Engineering Economy

Interest Calculations
Engineering economy is founded on the concept of time value of money. Everyone knows that
money provides an advantage to the bearer. Time value means that people are willing to pay for that
advantage as a function of time. A payment of that type is known as interest, which, in essence,
represents a form of rent. Interest has the dimensions of percent per unit time (like 10% per year). Thus,
if $1000 is borrowed for one year at an interest rate of 10% per year, the amount of interest that is
generated in the transaction is $100 (i.e. 1,000 * 0.10).
Calculations such as this engender the term equivalence, which means that different sums of
money at different points in time can have the same economic value. In this example, $1000 now is
equivalent to $1,100 one year from now, when the interest rate is 10% per year. When the length of time
the money is ‘rented’ exceeds one interest period (one year in the above calculation), the
terms simple and compound interest become important. Simple interest means that the interest rate
applies only to the principal (P) amount of money involved (i.e. the original amount that was borrowed or
deposited). Compound interest means that the interest rate applies not only to the principal, but to all of
the interest that was accrued between the time the money was borrowed (or deposited) and the time the
money was repaid (or withdrawn).
Example
If $10,000 is borrowed at an interest rate of 10% per year, determine the amount of money that is owed
at the end of 3 years if the interest is (a) simple, and (b) compound
Solution:
(a) Simple interest is charged on the principal. Therefore, the amount of money owed after 3 years is:
Amount owed year 3 = principal + interest

= 10,000 + 10,000 (0.10) (3)
= $13,000
(b) Compound interest is charged on the principal and the accrued interest. Thus,
Amount owed year 1 = 10,000 + 10,000 (0.10)

= $11,000
Amt owed year 2 = 11,000 + 11,000 (0.10)

= $12,100
Amt owed year 3 = 12,100 + 12,100 (0.10)

= $13,310
Thus, compound interest generates $310 more (in time value) than simple interest.
An interesting observation that was made a long time ago about compound interest is known as the rule
of 72. It states that the length of time required for money to double in amount when interest is
compounded is approximately equal to 72 divided by the interest rate. For example, $1,000 will double
to $2000 in approximately 7.2 years when the interest rate is compounded at 10% per year (i.e. 72/10 =
7.2).
Sample Problem:
1. A large bank that was trying to attract new customers started a program wherein a person starting
a checking account could borrow up to $10,000 at an interest rate of 6% per year simple interest
for up to 3 years. A person who borrows the maximum amount for the maximum time would owe
how much money at the end of the 3-year period?
Amt owed = Principal + interest

= 10,000 + 10,000 (0.06) (3)
= $11,800
2. A sum of $50,000 now would be equivalent to how much money two years from now at an
interest rate of 20% per year?
(A) Less than $65,000 (B) $70,000 (C) $72,000 (D) Over $73,000
3. An engineer invested his bonus check of $7,000 in a mutual fund two years ago. If the value of
his investment now is $10,000, the rate of return he made on his investment was closest to:
7000 (1 + i) (1 + i) = 10,000
(1 + i)2 = 1.4286
1 + i = 1.1952
i = 19.52%
4. At a simple interest rate of 10% per year, the length of time it would take for money to double
would be closest to:
(A) 7 years (B) 10 years (C) 12 years (D) Over 12years
5. According to the rule of 72, the length of time it would take for $1000 to accumulate to $4,000
at an interest rate of 4% per year would be closest to:
Time to double = 72 / 4
= 18 yrs
Time to quadruple = 2 * 18
= 36 years
6. A sum of $30,000 one year from now would be equivalent to how much money now, at an
Interest rate of 25% per year?
(A) Less than $24,000 (B) $24,000 (C) $27,500 (D) $37,500
Single Payment Formulas

The simplest problems to solve in engineering economic analysis involve finding the value of a single
amount of money at an earlier or later date than that which is given. Such problems involve finding
either the future worth (F) of a specified present amount (P), or vice versa. The two equations which
apply are as follows:
The terms (1 + i )n and [ 1/ (1 + i ) n ] are called factors whose numerical values are available in tables of
various interest ( i ) and periods (n) or by direct calculation using the formulas. The factors are
represented symbolically in standard factor notation as :
( F/P,i,n ) and ( P/F,i,n )
Where the letter on top of the slash represents what is to be found and the letter on the bottom
represents what is given. The following example illustrates their use.
Example - Use of F/P Factor:
1. A Civil Engineer deposits his $5,000 bonus into a money market account which earns interest at
a rate of 8% per year. The amount that would be in the account at the end of 10 years is closest
to:
Solution:
The $5,000 represents a present amount (P). Therefore, the equivalent future amount (F) is:
F = 5000 (F/P,8%,10)
= 5000 (2.1589)
= $10,794.50
2. A video-card manufacturing company is trying to decide whether it should update its shipping
department now or wait and do it three years from now. The cost now would be $22,000, but in
three years the cost is estimated to be $30,000. If the company uses an interest rate of 15% per
year, the net present savings associated with updating three years from now would be:
Solution:
The $30,000 represents a future amount (F). Therefore, the equivalent present amount (P) is:
P = 30000 ( P/F,15%, 3 )
= 30000 (0.6575)
= $19,725
Net Present Savings = 22,000 - 19,725

= $2,275
Sample Problem:
1. The present worth at i = 15% per year of a cost of $10,000 in year 20 is closest to:
P = 10,000 (P/F, 15%, 20)

= 10,000 (0.0611)
= $611
2. An investment of $25,000 now at an interest rate of 12% per year is equivalent to how much 15
years from now:
F = 25,000 (F/P, 12%, 15)

= 25,000 (5.4736)
= $136,840
3. How much could Nissan Motor Company afford to spend now in lieu of spending $75,000 three
years from now if the interest rate is 20% per year?
P = 75,000 (P/F, 20%, 3)

= 75,000 (0.5787)
= $43,403
4. How much money would be accumulated in 12 years if $10,000 were deposited now at an
(A) $ 25,182 (B) $ 16,211 (C) $ 19,233 (D) $ 23,452
5. A plaintiff in a civil lawsuit has been offered a settlement of $200,000 now. If the plaintiff rejects
the settlement, the defendant threatens to keep the case tied-up through legal maneuvering for
ten years. At an interest rate of 10% per year, how much would the plaintiff have to get at that
time (i.e. 10 years from now) so that the award would be equivalent to the present offer?
(A) $ 421,630 (B) $ 463,450 (C) $ 518,740 (D) $ 602,100
6. What is the present worth of a proposed real-estate development that is expected to cost
$1,000,000 four years from now if the interest rate is 12% per year?
(A) $ 562,600 (B) $ 635,500 (C) $ 755,800 (D) $ 492,700
Uniform Series Formulas, P/A and A/P
There are four uniform series formulas which, by definition, involve A, where A means that:
• The cash flow occurs in consecutive interest periods, and

• The cash flow amount is the same in each period
The formulas relate a present worth, P, or a future worth F to a uniform series amount, A. This section
deals with P and A relationships. The two equations which apply are as follows:
In standard factor notation, the equations are P = A(P/A, i,n) and A = P (A/P, i,n), respectively. It is
important to remember that in these equations, the P and the first A value are separated by one year.
That is, the present worth, P, is always located one interest period prior to the first A value. It is also
important to remember that the n is always equal to the number of A values.
Example - Use of P/A Factor:

How much money could a start-up software company afford to borrow now if it promises to repay the
loan with five equal year-end payments of $10,000 if the interest rate is 10% per year?
Solution:
The amount that could be borrowed is the present worth of the $10,000 series:
P = 10,000 (P/A, 10%, 5)
= 10,000 (3.7908)
= $37,908
Sample Problem:
1. How much money could a software start-up company borrow now if it agrees to repay the loan
in five, equal year-end payments of $30,000 at an interest rate of 15% per year?
P = 30,000 (P/A, 15%, 5)

= 30,000 (3.3522)
= $100,566
2. Pebble Beach Country Club installed a new computer-controlled irrigation system that uses
reclaimed sewage for watering the fairways. The cost of the pumps, piping, and controls was
$1,100,000. If the club expects to recover its investment in 10 years using an interest rate of
10% per year, the annual savings in water cost must be nearest to:
A = 1,100,000 (A/P, 10%, 10)

= 1,100,000 (0.16275)
= $179,025
3. An elastomeric roofing material can be installed on a parts warehouse for $10,000. If the
company expects to recover its investment in seven years through reduced energy costs, the
required annual savings at an interest rate of 20% per year is closest to
A = 10,000 (A/P, 20%, 7)

= 10,000 (0.27742)
= $2774.20
4. American Airlines estimates that unpainted airplanes use less fuel (because of less weight) to
the extent of $20,000 per year per plane. How much could the company afford to spend now to
strip the paint from an airplane if it expects to recover its investment in five years at an interest
rate of 20% per year?
(A) $ 53,626 (B) $ 59,812 (C) $ 64,701 (D) $ 66,892
5. Wendy's International has received a bid of $9,000 to re-coat a parking lot with a water sealer
and repaint the parking-space lines. What is the equivalent annual cost of the job if the
company expects to recover its investment in four years at an interest rate of 20% per year?
(A) $ 2,991 (B) $ 3,102 (C) $ 3,477 (D) $ 4,316
6. How much should a company which manufactures corrugated pipe be willing to pay a contractor
who claims he has a device which will reduce the company's energy bill by at least $4,000 per
year. Assume the company wants to recover its investment in five years at an interest rate of
15% per year.
(A) $ 19,362 (B) $ 11,156 (C) $ 15,329 (D) $ 13,409
Uniform Series Formulas, F/A and A/F
The uniform series formulas which relate a uniform cash flow, A, and a future amount, F, are the
uniform series compound amount (F/A, i,n) and sinking fund (A/F, i,n) equations. The equations are as
follows:
It is important to remember that these equations were derived wherein the last A value occurs in the
same time period as the future worth F, and n is always equal to the number of A’s
Example: Use of A/F Factor
A consulting engineering firm wants to establish a contingency fund having a total of $100,000. If the
firm wants to have the money available in five years, the annual amount that must be deposited at 8%
per year interest is nearest to:
Solution:
The annual deposit required is calculated as follows:
A = 100,000 (A/F, 8%, 5)
= 100,000 (0.17046)
= $17,046
1. The future worth of a deposit of $6,000 per year for 12 years at an interest rate of 12% per year
is closest to:
F = 6000 (F/A, 12%, 12)
= 6000 (24.1331)
= $144,798.60
2. A manufacturer of mini, submersible data loggers is planning for equipment replacement six
years from now. If the company wants to have $300,000 available at that time, how much must
be deposited each year into a sinking fund that earns interest at a rate of 12% per year?
A = 300,000 (A/F, 12%, 6)

= 300,000 (0.12323)
= $36,969
3. A young petroleum engineer wants to start saving for her son's college education so that the
money will be available 18 years from now. If she deposits $2,000 each year into an account
which earns 10% per year interest, how much will she have at that time?
F = 2000 (F/A, 10%, 18)

= 2000 (45.5992)
= $91,198.40
4. Radio Shack estimates that the cost of replacing a parts tracking system will be $80,000. If the
company wants to replace the system 3 years from now, what is the equivalent annual amount
it could spend in lieu of spending the $80,000 in 3 years? Use an interest rate of 15% per year.
(A) $18,160 (B) $19,420 (C) $21,360 (D) $23,040
5. A subcontractor to North America Moving Co. wants to replace some old trucks with newer
models. If he deposits $25,000 each year starting one year from now and earns 10% per year,
how much will be available in 4 years.
(A) $114,000 (B) $116,000 (C) $118,000 (D) $120,000
Interpolation
When a factor value for an interest rate or n value is not listed in the interest tables, the desired value
can be obtained in one of two ways: (1) by using the formulas, or (2) by interpolation. While it is always
more accurate to obtain the values from the formulas, interpolation is sometimes easier and faster,
especially when i or n is the unknown.
The general relation for linear interpolation is a / b = c / d or c = a d / b where the values of a,b,c, and d
are as shown below:
The following example illustrates the procedure.
Example - Interpolation
The interpolated value of the P/F factor for i = 4% and n=48 is closest to :
Solution:
Use the known P/F factors at n=45 and n=50 in the 4% table:
45 -----------------0.1712
48 ----------------- x
50 -----------------0.1407
(48-45)/(50-45) = c /(0.1712-0.1407)
c = 0.0183
Since the value of the factor decreases as n increases, c is subtracted from the factor value for n=45:
x = (P/F, 4%, 48)
= 0.1712 - 0.0183
= 0.1529
Sample Problem:
1. Find the value of the factor for (P/G, 18%, 21) by interpolation
20 ------------25.6813
21 ------------x
22 ------------26.8506
1 / 2 = c / (26.8506-25.6813)
2c = 1.1693
c = 0.5847
x = (P/G, 18%, 21)

= 25.6813 + 0.5847
= 26.2660
2. Find the value of the F/A factor for i = 14.3% and n = 20 by interpolation
Interpolate between i = 14% and 15%
14% ----------91.0249
14.3%---------x
15% ----------102.4436
0.3 / 1 = c / ( 102.4436-91.0249 )
c = 0.3 (11.4187)
= 3.4256
x = (F/A, 14.3%, 20)

= 91.0249 + 3.4256
= 94.4505
3. Find the value of the factor for (F/P, 7%, 43) by interpolation
(A) 17.3022 (B) 18.5913 (C) 19.6301 (D) 20.0032
4. Find the value of ( P/A, 9.7%, 22) by interpolation

(A) 9.9120 (B) 9.2411 (C) 8.9728 (D) 8.3019
Arithmetic Gradients
An arithmetic gradient cash flow is one wherein the cash flow changes (increases or decreases) by the
same amount in each cash flow period. For example, if the cash flow in period 1 is $800, and in period 2
it is $900, with amounts increasing by $100 in each subsequent period, this is an arithmetic gradient cash
flow series with the gradient, G, equal to $100. The standard factor notation equation for the present
worth of an arithmetic gradient cash flow is P = G (P/G, i,n). This equation finds the present worth of only
the gradient (i.e. the $100 increases in the above example), not the base amount of money that the
gradient was built upon (i.e. the $800 in the above example). The base amount in time period 1 must be
handled separately as a uniform cash flow series. The general equation to find the present worth of an
arithmetic gradient cash flow series is:
P = present worth of base amount + present worth of gradient amount
= A (P/A,i,n) + G (P/G, i,n)
where:
A = amount of money in period 1
G = change in amount between periods 1 and 2
n = number of periods from 1 thru end of gradient
i = interest rate per period
If the gradient cash flow decreases from one period to the next instead of increases, the only change in
the general equation is that the plus sign becomes a minus sign.
Example - Present worth of Arithmetic Gradient

The Texas Highway Department expects the cost of maintenance for a particular piece of heavy equipment
to be $5000 in year 1, $5,500 in year 2, and amounts increasing by $500 through year 10. At an interest
rate of 10% per year, the present worth of the maintenance cost is nearest to:
Solution:
The cash flow can be represented as an increasing gradient with G = $500 and a base amount A of
$5,000.
P = 5000 (P/A, 10%,10) + 500 (P/G,10%,10)

= 5000(6.1446) + 500(22.8913)
= $42,168.55
In the above example, an arithmetic gradient was converted into a present worth P, by using the P/G
factor. If one wanted an A value instead of a P, the A/G factor could be used to convert the gradient. As
is true for the P value, this factor converts only the gradient into an A value. The base amount in year 1
(i.e. A) must be added to the value obtained from the A/G factor to obtain the total annual worth of the
cash flow:
AT = A1 + AG
Where: A1 = cash flow in period 1 (i.e. base amount)
AG = annual worth of gradient
Alternately, the annual worth of the gradient cash flow could be obtained by first finding the present
worth, P, of the cash flow (as in the example above) and then converting the P value into an A value
using the relation A = P(A/P, i,n).
Example - Annual Worth of a Decreasing Arithmetic Gradient
The cash flow associated with a strip mining operation is expected to be $200,000 in year 1, $180,000 in
year 2, and amounts decreasing by $20,000 per year through 8. At an interest rate of 12% per year, the
equivalent annual cash flow is nearest to
Solution:
AT = A1 + AG
= 200,000 - 20,000 (A/G, 12%, 8)
= 200,000 - 20,000 (2.9131)
= $142,738
Sample Problem:
1. The utility bill of Master Fiber Recycling has been increasing by $400 per year. If the utility bill in
year 1 is $3500, what would be the equivalent annual worth in years 1 thru 6 at an interest rate
of 20% per year?
A = 3500 + 400(A/G,20%,6)
= 3500 + 400(1.9788)
= $4,291.52
2. Costs for support of a certain printer made by Hewlett-Packard have been decreasing by $20,000
each year. If the costs in year 1 are $250,000, what would be the present worth of the costs
through year 8 at an interest rate of 15% per year?
F = 250,000(P/A,15%,8) - 20,000(P/G,15%,8)
= 250,000(4.4873) - 20,000(12.4807)
= $872,211
3. Find the equivalent annual worth in years 1 thru 9 of the cash flow described by the following
equation. Use an interest rate of 15% per year.
CF = 2,800 + 120 G , Where G is in years ranging from 1 thru 9
(A) $2,982 (B) $3,171 (C) $3,233 (D) $3,406
4. The equivalent uniform annual costs of fuel for a small foundry over a certain 7 year time period
were calculated to be $15,000 per year. The costs were known to follow a uniform arithmetic
gradient. If the cost in year 1 was $12,000 and the company used an interest rate of 12% per year,
what was the amount of the gradient?
(A) $1,035 (B) $2,066 (C) $1,176 (D) $2,413
Geometric Gradients
In the previous section, the procedure for handling cash flows which change by a constant amount from
one interest period to the next (i.e. arithmetic gradients) was introduced. In this section, cash flows which
change by a constant percentage from one interest period to the next (i.e. geometric gradients) are
discussed. The equation for calculating the present worth of a geometric gradient is:
For a decreasing gradient, change the sign in front of both g's in the present worth equation.
When g = i, the present worth of a geometric gradient series is:
P= An/(1+i)
Example - Increasing Geometric Gradient
A mechanical contractor is trying to calculate the present worth of personnel salaries over the next five
years. He has four employees whose combined salaries thru the end of this year are $150,000. If he
expects to give each employee a raise of 5% each year, the present worth of his employees' salaries at an
interest rate of 12% per year is nearest to:
The cash flow at the end of year 1 is $150,000,
increasing by g=5% per year. Therefore,
the present worth is:
Sample Problem:
1. Income from sales of by-products at a small meat packing plant have been increasing by 10%
each year. If the sales in year 1 were $22,000, what is the present worth of sales for years 1 thru
8 at an interest rate of 10% per year?
Since i = g,
P = An/(1+i)
= (22,000)(8)/( 1 + 0.10 )
= $160,000
2. Transportation costs at a medium-size appliance distributor have been increasing by 9% per year.
The company expects this year's cost to be $25,000. Find the equivalent present worth of the
costs for years 1 thru 10 at an interest rate of 12% per year.
P = 25,000[1 - (1 + 0.09)10/(1 + 0.12)10 ] / ( 0.12 - 0.09 )

= 25,000[0.23777] / 0.03
= $198,144
3. Maintenance costs for a certain machine are expected to be $3000 in year one, $3,300 in year 2,
and amounts increasing by 10% each year. At an interest rate of 15% per year, the present
worth of the costs for 20 years is nearest to:
(A) $29,960 (B) $32,150 (C) $35,340 (D) $37,660
4. Because of increased productivity, the costs for a certain manufacturing operation are expected
to decrease by 6% each year. If the cost in year 1 is $20,000, what will be the present worth of
these costs for years 1 thru 8 at an interest rate of 15% per year?
(A) < $75,000 (B) $76,260 (C) $85,920 (D) > $86,000
Unknown Interest Rate
In all of the previous sections of this material, the i and n values were given and they were used in solving
for an unknown P,F, or A value. In this section, i is the unknown, with n and two of the three other values
given. Problems of this type can sometimes be solved directly by plugging the values into the appropriate
equation and solving for i, but more often than not, trial and error or interpolation in the interest tables
is required. In this section, the latter procedure is emphasized.
Example - Finding i in a Uniform Series
A small privately-held manufacturing company has been investing $25,000 per year into an employees'
benefits fund. The current value of the fund is $350,000. If the company had been investing for 8 years,
the rate of return that it made was closest to:
Solution:
This problem involves the use of the A/F of F/A factors (either one). Using F/A:
F = A (F/A, i, 8)
350,000 = 25,000 (F/A, i,8)
(F/A,i,8) = 14.000
Looking in the interest tables under the F/A column at n=8, the value of 14.000 lies between 15%
(13.7268) and 16% (14.2401), being slightly closer to 16%.
Sample Problem:
1. Fifteen years ago, a person deposited $5,000 into an account which is now worth $20,000. What
is the rate of return on the investment?
Use F/P or P/F factor equation. Using F/P:
20,000 = 5,000 (F/P, i, 15)

