MECHANICAL ENGINEERING

DEPARTMENT
2nd Year

Engineering Economy & Accounting

MEC210

Lecture #06
Time value of money,
Cash flow & effects of
inflation
Prepared By: Dr. Sayed Ali Zayan 1st Term 2023/2024
Geometric Gradient Series Factors
A geometric gradient series is a cash flow series that either increases or
decreases by a constant percentage each period. The uniform change is
called the rate of change.

The total present worth Pg for the entire cash flow series is:
Geometric Gradient Series Factors
The term in brackets in pervious equation is the (P∕A, g%, i%, n) or
geometric gradient series present worth factor for values of g not
equal to the interest rate i.
 g = constant rate of change, in decimal form, by which cash flow values increase or
decrease from one period to the next. The gradient g can be + or −.

 A1 = initial cash flow in period 1 of the geometric series

 Pg = present worth of the entire geometric gradient series, including the initial amount
A1
Note that: the initial cash flow A1 is not considered separately when
working with geometric gradients.

When g = i :
Geometric Gradient Series Factors
The (P∕A, g%, i% , n) factor calculates Pg in period t = 0 for a geometric
gradient series starting in Period 1 in the amount A1 and increasing by a
constant rate of g each period.
The equation for Pg and the (P∕A, g%, i% , n) factor formula are:

It is possible to derive factors for the equivalent A and F values; however, it is

easier to determine the Pg amount and then multiply by the A∕P or F∕P factor.
Example:
A coal-fired power plant has upgraded an emission
control valve. The modification costs only $8000 and
is expected to last 6 years with a $200 salvage
value. The maintenance cost is expected to be high
at $1700 the first year, increasing by 11% per year
thereafter. Determine the equivalent present worth
of the modification and maintenance cost at 8% per
year.
Solution:

The cash flow diagram (Figure) shows the salvage value as a positive cash flow and all
costs as negative. For g ≠ i, and the total PT is the sum of three present worth
components:
Calculations for Uniform Series That Are Shifted
When a uniform series begins at a time other than at the end of period 1, it is called a shifted
series. In this case several methods can be used to find the equivalent present worth P. For
example, P of the uniform series shown in Figure could be determined by any of the following
methods:

 Use the P∕F factor to find the present worth of each disbursement at year 0 and add them.
 Use the F∕P factor to find the future worth of each disbursement in year 13, add them, and
then find the present worth of the total, using P = F(P∕F,i,13).
 Use the F∕A factor to find the future amount F = A(F∕A,i,10), and then compute the present
worth, using P = F(P∕F,i,13).
 Use the P∕A factor to compute the “present worth” P3 = A(P∕A,i,10) (which will be located
in year 3, not year 0), and then find the present worth in year 0 by using the (P∕F,i,3)
factor.
Calculations for Uniform Series That Are Shifted
 The present worth is always located one period prior to the first uniform series
amount when using the P∕A factor.

 The future worth is always located in the same period as the last
uniform series amount when using the F∕A factor.
Example:

The offshore design group at Bechtel just purchased

upgraded CAD software for $5000 now and annual
payments of $500 per year for 6 years starting 3
years from now for annual upgrades. What is the
present worth in year 0 of the payments if the
interest rate is 8% per year?
Solution:

Note that:
P'A is located in actual year 2, not year 3. Also, n = 6, not 8, for the P∕A factor. First
find the value of P'A of the shifted series.
P'A = $500(P∕A,8%,6)
Since P'A is located in year 2, now find PA in year 0.
PA = P'A(P∕F,8%,2)
The total present worth is determined by adding PA and the initial payment P0 in
year 0.
PT = P0 + PA = 5000 + 500(P∕A,8%,6)(P∕F,8%,2)
= = 5000 + 500(4.6229)(0.8573) = $6981.60
Calculations Involving Uniform Series and Randomly
Placed Single Amounts

When you calculate the A value for a cash flow series that
includes randomly placed single amounts and uniform
series, first convert everything to a present worth or a future
worth. Then you obtain the A value by multiplying P or F by
the appropriate A∕P or A∕F factor.
 Factor Values for Untabulated i or n Values
Often it is necessary to know the correct numerical value of a factor with an i
or n value that is not listed in the compound interest tables. Given specific
values of i and n, there are several ways to obtain any factor value.
 Use the formula listed in this lecture.
 Use an Excel function with the corresponding
P, F, or A value set to 1.
 Use linear interpolation in the interest tables.

