give the students a sound understanding of the basic concepts
of the course and some insights into approaches that can be used for making sound
economic decisions. They shall also be able to familiarize and identify the different possible
alternatives of economic studies in the different fields of specialization as presented mostly
by Hipolito B. Sta. Maria.

This module tackles on engineering science course particularly the essentials of

Engineering Economy and their functions This 3-unit course is offered to all officially
enrolled Engineering students with allotted lecture of three-hours per week.

TOPICS:

This module presents the following topics:

1. Economic Environment
a. Consumer and Producer Goods and services;
b. Necessities and Luxuries;
c. The Law of Supply and Demand;
d. Competition, Monopoly and Oligopoly;
e. Law of Diminishing Returns
2. Interest and Money – Time Relationship
a. Simple Interest;
b. Compound Interest;
c. Annuities

LEARNING OUTCOMES

At the end of this course, the student must be able to

1. Explain the time value of money and discounting at normal and inflationary conditions;
a. Determine the future value of an investment and the present worth of a targeted
future amount;
b. Prepare using manual computations and computer the detailed investments,
operating costs; financial an economic benefits of any engineering projects;
 PRETEST

Direction: Choose the letter of the correct answer. Do not write your answer on this
manual.
1. It 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 use of capital.
a. Engineering Economy b. Economic Analysis c. Economics d. All of the above
2. These are those products that are directly used by people to satisfy their wants.
a. Consumers goods b. Producers goods c. Dry goods d. Wet goods
3. These are goods used to produce consumer goods or other goods.
a. Dry goods b. Wet goods c. Consumers goods d. Producers goods
4. These are those products or services that are required to support human life activities.
a. Food b. Clothing c. Shelter d. Necessities
5. These are those products or services that are desired by humans and will be
purchased if money is available after the required necessities have been obtained.
a. Wants b. Luxuries c. Needs d. Excess
6. It is a quantity of a certain commodity that is bought at a certain price at a given time.
a. Supply b. Demand c. Bulk purchased d. Panic Buying
7. In the cash-flow diagram shown in the given figure

a. Equal deposits of Rs 3,000 per year (A) are made, starting now
b. The rate of interest is 10% per year account
c. The amount accumulated after the 7th deposit is to be computed
d. All of the above
8. The interest calculated on the basis of 365 days a year, is known as:
a. Interest b. Ordinary simple interest c. Exact simple interest d. None of
these
9. If ‘P’ is principal amount, ‘I” is the rates of interest per annum and ‘n’ is the number of
periods in years, the compound amount factor (CAF) is:
a. (1 – i)n b. (1 – i)n/12 c. (1 – i/12)n d. (1 – ni)
10. Pick up the correct statement from the following:
a. The change in the amount of money over a given time is called “time value” of
money, a most important concept in engineering economy
b. The manifestation of the time value of money is termed as current asset.
c. Interest on borrowing = future amount owed-original loan.
d. none of the above
.

Key Terms

Time Value of Money. It is a fact that money makes money. This concept explains the
change in the amount of money over time for both owned and borrowed funds.
Economic Equivalence A combination of time value of money and interest rate that
makes different sums of money at different times have equal economic value
Cash Flow The flow of money into and out of a company, project, or activity. Revenues
are cash inflows and carry a positive (+) sign; expenses are outfl ows and carry a
 negative (−) sign. If only costs are involved, the − sign may be omitted, e.g., benefi
t/cost (B/C) analysis.
Loan An amount of borrowed capital or money from any entity such as banks or persons.
End-of-Period Convention To simplify calculations, cash fl ows (revenues and costs) are
assumed to occur at the end of a time period . An interest period or fi scal period is
commonly 1 year . A half-year convention is often used in depreciation calculations.
Cost of Capital The interest rate incurred to obtain capital investment funds. COC is
usually a weighted average that involves the cost of debt capital (loans, bonds, and
mortgages) and eq-uity capital (stocks and retained earnings).
Minimum Attractive Rate of Return (MARR) A reasonable rate of return established for
the evaluation of an economic alternative. Also called the hurdle rate, MARR is
based on cost of capital, market trend, risk, etc. The inequality ROR ≥ MARR >
COC is correct for an eco-nomically viable project.
Opportunity Cost A forgone opportunity caused by the inability to pursue a project. Nu-
merically, it is the largest rate of return of all the projects not funded due to the lack
of capital funds. Stated differently, it is the ROR of the fi rst project rejected
because of unavailability of funds.
Nominal or Effective Interest Rate ( r or i ) A nominal interest rate does not include any
compounding; for example, 1% per month is the same as nominal 12% per year.
Effective interest rate is the actual rate over a period of time because compounding
is imputed; for example, 1% per month, compounded monthly, is an effective
12.683% per year. Infl ation or defl ation is not con-sidered.
Placement of Present Worth ( P ; PW) In applying the ( P/A , i %, n ) factor, P or PW is
always located one interest period (year) prior to the fi rst A amount . The A or AW
is a series of equal, end-of-period cash fl ows for n consecutive periods, expressed
as money per time (say, $/year; /year).
Placement of Future Worth ( F ; FW) In applying the ( F/A , i %, n ) factor, F or FW is
always located at the end of the last interest period (year) of the A series .