4.000 = (F/P, i, 15)
Looking in the F/P column at n=15 in various interest tables, the value of 4.0000 is between 9%
(3.6425) and 10% (4.1772). Actual i value is 9.7% (Using IRR function in Excel)
2. A corporation which manufactures residual chlorine analyzers borrowed $200,000 and repaid
the loan with five equal, year-end payments of $50,000. What was the interest rate on the loan?
Use P/A or A/P factor equation. Using A/P:
50,000 = 200,000 (A/P, i, 5)

(A/P, i, 5) = 0.2500
Looking in interest tables under the A/P column at n=5, the value of 0.25000 is between 7%
(0.24389) and 8% (0.25046). Actual i value is 7.9% (Using IRR function in Excel)
3. An engineer who was planning for his daughter's college education deposited $1,000 per year
into a stock fund for 18 years. At the end of the 18 year period, the fund was worth $50,000.
What was the rate of return that the fund earned?
Use A/F or F/A factor equation. Using F/A:
50,000 = 1000 (F/A, i, 18)

50.0000 = (F/A, i, 18)
Looking in the interest tables under the F/A column at n=18, the value of 50.0000 is between
10% (45.5992) and 11% (50.3959). Actual i value is 10.92% (Using IRR function in Excel)
4. In an effort to control combined sewer overflows (CSO), the city of Bangor, Maine planned to
construct an underground storage tank that was 50 m long by 25m wide by 5m deep for a cost
of $3.0 million. Before the project was even started, the cost three years into the future was
projected to be $5.0 million. What was the expected annual rate of increase?
(A) 14% (B) 16% (C) 19% (D) 22%

5. A short-haul trucking company purchased a lot and building six years ago for $200,000. The
company plans to sell and move to a larger location. If the company sells the present location
for $300,000, what was its rate of return on the property investment?
(A) 4% (B) 5% (C) 7% (D) 9%

6. A metal plating company claims to have a process which can be used to apply chrome to
plastics. The company says that a buyer of its technology can expect to make at least $100,000
per year in profits. If the cost of the equipment is $300,000 and it would have a useful life of five
years, what rate of return would a prospective buyer make?
(A) 14% (B) 16% (C) 17% (D) 20%
Unknown n
In all of the previous calculations, n was given and one of the other values was determined. In this section,
n is the unknown. In these types of problems, the value of n can sometimes be determined directly by
plugging into the appropriate equation. Most of the time, however, a trial and error solution or
interpolation in interest tables is easier. The procedure for using the interest tables is demonstrated
below.
Example - Solving for n in a Uniform Series
A chemical engineer who owns his own consulting business plans to retire when he has accumulated
$1,500,000. He estimates that he can invest $25,000 per year and make a 15% per year rate of return. If
he is now 22 years old, his age when he retires will be closest to:
Solution:
The problem can be set up using either the A/F or F/A factor. Using A/F:
A = F (A/F, 15%, n)
25,000 = 1,500,000 (A/F, 15%, n)
(A/F, 15%, n) = 0.01667
Looking in the 15% interest table under the A/F column, the value of 0.01667 lies between n = 16(i.e.
0.01795) and n = 17(i.e. 0.01537), being closer to 17. When 17 is added to his present age of 22, he will
be able to retire when he is 39.
Sample Problem:
1. How long would it take for a single investment of $5,000 to accumulate to $50,000 at an interest
rate of 10% per year?
50,000 = 5000 (F/P, 10%, n)
(F/P, 10% n) = 10.000
From 10% interest table, n is between 24 (i.e. 9.8497) and 25 (i.e. 10.8347) years
2. If a company borrows $170,000 and agrees to make annual payments of $20,000, how long
would it be before the loan is repaid at an interest rate of 10% per year?
170,000 = 20,000 (P/A, 10%, n)
(P/A, 10%, n) = 8.5000
From 10% interest table, n is between 19 (i.e. 8.3649) and 20 (i.e. 8.5136) years
3. A manufacturing company expects replacement costs for a certain production line to be either
$75,000 now or $125,000 later. At an interest rate of 15% per year, when is the soonest the
company should replace the equipment if it doesn’t do it now?
(A) 2 years (B) 4 years (C) 5 years (D) > 5 years
4. How long will it take for annual deposits of $3000 per year to accumulate to $300,000 at an
(A) 20 years (B) 24 years (C) 29 years (D) 35 years

Shifted Uniform Series
When a uniform series cash flow begins at a time other than year 1, it becomes necessary to use more
than one engineering economy factor to find the present worth at time 0. In this regard, it is important to
remember that when using the P/A factor, the 'P' value is always located one year prior to the first 'A'
value because that 's how the equation was derived. For example, if a uniform series of payments
extended from year 5 through year 10, the P/A factor (for n=6) would yield a 'P' value in year 4, not year
5! Thus, if one wanted to find the present worth in actual year 0, it would be necessary to move the 'P'
value back 4 years (not 5) by using the P/F factor. The next example illustrates this procedure.
Example - Present worth of shifted uniform series
Sun Oil Company (Sunoco) is considering the installation of new magnetic flow meters (magmeters) in
one of its pipelines. If the company goes ahead with the project, it will spend $55,000 each year for five
years, starting 3 years from now. What is the present worth of the investment at an interest rate of 20%
per year?
Solution:
The uniform series of $55,000 extends from year 3 through year 7. Thus, the 'P' value obtained using the
P/A factor for n=5 is located in year 2 (not year 0):
P = $55,000 (PA, 20%, 5)
= $55,000 (2.9906)
= $164,483 (located in year 2)
The P/F factor for n=2 can now be used to find the present worth in year 0:
P = $164,483 (P/F, 20%, 2)

= $164,483 (0.6944)
= $114,217
Example - Future worth of shifted series
An engineer working for a DSL provider expects to earn bonuses of $10,000 per year for 8 years,
beginning 2 years from now. If the engineer invests the money at 12% per year, how much will she have
in the account immediately after she makes the last deposit?
Solution:
The uniform series extends from year 2 through year 9 (i.e. n=8). Therefore, the future worth, F, is
located in year 9:
F = $10,000 (F/A, 12%, 8)

= $10,000 (12.2997)
= $122,997
Sample Problem:
1. An engineer wants to have $75,000 available for a new Mercedes 8 years from now. How much
must he invest each year if he starts 3 years from now and he earns 15% per year. Assume the
money is to be available immediately after the last deposit.
A = $75,000(A/F, 15%, 6)
= $75,000(0.11424)
= $8,568
2. In order to expand its product lines, a manufacturer of personal care products is planning to
increase the size of its warehouse. To finance the expansion, the company will borrow $250,000
two years from now. If the company wants to repay the loan with four equal payments, starting
one year after it gets the loan, what must be the size of each one at an interest rate of 12% per
year?
A = $250,000(A/P, 12%, 4)
= $250,000(0.32923)
= $82,307.50
3. If a person deposits $5,000 per year for six years beginning four years from now, how much will
be in the account 17 years from now if the account earns interest at 10% per year?
F = $5,000(F/A, 10%, 6)(F/P, 10%, 8)

= $5,000(7.7156)(2.1436)
= $82,695.80
4. For the series of deposits shown below, how much would be in the account in year 24 if the
account earns 12% per year?
Years Deposit/Year
1-4 $2,000
5-9 $0
10-15 $3,000
F15 = $2,000 (F/A, 12%, 4)(F/P, 12%, 11) + $3,000(F/A, 12%,6)

= $2,000(4.7793) (3.4785) + $3,000 (8.1152)
= $57,595
F24 = $57,595(F/P, 12%, 9)

= $57,595(2.7731)
= $159,717
5. A series of payments of $2,000 for three years beginning in year 5 would be equivalent to how
much in year 14 at an interest rate of 12% per year?
(A) $14,920 (B) $15,220 (C) $16,130 (D) $17,030
6. How much money would have to be deposited in years 0 thru 4 (i.e. five deposits) if one wanted
to withdraw $7,000 per year in years 10 thru 20. Assume the interest rate is 15% per year?
(A) $9,056 (B) $3,915 (C) $3,130 (D) $2,702

7. What is the present worth in year 0 of a uniform series of payments of $1,000 in years 2 thru 5
and another series of $2,000 payments in years 8 thru 12 at an interest rate of 12% per year?
(A) $5,019 (B) $5,661 (C) $5,973 (D) $6,298
8. If a person begins saving immediately (i.e. at time 0) for a child's college education, the number
of annual deposits of $4,000 required to accumulate at least $60,000 at an interest rate of 10%
per year is closest to:
9. If a company began investing $10,000 per year five years ago and has continued thru the
present time (i.e. six deposits), the single amount eight years from now that would be
equivalent to those deposits at 10% per year is nearest to:
(A) $162,480 (B) $165,390 (C) $170,660 (D) $172,180
Shifted Uniform Series and Single Amounts
When a projects' cash flow includes both uniform series amounts and randomly placed single amounts,
the procedures discussed in the previous section (i.e.3.1) are applied to the uniform series and the single
payment formulas are applied to the single-payment amounts. The infinite number of combinations of
the formulas already derived allows for solving problems involving virtually any type of cash flow
imaginable.
Example - PW of shifted uniform series and single amount
The manager of a hangar at a small airport is contemplating a series of improvements ranging from
replacement of some fuel storage tanks to remodeling of the reception area. The costs are expected to
be $3,000 in years 0 thru 2, $15,000 in year 4, and $10,000 in years 5 thru 9. Determine the present
worth (year 0) of the improvements using an interest rate of 12% per year.
Solution:
One way to work this problem is to convert each uniform series into a single amount (P or F) and then
move all of the single amounts to year 0. Using P/A factors, the present worth in year 0 of the $3,000
series is:
P-1 = $3,000 (P/A, 12%, 3) (F/P, 12%, 1)

= $3,000 (2.4018) (1.1200)
= $8,070
Similarly, the present worth of the $10,000 series is:
P = $10,000 (P/A, 12%, 5) (P/F, 12%, 4)

= $10,000 (3.6048) (0.6355)
= $22,909
Note that n =4 in the P/F factor, not 5. The present worth of the $15,000 single amount in year 4 is:
P = $15,000 (P/F, 12%, 4)

= $15,000 (0.6355)
= $9,533
Therefore, the total present worth is:
P = P of $3,000 series + P of $10,000 series + P of $15,000 single amount

= $8,070 + $22,909 + $9,533
= $40,512
Sample Problem:
1. Find the future worth in year 15 of the cash flow shown below using an interest rate of 12% per
year:
F12 = $2,000 (F/A, 12%, 2) (F/P, 12%, 13) + $4,000 (F/P, 12%, 12) + $5,000 (F/A, 12%, 12)
= $2,000 (2.1200) (4.3635) + $4,000 (3.8960) + $5,000 (24.1331)
= $154,751
F15 = $154,751 (F/P, 12%, 3)

= $154,751 (1.4049)
= $217,410
2. Find the equivalent annual worth in years 1 thru 5 of the cash flow shown below. Use an interest
rate of 15% per year:
P0 = $3,000 + $3,000 (P/A, 15%, 5) + $1,000 (P/F, 15%, 2)

= $3,000 + $3,000 (3.3522) + $1,000 (0.7561)
= $13,813
A = $13,813 (A/P, 15%, 5)

= $13,813 (0.29832)
= $4,121
3. Find the present worth (year 0) of uniform series amount of $5,000 in years 3 thru 6 and single
amounts of $10,000 in years 5, 10, and 15. Use an interest rate of 15% per year:
P = $5,000 (P/A, 15%, 4) (P/F, 15%, 2) + $10,000 [(P/F, 15%, 5) + (P/F, 15%,10) + (P/F, 15%, 15)]
= $5,000 (2.8550) (0.7561) + $10,000 [0.4972 + 0.2472 + 0.1229]
= $19,466
4. If an engineer invests $10,000 now (i.e. year 0) and he earns 10% per year in years 1 thru 5 and
12% per year in years 6 thru 10, how much will he have at the end of year 10?
(A) $25,190 (B) $26,630 (C) $28,380 (D) $29,570
5. By investing $10,000 now and $10,000 in each of the next 3 years, Carl's Jr. can avoid having to
replace the asphalt in its parking lots 5 years from now. At an interest rate of 12% per year, what
is the single amount the company could afford to spend in five years instead of the four $10,000
amounts
(A) $58,130 (B) $59,950 (C) $60,540 (D) $62,790
6. What uniform amount of money in years 3 thru 10 would be equivalent to $10,000 in years 0
thru 5 at an interest rate of 15% per year?
(A) $11,460 (B) $12,830 (C) $13,790 (D) $14,820
7. Erosion of the bluff of some beach-front property in California occurs periodically because of
severe storms. A house with a spectacular view is in danger of being undermined and falling into
the ocean. If the house is worth $2 million now, what uniform amount could the owner afford to
spend in years 2,4, and 5 (to prevent its collapse) if he expects it to be worth $3 million five years
from now? Use an interest rate of 10% per year
(A) $291,460 (B) $356,230 (C) $421,160 (D) $496,780
Shifted Gradients
You should recall that when the equation for calculating the present worth of an arithmetic gradient was
derived, the gradient started between periods 1 and 2. Therefore, the present worth of a shifted
gradient (i.e. one that does not start between periods 1 and 2) will always be located 2 periods before
where the gradient starts. For example, in the cash flow diagram shown below, the ‘present worth’
obtained by using the P/G factor would be located in year 3, because the first change equal to G (i.e.$20)
occurs between years 4 and 5. Errors might be avoided by renumbering the gradient portion of the
diagram as shown.
Example– Present worth of shifted gradient
The present worth (year 0) of the cash flow shown in the diagram above at an interest rate of 12% per
year is closest to
Solution:
In using the P/G factor, the ‘P’ will be located in year 3 (i.e. year 0 of the gradient years) and, therefore,
will have to be moved back 3 years using the P/F factor. Also, note that n is equal to 4 for the P/G
factor:
P3= $100 (P/A, 12%, 4) + $20 (P/G, 12%, 4)
= $100 (3.0373) + $20 (4.1273)
= $386.28
P0 = P3 (P/F, 12%, 3)
= $386.28 (0.7118)
= $274.95
Sample Problem:
1. Fuel costs for intermittent use of a backup generator are expected to be $1,000 in years 1 thru
4, with amounts increasing by $100 per year thru year 10. At an interest rate of 12% per year,
the present worth of the fuel costs is most nearly
P = $1,000 (P/A, 12%, 10) + $100 (P/G, 12%, 7)

= $1,000 (5.6502) + $100 (11.6443)
= 5,650.20 + 1164.43
= $6,814.63
2. Find the equivalent annual worth of $500 in years 1 thru 5, with amounts increasing by $30 per
year thru year 13. Use an interest rate of 15% per year
First find P in year 0 then annualize.

P = $500 (P/A, 15%, 4) + [$500 (P/A, 15%, 9 ) + $30 (P/G, 15%, 9)] (P/F,15%, 4)
= $500 (2.8550) + [$500 (4.7716) + $30 ( 14.7548)] (0.5718)
= $3,044.80
A = $3,044.80 (A/P, 15%, 5)

= $3,044.80 (0.29832)
= $908.32
3. Due to increased demand for replacement parts, material handling costs at a small
manufacturing plant are expected to begin increasing 3 years from now. The costs for years 1
and 2 are $4,000, but they will be $4,200 in year 3 with amounts increasing by 5% per year thru
year 10. At an interest rate of 15% per year, the present worth is closest to:
First find P in year 1 and then move back 1 year.
P1 = $4,000 + $4,000 [1- (1.05/1.15)9] / (0.15 - 0.05)

= $4,000 + $4,000 [0.5590] / 0.10
= $4,000 + $22,361
= $26,361
P0 = $26,361 (P/F, 15%, 1)

= $26,361 (0.8696)
= $22,924
4. The equivalent annual worth (years 1-12) at 12% per year of $2,000 in years 0 thru 5, $2,200 in
year 6, $2,400 in year 7 and amounts increasing by $200 per year thru year 12 is closest to:
(A) $2,620 (B) $4,120 (C) $5,690 (D) $16,230
5. Find present worth of the cash flow shown below using an interest rate of 15% per year.
6. A chemical company, which manufacturers environmentally friendly pesticides, plans to spend

more money for advertising in each of the next 10 years. If the cost now (i.e. year 0) is $30,000
and it will be $33,000 in year 1, and amounts increasing by 10% each year, the equivalent value
now at 15% per year interest is closest to:
7. Find the equivalent annual worth (years 1 thru 10) of the cash flow described by the following
equation. Use an interest rate of 12% per year.
CFk = $5,000 + $300 (k) where k is years varying from 3 thru 10.
(A) < $13,000 (B) $26,826 (C) $33,650 (D) > 34,00
Decreasing Shifted Gradients
Decreasing shifted arithmetic gradients are handled using the same procedures followed for increasing
arithmetic gradients, except the sign in front of the gradient term is negative. The next example illustrates
the procedure.
Example – Shifted Decreasing Arithmetic Gradient
Increased sales for a skin conditioning product are expected to result in lower unit costs for packaging,
advertising, etc. The costs can be described by a decreasing gradient beginning in year 4 and extending
thru year 9. The costs per package for the first 3 years will be $3.00, but beginning in year 4, they will
decrease by $0.25 per year thru year 9 to $1.50. At an interest rate of 15% per year, what is the present
worth of these costs in years 3 through 9?
Solution:
The ‘P’ from the P/G factor will be located in year 2. The present worth in year 0 is:
P0 = [3 (P/A, 15%, 7) - $0.25 (P/G, 15%, 7)] (P/F, 15%, 2)
= [3 (4.1604) – 0.25 (10.1924)] (0.7561)
= $7.51
Find the present worth of the cash flow shown below at an interest rate of 12% per year.
P = 10,000 + 3000 (P/A, 12%, 2) + [3000 (P/A, 12%, 7) - 1000 (P/G, 12%, 7)] (P/F, 12%, 2)
= 10,000 + 3000 (1.6901) + [3000 (4.5638) - 1000 (11.6443)] (0.7972)
= $16,702
The cost of computer projectors has been declining steadily for several years. Calculate the equivalent
annual cost of the projectors (in years 1 thru 5) if their costs have been as shown below. Use an interest
rate of 12% per year.
P-4 = 10,000 (P/A, 12%, 9) – 1000 (P/G, 12%, 9)

= 10,000 (5.3282) – 1000 (17.3563)
= $35,926
P0 = 35,926 (F/P, 12%, 4)

= 35,926 (1.5735)
= $56,529
A = 56,529 (A/P, 12%, 5)

= 56,529 (0.27741)
= $15,682
Sample Problem:
1. Determine the future worth (year 7) of the cash flow shown below at an interest rate of 10% per
year.
2. Find the present worth (year 0) of cash flow described by the following equation 20,000 - 1000
(G), where G is years ranging from -2 to 8. Use an interest rate of 15% per year.
Nominal And Effective Rates
The relationship between a nominal and an effective interest rate is the same as that between a simple
and a compound interest rate. That is, nominal and simple interest rates do not include interest on
interest earned in previous compounding periods while effective and compound interest rates do. The
only difference between the terms nominal and simple interest is that nominal rates usually apply to
compounding periods of less than a year.
Since all of the formulas that were derived were based on compound interest rates , it should be
obvious that nominal interest rates can never be used in any of the interest rate formulas. Therefore,
when a nominal interest rate is given, the first step is to convert it into an effective interest rate as
discussed below.
All nominal rates come from effective rates and all effective interest rates begin with a rate expressed
over its compounding period. For example, an interest rate of 1% per month compounded monthly is an
effective interest rate, as is the rate of 7% per year compounded yearly. Nominal rates and other
effective rates are derived from rates like these. Obviously, it is critical to be able to recognize nominal
and effective rates in the many ways they can be stated so that, when necessary, they can be properly
converted into other rates as discussed below.
There are 3 general ways of expressing interest statements:
(1) An interest rate is stated over a designated time period and the compounding period is not
specified. These rates are assumed to be effective with a compounding period the same as that of the
stated interest rate. For example, '10% per year' means the interest rate is an effective rate and it is
compounded yearly.
(2) An interest rate is stated over a designated time period with a compounding period that is different
than the interest rate period. These rates are nominal rates (unless the interest rate statement explicitly
states that they are effective as discussed below). Examples of nominal rates are '12% per year,
compounded monthly' or '7% per six months, compounded quarterly'. These rates must be converted
into effective rates before they can be used in any of the interest formulas.
(3) An interest rate is stated over a designated time period with a different compounding period (as in
2 above), but the statement says that it is an effective rate. These rates are obviously effective rates. An
example is 'effective 12% per year, compounded monthly'.
Sample Problem:
1. All of the following are nominal interest rates except:
(A) i = 12% per year, compound quarterly

