BORINAGA, KIM G.

BSEE-2A
ECON 223- Engineering Economy

CHAPTER 9
(Question - Answers)
Q9-1. Your rich aunt is going to give you end of year gifts of $1,000 for each of the next to years.
A. If general price inflation is expected to average 47% per year during the next 10 year, what is the equivalent
value of these gifts at the present time? The real interest rate is considered to be 1% per year.
Answer:
Inflation-adjusted value year 10 = $1,000 / (1 + 0.06)^1 = $943.40
PV= ($1,000 * (1 – (1 + 0.04)^-10)) / 0.04 = $8,110.86
Therefore, the present value of the gifts is $8,110.86.
b. Suppose that your aunt specified that the annual gifts of $1,000 are to be increased by 6% each year to
keep pace with inflation with a real interest rate of 4% what is the current IW of the gifts?
Answer:
IW =A*[1+g/1+r*1-(1+r)^-n/r-g]
IW=$1,000*[1+0.06/1+0.04*1-(1+0.04^-10/0.04-0.06]
IW=$10,945.72

Q9-2. Because of general price inflation in our economy, the purchasing power of the dollar shrinks with the
passage of time. If the average general price inflation rate is expected to be 8% per year in the foreseeable
future, how many years all it take for the dollar’s purchasing power to be one-half of what it is now?
Answer:
N= 72/8 = 9 years

Q9-3. Which of these situations would you prefer.

a. You invest $2,500 in a certificate of deposit that earns an effective interest rate of 8 per year. You plan to
leave the money alone has 5 years, and the general price inflation rate is expected to average 5% per year.
Taxes are ignored.
b. You spend $2,500 on a piece of antique furniture. You believe that in 5 years the furniture can be sold for
$4,000. Assume that the average general price inflation rate is 3% per year. Again, taxes are ignored.
Answer:

a. Certificate of deposit (CD) b. Antique furniture Therefore,

investing in a
The PW of the CD investment option is The PW of the antique furniture investment Certificate of
calculated as follows: option is calculated as follows: Deposit with
PW = -2,500 + (2,500*(1+8%)^5)/(1+5%)^5 PW = -2,500 + 4,000/(1+3%)^5 an interest
PW = -2,500 + 3,301.40 PW = -2,500 + 3,214.02 rate of 8% for
PW = 801.40 PW = -285.98 5 years is the
Therefore, the PW of investing $2,500 in a Therefore, the PW of spending $2,500 on better
CD with an interest rate of 8% for 5 years is antique furniture that is expected to sell for investment
$801.40. $4,000 in 5 years is -$285.98. option.
Q9-4. Operating and maintenance costs for two alternatives have been estimated on different bases as
follows.
End of Year Alternative A costs Estimated Alternative B Costs If the average
in actual (inflated) dollars Estimated in real (constant) general price
dollars with b=0 inflation rate
1 120,00 100,000 is expected to
2 132,000 110,000 be 6% per
3 148,000 120,000 year and
4 160,000 130,000
money can
earn a real rate of interest of 9% per year, show which alternative has the least negative PW at time 0.
Answer9-4:
BORINAGA, KIM G. BSEE-2A
ECON 223- Engineering Economy
PW = F/(1+i)^n

For Alternative A, we need to first inflate the Then, we can find the PW of this cost at time
costs to actual dollars at the end of year 3 0 using the real interest rate of 9% and n = 3
using the average general price inflation rate (since the last cost is incurred at the end of
of 6%: year 3):

End of Year 1: $120,000 PW(A) = $617,942.4/(1+0.09)^3 =

End of Year 2: $132,000 * 1.06 = $139,920
End of Year 3: $148,000 * 1.06^2 =
$164,422.4
End of Year 4: $160,000 * 1.06^3 = $193,600
Total inflated cost = $617,942.4
$465,785.59
PW(B) = ($100,000/(1+0.09)^1) +
($120,000/(1+0.09)^2) +
($130,000/(1+0.09)^3)
= $100,000/1.09 + $120,000/1.09^2 +
$130,000/1.09^3
= $325,829.16 Therefore, Alternative B
has the least negative PW at time 0.

Q9-5. Suppose that you deposit $1,000 in a Swiss bank account that earns an effective interest rate of 18%
per year, and you withdraw the principal after 6 years. You receive the interest each year and spend it on your
favorite hobby. What is the real annual rate of return on your investment if the general price inflation rate is
10% per year?
Answer:

Real rate (1 + nominal rate)/(1 + inflation rate) – 1.