LEARNING PLAN

READING RESOURCES AND INSTRUCTIONAL ACTIVITIES

What to know
Do you want to be a successful engineer-economist? Let’s find
out how?

Let's get started:

Introduction

The need for engineering economy is primarily motivated by the work that engineers do in
performing analyses, synthesizing, and coming to a conclusion as they work on projects of
all sizes. In other words, engineering economy is at the heart of making decisions. These
decisions involve the fundamental elements of cash flows of money, time, and interest
rates. This chapter introduces the basic concepts and terminology necessary for an
engineer to combine these three essential elements in organized, mathematically correct
ways to solve problems that will lead to better decisions.

Economy Environment

Engineering economy is the analysis an 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 use of capital.
Consumer and Producer Goods and Services

Consumer goods and services are those products or services that are direct use by people
to satisfy their wants. Producer goods and services are used to produce consumer goods
and services or other producer goods.

Necessities and Luxuries

Necessities are those products or services that are required to support human life and
activities that will be purchased in somewhat the same quantity even though the price
varies considerably. Luxuries are those products or services that are desire by humans
and will be purchased if money is available after the required necessities have been
obtained.

Law of Supply and demand

Supply is the quantity of a certain community that is offered for sale at a certain price at a
given place and time. Demand is he quantity of a certain commodity that is bought at a
certain price at a given place an time. Elastic demand occurs when a decrease in selling
price result in a greater than proportionate increase in sales. Inelastic demand occurs
when a decrease in the selling price produces a less than proportionate increase in sales.
Unitary elasticity of demand occurs when the mathematical product of volume and price is
constant.

The law of supply and demand is a theory that explains the interaction between the sellers
of a resource and the buyers for that resource. The theory defines what effect the
relationship between the availability of a particular product and the desire (or demand) for
that product has on its price. Generally, low supply and high demand increase price and
vice versa. Perfect examples of supply and demand in action include PayPal.

The law of demand states that, if all other factors remain equal, the higher the price of a
good, the less people will demand that good. In other words, the higher the price, the
lower the quantity demanded. The amount of a good that buyers purchase at a higher
price is less because as the price of a good goes up, so does the opportunity cost of
buying that good. As a result, people will naturally avoid buying a product that will force
them to forgo the consumption of something else they value more. The chart below shows
that the curve is a downward slope.

Like the law of demand, the law of supply demonstrates the quantities that will be sold at a
certain price. But unlike the law of demand, the supply relationship shows an upward
slope. This means that the higher the price, the higher the quantity supplied. Producers
supply more at a higher price because selling a higher quantity at a higher price increases
revenue.

Unlike the demand relationship, however, the supply relationship is a factor of time. Time
is important to supply because suppliers must, but cannot always, react quickly to a
change in demand or price. So it is important to try and determine whether a price change
that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an
unexpected rainy season; suppliers may simply accommodate demand by using their
production equipment more intensively. If, however, there is a climate change, and the
population will need umbrellas year-round, the change in demand and price will be
expected to be long term; suppliers will have to change their equipment and production
facilities in order to meet the long-term levels of demand.
Key Takeaways

1. The law of demand says that at higher prices, buyers will demand less of an economic
good.
2. The law of supply says that at higher prices, sellers will supply more of an economic
good.
3. These two laws interact to determine the actual market prices and volume of goods
that are traded on a market.
4. Several independent factors can affect the shape of market supply and demand,
influencing both the prices and quantities that we observe in markets.

Competition, Monopoly and Oligopoly

Perfect competition occurs in a situation where a commodity or service is supplied by a

number of vendors an there is nothing to prevent additional vendors entering the market..

Monopoly is the opposite of the prefect competition. A perfect monopoly exists when a
unique product or services is available from a single vendor and that vendor can prevent
the entry of all others into the market.

Oligopoly exists when there are a few suppliers of a product or services that action by one
will almost inevitably result in similar action by the others

What to process
At this point, let us examine ourselves if we really capable of
becoming an Economist. Let us know our chances.

Activity #1:

This is a self-examination activity. After knowing the basic concepts of economic process,
examine yourself if you really understands economy itself. Simply put check ( ) if that
particular process will you really do or an x (X) if you will not do it. Comment on your own
status by giving possible options that can help you acquire it.

Will I Do Realizations
this? (What are my options?)
Economic Process Producer’s goods or
YES NO
Consumers goods;
( ) (X)
Necessities or Luxuries
1 I always buy classical books. Books are consumers good,
classical books are Luxuries
since I should rather buy
engineering books
2 I rather photocopy a books than buying
them
3 I always buy bags every semester as
my lucky charm.
4 I only buy new bag when my old bag is
unusable.
5 I always add more supplies of
ingredients whenever my parents ask
me for an errand for allowance
purposes.
6 I always check the exact amount of
ingredients needed to avoid wastage.
7 I always ride my motorcycle no matter
how near it is.
8 I always ride my motorcycle no matter
how far it is.
9 I intend to make my assignments
written carefully to avoid erasure to
save my money for bond papers.
10 It doesn’t matter whether I will rewrite
my assignment as long as I can submit
my work neatly.