(B) i = 12% per year, compounded yearly
(C) i = 1% per month, compounded weekly
(D) i = 3% per quarter, compounded monthly
2. All of the following are effective interest rates except:
(A) i = 1% per month

(B) i = 10% per year, compounded yearly
(C) i = effective 10% per year, compounded monthly
(D) i = 8% per year, compounded monthly
3. All of the following are effective interest rates except:

(B) i = effective 13% per year, compounded monthly
(C) i = effective 10% per year, compounded yearly
(D) i = 15% per year, compounded semi-annually
4. All of the following are nominal interest rates except:

(A) i = 1% per quarter
(B) i = 1% per month, compounded weekly
(C) i = 1% per day, compounded hourly
(D) i = nominal 9% per year, compounded quarterly
Effective Interest Rate Formulation
All nominal rates are derived from effective rates by multiplying the effective rate by a certain number
of time periods. For example, an effective interest rate of 1% per month can be converted into a
nominal quarterly, semiannual, or yearly rate by multiplying by 3,6, or 12 respectively. In equation form,
a nominal interest rate, r, is:
r = effective interest rate per period x number of periods
A nominal interest rate is converted into an effective rate by using the following formula:
i = (1 + r/m)m – 1
where i = effective interest rate per period

r = nominal interest rate per period
m = number of compounding periods
This formula can be used to convert a nominal rate into an effective rate over any period of time longer
than the compounding period as shown in the next section.
Sample Problem:
1. An interest rate of 1% per quarter is equal to a nominal semi-annual rate of:
(A) 1% (B) 2% (C) 3% (D) 6%
2. An interest rate of 3% per six months, compounded semi-annually is the same as a nominal:
(A) 1% per month, compounded monthly

(B) 6% per year, compounded yearly
(C) 6% per year, compounded semiannually
(D) 6% per year, compounded quarterly
3. A nominal rate of 24% per year, compounded monthly is the same as:

(B) i = 4% per quarter
(C) i = 2% per month
(D) i = 1% per week
4. An interest rate of 12% per year, compounded quarterly is the same as:
(A) i = 4% per quarter

(B) i = 3% per quarter
(C) i = 6% per quarter
(D) i = 4% per six months
5. An interest rate of 0.6 % per month is the same as:

(A) Nominal 7.2% per year
(B) Nominal 7.2% per year, compounded monthly
(C) Nominal 2.4% per quarter, compounded monthly
(D) Nominal 3.6% per year, compounded monthly
6. For an interest rate stated as 4% per quarter, all of the following are equivalent
nominal rates except:
(A) i = 8% per six months, compounded quarterly
(B) i = 16% per year, compounded quarterly
(C) i = 32% per 2 years, compounded quarterly
(D) i = 1% per month, compounded monthly
Calculation of Effective Rates
Effective rates can be found from nominal rates for any time period longer than the compounding
period by using the effective interest rate equation:
i = (1 + r/m)m – 1
In using this equation, the time period on the left hand side of the equation for i must be exactly the
same as the time period for the r, with m equal to the number of times interest is compounded over
those time periods. For example, if the interest rate is given as nominal 24% per year compounded
monthly, the effective interest rate per quarter would be determined as follows:
Note that the time period for i is exactly the same as the time period for r and that m is equal to 3
because interest is compounded 3 times in a quarter when interest is compounded monthly.
Sample Problem:
1. In calculating an effective semi-annual rate from an interest rate of 1.5 % per month, the value
of r and m in the effective interest rate equation are:
(A) 0.03 and 3 (B) 0.045 and 6 (C) 0.09 and 3 (D) 0.09 and 6
2. For an interest rate of 3% per quarter, the effective annual rate is closest to:
(A) 12% (B) 12.33% (C) 12.55% (D) 12.68%
3. For an interest rate of 9% per year, compounded monthly, the effective monthly rate is closest
to:
(A) 0.75% (B) 0.86% (C) 3.16% (D) 9.38%
4. For an interest rate of 16% per year, compounded quarterly, the effective i per six months is
closest to:
(A) 8% (B) 8.16% C) 12.49% (D) 16.99%
5. For an interest rate of effective 18% per year, compounded monthly, the effective monthly rate
is closest to:
(A) 1.39% (B) 1.50% (C) 1.67% (D) 1.73%

Matching i and n Values
When using the single payment formulas (i.e. P/F or F/P), an effective interest rate over any time period
can be used, as long as n is adjusted to equal the number of interest periods over the total time span
between the P and F values.
For example, if the interest rate is 1% per month, an effective interest rate of 3.03% per quarter could
be used in either the F/P or P/F factors for a 10-year period of time, and n would be 40 (i.e. 10 years x 4
quarters/year).
Effective rates over other time periods could also be used, as long as n is adjusted accordingly.
For example, if i of 1% per month is used, n would be 120. Single payment calculations are
demonstrated later topics.
On the other hand, when any of the uniform series or gradient formulas are used, only one value of n
can be used and it is equal to the number of cash flow values in the cash flow series. The interest rate
must then be adjusted (if necessary) to an effective rate over the same time period as the n.
For example, if one wanted to know the amount of money that would be accumulated in 10 years
from semiannual deposits of $500 at an interest rate of 1% per month, the n would have to be 20
because of the semiannual deposits and, therefore, the i would have to be the effective semiannual
interest rate (as calculated from the effective interest rate formula). No other combination of n and i
values could be used.
Example:
A manufacturing company wants to make a single deposit now so that it will have enough money in six
years to replace a machine that costs $50,000. At an interest rate of 10% per year, compounded
semiannually, all of the following equations are correct except
(A) P = 50,000 (P/F, 5%, 12)

(B) P = 50,000 (P/F, 10%, 6)
(C) P = 50,000 (P/F, 10.25%, 6)
(D) P = 50,000 (P/F, 79.59%, 1)
Equation (A) has an effective i per 6 mos with n equal to the number of 6-month periods. – o.k.
Equation (C) has an effective i/yr. with n equal to the number of years. – o.k.
Equation (D) has an effective i/5 yrs with n equal to the number of 5-year periods. -o.k.
Equation (B) has a nominal interest rate in the equation. – not o.k.
Example:
If deposits of $500 are made quarterly into a savings account for 5 years at an interest rate of 12% per
year, compounded monthly, the correct i and n values to use in the F/A equation are
effective i/quarter = (1 + 0.03/3) 3 - 1

= 3.03%
n=5*4
= 20
Sample Problem:
1. An engineer working for a small chemical company estimates that the cost for improving the
efficiency of a certain process now would be $100,000. The company president wants to know
the equivalent cost for doing it 4 years from now at an interest rate of 12% per year,
compounded quarterly. The correct values of i and n to use in the F/P equation are
(A) 12% and 4 (B) 6% and 8 (C) 3% and 16 (D) All of the above
2. Energy costs for a certain process are expected to be $3000 in year 1, $3,200 in year 2, and
amounts increasing by $200 per year thru year 10. At an interest rate of 12% per year,
compounded monthly, the correct values of i and n to use in the P/A and P/G equations are:
(A) 1% and 120 (B) 12.68% and 10 (C) 6% and 20 (D) All of the above
Single Payment Formulas
When using the single payment formulas, any combination of i and n values can be used wherein i is an
effective interest rate over any time period and n is the number of those interest rate periods between
the P and F values. For example, for P and F values 6 years apart and interest compounded monthly,
some of the possible i and n values that could be used are: i/mo and n = 72, i/quarter and n = 24, i/6
mos and n = 12, etc. The i must be an effective rate.
Example – P/F Factor and Effective Interest Rates
A garage door manufacturing company wants to make a single deposit now so that it can replace a small
production line in 5 years. If the company wants to have $1.2 million available and it can earn interest
at 14% per year compounded semiannually, the amount of the deposit is closest to:
Solution:
The easiest effective interest rate to obtain is the semiannual rate of 7%. Using this rate,
P = 1.2 (P/F, 7%, 10)
= 1.2 (0.5083)
= $609,960
Sample Problem:
1. How much can a consulting firm afford to spend now for upgrading office software if the cost 3
years from now would be $25,000 and the interest rate is 12% per year, compounded
semiannually?
P = 25,000 (P/F, 6%, 6)

= 25,000 (0.7050)
= $17,625
2. How much will be accumulated in 10 years if an engineer deposits $10,000 now into a savings
accounts which earns interest at 8% per year, compounded quarterly?
F = 10,000 (F/P, 2%, 40)

= 10,000 (2.2080)
= $22,080
3. What is the present worth of $20,000 eighteen years from now if the interest rate is an effective
12% per year compounded monthly?
P = 20,000 (P/F, 12%, 18)

= 20,000 (0.1300)
= $2,600
4. At an interest rate of effective 12.36% per year, compounded monthly, the amount that would
be accumulated after 20 years from a single deposit of $10,000 at time 0 would be closest to:
5. The amount of money a company could afford to spend now instead of spending $100,000 six
years from now at an interest rate of 16% per year, compounded quarterly is closest to:
(A) $39,010 (B) $45,650 (C) $49,380 (D) Over $50,000
6. The cost of overhauling a certain production line would be $25,000 if done now. What is the
lowest amount the overhaul would have to cost in five years to justify doing the job now if the
interest rate is 18% per year, compounded semiannually?
(A) $16,250 (B) $17,320 (C) $59,185 (D) $61,350
Payment Periods Compounding Periods
When an alternative’s cash flows follow either a uniform series or gradient sequence, the first
step is to determine the relationship between the payment period (i.e. the period over which the cash
flow occurs) and the compounding period. There are only 3 possible relationships (1) the PP is equal to
the CP, (2) the PP is > CP, and (3) the PP < CP. In this section, we will discuss how to handle the first two
situations.
When the PP = CP or when the PP>CP, n is always equal to the number of A values in the
series. This means that the only i value that can be used is an effective rate expressed over the same time
period as the n. No other combination of i and n values can be used. The procedure to follow when the
cash flow involves the use of either uniform series or gradient factors can be summarized as follows:
Determine the relationship between the payment period and the compounding period
If the PP = CP or if PP>CP, then n is the number of cash flow values, A, in the sequence
Calculate (if necessary) the effective interest rate that corresponds to the time periods of n. That is, if n
is in months, i must be an effective monthly rate. If n is in quarters, i must be an effective quarterly rate,
etc.
Example – PP > CP
The present worth of semiannual cash flows of $500 for 8 years, beginning 6 months from now at an
interest rate of 12% per year, compounded monthly is closest to:
Solution:
The payment period (i.e. 6 mos.) is greater than the CP (i.e. 1 month). Therefore, n is equal to the
number of A values, which is 16 in this case. The only interest rate that can be used is an effective rate
per semiannual period because n is in semiannual periods. The effective rate per 6 months must be
calculated from the effective interest rate formula as follows:
i /6 mos = (1 + 0.06 / 6 ) 6 - 1
= 6.15%
Now,
P = 500 (P/A, 6.15%, 16) = $5,001.30 (PV function in Excel)
Sample Problem:
1. A manufacturing company invests $250,000 in a new warehouse facility. At an interest rate of

12% per year, compounded quarterly, the equivalent cost per year over a 5 year recovery period
would be closest to:
Since cash flow is for yearly time periods, must use an effective interest rate per year:
i/year = (1 + 0.12/4)4 – 1
= 12.55%
A = 250,000 (A/P, 12.55%, 5)

= 250,000 [0.1255 (1 + 0.1255)5] / [ (1 + 0.1255)5 – 1 ]
= 250,000 (0.2812)
= $70,300
2. What is the maximum amount a company can afford to spend now to insulate a building if the
savings are expected to be $800 every 6 months? Assume the company's MARR is 12% per year,
compounded monthly and the study period is 5 years.
The cash flow occurs over 10 semiannual time periods. Therefore, an effective semiannual
interest rate is needed:
i /6 mos = (1 + 0.06/6)6 – 1
= 6.15% per six months
P = 800 (P/A, 6.15%, 10)

= 800 [ (1 + 0.0615)10 – 1 ] / [ 0.0615 (1 + 0.0615)10 ]
= 800 (7.3081)
= $5,846
3. How much money can be withdrawn every 3 months (beginning 3 months from now) for 12 ½
years from an account which earns interest of 24% per year, compounded monthly, if the
account contains $100,000 and the last withdrawal will empty the account?
(A) $6,450 (B) $8,580 (C) $9,740 (D) Over $10,000

4. Determine the present worth of $1,000 per month in months 1 thru 24 and $2000 every 3
months beginning in month 27 and continuing thru month 48, all at an interest rate of 12% per
year, compounded monthly.
5. How much money will an engineer have 5 years from now if she deposits $100 in month 1, $110
in month 2 and amounts increasing by $10 each month if the account earns interest at a rate of
6% per year, compounded monthly?
Payment Periods < Compounding Periods
When the payment period of a series is shorter than the compounding period, the most common situation
is that interperiod transactions earn no interest. This means that all withdrawals are assumed to have
taken place at the beginning of the period within which they were made and all deposits are assumed to
have occurred at the end. This is the only situation wherein the timing of the cash flow is changed from
what actually occurred. After the withdrawals and deposits have been moved as indicated, the resulting
cash flow is one where the payment period is equal to the compounding period, and the procedure of the
previous section is followed.
Example – Interperiod Deposits and Withdrawals
And engineer deposited $400 every month for 5 years into a savings account which paid interest at 6%
per year compounded semiannually. If he made one withdrawal of $3,000 in month 16, the amount in
the account after the last deposit in year 5 was closest to
Solution:
The monthly deposits of $400 were assumed to have been $2,400 deposits made at the end of each
semiannual time period. The $3,000 withdrawal was assumed to have occurred at the beginning of the
third period (i.e. end of semiannual period 2). The revised cash flow diagram is as follows:
There are 10 semiannual payment periods (i.e. n = 10) and the effective semiannual rate is 6/2 =
3%. Thus,
F = 2400 (F/A, 3%, 10) – 3000 (F/P, 3%, 8)
= 2400 (11.4639) – 3000 (1.2668)
= $23,713
Sample Problem:
1. An engineer deposits $100 per month (beginning one month from now) into an account for 10
years which earns interest at 6% per year compounded semiannually. The amount in the
account immediately after the last deposit is closest to:
Move deposits to end of compounding period and then use effective i of 3% per six months in
F/A factor:
F = 600 (F/A, 3%, 20)

= 600 (26.8704)
= $16,122
2. An engineer deposits $1000 every 3 months (beginning 3 months from now) into an account for
10 years which earns interest at 6% per year compounded semiannually. If the engineer
withdraws $3000 at the end of each year (including year 10), the equation which represents
how much will be in the account immediately after the transactions in year 10 are completed is:
Move deposits to end of compounding period and use effective i of 3% per six months. For
withdrawals, must find effective i per year:
i/yr = (1 + 0.06/2)2 – 1
= 6.09%
3. If a company wants to make monthly deposits to accumulate $50,000 in five years, how much
must it deposit each month if the account earns interest at 8% per year, compounded quarterly?
(A) $686 (B) $1,230 (C) $2,058 (D) Over $2,100
4. For the deposits and withdrawals shown below, determine the amount that would be in the
account at the end of year 2 if the account earns interest at 10% per year compounded
semiannually.
Continuous Compounding
As the compounding period becomes infinitely shorter, interest is said to be compounded

continuously. For this case, the effective interest rate formula becomes
𝑖 = 𝑒𝑟 – 1
where i is the effective interest rate over the time period represented by the nominal interest rate, r.
All alternatives which involve continuous compounding of interest are obviously of the type where the
payment period is longer than the compounding period
Example - Continuous Compounding of Interest
The present worth of payments of $1000 per quarter for 5 years starting 3 months from now at an
interest rate of 12% per year compounded continuously is closest to
Solution:
Since PP>CP, n is equal to the number of payments, which is 20 in this case. Since the time period for n is
quarters, i must be an effective rate per quarter. Using the effective interest rate equation,
i/quarter = 𝑒 (0.03) – 1
= 3.045%
Now,
P = 1,000 (P/A, 3.045%, 20)
= $14,815.77
Sample Problem:
1. For an interest rate of 12% per year compounded continuously, the effective interest rate per
month is closest to:
r /mo = 0.12/12
= 1%
effective i /mo = 𝑒 (0.01) – 1

= 1.005%
2. For an interest rate of 0.5% per month compounded continuously, the effective rate per
semiannual period is closest to:
r /6 mos = 0.005 * 6
= 3%
effective i /6 mos = 𝑒 (0.03) – 1

= 3.05%
3. How much money would be accumulated in 10 years from a deposit of $10,000 if the interest
rate is 10% per year compounded continuously?
effective i /yr = 𝑒 (0.10) – 1

= 10.52%
F = 10,000 (F/P, 10.52%, 10)

= 10,000 (1 + 0.1052)10
=$27,190
4. The amount of money that must be deposited each year in years 0 thru 10 to have $20,000 in
year 24 at an interest rate of 7.5% per year compounded continuously is closest to:
Cash flow is monthly, so effective i/mo is needed.
effective i /yr 𝑒 (0.075) – 1

= 7.79%
Amt in year 10 = 20,000 (P/F, 7.79%, 14)

= 20,000 [1/(1 + 0.079)14]
= $6,799
A = 6,799 (A/F, 7.79%, 11)
= (6799) 0.0779 (1 + 0.0779)11 – 1
= 6,799 (0.06075)
= $413
5. An interest rate of 1.5% per month compounded continuously is equivalent to an effective
quarterly rate closest to:
(A) 1.51% (B) 4.5% (C) 4.6% (D) 4.7%
6. The present worth of $100,000 in year 10 at an interest rate of 15% per year compounded
continuously is closest to:
7. The present worth (year 0) of $1000 now and $1000 every 3 months for 5 years at an interest
rate 3% per six months compounded continuously is closest to:
(A) $17,150 (B) $18,150 (C) $19,150 (D) Over $19,500
Varying Interest Rates
When interest rates vary over time, cash flow that is moved through periods having different rates
should be adjusted with each period’s rate. For example, if the interest rates in years 1, 2, and 3 were
10%, 11%, and 12%, respectively, the equation for finding the present worth of a $3000 amount in year
3 would be
P = 3000 (P/F, 12%, 1) (P/F, 11%, 1) (P/F, 10%, 1)
If there were other cash flows in the alternative, they would be handled similarly.
An equivalent A value could be found by first finding the P value as discussed above and then
substituting A for each cash flow value in the equation and solving for A.
Example - Equivalent A Value for Varying Interest Rates
The equivalent annual worth of $1,000 per year in years 1-3 and $2,000 in year 4 at interest rates of 10%
in years 1-3 and 18% in year 4 is closest to:
Solution:
First, find the present worth of the cash flows:
P = 1000 (P/A, 10%, 3) + 2000 (P/F, 18%, 1) (P/F, 10%, 3)

= 1000 (2.4869) + 2000 (0.8475) (0.7513)
= $3760.35
Now, substitute A for all cash flow values and set the equation equal to the P value of $3760.35
3,760.35 = A (2.4869) + A (0.8475) (0.7513)

A = $1,203.84
Sample Problem:
1. Calculate the present worth of $10,000 in year 10 if the interest rate is 4% per year for the first 3
years and 8% per year for the last 7.
P = 10,000 (P/F, 8%, 7) (P/F, 4%, 3)