Linear interpolation:

or

The value of d will be positive or negative if

the factor is increasing or decreasing,
respectively, in value between x1 and x2 .
Example:
Determine the P∕A factor value for i = 7.75% and n = 10 years, using the three
methods described previously.
Solution
Factor formula:

Spreadsheet: Utilize the spreadsheet function in Figure, that is, = −PV(7.75%,10,1), to

display 6.78641.
Linear interpolation:
the bounding interest rates are i1 = 7% and i2 = 8%, and the corresponding P∕A
factor values are f1 = (P∕A,7%,10) = 7.0236 and f2 = (P∕A,8%,10) = 6.7101. where x
is the interest rate i,
Ch03: Selection among competing alternatives
The analysis Methods:
1. Present-Worth Analysis:
2. Future Worth Analysis
3. Capitalized Equivalent Method
4. Annual Equivalent-Worth Analysis
5. Rate-of-Return Analysis
6. Benefit–Cost Analysis
7. Payback Period analysis
1. Present-Worth Analysis:
The basic procedure for applying the net-present-worth criterion to a
typical investment project:
• Determine the interest rate that the firm wishes to earn on its
investments. The interest rate you determine represents the rate at
which the firm can always invest the money in its investment pool. This
interest rate is often referred to as either a required rate of return or a
Minimum Attractive Rate of Return (MARR). Usually, selection of the
MARR is a policy decision made by top management.
• Estimate the service life of the project.
• Estimate the cash inflow for each period over the service life.
• Estimate the cash outflow over each service period.
• Determine the net cash flows (net cash flow=cash inflow-cash outflow).
1. Present-Worth Analysis:
 Find the present worth of each net cash flow at the MARR. Add up all
the present worth figures; their sum is defined as the project’s NPW,
given by
1. Present-Worth Analysis:
Single Project Evaluation:
The decision rule is:

Comparing Multiple Alternatives.

 Compute the PW(i) for each alternative and select the one with the
largest PW(i).
 When you compare mutually exclusive alternatives with the same
revenues, they are compared on a cost-only basis.
 In this situation (because you are minimizing costs, rather than
maximizing profits), you should accept the project that results in the
smallest or least negative, NPW.
1. Present-Worth Analysis:
Meaning of Mutually Exclusive :
Several alternatives are mutually exclusive when any one of them will fulfill
the same need and the selection of one of them implies that the others will be
excluded.
“Do Nothing” Is a Decision Option
 When considering an investment, we are in one of two situations:
Either the project is aimed at replacing an existing asset or system, or it is
a new endeavor. In either case, a do nothing alternative may exist. On the
one hand, if a process or system already in place to accomplish our
business objectives is still adequate, then we must determine which, if
any, new proposals are economical replacements. If none are feasible,
then we do nothing. On the other hand, if the existing system has failed,
then the choice among proposed alternatives is mandatory (i.e., do
nothing is not an option).
1. Present-Worth Analysis:
Service Projects versus Revenue Projects:
 Service projects are projects whose revenues do not depend on the
choice of project; rather, such projects must produce the same
amount of output (revenue). In this situation, we certainly want to
choose an alternative with the least input (or cost).
 Revenue projects, by contrast, are projects whose revenues
depend on the choice of alternative. With revenue projects, we are
not limiting the amount of input going into the project or the
amount of output that the project would generate. Then our
decision is to select the alternative with the largest net gains
(output – input).
1. Present-Worth Analysis:
Analysis Period:
The analysis period is the time span over which the economic effects of an
investment will be evaluated. The analysis period may also be called the study
period or planning horizon. The length of the analysis period may be determined
in several ways: It may be a predetermined amount of time set by company
policy, or it may be either implied or explicit in the need the company is trying to
fulfill. In either of these situations, we consider the analysis period to be the
required service period.
 Analysis Period Equals Project Lives
When the project lives equal the analysis period, we compute the NPW for
each project and select the one with the highest NPW.
 Analysis Period Differs from Project Lives
If Analysis Period Is Not Specified
 Use Lowest Common Multiple (LCM) of Project Lives
1. Present-Worth Analysis:
 Analysis Period Differs from Project Lives
Often, project lives do not match the required analysis period or do not match each other (or both).
 Project’s Life is Longer than Analysis Period (Salvage value )
 Project’s Life Is Shorter than Analysis Period (Replacement projects)
 Analysis Period Coincides with Longest Project Life
Example: A machine shop is considering combining machining and turning centers into a
single Mazak Multi- Tasking® machine center. Multitasking in the machine
world is the combining of processes that were traditionally processed on multiple
machines onto one machine. The ultimate goal is to turn, mill, drill, tap, bore,
and finish the part in a single setup. The initial investment of $1,800,000 and the
projected cash savings over a seven-year project life are as follows:

You have been asked by the president of the company to evaluate the economic
merit of the acquisition. The firm’s MARR is known to be 15% per year.
Solution:

PW(15%) = -$1,800,000 + $454,000(P/F, 15%, 1) + $681,000 (P/F, 15%, 2)

+ $908,000(P/A, 15%, 4)(P/F, 15%, 2) + $1,268,000(P/F, 15%, 7)
= $1,546,571.
Since the project results in a surplus of $1,546,571, the project is acceptable. It is
returning a profit greater than 15%.
Example: Monroe Manufacturing owns a warehouse that has been used for storing finished
goods for electro-pump products. As the company is phasing out the electro-pump
product line, the company is considering modifying the existing structure to use for
manufacturing a new product line. Monroe’s production engineer feels that the
warehouse could be modified to handle one of two new product lines. The cost and
revenue data for the two product alternatives are as follows:

After eight years, the converted building will be too small for efficient production of
either product line. At that time, Monroe plans to use it as a warehouse for storing
raw materials as before. Monroe’s required return on investment is 15%. Which
product should be manufactured?
 Solution:
CFA = 215,000 – 126,000 = $89,000 CFB = 289,000 – 168,000 = $121,000

PW(15%)A = -$365,000 + $89,000(P/A, 15%, 8) + $25,000(P/F, 15%, 8) = $42,544.

PW(15%)B = -$504,000 + $121,000(P/A, 15%, 8) + $35,000(P/F, 15%, 8) = $50,407.
For revenue projects, we select the one with the largest NPW, so producing product B is
more economical.
Example:
Solution:

PWCont1 =-50,000+10,000(P/A,9%,5) +20,000((P/A,9%,10) (P/F,9%,5))

-50,000(P/F,9%,15) + 10,000(P/A,9%,5) (P/F,9%,15)
+ 20,000(P/A,9%,10) (P/F,9%,20)
= -50,000+10,000(3.890) +20,000(6.418) (0.6499)
- 50,000 (0.2745) + 10,000(3.890) (0.2745) + 20,000 (6.418)
(0.1784) = + $92,173.638
Solution:

PWCont2 = -50,000+10,000 (P/A,9%,10) + 3000 (P/G,9%,10)

-50,000(P/F,9%,10) +[10,000(P/A,9%,10) + 3,000(P/G,9%,10)]
(P/F,9%,10) – 50,000(P/F,9%,20) + [10,000(P/A,9%,10)
+3,000(P/G,9%,10)] (P/F,9%,20)
=-50,000+10,000(6.418) +3,000(24.373)-50,000(0.4224)
[10,000(6.418) +3,000(24.373)] (0.4224) – 50,000(0.1784)
+ [10,000(6.418) + 3,000(24.373)] (0.1784) = +$139,708.24
PWCont2 > PWCont1 The genius should choose the second contract as it has the higher PW.