The next activity will test your knowledge on the law of supply and demand as well as the
business establishment scenario undertaken. Write the letter corresponding the business
establishment that practice whether Perfect Competition (P), Monopoly (M), or Oligopoly
(O). Write your insight on their supply and demand analysis

Economics Supply and Demand

Business Establishments
Practice analysis
1 Northern Samar Electric Cooperative M Electric supply is monopolized
(Norsamelco) since it is the only electric
establishment in the province.
The electric demand is high
during Christmas Season
2 Cable Television Services

3 Sari-sari Stalls

4 Caltex

5 Sugar Industry

6 Meat Section Market

7 Airlines

8 Gaisano Grand Mall

9 Pharmaceuticals

10 Dry Goods Section

11 Computer & Software

12 Coconut Industry
Interest and Money – Time Relationships

Interest is the manifestation of the time value of money. It is the amount of money paid for
the use of borrowed capital or the income produced by the money which has been loaned.

Computationally, interest is the difference between an ending amount of money and the
beginning amount. If the difference is zero or negative, there is no interest. There are
always two perspectives to an amount of interest—interest paid and interest earned.
These are illustrated in Fig.1..

Interest is paid when a person or organization borrowed money (obtained a loan) and
repays a larger amount over time. Interest is earned when a person or organization saved,
invested, or lent money and obtains a return of a larger amount over time. The numerical
values and formulas used are the same for both perspectives, but the interpretations are
different. Interest paid on borrowed funds (a loan) is determined using the original amount,
also called the principal,

DIMENSIONAL ANALYSIS:

Interest = amount owed now − principal (Eq. 1)

When interest paid over a specific time unit is expressed as a percentage of the principal,
the result is called the interest rate.

Interest rate (%) = × 100% (Eq. 2)

The time unit of the rate is called the interest period. By far the most common interest
period used to state an interest rate is 1 year. Shorter time periods can be used, such as
1% per month.

Thus, the interest period of the interest rate should always be included. If only the rate is
stated, for example, 8.5%, a 1-year interest period is assumed.

Fig. 1 (a) Interest paid over time to lender. (b) Interest earned over time by investor.
EXAMPLE 1

An employee at Gaisano Grand Mall borrows ₱10,000 on May 1 and must repay a total of
₱10,700 exactly 1 year later. Determine the interest amount and the interest rate paid.

Given: borrowed amount = ₱ 10,000

Repayment = ₱ 10,700

Required Interest

Solution

The perspective here is that of the borrower since ₱10,700 repays a loan. Apply Equation

Interest = amount owed now − principal

To determine the interest paid. Interest paid = ₱10,700 − ₱10,000 = ₱700

Then determine the interest rate paid for 1 year.

Interest rate (%) = × 100%

Percent Interest rate (%) = × 100% = 7% per year

EXAMPLE 2

Stereophonics, Inc. plans to borrow ₱20,000 from a bank for 1 year at 9% interest for new
recording equipment. (a) Compute the interest and the total amount due after 1 year. (b)
Construct a column graph that shows the original loan amount and total amount due after
1 year used to compute the loan interest rate of 9% per year.

Solution

(a) Compute the total interest accrued by solving Equation [2] for interest accrued.
Interest = ₱20,000(0.09) = ₱1800
The total amount due is the sum of principal and interest.
Total due = ₱20,000 + 1800 = ₱21,800

(b) Figure 2 shows the values used in Equation [2]: $1800 interest, $20,000 original loan
principal, 1-year interest period.
 Fig. 2. Values used to compute an interest rate of 9% per year.

ENGINEERING ANALYSIS:

Simple interest is calculated using the principal only, ignoring any interest that had been
accrued in preceding periods. In practice, simple interest is paid on short-term loans in
which the time of the loan is measured in days .

I = Pni (Eq 3)
F = P + I = P + Pni
F = P (1 +ni) (Eq. 4)
where:
I = interest
P = principal or present worth
n = number of interest periods
i = rate of interest per interest period
F = accumulated amount or future worth

(a) Ordinary simple interest is computed on the basis of 12 months of 30 days each or
360 days a year.
1 interest period = 360 days

(b) Exact simple interest is based on the exact number of days in a year, 365 days for an
ordinary year and 366 days for leap year.

1 interest period = 365 or 366 days

EXAMPLE 3

Determine the ordinary simple interest on ₱ 700 for 8 months and 15 days if the rate of
interest is 15%

Given: P = ₱ 700, n = 8 mos & 15 days i = 15%

Solution:

Number of days = (8) (30) + 15 = 255 days

From Eq.1: I = Pni

I = ₱ 700 x x 15% = ₱ 74.38

EXAMPLE 4

Determine the exact simple interest on ₱ 500 for the period from January 10 to October
28, 2016 at 16% interest

Given: P = ₱ 500, n = Jan 10 – Oct 28 i = 16%

Required Exact interest

Solution Jan 10-31 = 21 (excluding 10)

February = 29
March = 31
April = 30
May = 31
June = 30
July = 31
August = 31
September = 30
October = 28 ( including 10)
292 days

Exact simple Interest = ₱ 500 x x 16% = ₱ 63.83

EXAMPLE 5

What will be the future worth of the money after 14 months, if a sum of ₱ 10,000 is
invested today at a simple interest rate of 12% per year?