= 10,000 (0.5835) (0.8890)
= $5,187.32
2. If deposits of $100 are made each month (beginning 1 month from now) for 5 years into an
account which earns interest at 6% per year compounded monthly for the first 2 years and 1%
per month for the last 3 years, how much will be in the account immediately after the last
deposit?
F = 100 (F/A, 0.5%, 24) (F/P, 1%, 36) + 100 (F/A, 1%, 36)
= 100 (25.4320) (1.4308) + 100 (43.0769)
= $7,946
3. The costs of maintaining a certain machine are shown in the table below with the interest rate
that was in effect during the corresponding year. Find the present worth of the cash flow.
4. The equivalent annual worth in years 1 thru 3 of the cash flow shown in problem 1 above is
closest to:
(A) $8,621 (B) $8,810 (C) $8,904 (D) $9,212
Present Worth Interest
Mutually Exclusive and Independent Alternatives
In conducting an economic evaluation of two or more alternatives, the first step is to determine if the
alternatives are mutually exclusive or independent. When alternatives are mutually exclusive only one
can be selected because only one is needed. Therefore, the alternatives are compared against each
other and the one having the most favorable PW is identified as “the best”. For example, in evaluating
locations for construction of a new manufacturing facility, only one site would be selected because only
one is needed. As soon as the best one is identified, all of the others are automatically excluded. Mutually
exclusive projects can be of two general types: those having only costs (because they are part of a larger
project which has already been economically justified) and those having both costs and revenues. The
former are identified as cost alternatives and the latter are known as revenue alternatives. For cost
alternatives, one must be selected, and it would be the one with the lowest cost (i.e. least negative). For
revenue alternatives, one may be selected, but only if one or more had a PW³0, in which case the one
with the largest PW would be chosen. On the other hand, when alternatives are said to be independent,
they must be revenue alternatives, and none, one, more than one, or all of them can be selected. This is
because the alternatives are only compared against the MARR, not against each other. Therefore, all
alternatives which yield a return of at least the MARR are accepted. In terms of a present worth analysis,
all alternatives which have a PW equal to or greater than 0 when i is equal to the MARR would be
considered as acceptable alternatives. For example, in evaluating which new products a company should
manufacture, all those whose present worth of costs is lower than their present worth of receipts would
be manufactured.
Hereafter, alternatives are assumed to be mutually exclusive unless otherwise specified.
Example – Mutually Exclusive Cost Alternatives
An economic analysis of three mutually exclusive cost projects yielded the results shown below. Which
one(s) should be selected?
Project ID AX BX CX
PW @ i = MARR -$10,000 -$7000 -$15,000
Solution: Since the projects are mutually exclusive cost projects, only one can be selected. The one with
the lowest cost is alternative BX.
Example – Mutually Exclusive Revenue Alternatives
From the economic analysis results of the mutually exclusive revenue alternatives shown below,
determine which ones should be selected:
Project ID A5 B5 C5
PW @ i = MARR -$10,000 -$2000 -$6,000
Solution: Since the projects are mutually exclusive revenue alternatives, only one can be selected, but
only if the PW @ i = MARR is greater than 0. In this case, none exceed the MARR (because all PW’s are
<0 and they are revenue alternatives).
Sample Problem:
1. From the analysis of mutually exclusive revenue projects shown below, identify the one(s) which
should be selected
Project ID A1 B1 C1 D1
PW @ i = MARR -$5000 $300 $2000 -$1500
Since the projects are mutually exclusive, only one can be selected. The one with the most
favorable PW is project C1.
2. The results from an economic analysis of independent alternatives are shown below. Identify
which one(s) should be selected
Project ID A2 B2 C2 D2 E2
PW @ i = MARR $200 $2,000 -$700 -$3,200 $4,200
The alternatives are independent. Therefore, select all which have PW ³ 0. Those are
alternatives A2, B2, and E2.
3. From the economic analysis results for the independent projects shown below, determine which
one(s) should be selected
Project ID X1 X2 X3 X4 X5
PW @ I = MARR -$700 -$3000 -$1200 -$1000 -$5000
(A) Only X4 (B) Only X5 (C) All (D) None
4. From the economic analysis results for the mutually exclusive revenue projects shown below,
determine which one(s) should be selected
Project ID Z1 Z2 Z3 Z4
PW @ I = MARR -$2500 -$1000 -$3000 -$7000
(A) Only Z2 (B) Only Z4 (C) All (D) None
PW for Equal–Life Alternatives
A present worth comparison of alternatives involves converting all cash flows into their present worth
and then selecting the one alternative which has the lowest cost (or highest profit). Costs can be
preceded by either a plus sign (+) or a minus sign (-), as long as revenues (such as salvage values) are
preceded by the opposite sign. In this presentation, costs will be considered as negative values in all
economic equations.
Example – PW of Equal-Life Alternatives
Compare the alternatives shown below on the basis of their present worths using an interest rate of
15% per year.
Alt C Alt D
First cost, $ $12,000 $18,000
Annual M&O Cost, $/yr 5,000 4,000
Salvage value, $ 3,000 6,000
Life, years 5 5
Solution: The present worth of each alternative are as follows:

PWC = -12,000 – 5,000 (P/A, 15%, 5) + 3,000 (P/F, 15%, 5)
= -12,000 – 5,000 (3.3522) + 3,000 (0.4972)
= -$27,269
PWD = -18,000 – 4,000 (P/A, 15%, 5) + 6,000 (P/F, 15%, 5)

= -18,000 – 4,000 (3.3522) + 6,000 (0.4972)
= -$28,426
Machines A and B are under consideration for a certain project. Machine A has a first cost of $55,000,
an annual operating cost of $40,000, and a $10,000 salvage value after 5 years. Machine B has a first
cost of $80,000, an annual operating cost of $30,000, and a $15,000 salvage value after 5 years. At an
interest rate of 12% per year, the present worth of the alternative B is closest to:
PWB = -80,000 – 30,000 (P/A, 12%, 5) + 15,000 (P/F, 12%, 5)

= -80,000 – 30,000 (3.6048) + 15,000 (0.5674)
= -$179,633
The cost estimates for two machines under consideration are shown below. The company wants the
economic evaluation done over a 4-year planning horizon. At an interest rate of 12% per year, the
present worth of machine X is closest to
(A) Less than -$165,000 (B) -$178,000 (C) -$183,000 (D) -$198,000
X Y
First cost, $ $60,000 $95,000
Annual cost, $/yr 35,000 30,000
Salvage value after 3 years, $ 25,000 40,000
PWX = -60,000 – 35,000 (P/A, 12%, 4) + 18,000 (P/F, 12%, 4)

= -60,000 – 35,000 (3.3073) + 18,000 (0.6355)
= -$164,317
PW for Different-Life Alternatives
When conducting a present worth comparison of alternatives which have different lives, it is necessary to
adopt a procedure which yields present worth for equal service. This must be done because by definition,
a present worth value is the single number which represents the equivalent worth of all cash
flows. Clearly, when the alternatives under consideration involve only costs, the one with the shortest
life will likely have the lowest present cost, even if it is not the most economical one.
There are two procedures for insuring that the comparison is made for equal service:
(1) Compare the alternatives over the least common multiple (LCM) of their lives, or
(2) Compare the alternatives over a specified time horizon. In the first case, it is commonly
assumed that the cash flows associated with the first life cycle will be the same in all succeeding
life cycles. In the second case, all cash flows are assumed to terminate at the end of a specified
study period, with residual salvage values estimated for the remaining life of the assets involved.
Example – PW of Different-Life Alternatives
Compare the alternatives shown below on the basis of their present worths using an interest rate of
14% per year
Alt F Alt G
First cost, $ $60,000 $100,000
Annual cost, $/yr 10,000 3,000
Life, yrs 3 6
Solution:
The least common multiple of their lives is 6 years. The present worth equations are as follows:
PWF = -60,000 – 60,000 (P/F, 14%, 3) – 10,000 (P/A, 14%, 6) + 9000 (P/F, 14%, 3) + 9000 (P/F, 14%, 6)
= -100,000 – 3000 (3.8887) + 12,000 (0.4556)
= -$106,199
PWG = -100,000 – 3000 (P/A, 14%, 6) + 12,000 (P/F, 14%, 6)

= -100,000 – 3000 (3.8887) + 12,000 (0.4556)
= -$106,199
Sample Problem:
1. The costs associated with making a certain titanium part are shown below. At an interest rate
of 12% per year, the PW of alternative A that would be used in a present worth comparison of
the alternatives is closest to:
(A) -$145,600 (B) -$152,500 (C) -$159,800 (D) -$166,300
A B C
First cost, $ 20,000 35,000 60,000
Annual cost, $/yr 25,000 20,000 15,000
Salvage value, $ 3,000 5,000 7,000
Life, years 2 3 6
PWA = -20,000 - 25,000 (P/A, 12%, 6) - 17,000 (P/F, 12%, 2) - 17,000 (P/F, 12%, 4) + 3000 (P/F, 12%, 6)
= -20,000 - 25,000 (4.1114) - 17,000 (0.7972) - 17,000 (0.6355) + 3000 (0.5066)
= -$145,621
2. The costs for two alternatives are shown in the table below. The equation for finding the
present worth of alternative X for comparison to alternative Y at an interest rate of 15% per
year is
(A) PWX = -40,000 (P/A, 15%, 3) - 30,000 + 10,000 (P/F, 15%, 3)

(B) PWX = -40,000 - 30,000 (P/A, 15%, 3) + 10,000 (P/F, 15%, 3)
(C) PWX = -40,000 - 30,000 (P/A, 15%, 6) + 10,000 (P/F, 15%, 6)
(D) PWX = -40,000 - 30,000 (P/A, 15%, 6) - 20,000 (P/F, 15%, 3) + 10,000 (P/F,15%, 6)
X Y
First cost, $ 40,000 90,000
Annual cost, $/yr 30,000 20,000
Life, years 3 6
3. Two types of linings are under consideration for a certain chemical tank. A bituminous lining
will have an initial cost of $6000 and, if touched-up after 3 years at a cost of $2000, it will last
for 5 years. An epoxy coating will cost $18,000 initially, but it will last for 10 years. At an
interest rate of 12% per year, the present worth of the alternatives are closest to:
(A) PWB = -$9,630, PWE = -$18,000 (B) PWB = -$11,640, PWE = -$18,000
(C) PWB = -$13,950, PWE = -$18,000 (D) PWB = -$16,100, PWE = -$18,000
PWB = -6000 – 2000 (P/F, 12%, 3) – 6000 (P/F, 12%, 5) – 2000 (P/F, 12%, 8)
= -6000 – 2000 (0.7118) – 6000 (0.5674) – 2000 (0.4039)
= -$11,636
PWE = -$18,000
4. A farm equipment manufacturer is considering two types of controllers for one part of its
production facility. Alternative 1 will have an equipment cost of $80,000, an installation cost of
$25,000, annual M&O costs of $50,000, and a $5000 salvage value after 4 years. Alternative 2
will have an initial cost of $170,000 (including installation), an annual operating cost of $35,000,
and $10,000 salvage value after its 8 year life. At an interest rate of 12% per year, the present
worth of the two alternatives are closest to:
(A) PW1 = -$362,500, PW2 = -$341,700 (B) PW1 = -$362,500, PW2 = -$414,900
(C) PW1 = -$362,500, PW2 = -$339,800 (D) PW1 = -$414,900, PW2 = -$339,800
5. Janitorial service for a corporation housed in a large office building/training complex can be
provided in one of two ways. A service contract for 4 years will cost $35,000 per year, payable at
the beginning of each year. If renewed for 4 more years, the cost will be $38,000 per year. A
different service contract can be obtained at a lower cost of $20,000 per year, provided the
corporation purchases certain equipment that will cost $8000 and have a life of 8 years with no
salvage value. Supplies costing $6000 per year will also be needed for this option. If the first
option is identified as no. 1 and the second as no. 2, at an interest rate of 18% per year, the
present worth of alternative 2 is closest to:
(A) -$126,700 (B) -$127,700 (C) -$128,700 (D) -$129,700
6. A petrochemical company is considering two alternatives for handling crude oil on-
site. Alternative A will cost $300,000 to install and will have an annual M&O cost of $50,000. It
will be useful for 6 years with no salvage. Alternative B will cost $400,000 initially, but its annual
cost will be only $20,000 in year 1, $22,000 in year 2, and amounts increasing by $2000 per year
through its 12 year useful life, after which time it will have a $40,000 salvage value. At an interest
rate of 12% per year, the present worths of the two alternatives are closest to:
(A) PWA = -$505,570, PWB = -$566,000 (B) PWA = -$761,700, PWB = -$566,000
(C) PWA = -$497,600, PWB = -$566,000 (D) PWA = -$761,700, PWB = -$460,700
Future Worth Comparison of Alternatives
Alternatives can be compared on the basis of their future worth by using the same assumptions and
procedures established for present worth comparisons. In particular, alternatives which have different
lives must be compared on the basis of equal service. This means that they must be compared over a
specified planning horizon or over their least common multiple of lives. In either case, if the comparison
time period is longer than the life of one or more of the alternatives, then intermediate first costs and
salvage values must be accounted for.
Example – Comparison of Alternatives Using Future Worth
U.S. Printing is considering two alternatives for delivering ink to major newspaper and magazine
publication customers. Alternative A will have a first cost of $100,000, an annual cost of $25,000, and a
$30,000 salvage value at the end of its 3 year life. Alternative B will have a first cost of $200,000, with no
annual cost or salvage value because it involves a third party contract for 6 years. At an interest rate of
15% per year, the future worth of the alternatives are closest to:
Solution: For equal service, compare the alternatives over a 6 year period.
FA = -100,000 (F/P, 15%, 6) – 25,000 (F/A, 15%, 6) + 30,000 (F/P, 15%, 3) -100,000 (F/P, 15%, 3) + 30,000
= -100,000 (2.3131) – 25,000 (8.7537) + 30,000 (1.5209) – 100,000 (1.5209) + 30,000
= -$526,616
FB = -200,000 (F/P, 15%, 6)

= -200,000 (2.3131)
= -$462,620
Sample Problem:
1. Compare the alternatives shown below on the basis of their future worth using an interest rate
of 20% per year.
FWX = -10,000 (F/P, 20%, 4) - 6,500 (F/P, 20%, 2) - 6,000 (F/A, 20%, 4) + 3,500
= -10,000 (2.0736) - 6500 (1.4400) - 6000 (5.3680) + 3,500
= -$58,804
FWY = -25,000 (F/P, 20%, 4) - 3000 (F/A, 20%, 4) + 1,000

= -25,000 (2.0736) - 3,000 (5.3680) + 1000
= -$66,944
2. Alternative Q has a first cost of $32,000, an operating cost of $5000 in year 1, $5500 in year 2, and
amounts increasing by $500 thru year 10. Its salvage value at that time will be 20% of its first
cost. Alternative T will have a first cost of $20,000, an annual operating cost of $3000, a 5 year
life and no salvage value. At an interest rate of 15% per year, their future worth are closest to:
First find PW for alternative Q and then convert to FW:

PWT = -32,000 - [5000 (P/A, 15%, 10) + 500 (P/G, 15%, 10)] + 32,000 (0.20) (P/F, 15%, 10)
= -32,000 - [5000 (5.0188) + 500 (16.9795)] + 6,400 (0.2472)
= -$64,002
FWQ = -64,002 (F/P, 15%, 10)

= 64,002 (4.0456)
= -$258,925
FWT = -20,000 (F/P, 15%, 10) - 20,000 (F/P, 15%, 5) - 3000 (F/A, 15%, 10)
= -20,000 (4.0456) - 20,000 (2.0114) - 3,000 (20.3037)
= -$182,051
3. Compare the alternatives shown below on the basis of their future worth using an interest rate
of 12% per year, compounded semiannually.
Alt M Alt N
First cost, $ $50,000 $70,000
Semiannual operating cost, $/6 mos 10,000 8,000
Life, yrs 2 4
(A) FWM = -$230,500, FWN = -$170,700 (B) FWM = -$230,000, FWN = -$110,200
(C) FWM = -$95,300, FWN = -$110,200 (D) FWM = -$151,300, FWN = -$175,600
4. Compare the alternatives below on the basis of their future worths using an interest rate of 15%
per year.
Alt Z1 Alt Z2
First cost, $ $30,000 $20,000
Operating cost, $/yr $5000 yr.1, increasing by $500 per year $10,000
Life, years 6 3
(A) FWZ1 = -$51,160, FWZ2 = -$144,000

(B) FWZ1 = -$118,300, FWZ2 = -$144,000
(C) FWZ1 = -$51,160, FWZ2 = -$132,000
(D) FWZ1 = -$118,300, FWZ2 = -$201,000
Capitalized Cost
Capitalized cost refers to the present worth of cash flows which go on for an infinite period of time. Some
public works projects like dams, bridges and parks fall into this category. In addition, some permanent
endowment calculations require capitalized cost considerations. The cash flows involved in the
calculations can be categorized as one of two types: recurring (i.e. periodic/repeating) and non-recurring
(i.e. finite time interval). The repainting of a bridge every three years is an example of a recurring
cost. The initial investment cost or a partial annual series which occurs only in years 1 thru 10 are
examples of non-recurring cash flows. The basic equation involved in capitalized cost calculations is:
P=A/i
The validity of this equation can be easily demonstrated thru an example. Suppose one wanted to know
how much money could be withdrawn forever from an account which contains $1000 earning interest at
a rate of 10% per year. Obviously, it is the interest ($100 per year in this case) that can be withdrawn
forever. In equation form,
Interest = Principal * Interest rate
A = Pi, or P = A / i
The procedure to find the capitalized of cash flows which contain an infinite series is
Find the PW of all finite-interval cash flows using the regular engineering economy formulas (P/F, P/A,
P/G, etc)
Convert all (non-annual) recurring amounts into annual worth over one life cycle and add all A values
together
Divide the A values obtained in step (2) by i to get the PW of the annual amounts.
Add all PW’s together to get the capitalized cost.
Example: A dam will have a first cost of $5,000,000, an annual maintenance cost of $25,000 and minor
reconstruction costs of $100,000 every five years. At an interest rate of 8% per year, the capitalized cost
of the dam is nearest to:
Solution:
The $5,000,000 first cost is already a present worth. The $100,000 which occurs every five years can be
converted into an infinite A value using the A/F factor for one life cycle. Dividing the A values by i and
adding to the $5,000,000 PW will yield the capitalized cost, CC.
CC = -5,000,000 - 25,000/0.08 - 100,000 (A/F, 8%, 5) / 0.08

= -5,000,000 - 312,500 - 100,000 (0.1705)/0.08
= -$5,525,625
Occasionally, it may be necessary to determine the capitalized cost of an alternative which has a finite
life such as when it is compared against one which has an infinite-life. In such a case, the capitalized
cost of the finite-life alternative can be found by first converting all of its cash flows into an equivalent
annual worth (A) over one life cycle and then dividing by i.
Example: The first cost of a certain piece of equipment is $50,000. It will have an annual operating cost
of $20,000 and $5,000 salvage value after its 5-year life. At an interest rate of 10% per year, the
capitalized cost of the equipment is closest to:
Solution: Convert all values into an equivalent A value thru one life cycle and divide by i:
A = -50,000 (A/P, 10%, 5) – 20,000 + 5,000 (A/F, 10%, 5)

= -50,000 (0.26380) – 20,000 + 5,000 (0.16380)
= -$32,371
CC = -32,371 / 0.10
= -$323,710
Sample Problem:
1. The capitalized cost of a present sum of $60,000 and annual amounts $10,000 per year for an
infinite time at 10% per year is closest to:
CC = -60,000 - 10,000 / 0.10

= -$160,000
2. A water supply dam will cost $7 million to build and it will have erosion control costs of $800,000
every 5 years forever. At an interest rate of 10% per year, the capitalized cost of the dam is closest
to:
CC = -7,000,000 – 800,000 (A/F, 10%, 5) / 0.10

= -7,000,000 – 800,000 (0.16380) / 0.10
= -$8,310,400
3. A wealthy alumnus of a major university wants to start a permanent endowment in his name. He
wants to be able to give scholarships to 5 engineering students each year beginning 10 years from
now. If he wants the scholarships to be in the amount of $6,000 for each student, how must he
donate now if the account earns interest at a rate of 8% per year?
CC = -5 (6000) / 0.08 (P/F, 8%, 9)

= -$375,000 (0.5002)
= -$187,575
Payback Period Analysis
The payback period refers to the time it takes (i.e. n) to recover the initial investment costs (i.e. P) of an
alternative. It is a form of breakeven analysis. The general equation is
0 = -P ± A (P/A, i, n) ± F (P/F, i, n)
The value of n that satisfies the equation (usually a trial and error procedure) is the payback period, or
time required for breakeven.
Business persons sometimes make what is called a simple payback calculation wherein the first cost, P, is
divided by the net annual income to obtain the time required to recover the initial investment. Such a
calculation, while easy to make, obviously ignores the time value of money and will always yield an n value
lower than the correct one.
Example: An asset which has a first cost of $40,000 will generate a net annual income of $11,000 per
year. The asset can be sold for $10,000 at any time within the first 5 years of its life. Thereafter, it can be
sold for $2,000. Find the payback period of the asset using (a) i = 15% per year, and (b) i = 0% per year.
Solution:
(a) For n £ 5 years: 0 = -40,000 + 11,000 (P/A, 15%, n) + 10,000 (P/F, 15%, n)
Try n = 4: 0 = -40,000 + 11,000 (2.8550) + 10,000 (0.5718)

0 ¹= - $2877
Try n = 5: 0 = -40,000 + 11,000 (3.3522) + 10,000 (0.4972)