Nominal rate (1 + effective rate)^(1/number of periods) – 1

Nominal rate (1 + effective rate)^(1/number of periods) – 1

Nominal rate 0.0294 or 2.94%

Nominal rate (1 + 0.0294)/(1 + 0.10) – 1 = -0.0706 or -7.06 %

Q9-6. A recent engineering graduate has received the annual salaries shown in the following table over the
past 4 years. During this time, the CPI has performed as indicated. Determine the engineer’s annual salaries in
year 0 dollars (b= 0) if the CPI is the appropriate indicator of general price inflation for this person

End of Year Salary (AS) CPI

1 34,000 7.1%
2 36,200 5.4%
3 38,800 8.9%
4 41,500 11.2%

Answer: 9-6

Salary in Year 0 Dollars = Salary in Current
Dollars / (1 + CPI%)^(Number of Years Since
Salary)
For example, to find the engineer’s salary in
year 0 dollars for year 4:
Salary in Year 0 Dollars = $41,500 / (1 +
11.2%)^4
Salary in Year 0 Dollars = $27,133.15
Therefore, if the CPI is the appropriate
indicator of general price inflation for this
person, the engineer’s annual salaries in year
0 dollars are $31,667.12, $33,102.43,
$32,530.52, and $27,133.15 for years 1, 2, 3,
and 4, respectively

Q9-7. Your company has just issued bonds, each with a face value of $1,000. They mature in 10 years and
pay annual dividends of $100. At present they are being sold $887. If the average annual price inflation rate
over the next 10 years is expected to be 6%, what is the rate return per year on this investment?
Answer:
YTM = (C + ((FV – P) / n)) / ((FV + P) / 2)

Plug in the values: Real rate of return = Nominal rate of return –

YTM = ($100 + (($1,000 - $887) / 10)) / Inflation rate
(($1,000 + $887) / 2) Real rate of return = 20.1% - 6%
YTM = $190 / $943.5 Real rate of return = 14.1%
YTM = 0.201 or 20.1%
BORINAGA, KIM G. BSEE-2A
ECON 223- Engineering Economy

Q9-8. A reactor vessel cost $375,000 10 years ago.The reactor had the capacity of producing 500 pounds of
product per hour. Today, it is desired to build a vessel of 1,000 pounds per hour ca- pacity. With a general
price inflation rate of 5% per year and assuming a cost-capacity factor to reflect economies of scale, X, to be
0.75, what is the approximate future cost of the new reactor in 5 years?
Answer:

A = P(1+r)^n Assuming a cost-capacity Assuming a time frame of 5

A = 375,000(1+0.05)^10 factor of 0.75: years:
A = 375,000(1.628) X = 610,500/1,000^0.75 C2 = 610,500/1,931.13^0.75
A = 610,500 X = 610,500/316.228 C2 = 610,500/1,117.09
X = C1/C2^k X = 1,931.13 C2 =$ 546.65
C2 = C1/X^k

Q9-9. A product design team is standardizing selected components in the designs for several related company
products. One cylinder-type component used in hydraulic systems has been identified for standardization. The
projected procurement cost each year, for the next 5 years, is needed for the design team to complete the
economic analysis of alternatives. The purchasing department has estimated that the current cost (in quantities
required) would $53.80 each, and the general inflation rate, which is considered the best estimate of price
change for the component, would average 4.7% per year. What is the estimated cost in actual dollars for the
component each year for the next 5 years? (9.2)

Answer:9-9

Using the inflation rate of 4.7%, we can Therefore, the estimated cost in actual dollars
calculate the estimated cost for the for the component each year for the next 5
component each year: years would be:

Year 1: $53.80 x 1.047 = $56.34 Year 1: $56.34

Year 2: $56.34 x 1.047 = $58.92 Year 2: $58.92

Year 3: $58.92 x 1.047 = $61.54 Year 3: $61.54

Year 4: $61.54 x 1.047 = $64.21 Year 4: $64.21

Year 5: $64.21 x 1.047 = $66.92 Year 5: $66.92

Q9-10. The operating budget estimate for an engi- neering staff for fiscal year 1993 is $1,780,000. The actual
budget expenditures of the staff for the previous 2 fiscal years, as well as estimates. for the next 2 years, are
as shown in the follow- ing table. These are actual dollar amounts. Man- agement, however, also wants annual
budget amounts for these years, using a constant dollar perspective. The 1993 fiscal year is to be used for this
purpose (b= 1993). The estimated annual general price inflation rate is 5.6%. What are the annual constant
(real) dollar budget amounts? (9.2)

Fiscal Year Budget Amount (A$)

1991 1,615,000
1992 1,728,000
1993 1,780,00
1994 1,858,300
1995 1,912,200
Answer:

First, we'll adjust the Next, we'll adjust the Finally, we'll adjust So the annual
actual amounts for estimated amounts the budget estimate constant (real) dollar
the previous two for the next two fiscal for fiscal year 1993: budget amounts are:
fiscal years: years:

Fiscal year 1991: Fiscal year 1994: Fiscal year 1993: Fiscal year 1991:
$1,600,000 x (1 + $1,900,000 / (1 + $1,780,000 $1,833,059
0.056)^2 = 0.056)^1 =
$1,833,059 $1,797,821 Fiscal year 1992:
BORINAGA, KIM G. BSEE-2A
ECON 223- Engineering Economy
$1,794,200
Fiscal year 1992: Fiscal year 1995:
$1,700,000 x (1 + $2,000,000 / (1 + Fiscal year 1993:
0.056) = $1,794,200 0.056)^2 = $1,780,000
$1,759,432
Fiscal year 1994:
$1,797,821