Given: P = ₱ 10,000, n = 14 mos i = 12%

Required Future worth (F)

Solution: F = P (1 + ni) = ₱ 10,000 1 + (0.12) = ₱ 11,400.00

Cash Flow Diagram

A cash-flow diagram is simply a graphical representation of cash flows drawn on a time

scale. Cash-flow diagram for economic analysis problems is analogous to that of free body
diagram for mechanics problems.

This represents a receipt (positive cash flow or cash inflow)

This represents a disbursement (negative cash flow of cash outflow)

Illustration 1:

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

₱ 150

l l I i
0 1 2 3 4 5

₱ 100

Cash flow diagram on the viewpoint of the lender

₱ 100

l l l I
0 1 2 3 4 5

₱ 150

Cash flow diagram on the viewpoint of the borrower

Compound Interest

In calculations of compound interest, the interest for an interest period is calculated on the
principal plus total amount of interest accumulated in previous periods Thus compound
interest means 'interest on top of interest.'

l l l- - - - n-1 n
0 1 2 3

Table 1. Compound Interest (Borrower's Viewpoint)

Interest Principal at Interest Earned Amount at End

Period Beginning of During Period of Period
Period
1 P Pi P + Pi = P(1 + ni)
2 P (1 + i) P (1 + i) i P(1 + i) + P(1+ i)i = P(1 + i)2
3 P (1 + i)2 P (1 + i)2 i P(1 + i)2 + P(1+ i)2i = P(1 + i)3
--- --- --- ---
n P (1 + i)n-1 n-1
P (1 + i) i P (1 + i) n

F = P(1+ i)n (Eq. 5)

 The quantity (1 + i)n is commonly called the ֞ single payment compound amount factor ֞
and is designated by the functional symbol F/P, i%, n. Thus,

F = P (F/P, i%, n) (Eq. 6)

The symbol F/P, i%, n is read as ֞F given P at i percent in n interest periods.֞ From Eq. 6

P = F(1 + i)-n (Eq. 7)

The quantity (1 + i)-n is called the ‘‘single payment present worth factor'' and is designated
by the functional symbol P/F, i%, n. Thus,

P = F(P/F, i%, n) (Eq. 8)

The symbol P/F, i%, n is read as ֞P given F at i percent in n interest periods.֞ From Eq. 8

Rates of Interest

Nominal and effective interest rates are similar to simple and compound interest rates,
with a nominal rate being equivalent to a simple interest rate. All of the equations
expressing time value of money are based on compound (i.e., effective) rates, so if the
interest rate that is provided is a nominal interest rate, it must be converted into an
effective rate before it can be used in any of the formulas. The first step in the process of
insuring that only effective interest rates are used is to recognize whether an interest rate
is nominal or effective. Table 1 shows the three ways interest rates may be stated.

Table 2. Various interest statements and their interpretation

Interest Rate Statement Interpretation Comment

i = 12% per year
i = 1% per month
i = 3-1/2% per quarter
i = 8% per year,
compounded monthly
i = 4% per quarter
compounded monthly
i = 14% per year
compounded
semiannually
i = effective 10% per year
compounded monthly
i = effective 6% per quarter
i = effective 1% per month
compounded daily
i = effective 12% per year When no compounding
compounded yearly period is given, interest rate
i = effective 1% per month is an effective rate, with
compounded monthly compounding period
i = effective 3-1/2% per assumed to be equal to
quarter compounded stated time period
quarterly
i = nominal 8% per year When compounding period
compounded monthly is given without stating
i = nominal 4% per quarter whether the interest rate is
compounded monthly nominal or effective, it is
i = nominal 14% per year assumed to be nominal.
compounded Compounding period is as
semiannually stated.
i = effective 10% per year If interest rate is stated as
compounded monthly an effective rate, then it is
i = effective 6% per quarter an effective rate. If
compounded quarterly compounding period is not
i = effective 1% per month given, compounding period
compounded daily is assumed to coincide with
stated time period.

The three statements in the top part of the table show that an interest rate can be stated over
some designated time period without specifying the compounding period. Such interest rates
are assumed to be effective rates with the compounding period (CP) assumed to be the same
as that of the stated interest rate.

For the interest statements presented in the middle of Table 2, three conditions prevail:
1. the compounding period is identified,
2. this compounding period is shorter than the time period over which the interest is
stated, and
3. the interest rate is not designated as either nominal or effective.

In such cases, the interest rate is assumed to be nominal and the compounding period is
equal to that which is stated. (We show how to get effective interest rates from these in the
next section.)

For the third group of interest-rate statements in Table 3, the word effective precedes or
follows the specified interest rate and the compounding period is also stated. These interest
rates are obviously effective rates over the respective time periods stated. Likewise, the
compounding periods are equal to those stated. Similarly, if the word nominal had preceded
any of the interest statements, the interest rate would be a nominal rate. Table 3 contains a
listing of several interest statements (column 1) along with their interpretations (columns 2
and 3).