0 ¹= $1,846.2
n = 4.6 years
(b) For i = 0% and n £ 5 years
0 = -40,000 + 11,000(n) + 10,000
n = 2.7 years
Sample Problem:
1. An alternative with a first cost of $100,000 will have income of $20,000 per year for 20 years. At
an interest rate of 12% per year, the payback period for the investment is closest to:
0 = -100,000 + 20,000 (P/A, 12%, n)

(P/A, 12%, n) = 5.0000
From 12% interest tables, n is between 8 and 9 years
2. An unscrupulous business person who is trying to entice unsophisticated persons into “investing”
money in his company stated that for an initial sum of $500,000, the investor will receive $20,000
in year 1, $80,000 in year 2, and then $100,000 per year for 4 more years, which represents a “six-
year payback period”. This would of course be true at zero interest. If a person did make such an
investment and did receive the amounts promised in years 1 and 2, how many of the $100,000
per year receipts would the person have to get in order to earn a rate of return of 15% per year?
0 = -500,000 + 20,000 (P/F, 15%, 1) + 80,000 (P/F, 15%, 2) + 100,000 (P/A,15%,n) (P/F, 15%, 2)
0 = -500,000 + 20,000 (0.8696) + 80,000 (0.7561) + 100,000 (P/A, 15%, n)(0.7561)
75610 (P/A,15%, n) = $422,120

(P/A,15%, n) = 5.5829
From 15% interest tables in P/A column, n is between 12 and 13 years
3. An electronics company estimated the investment cost for equipment for producing
replacement TV/VCR transmitters will be $800,000. The operating cost is expected to be
$500,000 per year with revenues estimated at $650,000 per year. At a MARR of 15% per year,
the payback period is closest to:
(A) Less than 8 years (B) 10 years (C) 12 years (D) More than 12 years
4. The cash flows associated with the manufacture of a certain item are shown below. At an
interest rate of 12% per year, the payback period is closest to:
(A) Less than 5 years (B) 6 years (C) 8 years (D) more than 10 years
First cost, $ 650,000

Operating cost, $ 150,000 yr 1, increasing by $5,000 per year
Annual revenue, $/yr 320,000
Present Worth of Bonds
A bond is note-payable (i.e. an IOU) issued by a corporation or governmental entity for the purpose of
financing long-term projects. In essence, the issuer of the bonds receives money now in return for a
promise to pay later, with interest paid between the time the money is borrowed and the time it is
repaid. There are literally hundreds of classifications of bonds, but this presentation will be limited to the
general characteristics of the most common types.
The most common type of bonds has 4 important variables:
1. the bond face value

2. the bond interest rate (also called coupon rate),
3. the bond interest payment period,
4. the bond maturity date. These conditions of repayment are specified at the time the bonds are
issued.
The bond face value, which refers to the denomination of the bond, is usually an even denomination
starting at $100, with the most common being the $1000 bond. The face value is important for two
reasons:
1. It represents the lump-sum amount that will be paid to the bondholder on the bond maturity date.
2. The amount of interest I paid per period prior to the bond maturity date is determined by
multiplying the face value of the bond by the bond interest rate per period as follows:
(face value)(bond interest rate)
𝐼 = Number of payment periods per year
𝑉𝑏
𝐼= 𝑐
Often a bond is purchased at a discount (less than face value) or a premium (greater than face value),
but only the face value, not the purchase price, is used to compute the bond interest
amount I. Examples 5.9 and 5.10 illustrate the computation of bond interest.
Example: A bicycle manufacturing company planning an expansion issued 4% $1000 bonds for financing
the project. The bonds will mature in 20 years with interest paid semiannually. Mr. John Doe purchased
one of the bonds through his stockbroker for $800. What payments is Mr. Doe entitled to receives
Solution
The face value of the bond is $1000. Therefore, Mr. Doe will receive $1000 on the date the bond
matures, 20 years from now. In addition, Mr. Doe will receive the semiannual interest the company
promised to pay when the bonds were issued. The interest every 6 months will be computed using V =
$1000, b = 0.04, and c = 2 in Equation [5.1]:
I = 1000(0.04) / 2 = $20 every 6 months
Example: Determine the amount of interest you will receive per period if you purchase a 6% $5000 bond
which matures in 10 years with interest payable quarterly.
Solution
Since interest is payable quarterly, you would receive the interest payment every 3 months. The
amount is
I = 5000(0.06) / 4 = $75
Therefore, you will receive $75 interest every 3 months in addition to the $5000 lump sum after 10
years.
After a bond has been issued, it can be bought and sold by institutions and individual investors in the open
market place. Whenever the interest rate in the market place is different from the interest rate on a
bond---a common occurrence because bond interest rates are usually fixed while the market interest rates
continually vary --- then the present worth of a bond is not equal to its face value. This is because the
future income stream (i.e. interest payments and face value) is discounted at an interest rate (i.e. the
market rate) that is different from the interest rate that the payments were based on (i.e. the bond
interest rate). The present worth of a conventional bond is calculated from the following general
equation:
PW = I (P/A, i, n) + FV (P/F, i, n)
where: I = Bond interest payments
FV = Bond face value
n = Number of interest periods to maturity
i = Market interest rate per period
Example: Determine the present worth of $10,000 bond that has a bond interest rate of 8% per year,
payable semiannually with a maturity date of 20 years from now. Assume the market interest rate is
12% per year, compounded semiannually.
Solution: First calculate the semiannual interest payments, I, the bondholder will receive:
I = (10,000) (0.08) / 2
= $400 every six months
Next, draw the cash flow diagram
PW=?
Finally, set up the equation and solve for PW
PW = 400 (P/A, 6%, 40) + 10,000 (P/F, 6%, 40)

= 400 (15.0463) + 10,000 (0.0972)
= $6,990.52
A zero-coupon bond does not pay periodic interest, so the coupon rate is zero. Because of this, they often
sell at discounts of more than 75% of their face value so that their yield to maturity will be sufficient to
attract investors. Stripped bonds are simply conventional bonds whose interest payments are sold
separately from the face value. The stripped bond then behaves as if it were a zero-coupon bond.
Sample Problem:
The next three problems are based on the following statement:
A $20,000, thirty year bond that was issued 25 years ago with a bond interest rate of 4% per year, payable
quarterly is for sale for $15,000. The market interest rate is 12% per year, compounded quarterly
1. The interest payments associated with this bond are:

I = (20,000)(0.04) / 4
= $200 every 3 months
2. The remaining number of interest payments the bond holder will receive is
Number of interest payments remaining = 5*4 = 20
3. The present worth of the bond is closest to
PW = 200 (P/A, 3%, 20) + 20,000 (P/F, 3%, 20)

= 200 (14.8775) + 20,000 (0.5537)
= $14,050
The next two problems are based on the following statement:
A bond which was issued 12 years ago has a maturity date of 30 years from the time it was issued. The
bond has a face value of $5,000 and an interest rate of 6% per year payable annually. The market interest
rate is 16% per year.
1. The interest a current purchaser of this bond will receive is
(A) $300 per year for 18 years

(B) $300 per year for 30 years
(C) $800 per year for 18 years
(D) $800 per year for 30 years
2. The present worth of the bond is closest to:
(A) $2,090 (B) $3,120 (C) $3,950 (D) $4,320
3. An investor who purchased a corporate $10,000 bond 6 years ago wants to sell the bond. The bond
has an interest rate of 8% per year, payable semiannually and matures 20 years from the date it
was issued. If the interest rate in the marketplace is 14% per year, compounded semiannually, the
amount the seller can expect to get is closest to:
(A) $4,520 (B) $5,170 (C) $5,890 (D) $6,360
Annual Worth Calculations
The AW method is commonly used for comparing alternatives. As illustrated in Chapter 4, AW means that
all incomes and disbursements (irregular and uniform) are converted into an equivalent uniform annual
(end-of-period) amount, which is the same each period. The major advantage of this method over all the
other methods is that it does not require making the comparison over the least common multiple (LCM)
of years when the alternatives have different lives. That is, the AW value of the alternative is calculated
for one life cycle only. If the project is continued for more than one cycle, the equivalent annual worth
for the next cycle and all succeeding cycles will be exactly the same as for the first, provided all cash flows
are the same for each cycle in constant-value dollars (discussed in Chapter 12).
The repeatability of the uniform annual series through various life cycles can be demonstrated by
considering the cash-flow diagram in Figure below, which represents two life cycles of an asset with a first
cost of $20,000, an annual operating cost of $8000, and a 3-year life.
The AW for one life cycle (i.e., 3 years) would be calculated as follows:
AW = -20,000 (A/P, 22%, 3) – 8000

= -$17,793
The AW for two life cycles is calculated as
AW = -20,000 (A/P, 22%, 6) – (20,000)(P/F, 22%, 3)(A/P, 22%, 6) – 8000

= -$17,793
The AW value for the first life cycle is exactly the same as that for two life cycles. This same AW will be
obtained when three, four, or any other number of life cycles are evaluated. Thus, the AW for one life
cycle of an alternative represents the equivalent uniform annual worth of that alternative every time the
cycle is repeated.
When an asset has a terminal salvage value, there are several ways by which the AW can be
calculated. The two that will be discussed here are the salvage sinking fund method, which is
represented by the general equation:
AW = -P (A/P, i, n) + S (A/F, i, n)
And the capital recovery plus interest method, which is represented by
AW = -(P – S) (A/P, i, n) – Si
Their equivalence can be demonstrated by considering an asset which has a first cost of $20,000, an
annual operating cost of $10,000 per year, and a $5000 salvage value at the end of its 5 year life. The
annual worth at 12% per year by the first method is:
AW = -20,000 (A/P, 12%, 5) – 10,000 + 5000 (A/F,12%, 5)

= -20,000 (0.27741) – 10,000 + 5,000 (0.15741)
= -$14,761
The annual worth by the second method is:
AW = -(20,000 - 5000) (A/P, 12%, 5) - 10,000 - 5000 (0.12)

= -15,000 (0.27741) - 10,000 - 600
= -$14,761
Thus, the AW values are the same by either method, but only the former will be used hereafter.
Sample Problem:
1. At an interest rate of 18% per year, the annual worth of an asset which has a first cost of $50,000,
an annual operating cost of $30,000, and a $10,000 salvage value after a 4-year life is closest to:
AW = -50,000 (A/P, 18%, 4) – 30,000 + 10,000 (A/F, 18%, 4)

= -50,000 (0.37174) – 30,000 + 10,000 (0.19174)
= -$46,670
2. A certain machine is expected to cost $40,000 and have an annual operating cost of $25,000. If the
machine is updated at the end of 3 years at a cost of $15,000, it will have a useful life of 5 years,
after which it can be sold at salvage for $10,000. At an interest rate of 12% per year, the AW of the
machine is closest to:
AW = -40,000 (A/P, 12%, 5) – 15,000 (P/F, 12%, 3)(A/P, 12%, 5) – 25,000 + 10,000 (A/F, 12%, 5)
= -40,000 (0.27741) – 15,000 (0.7118) (0.27741) – 25,000 + 10,000 (0.15741)
= -$37,484
3. The first cost of alternative A is $100,000. It will have an annual operating cost of $40,000 per year
with a $10,000 salvage value after its 10 year life. At an interest rate of 12% per year, the AW of
the alternative is closest to:
(A) -$52,400 (B) -$57,130 (C) -$60,030 (D) -$61,950
4. A certain machine will have a first cost of $30,000, a monthly operating cost of $5,000, and $10,000
salvage value after a 5 year useful life. At an interest rate of 18% per year, compounded monthly,
the AW/month is closest to:
(A) Less than -$5000 (B) -$5,660 (C) -$8,130 (D) -$12,330
5. A construction company is considering the purchase of a dump truck for $70,000. The operating
cost is expected to be $50,000 in year 1, $52,000 in year 2, and amounts increasing by $2000 per
year through a 5-year planning period. The truck is expected to have a $20,000 salvage value at
that time. At an interest rate of 12% per year, the AW of the truck is closest to:
(A) -$55,490 (B) -$58,110 (C) -$64,340 (D) -$69,820
Comparing Alternatives by Annual Worth
To compare two or more alternatives by the annual worth method, calculate the annual worth of each
one over its life cycle (not the least common multiple between them) and select the one with the lowest
equivalent annual worth for cost alternatives or highest annual worth for revenue
alternatives. Comparing different-life alternatives on the basis of their annual worth over one life cycle
assumes that
(1) The alternatives will be needed for at least their least common multiple of years, and
(2) The costs in all succeeding life cycles will change only by the inflation (or deflation) rate.
If either one of these assumptions is deemed to be unreasonable, then the cash flows for each
alternative must be estimated over a fixed study period, and their annual worths calculated
accordingly. The next example illustrates these calculations.
Example -Two alternatives are under consideration by a small manufacturing company. Alternative X
will have a first cost of $40,000, an annual operating cost of $25,000 and a $10,000 salvage value after 4
years. Alternative Y will have a first cost of $75,000, an annual operating cost of $15,000 and a $7,000
salvage value after its 6 year life. The interest rate is 12% per year. (a) Which alternative should be
selected on the basis of an AW analysis? (b) If the owner of the company plans to sell after 3 years,
which alternative is best, assuming the salvage value will be $14,000 for X and $20,000 for Y at that
time?
Solution:
(a) AWX = -40,000 (A/P, 12%, 4) – 25,000 + 10,000 (A/F, 12%, 4)

= -40,000 (0.32923) – 25,000 + 10,000 (0.20923)
= -$36,077
AWY = -75,000 (A/P, 12%, 6) – 15,000 + 7,000 (A/F, 12%, 6)

= -75,000 (0.24323) – 15,000 + 7,000 (0.12323)
= -$32,380
Select alternative Y
(b) AWX = -40,000 (A/P, 12%, 3) – 25,000 + 14,000 (A/F, 12%, 3)

= -40,000 (0.41635) – 25,000 + 14,000 (0.29635)
= -$37,505
AWY = -75,000 (A/P, 12%, 3) – 15,000 + 20,000 (A/F, 12%, 3)

= -75,000 (0.41635) – 15,000 + 20,000 (0.29635)
= -$40,299
Select alternative X
Sample Problem:
1. Two methods can be used for producing a certain machine part. Method A will have a first cost
of $60,000 with a $15,000 salvage value after its 3 year life. The operating cost with this
method will be $35,000 per year. Method B will cost $45,000, but it will last only 2 years. Its
salvage value is $10,000 with an operating cost of $25,000 per year. At an interest rate of 12%
per year, the annual worth of the two methods are closest to
AWA = -60,000 (A/P, 12%, 3) – 35,000 + 15,000 (A/F, 12%, 3)

= -60,000 (0.41635) – 35,000 + 15,000 (0.29635)
= -$55,536
AWB = -45,000 (A/P, 12%, 2) – 25,000 + 10,000 (A/F, 12%, 2)
= -45,000 (0.59170) – 25,000 + 10,000 (0.47170)
= -$46,910
2. The costs associated with making a certain cancer fighting drug are shown below. At an interest
rate of 18% per year, the annual worths of processes Y and Z are closest to
X Y Z
First cost, $ $150,000 $250,000 $200,000
Annual cost, $/yr 90,000 80,000 60,000
Salvage value, $ 10,000 20,000 5,000
Life, years 4 5 3
AWY = -250,000 (A/P, 18%, 5) – 80,000 + 20,000 (A/F, 18%, 5)

= -250,000 (0.31978) – 80,000 + 20,000 (0.13978)
= -$157,149
AWZ = -200,000 (A/P, 18%, 3) – 60,000 + 5,000 (A/F, 18%, 3)

= -200,000 (0.45992) – 60,000 + 5,000 (0.27992)
= -$150,584
3. A small solid waste recycling plant is considering two types of metal sorting processes whose
respective costs are shown below. The annual worth of the processes at an interest rate of 10%
per year are closest to
(A) AWJ = -$92,100, AWK = -$95,320 (B) AWJ = -$102,500, AWK= -$89,240
(C) AWJ = -$92,100, AWK = -$89,240 (D) AWJ = -$102,500, AWK = -$95,320
PROCESS J PROCESS K
First cost, $ $90,000 $120,000
Annual operating cost, $/yr 70,000 60,000
Life, years 5 4
Annual Worth of a Permanent Investment
When an alternative is expected to have an infinite life (such as large dams, national parks, etc.), its first
cost can be converted into an annual worth by multiplying it by the interest rate, i. In equation form,
A = Pi
Cash flows which occur at regular intervals can be converted into a perpetual annual worth simply by
finding their AW over one life cycle, as this is automatically an annual worth forever. All other non-infinite
cash flow amounts can be converted into a perpetual annual worth by first converting them into a PW at
time zero and then multiplying by i.
For alternatives which have a finite life, their perpetual equivalent annual worth is simply their annual
worth for one life cycle, as the same value will be obtained for all succeeding life cycles. The next example
illustrates these calculations.
Example: Compare the alternatives shown below on the basis of their annual worth using an interest
rate of 10% per year.
F G
First cost, $ $100,000 $800,000
Additional investment in year 5, $ ---------- $50,000
Annual cost, $/yr $60,000 $10,000
Minor reconstruction cost every 10 yrs, $ ---------- $30,000
Salvage value, $ $20,000 ----------
Life, years 7 ¥
Solution:
For alternative F, find the AW over one life cycle (i.e. 7 years).
AWF = -100,000 (A/P, 10%, 7) – 60,000 + 20,000 (A/F, 10%, 7)

= -100,000 (0.20541) – 60,000 + 20,000 (0.10541)
= -$78,433
For alternative G, first find the PW of the single amounts and multiply by i. Then, convert the $30,000
recurring cost into an A value over one life cycle by using the A/F factor:
AWG = -[800,000 + 50,000 (P/F, 10%, 5)]0.10 – 10,000 – 30,000 (A/F, 10%, 10)
= -[800,000 + 50,000 (0.6209)]0.10 – 10,000 – 30,000 (0.06275)
= -$94,987
Sample Problem:
1. A permanent monument will have an initial cost of $250,000, an annual maintenance cost of
$15,000, and a $25,000 restoration cost every 10 years. At an interest rate of 10% per year, the
AW of the monument is closest to
AW = -250,000 (0.10) – 15,000 – 25,000 (A/F, 10%, 10)

= -25,000 – 15,000 – 25,000 (0.06275)
= -$41,569
2. In order to improve access to remote parts of a national park, two routes are under
consideration for walking and bicycle paths. Their costs are shown below. At an interest rate of
10% per year, their annual worth are closest to
(A) AWA = -$41,650, AWB = -$75,390 (B) AWA = -$58,150, AWB = -$73,390
(C) AWA = -$41,650, AWB = -$85,000 (D) AWA = -$58,150, AWB = -$85,000
Route A Route B
Construction cost, $ $150,000 $800,000
Annual maintenance cost, $/yr. 40,000 5,000
Reconstruction every 15 years, $ 100,000 ----
AWA = -150,000 (0.10) – 40,000 – 100,000 (A/F, 10%, 15)
= -15,000 – 40,000 – 100,000 (0.03147)
= -$58,147
AWB = -800,000 (0.10) – 5,000
= -$85,000
3. A consulting engineering firm is considering two sites for a permanent flood control dam. Site A
will involve a first cost of $2.4 million with annual maintenance estimated at $150,000 per year. In
addition, equipment replacement costs of $50,000 are expected every 10 years. Site B will cost
$2.8 million initially with an additional one-time expenditure of $500,000 after 5 years. Annual
maintenance costs are expected to be $20,000 with equipment replacement costs of $15,000
every 15 years. At an interest rate of 10% per year, the annual worth of the two sites are closest
to:
(A) AWA = -$326,450, AWB = -$331,500 (B) AWA = -$326,450, AWB = -$393,140
(C) AWA = -$393,140, AWB = $-331,520 (D) AWA = -$393,140, AWB = -$406,490
Rate of Return
All engineering economy equations contain at least three known values (such as F, i, and n) and a different
value is being sought (such as P or A). In this section, i is the value that is being sought and, when taken
from the viewpoint of the investor, it is known as the rate of return. The rate of return is found by setting
up a valid engineering economy equation and solving for the unknown (i in this case), just as was done
when the PW was the unknown in a PW equation.
A rate of return equation is generally set up with 0 on the left-hand side of the equation and all other
values on the right-hand side preceded by the proper sign. A common general equation is:
0 = -P ± A (P/A, i, n) ± SV (P/F, i, n)
When a rate of return equation contains two or more factors (such as the P/A and P/F in this case), a
trial and error solution is required. The next example illustrates the procedure.
Example: A solid waste recycling company invested $130,000 in sorting equipment. The company had
net profits of $40,000 per year for 4 years, after which the equipment was sold for $23,000 (and replaced
with more sophisticated equipment). The rate of return per year on the investment was closest to:
Solution: The rate of return equation is
0 = -130,000 + 40,000 (P/A, i, 4) + 23,000 (P/F, i, 4)
When multiple choice answers are given, a time-saving technique is to plug one of the middle values (i.e.
not the highest or lowest) into the equation and solve. If it is not the correct value, only one other
calculation may be required. In this case, try i = 10%:
0 = -130,000 + 40,000 (P/A, 10%, 4) + 23,000 (P/F, 10%, 4)