Fiscal year 1995:

$1,759,432

Q9-11. An individual desire to have a preplanned amount in a savings account for retirement in 20 years. This
amount is to be equivalent to $30,000 in today's purchasing power. If the expected average inflation rate is 7%
per year and the savings account earns 5% interest, what lump sum should the person deposit now in the
savings account? (9.2)
Answer:
Formula: PV = FV / (1 + r)^n
FV_adjusted = $30,000 * (1 + 0.07)^20 = $138,230.79
PV = $138,230.79 / (1 + 0.05)^20 = $44,176.87

Q9-12. The AZROC Corporation needs to acquire a small computer system for one of its regional sales offices.
The purchase price of the system has been quoted at $50,000, and the system will reduce annual office
expenses by $18,000 per year in real dollars. Historically, these annual expenses have escalated at an
average rate of 8% per year, and this is expected to continue into the future. A maintenance agreement will
also be contracted for, and its cost per year in actual dollars is constant at $3,000. What is the minimum
(integer-valued) life of the system such that the new computer can be economically justified? Assume that the
com- puter's salvage value is zero at all times. The firm's MARR is 25% and includes an adjustment for
anticipated inflation in the economy. Show all calculations. (9.2)
Answer:9-12

Let's first calculate the annual cost savings in FORMULA: PV = CF / (1 + r)^n

future dollars, taking into account the 8%
escalation rate:
Year 1: $18,000
Year 2: $18,000 x 1.08 = $19,440
Year 3: $19,440 x 1.08 = $21,004.80
Year 4: $21,004.80 x 1.08 = $22,699.82
PV of cost savings = $55,785.15
PV of maintenance agreement = $2,111.83
(using the formula above with a cash flow of
$3,000 per year and a discount rate of 25%
adjusted for inflation)
Total PV of cost savings and maintenance
agreement = $57,896.98

Substitute:
$50,000 = $57,896.98 / (1 + 0.25)^n

(1 + 0.25)^n = $57,896.98 / $50,000 (1 +

0.25)^n = 1.15794

n = log(1.15794) / log(1.25) = 4.4

Rounding up to the nearest integer, we get a minimum life of 5 years to economically justify the purchase of
the computer system.

Q9-13. An investor lends $10,000 today, to be repaid in a lump sum at the end of 10 years with inter- est at
10% (i) compounded annually. What is the real rate of return, assuming that the gen- eral price inflation rate is
8% annually? (9.2)
Answer:
Formula:(1 + r) = (1 + i) / (1 + h)
(1 + r) = (1 + 0.10) / (1 + 0.08)
1 + r = 1.019230769
BORINAGA, KIM G. BSEE-2A
ECON 223- Engineering Economy
r = 1.9230769%

Q9-14. An investor established an individual savings account in 1981 that involves a series of 20 deposits as
shown in the following diagram. The account is expected to compound at an average interest rate of 12% per
year through the year 2001. General price inflation is expected to average 6% per year during this time. (9.2)

a. What is the FW of the savings account at the end of year

2001?
b. What is the FW of the savings account in 1981 (base time period) spending power?
Answer: 9-14

a. formula: b. formula:
FW = PV × (1 + r) FW (in base year dollars) = FW (in
n=2001-1981=20 current dollars) / (1 + i)n
n=2001 - 1981 = 20
PV = $2,000 × [(1 - (1 + 0.06)-20) /
0.06] = $33,295.68 FW (in base year dollars) =
$566,163.07 / (1 + 0.06)^20 =
FW = $33,295.68 × (1 + 0.12)^20 $95,304.49
= $566,163.07
Therefore, the FW of the savings
Therefore, the FW of the savings account in 1981 spending power
account at the end of year 2001 is is $95,304.49.
$566,163.07.

Q9-15. Consider a project requiring an investment of $20,000 that is expected to return, in actual dollars,
$6,000 at the end of the first year, $8,000 at the end of the second year, and $12,000 at the end of the third
year. The general price in- flation rate is 5% per year, and the real interest rate is 10% per year. Compare the
PW of this project using before-tax actual dollar and real dollar analysis. (9.2)
Answer:
The PW of the project using before-tax actual dollar analysis is calculated as follows:
PW = -20,000 + 6,000/(1+10%) + 8,000/(1+10%)^2 + 12,000/(1+10%)^3
PW = -20,000 + 5,454.55 + 6,280.99 + 8,976.09
PW = 727.63
Therefore, the PW of the project using before-tax actual dollar analysis is $727.63.

Year Real return PW = -20,000

1 $6,000 / (1+5%)^1 = $5,714.29 +
2 $8,000 / (1+5%)^2 = $6,880.74
3 $12,000 / (1+5%)^3 = $9,962.34

5,714.29/(1+10%) + 6,880.74/(1+10%)^2 + 9,962.34/(1+10%)^3

PW = -20,000 + 4,958.54 + 5,234.18 + 7,248.63
PW = -2,558.65
Therefore, the PW of the project using real dollar analysis is -$2,558.65, indicating that this project is not
economically viable when considering inflation.