Table 3. Specific examples of interest statements and interpretations

(1) (2) (3)

Interest Statement Nominal or Effective Compounding
Interest Period
15% per year compounded monthly Nominal Monthly
15% per year Effective Yearly
Effective 15% per year compounded Effective Monthly
monthly
20% per year compounded quarterly Nominal Quarterly
Nominal 2% per month compounded Nominal Weekly
weekly
2% per month Effective Monthly
2% per month compounded monthly Effective Monthly
Effective 6% per quarter Effective Quarterly
Effective 2% per month compounded Effective Daily
daily
1% per week compounded continuously Nominal Continuously
0.1% per day compounded continuously Nominal Continuously

All of the formulas used in making time value calculations are based on effective interest
rates. Therefore, whenever the interest rate that is provided is a nominal rate, it is necessary
to convert it to an effective interest rate. As shown below, an effective interest rate, i, can be
calculated for any time period longer than the compounding period.

The most common way that nominal interest rates are stated is in the form 'x% per year
compounded y' where x = interest rate and y = compounding period. An example is 18% per
year compounded monthly. When interest rates are stated this way, the simplest effective
rate to get is the one over the compounding period because all that is required is a simple
division. For example, from the interest rate of 18% per year compounded monthly, a
monthly interest rate of 1.5% is obtained (i.e., 18% per year/12 compounding periods per
year) and this is an effective rate because it is the rate per compounding period. To get an
effective rate for any period longer than the compounding period use the effective interest
rate formula.

i = (1+r/m)m - 1 (Eq. 9)
where:
i = effective interest rate per period
r = nominal interest rate per period
m = number of times interest is compounded per period

This effective interest rate formula can be solved for r or r/m as needed to determine a
nominal interest rate from an effective rate.

For continuous compounding, the effective rate formula is the mathematical limit as m
increases without bounds, and the formula reduces to

i = er - 1. (Eq. 10)

Example 6:

For an interest rate of 12% per year compounded quarterly, what is the effective interest
rate per year ?

Given: r = 12%

Required: effective rate

Solution: An effective interest rate per year is sought. Therefore, r must be expressed
per year and m is the number of times interest is compounded per year.
Using Eq. 9.

i = (1+r/m)m - 1 = (1 + 0.12 / 4)4 - 1 = 12.55 %

Example 7:

Find the nominal rate which if converted quarterly coul be used instead of 12%
compounded monthly. What is the corresponding effective rates?

Given: r (known) = 12%

Required effective rate

Solution: Let r = the unknown nominal rate

For two or more nominal rates to be equivalent, their corresponding effective rates must
be equal.

Nominal Rate Effective Rate

r% compounded quarterly ( 1 + )4 – 1
.
12% compounded monthly (1+ )12 – 1

.
Equating the Two Equation: ( 1 + )4 – 1 = ( 1 + )12 – 1
 1 + = (1.01)3 = 1.0303

r = 0.1212 or 12.12% compounded quarterly

Example 8:

Find the amount at the end of two years and seven months if ₱ 1,000 is invested at 8%
compounded quarterly using simple interest for anytime less than a year interest period.

Given: P = ₱ 1,000, r = 8% compounded, n = 2yr & 7mos

Required Future amount, F

%
Solution: For compound interest: i= = 2%, n = (2)(4) = 8
For simple interest: i = 8%, n =

F2

F1

l
0 1 2 2 yrs 7 mos
compound simple
interest interest
₱ 1000

F1 = P (1 + i)n = ₱ 1000 ( 1 + 0.02)8 = ₱ 1,171.66

F2 = F1 (1 + ni) = ₱ 1,171.66 1 + (0.08) = ₱ 1,226.34

Example 9:

A ₱ 2,000 loan was originally made at 8% simple interest for 4 years. At the end of this
period the loan was extended for 3 years, without the interest being paid, but the new
interest rate was made 10% compounded semiannually. How much should the borrower
pay at the end of 7 years?

Given: P = ₱ 2,000, i = 8% compounded, n1 = 4yrs n2 = 3yrs r = 10%

Required F7

Solution:
F7
F4

l l l l l l
0 1 2 3 4 5 6 7
simple compound
interest interest
₱ 2,000
 F4 = P (1 + ni) = ₱ 2,000⟦1 + (4)(0.08)⟧ = ₱ 2,640.00

F7 = F4 (1 + ni) = ₱ 2,640.00 (1 + 0.05)6 = ₱ 3,537.86

Equation of Value

An equation of value is obtained by setting the sum of the values on a certain comparison
or focal date of one set of obligations equal to the sum of the values on the same date of
another set of obligations.

Example 10:

A man bought a lot worth ₱ 1,000,000 if paid in cash. On installment basis, he paid a down
payment of ₱ 200,000, ₱ 300,000 at the end of one year; ₱ 400,000 at the end of three
years and a final payment at the end of five years.. What was the final payment if the
interest was 20%.