= -130,000 + 40,000 (3.1699) + 23,000 (0.6830)
0 != +12,505 too low
try i = 14%:
0 = -130,000 + 40,000 (2.9137) + 23,000 (0.5921)

= $+166
The difference got smaller, and since there are no other larger interest rates,
The exact answer is actually 14.06% (from Excel), and it would be obtained equally well from an annual
worth or future worth equation. For AW, the equation is
0 = -130,000 (A/P, i, 4) + 40,000 + 23,000 (A/F, i, 4)
Sample Problem:
1. An investment of $50,000 resulted in profits of $10,000 per year for 6 years and $20,000 in year
7. The rate of return per year was closest to:
(A) less than 11% (B) 12% (C) 13% (D) over 14%
The rate of return equation is as follows:
0 = -50,000 + 10,000 (P/A, i, 6) + 20,000 (P/F, i, 7)
Try i = 12%: 0 = -50,000 + 10,000 (4.1114) + 20,000 (0.4523)
0 น 160
i is slightly greater than 12% (i.e. 12.06%)

2. Determine the rate of return for the cash flow shown below:
Year Cash Flow

0 -200,000
1-5 +50,000
6-8 +30,000
(A) less than 10% (B) 11% (C) 13% (D) over 15%
0 = -200,000 + 50,000 (P/A, i, 5) + 30,000 (P/A, i, 3) (P/F, i, 5)
Try i = 13% : 0 = -200,000 + 50,000 (3.4331) + 30,000 (2.3216)(0.5194)
0 น $7,830 too small
(i is actually 15.3% from Excel)
3. A building contractor invested $400,000 at time 0 and another $70,000 three years
later. Income from the investment was $100,000 per year in years 1 thru 8. The rate of return
on the investment was closest to:
(A) Less than 12% (B) 13% (C) 14% (D) 15%
4. An entrepreneurial engineer invested $100,000 to start a consulting business. In years 1 and 2,

she invested another $50,000 each year. Her income was $30,000 in year 1, $40,000 in year 2,
and amounts increasing by $10,000 per year thru 10. The rate of return on her investment was
closest to:
(A) Less than 20% (B) 22% (C) 25% (D) Over 30%
Multiple Rate of Return Values
An aspect of rate of return (ROR) calculations that can render them more troublesome than PW, AW, or
FW calculations is the possibility of multiple i* values satisfying the rate of return equation. This can occur
when there is more than one sign change in the net cash flow sequence. Up to now, we have only
considered problems wherein the net cash flow changed from a negative value in period 0 to a positive
value in all of the other periods. Such cash flows (i.e. having only one sign change) are
termed conventional or simple cash flows, and there is only one i* value that satisfies the rate of return
equation. Those that have more than one sign change are termed nonconventional or nonsimple cash
flows and for them, it is possible to have multiple i* values in the minus 100% to plus infinity range that
will satisfy the rate of return equation. Descartes rule states that the total number of real number roots
(i.e. i* values) is always less than or equal to the number of sign changes in the net cash flow sequence
(imaginary values or infinity may also satisfy the equation). Norstrom’s criterion states that there is only
one positive root in a cumulative cash flow sequence that starts negatively and changes sign only
once. The next example illustrates the use of these rules.
Example: The net cash flows associated with a certain project are shown below. The maximum number
of i* values that may satisfy the rate of return equation is:
Year 0 1 2 3
Net Cash Flow,$ +2000 -500 -8100 +6800
Solution: The net cash flows and cumulative cash flows are shown in the table 7.1 below. Since there
are two sign changes in the net cash flow sequence (i.e. + to – in years 0 to 1 and – to + in years 2 to 3),
there are a maximum of two i* values (according to Descarte’s rule).
Table 7.1 – Net and Cumulative Cash Flows
Year Net Cash Flow CumulativeCash Flow
0 +2000 +2000
1 -500 +1500
2 -8100 -6600
3 +6800 +200
Since the cumulative cash flow sequence starts with a positive number, Norstrom’s criterion is not
satisfied for only one root. Therefore, two i* values are possible (Solution of the ROR equation yields
values of 7.47% and 41.35%).
Sample Problem:
1. On the basis of Descarte’s rule, the number of possible i* values for the cash flow shown below is
(a) 1 (b) 2 (c) 3 (d) 4
Year 1 2 3 4 5 6
Net Cash Flow +200 -300 -10,000 +15,000 -50 +800
There are 4 changes in sign in net cash flow and it starts out positively (so Norstom’s criterion is not
satisfied).
2. For the cash flow shown below, the number of possible i* values is
(a) 1 (b) 2 (c) 3 (d) 4
Year 1 2 3 4 5
Revenue 10,000 5,000 12,000 20,000 30,000
Costs 8,000 6,000 15,000 17,000 11,000

First, find the net cash flow and then apply the rules. The net cash flow shows that there are
two changes in sign and it starts out positively (Norstom’s criterion is not satisfied)
Year 1 2 3 4 5
Net Cash Flow +2000 -1,000 -3,000 +3000 +19,000
3. For a net cash flow sequence which has the signs shown below, the maximum number of i*
values that may satisfy the rate of return equation is
(A) 1 (B) 2 (C) 3 (D) 4
Signs for net cash flow sequence: + + - + + + + + -
4. According to Descarte’s rule and Norstrom’s criterion, the number of possible i* values for the
cash flow sequence shown below is
(A) 1 (B) 2 (C) 3 (D) 4
Year 0 1 2 3 4 5
Net Cash Flow -10,000 -6000 +25,000 -3,000 +5,000 -2,000
Rate of Return of a Bond Investment
Example: A bond which has a face value of $10,000 is for sale for $8,000. The bond interest rate is 6%
per year, payable semiannually and the bond will mature in 10 years. The rate of return that would be
made per six months by the purchaser is closest to:
(A) Less than 5% per six months

(B) 6% per six months
(C) 8% per six months
(D) Over 9% per six months
Solution: I = (10,000) (0.06) / 2

= $300 every six months
The rate of return equation (in terms of present worth) is
0 = -8000 + 300 (P/A, i, 20) + 10,000 (P/F, i, 20)
Try i = 6%: 0 = -8000 + 300 (11.4699) + 10,000 (0.3118)

0 = -1441 i too large
Answer is (A)
Sample Problem:
1. An investor purchased a $20,000 bond for $16,000 two years ago. The bond interest rate is 6%
per year payable quarterly. The bond will mature in 20 years. If the investor thinks he can sell
the bond for $17,000 one year from now, what nominal rate of return per year will he make on
the investment?
I = (20,000) (0.06) / 4
= $300 per quarter
0 = -16,000 + 300 (P/A, i, 12) + 17,000 (P/F, i, 12)
Try i = 3%/quarter: 0 = -16,000 + 300 (9.9540) + 17,000 (0.7014)

0 = -1090
i too high (actual i = 2.3% per quarter)
Nominal i/yr. = 2.3 * 4 = 9.2%
2. A water utility that needed money for a treatment plant expansion issued $5 million worth of 20
year bonds having an interest rate of 8% per year, payable semiannually. Before the bonds
could be sold, however, the market interest rate increased to the point where the utility actually
received only $4.6 million when the bonds were sold. If the investment banker received
$100,000 for handling the sale of the bonds, what was the nominal interest rate per year in the
marketplace when the bonds were sold?
The amount received from the sale of the bonds was $4,600,000 + $100,000 = $4,700,000. The
bond interest is
I = 5,000,000 (0.08) / 2
= $200,000 per six months
The rate of return the purchasers will receive if they hold the bonds to maturity is
0 = -4,700,000 + 200,000 (P/A, i, 40) + 5,000,000 (P/F, i, 40)
Try i = 5%/six months: 0 = -4,700,000 + 200,000 (17.1591) + 5,000,000 (0.1420)

0 = -558,180 i too large (i = 4.3% per six months)
Nominal i/yr: 4.3 * 2 = 8.6%
3. What rate of return per year would be made through the purchase of a $15,000 bond which has
an interest rate of 8% per year, payable annually if the purchaser paid $16,000 for the
bond? The maturity date is 13 years from now. Assume the purchaser holds the bond to
maturity.
(A) 5% (B) 7% (C) 9% (D) over 11%
4. A $50,000 municipal bond is for sale for $42,000. The bond was issued 5 years ago with a
maturity date of 30 years from the date of issue. The bond interest rate is 7% per year payable
semiannually. A purchaser who purchases the bond now and holds it to maturity would earn a
rate of return per six months that is closest to:
(A) 2% (B) 4% (C) 6% (D) 8%

Benefit/Cost Evaluation of Alternatives
The benefit/cost method of analysis is a procedure wherein the magnitude of the benefits (B) associated
with an alternative is compared with the magnitude of is costs (C). In dividing the benefits by the costs, a
number equal to or greater than one would obviously mean that benefits exceed costs, indicating
economic attractiveness.
A conventional B/C analysis is used almost exclusively for government projects. As such, the following
terms apply:
Benefits (B) - Favorable consequences to the public

Disbenefits (D) - Unfavorable consequences to the public
Costs (C) - Consequences to the government (savings to the government are regarded as negative costs)
The sign convention treats benefits and costs as positive values and disbenefits as negatives. Thus, a
conventional benefit-to-cost ratio is calculated as
B/C = (B - D) / C
In non-government evaluations, some analysts place maintenance and operation (M&O) costs in the
numerator as disbenefits, in which case the resulting ratio is known as a modified B/C ratio.
A B/C ratio can be conducted in terms of PW, AW, or FW values, as long as all values are expressed in
the same units. The next example illustrates the calculations involved.
Example: The U.S. Parks and Wildlife Service is considering providing public access to a previously
inaccessible portion of Carlsbad Caverns. The cost of the project is expected to be $1.8 million, with
maintenance expected to cost $60,000 per year. However, increased tourism is expected to generate
additional income of $250,000 per year to local businesses. Calculate the B/C ratio for the permanent
project using an interest rate of 8% per year.
Solution: Using an AW analysis,
B = 250,000
C = 1,800,000 (0.08) + 60,000 = 204,000
B/C = 250,000 / 204,000 = 1.22
Therefore, the project should be undertaken.
When only one alternative is involved, it is obviously being compared against the do-nothing alternative.
When two or more mutually exclusive alternatives are being compared, it is important to insure that the
alternative with the larger equivalent cost is also the one which yields the larger equivalent benefits.
When this is not the case, the higher cost alternative is obviously eliminated by inspection. Also, when
two or more alternatives are involved, do-nothing is added as an alternative unless otherwise stated or
when only costs are involved in the calculations, as shown in the next example.
Example: The costs associated with two routes for a new road are shown below. Using an interest rate
of 8% per year, determine which route should be selected according to a B/C analysis over a 25 year
study period.
Long Route Short Route
First cost, $ 10,000,000 15,000,000

Road user costs, $/yr 800,000 500,000
Life, yrs 30 30
Solution:
The consequences to the public are the road user costs. The benefits are the lower road-user costs
associated with the shorter route (the higher cost alternative). Thus,
B = 800,000 - 500,000
= $300,000 per year
C = (15,000,000 - 10,000,000) (A/P, 8%, 25)

= 5,000,000 (0.09368)
= $468,400
B/C = 300,000 / 468,400

= 0.64
Therefore, build the long route.
When two or more alternatives under consideration are independent rather than mutually exclusive,
then each one is compared only against the do-nothing alternative and all are selected which have a B/C
ratio >= 1. Mutually exclusive multiple alternatives are handled just as in a rate of return analysis. That
is, they must first be ranked in terms of increasing initial investment cost and then compared on an
incremental basis as shown in the next example.
Example: Determine which of the four alternatives shown below should be selected on the basis of a
B/C analysis using an interest rate of 10% per year.
Solution:
First rank the alternatives in terms of increasing initial investment cost, including do-nothing: DN, Z, X,
W, Y. Next, compare the first two alternatives on an incremental basis:
DN vs Z
B = 250,000
D = 20,000
C = 1,200,000 (A/P, 10%, 20) + 80,000
= 1,200,000 (0.11746) + 80,000
= $220,952
B/C = (250,000 - 20,000) / 220,952

= 1.04 eliminate DN
Z vs X
B = (260,000 - 250,000) - (15,000 - 20,000)

= $15,000
C = (1,500,000 - 1,200,000) (A/P, 10%, 20) + (60,000 - 80,000)

= 300,000 (0.11746) - 20,000
= $15,238
B/C = 15,000 / 15,238

= 0.98 eliminate X
Z vs W
B = (269,000 - 250,000) - (13,000 - 20,000)

= $26,000
C = (1,600,000 - 1,200,000) (A/P, 10%, 20) + (50,000 - 80,000)

= 400,000 (0.11746) - 30,000
= $16,984
B/C = 26,000 / 16,984

= 1.53 eliminate Z
W vs Y
B = (282,000 - 269,000) - (22,000 - 13,000)

= 4,000
C = (1,900,000 - 1,600,000) (A/P, 10%, 20) + (35,000 - 50,000)

= 300,000 (0.11746) - 15,000
= $20,238
B/C = 4,000 / 20,238
= 0.20 eliminate Y
Therefore, select alternative W
Sample Problem:
1. A decrease in tourism due to partial closure of a National Park would be considered as which of
the following in a B/C analysis
(A) Cost (B) Benefit (C) Disbenefit (D) Savings
2. The public works director for a western city is considering an expansion of an existing landfill. The
relevant data are as follows:
Capital investment, $ 2,300,000

Annual operating cost, $/yr 400,000
Annual benefits, $/yr 650,000
One-time disbenefits in yr. 0, $ 150,000
Life, years 15
Discount rate, %/yr 8
The benefit cost ratio at an interest rate of 8% per year is closest to
B = $650,000
D = 150,000 (A/P, 8%, 15)
= 150,000 (0.11683)
= $17,525
C = 2,300,000 (A/P, 8%, 15) + 400,000

= 2,300,000 (0.11683) + 400,000
= 668,709
𝐵 650,000 − 17,525
= = 0.95
𝐶 668,709
3. A veterans organization is considering a permanent memorial for soldiers who died while serving
in the armed forces during non-wartime periods. The cost of the memorial (including land and all
structures) is expected to be $8,000,000. Maintenance of the site will cost $300,000 per
year. Benefits and disbenefits have been identified which amount to $900,000 and $40,000 per
year, respectively. At an interest rate of 6% per year, the B/C ratio is closest to:
B = 900,000
D = 40,000
C = 8,000,000 (0.06) + 300,000
= 780,000
𝐵 900,000 − 40,000
= = 1.1
𝐶 780,000
4. A regional school district is considering four sites for locating a new “super school”. The school
has identified several advantages (B) and costs (C) with each site and has calculated their present
worths (in millions) as shown below. Which site should be selected by the board, assuming that
one of them must be selected (i.e. do-nothing is not an option).
PW of PW of
Site No. Benefits Costs
1 12 10 (A) Site 1
2 8 14 (B) Site 2
3 4 3 (C) Site 3
4 21 24 (D) Site 4
Rank sites according to increasing cost and then compare them incrementally (do-nothing is not
an option): Ranking = 3, 1, 2, 4
Site 3 vs 1
𝐵 12−4
= 10−3 = 1.14; 𝑒𝑙𝑖𝑚𝑖𝑛𝑎𝑡𝑒 3
𝐶
Site 1 vs 2
By inspection, site 2 has a higher cost and less benefits. Therefore, eliminate site 2
Site 1 vs 4
𝐵 21 − 12
= = 0.64; 𝑒𝑙𝑖𝑚𝑖𝑛𝑎𝑡𝑒 4
𝐶 24 − 10
5. state highway department is considering the economics of constructing a "loop" around a certain
city to ease congestion caused by "through traffic". The consequences expected from
implementation of the project are shown below. At an interest rate of 8% per year, its B/C ratio is
closest to:
Initial cost, $ 15,000,000

Annual maintenance cost, $/yr 200,000
Annual benefits, $/yr 2,300,000
Annual disbenefits, $/yr 130,000
Life, years 20
B = $2,300,000
D = 130,000
C = 15,000,000 (A/P, 8%, 20) + 200,000
= 15,000,000 (0.10185) + 200,000
= 1,728,000
𝐵 2,300,000 − 130,000
= = 1.26
𝐶 1,728,000
Economic Service Life
Until now, the life of an asset was always provided as part of the economic data (i.e. first cost, annual
operating cost, salvage value, etc). In this section, we show how the life of an asset is determined.
It should be obvious that an asset should be kept for a period of time that would minimize its cost to the
company. The time that would do that is known as its economic service life (also called its minimum cost
life) and it is found by calculating the asset's annual worth over various time periods and selecting the
time that corresponds with the lowest AW value. The next example illustrates the procedure.
Example: An asset which has a first cost of $40,000 is expected to have an annual operating cost of
$15,000 per year. It will provide the needed service for a maximum of 6 years. If the salvage value
changes as shown below, determine the economic life of the asset at 20% per year.
End of Year
Year Salvage value, $
1 $32,000
2 30,000
3 24,000
4 20,000
5 11,000
6 0
Solution: Solve for the AW of the asset for years 1 thru 6 and then pick the lowest value to determine
the economic life. For one year of retention, the AW is:
AW1 = -40,000 (A/P, 20%, 1) - 15,000 + 32,000

= -$31,000
For two years of retention, the AW is:
AW2 = -40,000 (A/P, 20%, 2) - 15,000 + 30,000 (A/F, 20%, 2)

= -$27,545
For three years of retention, the AW is:

AW3 = -40,000 (A/P, 20%, 3) - 15,000 + 24,000 (A/F, 20%, 3)
= -$27,396
Similarly, for years 4, 5, and 6, the AW values are -$26,726, -$26,897, and -$27,028. The lowest AW is -
$26,726 at n = 4. Therefore, the economic life is 4 years.
Sample Problem:
The Two problems are based on the following statement:
The cash flow for a machine with an initial cost of $80,000 is shown below. The company’s MARR is 20%
per year.
End of Year
Year Operating Cost,$ Salvage Value, $
1 30,000 55,000
2 32,000 40,000
3 35,000 30,000
4 40,000 15,000
5 47,000 9,000
6 61,000 0
1. The economic life of the machine is:

Solve for the AW of the machine for years 1 thru 6 to find the time that yields the lowest AW. For n
=1, AW is:
AW1 = -80,000 (A/P, 20%, 1) - 30,000 + 55,000 (A/F, 20%, 1)

= -$71,000
For n = 2, AW is
AW2 = -80,000 (A/P, 20%, 2) - 30,000 (P/F, 20%, 1) (A/P, 20%, 2) - 32,000
(A/F, 20%, 2) + 40,000 (A/F, 20%, 2)
= -$65,091
For n = 3, AW is
AW3 = -80,000 (A/P, 20%, 3) - [30,000 (P/F, 20%, 1) + 32,000 (P/F, 20%, 2)
+ 35,000 (P/F, 20%, 3)] (A/P, 20%, 3) + 30,000 (A/F, 20%, 3)
= -$61,769
Similar calculations for n = 4, 5, and 6 yield AW values of -$61,626, -$60,870, and -$62,212
Therefore, the economic life is 5 years

2. The annual worth of the machine over a time period equal to its economic life is closest to:
(A) -$61,770 (B) -$60,870 (C) -$58,210 (D) -$56,680
From the calculations is problem 1 above, the lowest annual worth is -$60,870 at n = 5.
3. Data for metal-trimming machinery are shown below. The original cost of the machines was
$210,000. The machinery can be sold now for $105,000. At an interest rate of 20% per year, the
economic life of the machinery is closest to:
4. For the data in problem 1 above, the AW of the machine in the year corresponding to its economic
life is closest to:
(A) -$100,090 (B) -$99,345 (C) -$98,200 (D) -$96,700
Performing a Replacement Study
Up to this point, when two (or more) alternatives were available for comparison, it was assumed
that neither one was currently owned. However, when one of the alternatives under evaluation is
presently owned, the evaluation is called a replacement (or retirement) analysis. In such a study, the
presently-owned asset is called the defender and its possible replacement is called the challenger. The
analyst then takes the viewpoint of an outsider or consultant whose perspective is that neither asset is
currently owned. Therefore, to acquire the services of the defender, it would have to be 'purchased' at a
price equal to its market value. This market value would then represent the defender's first cost, P, with
all other estimates (operating costs, salvage value, and life) made just as if the defender were to be
purchased now by the company.
The economic analysis is then conducted using any of the alternative comparison techniques discussed
thus far. However, an AW analysis is usually selected because the alternatives (i.e. the defender and
challenger) typically have different lives. The next example illustrates the procedure.
Example: A construction company is evaluating whether it should replace a currently-owned piece of

equipment now or at some time in the future. The company paid $75,000 for the equipment five years
ago. It can be sold now for $20,000. If kept, it will have an operating cost of $38,000 per year with a salvage
value of $5,000 after its remaining economic life of 7 more years. A new piece of equipment which will
perform the same service can be purchased for $90,000. It is expected to have an annual operating cost
of $25,000 per year with a salvage value of $15,000 after its 10-year economic life. At an interest rate of
18% per year, should the company keep the existing equipment or replace it with the challenger?
Solution:
The economic values that should be used in the comparison are as follows:
Defender Challenger
P = 20,000 P = 90,000
AOC = 38,000 AOC = 25,000
SV = 5,000 SV = 15,000
n = 7 years n = 10 years
AWD = -20,000 (A/P, 18%, 7) - 38,000 + 5000 (A/F, 18%, 7)

= -20,000 (0.26236) - 38,000 + 5000 (0.08236)
= -$42,835
AWC = -90,000 (A/P, 18%, 10) - 25,000 + 15,000 (A/F, 18%, 10)
= -90,000 (0.22251) - 25,000 + 15,000 (0.04251)
= -$44,388
Therefore, the company should keep the presently-owned equipment
An annual worth comparison like the one conducted above assumes that the services provided by both
the defender and the challenger can be acquired in succeeding life cycles at the same cost as calculated
for the first life cycle. When this assumption cannot be made, then the costs beyond the first life cycle
have to be estimated for both assets over a fixed study period and evaluated accordingly. The next
example illustrates this situation.
Example: A manufacturing company owns a machine which has the economic values shown below. The
company can use the present machine for a maximum of only 3 more years, after which it will have to
be replaced because a machine of that type will not be able to provide the service the company will
need beyond that point. The challenger shown below will provide the service now or at any time in the
future, depending on when the defender is replaced. Use a 10 year study period and an interest rate of
15% per year to determine whether the company should replace the machine now or do it three years
from now.
Defender Challenger
MV = $10,000 P = $120,000
AOC = $50,000 AOC = $30,000
SV = 0 SV after 7 years = $25,000
n = 3 years SV after 10 years = $15,000
Solution: The comparison is to be done over a 10-year period. Note that if the challenger replaces the
defender in year 3, its salvage value at the end of the 10-year study period will be $25,000. Using a PW
comparison,
PWD = -10,000 - 50,000 (P/A, 15%, 3) - 120,000 (P/F, 15%, 3) - 30,000(P/A, 15%, 7) (P/F, 15%, 3) +
25,000 (P/F, 15%, 10)
= -$278,950
PWC = -120,000 - 30,000 (P/A, 15%, 10) + 15,000 (P/F, 15%, 10)
= -266,855
Therefore, the company should replace the machine now.
Sample Problem:
1. A steel company is evaluating whether or not it should replace a certain machine in a production
line. The machine and ancillary equipment was purchased 12 years ago for $175,000. Several small
steel recyclers who make re-bar are interested in purchasing the used equipment if the company
decides to replace it. Recyclers A and B have offered to pay $25,000 and $29,000, respectively for
the equipment. Recycler C has offered to trade some of the products it makes for the machine. The
steel company places a value of $21,000 on the products it could receive in trade, but the recycler
says their value is $34,000. When calculating the annual worth of the machine, the value of P that
should be used by the steel company in the AW equation is:
(A) $21,000 (B) $25,000 (C) $29,000 (D) $34,000
The money that is foregone by keeping the machine is $29,000.
2. A machine that was purchased three years ago for $160,000 has a current market value of $80,000.
This market value will decrease by $20,000 each year until it has no value 4 years from now. The
operating cost of the machine is projected to be $25,000 if kept for 1 year, $30,000 if kept for 2
years, with amounts increasing by $5000 each year thru year four. At an interest rate of 15% per
year, the annual worth of the machine if kept for two years is closest to:
(A) -$61,350 (B) -$57,930 (C) -$54,720 (D) -$51,100
AW2 = -80,000 (A/P, 15%, 2) - [25,000 + 5000(A/G, 15%, 2)] + 40,000(A/F, 15%, 2)
= -80,000 (0.61512) - [25,000 + 5000 (0.4651)] + 40,000 (0.46512)
= -$57,930
3. The AW of the machine in problem 2 above if kept for its economic life (at i = 15% per year) is
closest to:
(A) -$57,000 (B) -$58,000 (C) -$59,000 (D) -$60,000
Find AW for each of four years and pick lowest value.

AW1 = -80,000 (A/P, 15%, 1) - 25,000 + 60,000
= -80,000 (1.15) + 35,000
= -$57,000
AW2 = -$57,930 (from question 2 above)
AW3 = -80,000 (A/P, 15%, 3) - [25,000 + 5000 (A/G, 15%, 3)] + 20,000 (A/F, 15%, 3)
= -80,000 (0.43798) - [25,000 + 5000 (0.9071)] + 20,000 (0.28798)
= -$58,814
AW4 = -80,000 (A/P, 15%, 4) - [25,000 + 5000 (A/G, 15%, 4)]

= -80,000 (0.35027) - [25,000 + 5000 (1.3263)
= -$59,653
Lowest AW is for n = 1 where AW = -$57,000
4. An engineering economist calculated the annual worths shown below for a certain machine (the
defender) and a challenger if kept for various years. The defender cannot be replaced with a similar
asset (i.e. its AW values apply only to the current years remaining in its life). Whenever the defender
is replaced, it will be replaced with the challenger and the challenger will have the annual worth
values shown. If the company tells the engineer to use a study period of 5 years and an interest rate
of 15% per year, the defender should be replaced in year.
(A) 0 (i.e.now) (B) 1 (C) 2 (D) 3
Find the annual worth values for five years for all combinations of the defender and challenger and
select the lowest one. Thus, if the defender is kept for one year,
AW1 = [-40,000 (F/P, 15%, 4) - 48,000 (F/A, 15%, 4)] (A/F, 15%, 5)
= [-40,000 (1.7490) - 48,000 (4.9934)] (0.14832)
= -$45,926
AW2 = -36,000 (P/A, 15%, 2) (A/P, 15%, 5) - 49,000 (F/A, 15%, 3)(A/F, 15%, 5)
= -36,000 (1.6257) (0.29832) - 49,000 (3.4725) (0.14832)
= -$42,696
AW3 = -45,000 (P/A, 15%, 3) (A/P, 15%, 5) - 55,000 (F/A, 15%, 2)(A/F, 15%, 5)
= -45,000 (2.2832) (0.29832) - 55,000 (2.1500) (0.14832)
= -$48,189
AW4 = -$48,000
AW5 = -$44,000
Lowest AW for 5-year study period occurs when the defender is kept for 2 years.
Answer is (C)
5. The annual worth of the most economical situation in problem 4 above is closest to:
(A) -$42,700 (B) -$45,500 (C) -$48,300 (D) -$49,900
From the solution in problem 4 above, lowest AW is AW2 = -$42,696.
6. An asset that was purchased three years ago for $85,000 has a current market value of $35,000.
Its monthly operating cost is $2000 in month 1 increasing by $50 per month. It is expected to have
a salvage value of $10,000 after its remaining 4 year economic life. A suitable challenger has a first
cost of $90,000, a monthly operating cost of $1,500 and a salvage value of $20,000 after its 9 year
economic life. At an interest rate of 18% per year compounded monthly, the equivalent monthly
worth of the defender is closest to:
(A) -$5,386 (B) -$6,015 (C) -$6,995 (D) -$7,425
7. An existing asset which has a current market value of $40,000 is expected to have the operating
costs and salvage values shown below. Its challenger will have an AW of -$42,000 over its 10 year
economic life. At an interest rate of 20% per year, in what year should the challenger replace the
defender? Assume the defender's AW values could be repeated in succeeding life cycles (i.e.
similar AW values for used assets will be available into the indefinite future).
(A) Replace now

(B) Replace in 1 year
(C) Replace in 2 years
(D) do not replace with challenger
Breakeven Analysis
A breakeven analysis involves the determination of the value of a specified variable that will make the
revenues exactly equal to the costs - i.e. breakeven. This technique can be used for one project or for
determining the best of two or more alternatives. The basic technique involves identifying the variable of
interest and then finding the magnitude of that variable that will lead to breakeven. Once the breakeven
point is known, the available information about whether that variable is likely to have a value above or
below the breakeven point can be used to determine which course of action should be taken. The next
example illustrates a breakeven calculation.
Example: A chemical company is trying to decide which type of coating to use inside its chemical storage
tanks. A bituminous coating will cost $6,000 initially and will last for 10 years if 'touched up' at the end
of year 4. An epoxy coating will cost $15,000, but it will last for 10 years with no other maintenance
required. At an interest rate of 15% per year, how much would the touch-up cost have to be in order for
the alternatives to break even?
Solution: Write an equation which sets the costs of the two alternatives equal to each other and then
solve for the unknown value. Using a present worth equation and letting x represent the value of the
touch-up in year 4,
-6000 - x (P/F, 15%, 4) = -15,000

x (0.5718) = 9,000
x = $15,740
Thus, if the touch-up cost is expected to be less than $15,740 four years from now, the bituminous
coating should be used. Otherwise, select the epoxy coating.
Breakeven-type problems oftentimes involve determining the level of production of a certain item that
is required for breakeven. Problems of this type usually have fixed costs which do not vary with level of
production (like rent, insurance, etc) and variable costs which vary directly with level of production (like
labor, materials, etc). The next example illustrates this type of problem.
Example: The cost of a machine for producing a certain part is $40,000. The machine is expected to have
a maintenance cost of $14,000 and an $8,000 salvage value after its 5-year economic life. If the variable
cost for producing the part is $1.50 per unit and the part can be sold for $4.00 per unit, how many parts
per year must the company sell in order to breakeven at an interest rate of 12% per year?
Solution - Let x represent the number of parts per year required for breakeven. The annual worth
equation is:
0 = -40,000 (A/P, 12%, 5) - 14,000 + 8000 (A/F, 12%, 5) - 1.50x + 4.00x

0 = -40,000 (0.27741) - 14,000 +8000 (0.15741) + 2.50x
2.50x = 23,837
x = 9,534 parts/yr
Thus, if the company expects to sell more than 9,534 parts per year, it should produce the part. At any
sales level below 9,534 parts per year, the company would lose money and, therefore, should not invest
in the machine.
When the economic analysis involves two alternatives with variable costs, the annual worths of the
alternatives are set equal to each other and the equation is solved for the unknown quantity as shown in
the next example.
Example: Two methods of weed control in an irrigation ditch are under consideration. Method A
involves lining the ditch at a cost of $30,000. The lining is expected to last 20 years. Maintenance with
this method will cost $2 per mile per year. Method B involves spraying a chemical which costs $45 per
gallon, with one gallon capable of treating 10 miles. Spraying equipment will cost $2,500 and will have a
life of 3 years with no salvage value. At an interest rate of 10% per year, (a) how many miles of ditch
must require treatment in order for the two methods to breakeven, and (b) if 400 miles of ditch must be
treated each year, which method should be selected?
Solution :
(a) Set the annual worths for the two methods equal to each other and solve for x miles/yr:
-30,000 (A/P, 10%, 20) - 2x = -2500 (A/P, 10%, 3) - 45/10x

-30,000 (0.11746) - 2x = -2500 (0.40211) - 4.5x
2.5x = 2518.53
x = 1,007 miles/year
(b) At 400 miles per year, the spray method has the lower cost (check by replacing x with 400 in each
equation and get -$4324 vs $-2805)
Sample Problem:
1. The fixed costs for producing a certain item are $200,000 per year. If the item sells for $50 per unit
and it has a variable cost of $10 per unit, the number of units the company must sell each year to
break even is:
(A) 1000 (B) 2000 (C) 4000 (D) 5000
-200,000 - 10x = -50x

x = 5000
2. A company can purchase a certain machine or rent one. If purchased, the machine will cost $15,000
and will have a 5-year life with a 10% salvage value. It’s operating cost will be $8000 per year. If
the machine is rented, it will cost $400 per day. At an interest rate of 10% per year, the minimum
number of days the machine must be needed to justify its purchase is:
(A) 30 (B) 40 (C) 50 (D) 60
-15,000 (A/P, 10%, 5) - 8,000 + 1,500 (A/F, 10%, 5) = -400x

-15,000 ( 0.2638 ) - 8,000 + 1,500 (0.1638) = -400x
x = 29.2
3. A certain part can be obtained by either of two methods. Method X will have fixed costs of
$50,000 per year and variable costs of $25 per unit. Method Y will have fixed costs of $80,000 per
year and variable costs of $8 per unit. The number of units that must be produced each year for
the two methods to breakeven is closest to:
(A) 1,765 (B) 1,921 (C) 2,365 (D) 2,832
4. A company whose employees make frequent trips to Dallas is considering the option of purchasing
a small condo for use by company personnel on overnight assignments. The condo will cost
$125,000 to buy and will have monthly maintenance costs of $260. Variable costs are expected to
be $20 each day that someone stays there. The company expects to be able to sell the condo in 5
years for $150,000. Alternatively, the cost for employees to stay in acceptable hotels is $270 per
day. At an interest rate of 0.5% per month, how many days per month (minimum) must the condo
be used to justify its purchase?
(A) 3 (B) 7 (C) 12 (D) 20
Inflation
Present Worth Computations with Inflation
Inflation is an increase in the amount of money necessary to obtain the same amount of goods. This
occurs when the value of the currency goes down from one time period to the next. Different-valued
currencies (in different time periods) must be accounted-for, because economic calculations span many
time periods. That is to say, we must account for not only for money's time value, but also its actual
value. Up to now, we assumed that the value (i.e. worth) of the currency was the same from one time
period to the next. In this chapter, we will relax that assumption.
There are two ways to make meaningful economic calculations when the value of the currency is
changing: (1) Convert the amounts that occur in the different time periods into amounts that make the
currencies have the same value before time value calculations are made, or (2) change the interest rate
that is used in the economic equations in such a way that it accounts for the different valued currencies
as well as the time value of money.
The first case is called making calculations in constant-value dollars (also known as today's dollars).
Money in one period of time, t1, will have the same value as money in another period of time, t2, when
the t2 amount is divided by the inflation that occurred between the two time periods. The general
equation is,
𝑑𝑜𝑙𝑙𝑎𝑟𝑠 𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡2
𝐷𝑜𝑙𝑙𝑎𝑟𝑠𝑖𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡1 = 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 𝑡
1 𝑎𝑛𝑑 𝑡2
Let dollars in period t1 be called today's dollars and dollars in period t2 be called future dollars or then-
current dollars. If f represents the inflation rate per period and n is the number of periods
between t1 and t2, Equation above becomes
𝑡ℎ𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑑𝑜𝑙𝑙𝑎𝑟𝑠
𝑇𝑜𝑑𝑎𝑦′𝑠 𝑑𝑜𝑙𝑙𝑎𝑟𝑠 = (1+𝑓)𝑛
Once this conversion has been made, then the interest rate that must be used in the economic
equations is the real interest rate. The real interest rate, i, is the rate that represents time-value-of-
money-only considerations when money is moved from one time period to another. This is the rate that
was used in all calculations up to this point. The market interest rate (or inflated interest rate) is a
combination of the real interest rate, i, and the inflation rate, f. In equation form, the inflated interest
rate, if, is
𝑖𝑓 = 𝑖 + 𝑓 + (𝑖 ∗ 𝑓)
where 𝑖 = real interest rate

𝑓 = inflation rate
𝑖𝑓 = inflated interest rate
Since the market interest rate (i.e. inflated interest rate) has inflation built into it, it automatically
accounts for different-valued currencies in different time periods. Thus, when using this interest rate in
the economic equations, it is not necessary to convert the then-current dollars into today's dollars in
order to move money from one time period to the next.
Thus, two procedures can be used for making present worth calculations when inflation must be taken
into account:
(1) Convert then-current dollars into constant value dollars (by dividing them by the inflation rate) and
then using the real-interest rate in the equations, or
(2) do-not convert then current dollars into today's dollars (i.e. leave them as then-current) but use the
inflated interest rate, if, in the economic equations. The next example illustrates these calculations.
Example: Find the present worth of $20,000 (then-current dollars) in year 10 at a real interest rate of
10% per year and an inflation rate of 6% per year when using (a) the real interest rate, and (b) the
inflated interest rate
Solution - (a) when using the real interest rate, the currency must be expressed in constant value dollars.
Thus,
20,000
Constant value dollars = = $11,168
(1 + 0.06)10
Now, use the real interest rate (i.e. 10%) in the P/F formula:
P = 11,168 (P/F, 10%, 10)

= 11,168 (0.3855)
= $4,305
(b) Find the inflated interest rate and use then-current dollars in the P/F formula:
𝑖𝑓 = 0.10 + 0.06 + (0.10) (0.06)
= 16.6%
P = 20,000 (P/F, 16.6%, 10)

= 20,000 [ 1/ (1 + 0.166)^10]
= $4,305
Thus, the present worth could be found using either procedure, but the latter is usually faster when
there are many cash flows that must be converted into constant value dollars (such as when a uniform
series is involved)
Sample Problems:
1. The cost of updating certain equipment will be $70,000 three years from now. If the real interest
rate is 7% per year and the inflation rate is 3% per year, the present worth of the equipment (with
inflation included) is closest to:
𝑖𝑓 = 0.07 + 0.03 + (0.07) (0.03)

= 10.21%
P = -70,000 (P/F, 10.2%, 3)
= -70,000 1 / (1 + 0.102)3
= -$52,310
The next two problems are based on the following statement:
Machine X will cost $30,000 to purchase and it will have an operating cost of $20,000 per year and a
$7000 salvage value after 5 years. The real interest rate is 8% per year and the inflation rate is 5% per
year.
2. The present worth of the machine at the market interest rate is closest to
Market interest rate = if
𝑖𝑓 = 0.08 + 0.05 + (0.08) (0.05)

= 13.4%
PW = -30,000 - 20,000 (P/A, 13.4%, 5) + 7000 (P/F, 13.4%, 5)

= -$95,931
3. The present worth of the machine using the inflated interest rate is closest to:
𝑖𝑓 = 0.08 + 0.05 + (0.08) (0.05)

= 13.4%
PW = -30,000 - 20,000 (P/A, 13.4%, 5) + 7000 (P/F, 13.4%, 5)

= -$95,931
The next three problems are based on the following statement:

Assume the real interest rate is 6% per year and the inflation rate is 2% per year. A company expects to
purchase a machine for $25,000 in year 15.
4. If inflation is to be considered, the present worth of the machine is closest to:
(A) -$7,751 (B) -$10,431 (C) -$18,575 (D) -$21,262Top of Form
5. In today's dollars, the cost of the machine in year 15 is closest to:
(A) -$7,751 (B) -$10,431 (C) -$18,575 (D) -$21,262
6. If the cost of the machine is expressed in today's dollars, the interest rate that should be used in
the present worth equation is closest to:
(A) 2% (B) 6% (C) 8.12% (D) 10.12%
Future Worth Computations With Inflation
In future-worth calculations, the future sum of money can represent any one of four different amounts:
Case 1. The actual amount of money that will be accumulated at time n.