Given: P = ₱ 1,000,000, CP1 = ₱ 200,000,

CP2 = ₱ 300,000 @ 1yr, CP3 = ₱ 400,000 @ 3yrs
i = 20% n = 5 yrs

Required Present worth after 5yrs (P5)

Solution:
₱ 800,000

0 1 2 3 4 5
l l

₱ 200,000 ₱ 300,000

P30,000(P/F,20%,1)

₱ 400,000

P40,000(P/F,20%,1)

P5
P5 (P/F,20%,1)

Using today as the focal date, the equation of value is

₱ 800.000 = ₱ 300,000 (P/F, 20%, 1) + ₱ 400,000 (P/F, 20%, 3) + P5 (P/F, 20%,, 5)

₱ 800,000 = ₱ 300,000 (1.20)-1 + ₱ 400,000 (1.20)-3 + P5(1.20)-5
₱ 800,000 = ₱ 300,000 (0.8333) + ₱400,000 (0.5787) + P5(0.4019
P5 = ₱ 792,560

Continuous Compounding
In discrete compounding the interest is compounded at the end of each finite – length
period, such as a month, a quarter or a year. In continuous compounding, it is assumed
that cash payments occur once per year

Formula; F = Pem or P = Fe-m where m = number of interest periods

Example 11:

Compare the accumulated amounts after 5 years of ₱ 1,000 invested at the rate of 10%
per year compounded (a) annually, (b) semiannually, (c) quarterly (d) monthly, (e) daily,
and (f) continuously.

Given: P = ₱ 1,000, r = 20% n = 5 yrs

Required Future Worth (a) annually, (b) semiannually, (c) quarterly (d) monthly,
(e) daily, and (f) continuously.

Solution: Using the formula, F = P (1 + 1)n

(a) F = ₱1,000 ( 1 + 0.10)5 = ₱ 1,610.51

.
(b) F = ₱1,000 ( 1 + )10 = ₱ 1,628.89
.
(c) F = ₱1,000 ( 1 + ) 20 = ₱ 1,638.62
.
(d) F = ₱1,000 ( 1 + )60 = ₱ 1,645.31
. 1825
(e) F = ₱1,000 ( 1 + ) = ₱ 1,648.61
m 0.10x5
(f) F = Pe = ₱1,000 e = ₱ 1,648.72

Discount

Discount on a negotiable paper is the difference between the present worth (the amount
received for the paper in cash) and the worth of the paper at some time in the future (the
face value of the paper or principal). Discount is interest paid in advance.

Discount = Future Worth - Present Worth

The rate of discount is the discount on one unit of principal for one unit time. Below shows
rate of discount cash flow

(1 + i)-1

0 1

₱ 1.00

d = 1 – (1 + i)-1 (Eq. 11)

i = (Eq. 12)

where
d = rate of discount
i = rate of interest of the same period
Example 12

A man borrowed ₱ 5,000 from a bank an agreed to pay the loan at the end of 9 months.
The bank discounted the loan and gave him ₱ 4,000 in cash. (a) What was the rate of
discount? (b) What was the rate of interest? (c) What was the rate of interest for one
year?

Given: P = ₱ 5.000, discount = ₱5,000 - ₱ 4,000 = ₱ 1,000

Required (a) d ; (b) i ; (c) i @ 1 yr,

Solution:

₱ 4,000 ₱ 0.08

0 9 mos 0 9 mos

₱ 5,000 ₱ 1.00

₱ ,
(a) d = = = 0.20 or 20%
₱ ,

Another solution, using Eq. 11

d = 1 – (1 + i)-1
d = 1 – 0.80 = 0.20 or 20%

₱ ,
(b) i = . = = 0.25 or 25%
₱ ,
.

Another solution using Eq 12

.
i = = = 0.25 or 25%
.

₱ ,
(c) i = .= = 0.3333 or 33.33%
₱ ,

Inflation

Inflation is the increase in the prices for goods and services from one year to another, thus
decreasing the purchasing power of money.

FC = PC (1 + f)n (Eq 13)

where:
PC = present cost of a commodity
FC = Future cost of the same commodity
f = annual inflation rate
n = number of years
In an inflationary economy, the buying power of money decreases as costs increase.
Thus,

F = ( )
(Eq. 14)

Where F is the future worth, measured in today’s pesos, of a present amount P.

If interest is being compounded at the same time that inflation is occurring, the future
worth will be

( )
F = ( )
=𝑃 (Eq. 15)

Example 13

An item presently costs ₱ 1,000. If inflation rate of 8% per year, what will be the cost of the
item in two years?

Given: PC = ₱ 1,000, f = 8%, n = 2yrs

Required: F

Solution: Using Eq. 13, we get

FC = PC (1 + f)n
= ₱ 1,000 (1 + 0.08)2
FC = ₱ 1,166.40

Example 14

An economy is experiencing, inflation at an annual rate of 8%. If this continues, what will
₱ 1,000 be worth two years from now, in terms of today’s pesos?

Given: PC = ₱ 1,000, f = 8%, n = 2 yrs

Required: FC

Solution: Using Eq. 14, we get

F = ( )
₱ ,
= ( )
.
F = ₱ 857.34

Example 15

A man invested ₱ 10,000 at an interest rate of 10% compounded annually. What will be
the final amount of his investment, in terms of today’s pesos, after five years, if inflation
remains the same at the rate of 8% per year?