Case 2. The buying power, in terms of today's dollars, of the actual amount of money accumulated at
time n.
Case 3. The number of future dollars required at time n to maintain the same purchasing power as a
dollar today; that is, no interest is considered.
Case 4. The number of dollars required at time n to maintain purchasing power and earn a stated real
interest rate. (Actually this case is the same as Case 1 when the company's real rate of return is the
same as the real rate of return in the marketplace.)
It should be clear that for case 1, the actual amount of money accumulated is obtained by using the
market interest rate, which we identify by if in this chapter because it includes inflation.
For case 2, the buying power of the future dollars is determined by using the market interest rate if to
calculate F and then dividing by (1 + f)n. Division by (1 + f)n deflates the inflated dollars. In equation
form, case 2 is
𝐹
𝐹 = 𝑃 ( , 𝑖, 𝑛) /(1 + 𝑓)𝑛
𝑃
As an illustration, suppose $1000 earns the market rate of 10%-per-year interest for 7 years. If the inflation rate for each y
F = [ 1000 (F/P, 10%, 7) ] / (1.04)^7

= $1,481
Also for case 2, the future amount of money accumulated with today's buying power could equivalently
be determined by calculating the real interest rate and using it in the F/P factor to compensate for the
decreased purchasing power of the dollar. This real interest rate can be obtained by solving for i in the
inflated interest rate equation:
𝑖𝑓 = i + f + ( i * f )
= i (1 + f) + f
i = ( 𝑖𝑓 - f) / (1 + f )
This equation allows us to calculate the real interest rate from the market (inflated) interest rate. The
real interest rate i represents the rate at which present dollars will expand with their same buying power
into equivalent future dollars. For the $1000 amount mentioned previously,
0.10−0.40
𝑖= = 0.0577 = 5.77%
1+0.04
F = 1000 (F/P, 5.77%, 7) = $1481
The calculation for i shows that the stated (market) interest rate of 10% per year has been reduced to
less than 6% per year because of the erosive effects of inflation.
Case 3 recognizes that prices increase during inflationary periods, and, therefore, purchasing something
at a future date will require more dollars than are required now for the same thing. Simply put, future
(then-current) dollars are worth less, so more are needed. No interest rate is considered at all in this
case. This is the situation present if someone asks, "How much will a car cost in 5 years if its current cost
is $15,000 and its price will increase by 6% per year?" (The answer is $20,073.38). No interest rate, only
inflation, is involved. To find the cost, F, substitute f directly for the interest rate in the F/P factor.
𝐹 = 𝑃(1 + 𝑓)𝑛 = 𝑃(𝐹/𝑃, 𝑓, 𝑛)
Thus, if $1000 represents the cost of an item which is escalating in price exactly in accordance with the inflation rate of 4%
F = 1000 (F/P, 4%, 7) = $1316

Sample problems:
1. A person deposits $15,000 into an account at a time when the inflation rate is 5% per year. How
much would have to be in the account 10 years from now if the person wants to earn a real rate of
return of 4%?
𝑖𝑓 = 0.04 + 0.05 + (0.04) (0.05) = 9.2%
F = 15,000 (F/P, 9.2%, 10)

= 15,000 (1 + 0.092)10
= $36,167
Bottom of Form
F = 15,000 (F/P, 5%, 10)
= 15,000 (1 + 0.05)10
= $24,433
The next three questions are based on the following statement:
A manufacturing company is considering the purchase of a machine which will have a cost of $60,000.
As the engineering economist for the company, the president wants you to answer a few questions. The
president tells you that the company expects to make a real rate of return of 10% on its investments and
that the inflation rate is expected to be 4% per year.
2. 1. If the company does not purchase the machine now, how much would it be expected to cost 3
years from now?
(a) $67,492 (b) $79,860 (c) $89,832 (d) $91,423

3. What interest rate will you have to use in engineering economic equations if all dollar amounts are
expressed in today's dollars?
(a) 4% (b) 10% (c) 12.2% (d) 14.4%

4. What interest rate will you have to use in engineering economic equations if all dollar amounts are
expressed in then-current dollars?
(a) 4% (b) 10% (c) 12.2% (d) 14.4%
Capital-Recovery and Sinking-Fund Calculations With Inflation Considered
In capital-recovery calculations, current capital dollars are recovered with future inflated dollars. Since
future dollars have less buying power than do today's dollars, it is obvious that more dollars will be
required to recover the present investment. This suggests the use of the inflated or market interest rate
in the A/P formula. For example, if $1000 is invested today at a real interest rate of 10% per year when
the inflation rate is 8% per year, the annual amount of capital that must be recovered each year for 5
years in then-current dollars will be
A = 1000 (A/P, 18.8%, 5) = $325.59
On the other hand, the decreased value of dollars through time means that investors may be willing to
spend fewer present (higher-value) dollars to accumulate a specified amount of future (inflated) dollars.
The annual equivalent (when inflation is considered) of F = $1000 five years from now in then-current
dollars is
A = 1000 (A/F, 18.8%, 5) = $137.59
Sample Problem:
1. If a company spends $20,000 now for new equipment, the amount it must receive each year to
recover its investment in 5 years at a real interest rate of 7% and an inflation rate of 3% per year is
closest to:
if = 0.07 + 0.03 + (0.07) (0.03)

= 10.21%
A = 20,000 (A/P, 10.21%, 5)

= $5,304
2. How much must a company set aside each year if it wants to have $35,000 available in four years?
The market interest rate is 12% per year with an inflation rate of 8% per year.
The company will earn interest at the market rate of 12%. Thus,
A = 35,000 (A/F, 12%, 4)
= 35,000 (0.20923)
= $7,323
3. If a person wants to have $40,000 in an account 12 years from now, the amount of money that
must be deposited each year when the market interest rate is 8% and the inflation rate is 5% per
year is closest to:
(a) Less than $2000 (b) $2108 (c) $3,251 (d) Over $3300
4. The first cost of a piece of machinery is $60,000. The machine will be used for 6 years, after which
time it will be salvaged for $10,000. The machine's operating cost is expected to be $17,000 per
year. If the inflation rate is 4% per year and the company's minimum attractive real rate of return
is 10% per year, the AW of the machine over its 6 year life is closest to:
(a) -$24,362 (b) -$26,938 (c) -$29,480 (d) -$31,439
Cost estimation
Cost Indexes
A cost index is a ratio of the cost of something today to its cost at some time in the past. As such, it is a
tool which can be used to estimate the cost of things today based on their cost some time ago. This
endeavor is especially important to engineers who are involved in design because cost is probably the
single most important factor in the design of anything.
Many of the indexes that are frequently used by engineers are updated monthly and published in
professional journals like Engineering News Record (ENR) and Chemical Engineering. Table 15-1 shows
the values for three of the most common indexes for the years 1985 thru 1999.
The general equation for updating costs through the use of a cost index is:
𝐶𝑡 = 𝐶𝑜 (𝐼𝑡 )/𝐼0
where 𝐶𝑡 = estimated cost at present time t
𝐶𝑜 = cost at previous time to
𝐼𝑡 = Index value at time t
𝐼0 = Index value at time to
The next example illustrates its use:
Example: An engineer involved in a major construction project discovered that a similar project had
been completed in 1990. If the previous project had a construction cost of $1.545 million, what would
the estimated construction cost be in 1999 based on the ENR construction cost index?
Solution: From Table above, the ENR construction cost index rose from a value of 4770.03 in 1990 to
6059.47 in 1999. Therefore, the estimated construction cost in 1999 would be
C1999 = 1.545 (6059.47) / 4770.03
= $1,963,000
While the cost indexes discussed above provide a valuable tool for estimating present costs from
historical data, they become even more valuable when combined with some of the other cost-
estimating techniques. One of the most widely used methods of obtaining preliminary cost information
is through the use of cost-capacity equations. As the name implies, a cost-capacity equation relates the
cost of a component, system, or plant to its capacity. Since many cost-capacity relationships plot as a
straight line on log-log paper, one of the most common cost-prediction equations is
𝐶2 = 𝐶1 (𝑄2 /𝑄1 )𝑥
where 𝐶1 = cost at capacity 𝑄1
𝐶2 = cost at capacity 𝑄2
x = exponent
Table 15-2 is a partial listing of typical values of the exponent for various units. When an exponent value
for a particular unit is not known, it is common practice to use the average value of 0.6. The next
example illustrates the use of Equation [2].
Table 15-2 Sample exponent values for cost-capacity equations
Component/System/Plant Size Range Exponent
Activated sludge plant 1-100 MGD 0.84
Aerobic digester 0.2-40 MGD 0.14
Blower 1,000-7,000 ft3/min 0.46
Centrifuge 40-60 in 0.71
Chlorine plant 3,000-350,000 tons/year 0.44
Clarifier 0.1-100 MGD 0.98
Compressor 200-2,100 hp 0.32
Cyclone separator 20-8,000 ft3/min 0.64
Dryer 15-400 ft2 0.71
Filter, sand 0.5-200 MGD 0.82
Heat exchanger 500-3,000 ft2 0.55
Hydrogen plant 500-20,000 scfd 0.56

Laboratory 0.05-50 MGD 1.02
Lagoon, aerated 0.05-20 MGD 1.13
Pump, centrifugal 10-200 hp 0.69
Reactor 50-4,000 gal 0.74
Sludge drying beds 0.04-5 MGD 1.35
Stabilization pond 0.01-0.2 MGD 0.14
Tank, stainless 100-2,000 gal 0.67
NOTE: MGD = million gallons per day; hp = horsepower; scfd = standard cubic feet per day.
Example: The total construction cost for a stabilization pond to handle a flow of 0.05 million gallons
per day (MGD) was $73,000 in 1987. Estimate the cost today of a pond 10 times larger. Assume the
index (for updating the cost) was 131 in 1987 and is 225 today. The exponent from Table 15-2 for the
0.01 to 0.2 MGD range is 0.14.
Solution: Using Equation [2], the cost of the pond in 1987 dollars is
𝐶2 = 73,000 (0.50 / 0.05 )0.14
= $100,768
Today’s cost can be obtained through the use of Equation [1] as follows:
𝐶𝑡 = (100,768) (225) / 131
(today’s dollars)
Sample Problems:
1. If the M&S index is used to update the cost of a piece of equipment that sold for $75,000 in 1991,
the cost in 1999 would be closest to:
C1999 = 75,000 (1068.3) / 930.6
= $86,098
2. The ENR Construction Cost Index values for 1990 and 1997 are 4770.03 and 5851.80, respectively.
If the index is changed so that 1990 is to have a base value of 100, the value in 1997 would be
closest to
Divide 1997 value by the 1990 value and multiply by 100:
1997 value = (5851.80) (100) / 4770.03 = 122.68
3. A 20 HP centrifugal pump (with motor) can be purchased for $1500. For an exponent value of 0.46
in the cost-capacity equation, the cost of a 100 HP pump would be estimated to be
C100 = 1500 (100/20)0.46 = $3,145
4. A certain labor cost index increased from a value of 703 in 1980 to 1362 in 2001. If the labor cost
for a certain job in 1980 was $350,000, the labor cost for a similar job in 2001 would be estimated
to cost
(a) $526,000 (b) $552,000 (c) $601,000 (d) $678,000
5. The M&S Equipment cost index was used to estimate the cost of a certain pump and motor. The
index value in 1987 was 813.6. In 1995, the value was 1027.5. If the pump was estimated to cost
$33,250 in 1995, the cost in 1987 was closest to
(a) Less than $25,000 (b) $26,300 (c) $27,900 (d) Over $29,000
6. A 100 gallon stainless steel tank was purchased for $600 in 1992. Using the M&S equipment cost
index and a value of 0.67 in the cost-capacity equation, the cost of a 1500 gallon tank in 1999
would have an estimated cost closest to:
(a) $3,682 (b) $3,825 (c) $4,171 (d) over $4200
Depreciation
Depreciation and Depletion
One definition of the word depreciation is to lessen in estimated value: lower the worth of. In general,
the value of an asset decreases with time because of age, wear, or obsolescence. A number of methods
for systematically expressing the decreasing value of assets with time have been developed over the
years. These so-called depreciation models result in values which (1) affect income taxes, and (2)
provide information to investors about the worth of the assets of public companies.
Depreciation affects income taxes because it is one of the deductions (from income) that businesses can
take before calculating the amount of taxes they owe per the following equation:
Taxes = (income – deductions) (tax rate)
Since depreciation is a deduction (just as labor costs, rent, and other expenses are for businesses), the
taxes owed are reduced by an amount equal to the depreciation times the tax rate (assuming income
stays the same). For example, a business that has a depreciation deduction of $5000 in a year when its
tax rate is 40% would have its tax bill reduced by $2000 that year (i.e. $5000 * 0.40). The depreciation
calculated for this purpose is called tax depreciation and must be determined using only IRS-approved
models. Book depreciation refers to the depreciation procedures used by corporations to more
accurately reflect to shareholders the value of their assets. Two of the models used for depreciating
assets are discussed below.
The modified accelerated cost recovery system (MACRS) is the only currently-approved depreciation
model allowed for tax depreciation in the United States. According to this model, the depreciation
charge for a given year is calculated by multiplying the asset’s depreciable amount (known as its basis, B,
which is usually its first cost) by a depreciation rate. In equation form, MACRS depreciation is
𝐷𝑡 = 𝑑𝑡 𝐵
where: 𝑑𝑡 = depreciation rate, %
B = Asset’s basis, $
The depreciation rates, dt, are available in tables like Table 16-2 shown below for assets which have
recovery periods (n) of 3 to 20 years.
Table 16-2 Depreciation rates, d, applied to the first cost B for the MACRS method
Thus, the depreciation charge in year 3 for a $10,000 asset which has a 5-year recovery would be $1,920
(i.e. $10,000 * 0.1920)
The book value of an asset refers to its undepreciated amount and is represented as the difference
between the first cost, B, and the sum of the depreciation that has been charged up to that time. In
equation form,
𝐵𝑉𝑡 = 𝐵 − ∑ 𝐷
For example, an asset that costs $10,000 and has a 5-year recovery period would have a book value at
the end of year 3 equal to:
𝐵𝑉3 = 10,000 – 10,000 (0.20) – 10,000 (0.32) – 10,000 (0.1920)
= 10,000 – 10,000 (0.20 + 0.32 + 0.1920)

= $2,880
While the MACRS model is the only one approved for tax depreciation, a model frequently used by
corporations for book depreciation is the straight line model. Under this model, the depreciation charge
is the same each year per the following equation:
D = (B – SV) / n
where: B = Asset first cost
SV = Asset salvage value
n = Asset life
Thus, an asset which has a first cost of $10,000 with an expected salvage value of $2000 after a 5-year
useful life would have a depreciation charge of $1,600 each year
[i.e.(10,000–2000)/5].
The book value of an asset depreciated by the straight line method would be
𝐵𝑉𝑡 = 𝐵 − 𝑡𝐷
where t = no. of years asset has been depreciated
The depreciation models discussed up to this point apply to assets that can be replaced. For assets that
cannot be replaced, like natural resources, different procedures are used for tax accounting
purposes. There are two methods which can be used to account for this so-called depletion: cost
depletion and percentage depletion.
Cost depletion involves the multiplication of a cost factor, pt, by the amount of resource removed in a
given year. The factor, Pt, is equal to the first cost of the resource divided by the total amount of
recoverable resource:
𝑃𝑡 = (𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡)/𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦
The annual depletion deduction is Pt times the amount of resource harvested in that year. For example,
if a gold mine which cost $1,000,000 had an estimated 4000 ounces of gold, the depletion factor would
be $250 per ounce (i.e. 1,000,000/4000). The depletion charge in a year when 1,000 ounces is removed
would be $250,000 (i.e. 250 * 1000).
Percentage depletion is a procedure wherein a certain percentage of the income from harvesting the
resource is taken as the deduction. The percentage that is taken is a function of the type of resource
involved as shown in the table below:
Thus, if 10,000 ounces of gold are harvested in a year when gold is selling for $270 per ounce, the
depletion allowance deduction would be (0.15) (10,000) (270) = $405,000 (subject to certain tax law
restrictions)
Sample Problems:
1. For a company in a tax bracket of 40%, a depreciation charge of $20,000 would represent a tax
savings of
Tax savings = 20,000 (0.40) = $8,000
2. A certain machine has a first cost of $50,000 with a $10,000 salvage value after 5 years. If the
company's MARR is 15% per year, the depreciation charge in year 2 according to the MACRS
method is closest to:
From table, d = 0.32

D2 = 50,000 (0.32) = $16,000
3. An asset with a first cost of $60,000 is expected to have a $10,000 salvage value after a 3-year life.
According to the straight line-method, the depreciation charge in year 3 would be
D = (60,000 - 10,000) / 3 = $16,667
4. A 10-year asset with a first cost of $80,000 and $10,000 salvage value is depreciated by the
MACRS method. The book value at the end of year 6 would be closest to
BV6 = 80,000 - depreciation in years 1 thru 6
= 80,000 - 80,000 (0.10 + 0.18 + 0.14 + 0.1152 + 0.0922 + 0.0737)

= $23,904
5. A coal mine which required an initial investment of $1,800,000 yielded coal which resulted in
income of $90,000 two years ago, $140,000 one year ago, and $110,000 this year. The depletion
allowance this year would be,
The depletion percentage for coal is 10%. Therefore, the depletion allowance this year would be
Allowance = 110,000 (0.10) = $11,000
6. A machine which had a first cost $45,000 and a $10,000 salvage value after 5-years was
depreciated by the straight line method. The machine's operating cost was $15,000 per year. The
book value of the machine at the end of year 3 was closest to,
(A) $7,000
(B) $15,000
(C) $24,000
(D) Over $24,000
7. An asset with B = $25,000, SV = $5,000 and a 5-year recovery period is depreciated by the MACRS
method. The operating cost is $20,000 per year. The depreciation charge in year 2 is closest to,
(A) Less than $8000

(B) $8,000
(C) $10,000
(D) Over $10,000
8. A gold mining company purchased a mine for $ 6 million which had recoverable gold estimated to
be 30,000 ounces. In a year when the operating cost was $100,000 and the production was 2000
ounces, the depletion deduction for that year was,
(A) Less than $200,000

(B) $300,000
(C) $350,000
(D) Over $350,000
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Interest Calculations

Amount owed year 3 = principal + interest

Amount owed year 1 = 10,000 + 10,000 (0.10)

Amt owed year 2 = 11,000 + 11,000 (0.10)

Amt owed year 3 = 12,100 + 12,100 (0.10)

Amt owed = Principal + interest

(A) 7 years (B) 10 years (C) 12 years (D) Over 12years

Single Payment Formulas

( F/P,i,n ) and ( P/F,i,n )

Example - Use of F/P Factor:

Net Present Savings = 22,000 - 19,725

P = 10,000 (P/F, 15%, 20)

F = 25,000 (F/P, 12%, 15)

P = 75,000 (P/F, 20%, 3)

(A) $ 25,182 (B) $ 16,211 (C) $ 19,233 (D) $ 23,452

(A) $ 421,630 (B) $ 463,450 (C) $ 518,740 (D) $ 602,100

(A) $ 562,600 (B) $ 635,500 (C) $ 755,800 (D) $ 492,700

Uniform Series Formulas, P/A and A/P

• The cash flow occurs in consecutive interest periods, and

Example - Use of P/A Factor:

P = 30,000 (P/A, 15%, 5)

A = 1,100,000 (A/P, 10%, 10)

A = 10,000 (A/P, 20%, 7)

(A) $ 53,626 (B) $ 59,812 (C) $ 64,701 (D) $ 66,892

(A) $ 2,991 (B) $ 3,102 (C) $ 3,477 (D) $ 4,316

(A) $ 19,362 (B) $ 11,156 (C) $ 15,329 (D) $ 13,409

Uniform Series Formulas, F/A and A/F

Example: Use of A/F Factor

A = 300,000 (A/F, 12%, 6)

F = 2000 (F/A, 10%, 18)

(A) $18,160 (B) $19,420 (C) $21,360 (D) $23,040

(A) $114,000 (B) $116,000 (C) $118,000 (D) $120,000

The following example illustrates the procedure.

x = (P/G, 18%, 21)

Interpolate between i = 14% and 15%

x = (F/A, 14.3%, 20)

(A) 17.3022 (B) 18.5913 (C) 19.6301 (D) 20.0032

4. Find the value of ( P/A, 9.7%, 22) by interpolation

P = present worth of base amount + present worth of gradient amount

= A (P/A,i,n) + G (P/G, i,n)

A = amount of money in period 1

G = change in amount between periods 1 and 2

n = number of periods from 1 thru end of gradient

i = interest rate per period

Example - Present worth of Arithmetic Gradient

P = 5000 (P/A, 10%,10) + 500 (P/G,10%,10)

Example - Annual Worth of a Decreasing Arithmetic Gradient

(A) $2,982 (B) $3,171 (C) $3,233 (D) $3,406

(A) $1,035 (B) $2,066 (C) $1,176 (D) $2,413

Example - Increasing Geometric Gradient

The cash flow at the end of year 1 is $150,000,

increasing by g=5% per year. Therefore,

the present worth is:

P = 25,000[1 - (1 + 0.09)10/(1 + 0.12)10 ] / ( 0.12 - 0.09 )

Unknown Interest Rate

Example - Finding i in a Uniform Series

Use F/P or P/F factor equation. Using F/P:

20,000 = 5,000 (F/P, i, 15)

50,000 = 200,000 (A/P, i, 5)

Use A/F or F/A factor equation. Using F/A:

50,000 = 1000 (F/A, i, 18)

(A) 14% (B) 16% (C) 19% (D) 22%

(A) 4% (B) 5% (C) 7% (D) 9%