Given: P = ₱ 10,000, i = 10%, f = 8% n = 5 yrs

Required: F
Solution: Using Eq. 15, we get

F = 𝑃
.
= ₱ 10,000
.
F = ₱ 10,960.86

Annuities

An annuity is series of equal payments occurring at equal period of time.

Symbols and their meaning:

P = value or sum of money at present
F = value of money at some future time
A = a series of periodic, equal amounts of money
n = number ate per interest period

Ordinary Annuity

An ordinary annuity is one where the payments are made at the end of each period

Finding P when A is Given

Solving for P gives

1  1  1 n   1  i n  1
P =A   =A  n 
(Eq. 16)
 i   i 1  i  

The quantity in 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', hence Equation 16 can be expressed as P = A (P/A, i%, n)

When P is given and we need to find A gives

 i 
A= P  n  (Eq. 17)
1  1  i  

The quantity in brackets is called the 'capital recovery factor' and is denoted by the
functional symbol A/P, i%, n, read as 'A given P at i percent in n interest periods', hence
Equation 17 can be expressed as A = P (A/P, i%, n)

Finding F When A is Given

Solving for F gives

 1  i n  1
F =A   (Eq. 18)
 i 

The quantity in brackets is called the 'uniform series compounded 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', hence Equation 18 can be expressed as F = A (F/A, i%, n)

When F is given and we need to find A gives

 i 
A= F   (Eq. 19)
 1  i   1
n

The quantity in brackets is called the 'sinking fund factor' and is denoted by the functional
symbol A/F, i%, n, read as 'A given F at i percent in n interest periods', hence Equation 19
can be expressed as A = F (A/P, i%, n)

Relation between A/P, i%, n and A/F, i%, n

i  i 1  i   i 1  i 
n n
i
 i = .
1  i n  1 i 1  i   1
n
1  i  n
i i
i =
1  i   1
n
1  1  i 
n

A/P, i%, n + 1 = A/F, i%, n

Thus, sinking fund factor + 1 = capital recovery factor

Example 16

What are the present worth and the accumulated amount of a 10-year annuity paying
₱10,000 at the end of each year, with interest at 15% compounded annually?

Given: A = ₱ 10,000, i = 15%, n = 10

Required: (a) P
 (b) F

Solution:

(a) Using Eq.16

P = A (P/A, i%, n)
1  1  i  n 
P = A  
 i 
1  1  0.1510 
P = ₱10,000  
 0.15 
P = ₱ 50,188

(b) Using Eq. 18

F = A (F/A, i%, n)
 1  i n  1
F = A  
 i 
 1  0.15 10  1
F = ₱10,000  
 0.15 

F = ₱ 203,037

Example 17

What is the present worth of ₱500 deposited at the end of every three months for 6 years
if the interest rate is 12% compounded semiannually?

Given: A = ₱ 500, r = 12%, n = 6yrs, m1 = 2 , m2= =4

Required: Present worth

Solution: Solving for interest per quarter

.
(1 + i)4 – 1 = (1+ )2 – 1
1+i = (1.06)0.5
i = 0.0296 or 2.96% per quarter
 P = A (P/A, 2.96%, 24)
1  1  0.0296 24 
P = ₱ 500  
 0.0296 
P = ₱ 500 (17.0087)
P = ₱ 8,504.00

PROBLEMS

Solve the following problems and show the cash flow and your step solution.

1. What is the annual rate of interest if ₱265.00 is earned in four months on an

investment of ₱ 15,000.00
2. A loan of ₱ 2,000.00 is made for a period of 13 months, from January 1 to January 31
the following year, at a simple interest rate 20%. What future amount is due at the end
of the loan period?
3. If you borrow money from your friend with simple interest of 12%, find the present
worth of ₱ 20,000.00, which is due at the end of nine months.
4. Determine the exact simple interest on ₱ 5,000.00 for the period from Jan.15 to
Nov.28, 1992, if the rate of interest is 22%.
5. A man wishes his son to receive ₱200,000.00 ten years from now. What amount
should he invest if it will earn interest of 10% compounded annually during the first 5
years and 12% compounded quarterly during the next 5 years?
6. By the conditions of a will, the sum of ₱ 25,000.00 is left to a girl to be held in trust by
her guardian until it amounts to ₱ 45,000.00. When will the girl receive the money if the
final is invested at 8% compounded quarterly?
7. At a certain interest rate compounded semiannually, ₱5,000.00 will amount to
₱20,000.00 after 10 years. What is the amount at the end of 15 years?
8. Jones Corporation barrowed ₱9,000.00 from Brown Corporation on Jan 1, 1980. Jones
Corporation made a partial payment of ₱ 7,000.00 on Jan. 1, 1981. It was agreed that
the balance of the loan would be amortized by two payments, one of Jan 1, 1982 and
the other on Jan 1, 1983, the second being 50% large than the first. If the interest rate
is 12%, what is the amount of each payment?
9. A woman burrowed ₱3,000.00 to paid after 1 ½ years with interest at 12%
compounded semiannually and ₱ 5,000.00 to be after 3 years at 12% compounded
monthly. What single payment must she pay after 3 ½ years at an interest rate of 16%
compounded quarterly to settle the two obligations?
10. Mr. J. dela Cruz borrowed money from a bank. He received from the blank ₱1,342.00
and promise to repay ₱1,500 at the end of 9 months. Determine the simple interest
rate and the corresponding discount rate or often referred to as the "Banker's
discount."
11. A man deposits ₱50,000.00 in a bank account at 6% compounded monthly for 5 years.
If the inflation rate of 6.5% per year continues for this period, will this effectively protect
the purchasing power of the original principal?
12. What is the future worth of ₱600 deposited at the end every month for 4 years if the
interest rate is 12% compounded quarterly?
13. A young woman 22 years old, has just graduated from college. She accepts a good job
and desires to establish her own retirement fund. At the end of each year thereafter
she plans to deposit ₱2,000.00 in a fund at 15% annual interest. How old will she be
when the fund has an accumulated value of ₱1,000,000.00?
14. Mr. Reyes borrows ₱600,000.00 at 12% compounded annually, agreeing to repay the
loan in 15 equal annual payments. How much of the original principal is still unpaid
after he has made the 8th payments?
FEEDBACK

If you solve the problems with difficulties, you need to back read the topics on " Interest
and Money – Time Relationships." There is a need to understand fully the present and
future worth. You may o some cross reference to fully understand those terminologies.
Never memorize the ready-made solution since memorization is not the recommended
way for you to learn. Instead, you must understand the underlying basic principles
involved. You need to solve more problems since constant practice makes your ability to
solve correctly.

SUMMARY

Engineering economy is the analysis and evaluation of the aspects that will mark the
economic achievement of engineering ventures to the end that endorsement can be made
which will indemnify the best use of investment.

Simple interest is calculated using the principal only, ignoring any interest that had been
accrued in preceding periods. I = Pni.

In calculations of compound interest, the interest for an interest period is calculated on the
principal plus total amount of interest accumulated in previous periods. F = P(1+ i)n

An annuity is series of equal payments occurring at equal period of time.

1  1  1 n   1  i n  1
P =A   or F = A  
 i   i 

SUGGESTED READINGS

Deferred Annuity of time value of Money

Annuity Due of time value of Money.

POSTTEST

Direction: Choose the letter of the correct answer. Do not write your answer on this
manual.
1. In a cash-flow diagram:.
a. Time 0 is considered to be the present
b. Time 1 is considered to be the end of time period 1
c. A vertical arrow pointing up indicates a positive cash flow
d. All of the above
2. In the cash-flow diagram shown in the given figure

a. Equal deposits of Rs 3,000 per year (A) are made, starting now
b. The rate of interest is 10% per year account
c. The amount accumulated after the 7th deposit is to be computed
 3. The interest calculated on the basis of 365 days a year, is known as:
` a. Interest b. Ordinary simple interest c. Exact simple interest d. None
4. If ‘P’ is principal amount, ‘I” is the rates of interest per annum and ‘n’ is the number of
periods in years, the compound amount factor (CAF) is:
a. (1 – i)n b. (1 – i)n/12 c. (1 – i/12)n d. (1 – ni)
5. In the cash flow diagram shown in the given figure

a. The disbursement occurs at the end of year 2

b. The second disbursement occurs at the end of year 4
c. The first receipt occurs at the end of year 1
d. All of the above.
6. The PICE student chapter wants to deposit a single amount of money today to
purchase a set of transit costing P50,000 five years from now. If the money can be
deposited into an account which earns an interest at 10% annually, how much amount
of money must be deposited by the PICE student chapter? .
a. ₱ 29,524.50 b. ₱ 80,525.50 c. ₱ 31,046.06 d. ₱ 84,675.44
7. What is the length of time required for a P10,000 to P67,275 in value at an interest rate
of 10% per annum?
a. 10 years b. 15 years c. 20 years d. 25 years
8. For an interest rate of 1.5% per month, what should be its effective semiannual rate?
a. 9.34% b. 8.43% c. 11.33% d. 12.43%
9. One of the engineering student deposits P100 per month into an account which pays
interest at a rate of 6% per year compounded monthly. What is the value of the
account after five years?
a. ₱ 6,977.00 b. ₱ 133.82 c. ₱ 3,298.76 d. ₱ 9,876.23
10. What the interest rate of effective 12% per year compound monthly?
a. 11.39% b. 9.31% c. 12.19% d. 8.67% .

REFERENCES:

Besa Villa, V.I. Engineering Economy Revised Edition. VB Publisher. Copyright 1989.
Hartman, J.C., Engineering Economy and Decision-Making Process. Prentice-Hall
Pearson. 2007
Sta Maria, Hipolito B., Engineering Economy, Second Edition, National Bookstore, 1993
Sullivan, William G; Wicks, Elin M; Koeling , Patrick; Engineering Economy 16th Edition,
Pearson Publishing, 2013
http://www.csun.edu/~ghe59995/docs/Glossary%20of%20Concepts%20&%20Terms%20i
n%20Engineering%20Economy.pdf
https://www.investopedia.com/terms/l/law-of-supply-demand.asp