The University of the West Indies

Faculty of Engineering
Notes for: ENGR1000/MENG1006 - INTRODUCTION TO ENGINEERING
Prepared by Dr T.M.Lewis

FUNDAMENTALS OF ENGINEERING PROJECT ECONOMICS

LECTURE 3

1 Uniform Annual Cash Flows

1.1 Loan Repayments and Provision of Funds for the Future
In engineering economic analysis, it is often necessary to consider repayment of loans, together with
interest, over a period of time in equal annual amounts. This is the way that mortgages on
properties are normally amortised. Likewise, in providing capital for future use, payments are
often made annually into a fund which is built up over a period of time while accumulating
interest. Pension funds tend to work in this way.

2 Annuities
2.1 An annuity is an annual payment of a fixed amount, over a given period of time, whose
accumulated value, whether present or future, may be of interest.

2.2 If a sum of $A is invested at the end of each year for n years, the total final amount will
obviously be the sum of the compounded amounts for the individual investments. The money
invested at the end of the first will earn interest for (n-1) years, so it will mount to A(1+i)n-1. The
second year's payment will be compounded up to A(1+i)n-2, and so on until the nth year, when
the last payment will earn no interest. The total future amount $F is, thus, given by the
expression:
F = A[1 + (1+i) + (1+i)2.....(1+i)n-1]

This can be put into a simpler form by multiplying both sides by (1+i) to get
F(1+i) = A[(1+i) + (1+i)2.......(1+i)n-1 + (1+i)n]

Now subtract the first equation from the second, and you will get:
Fi = A[(1+i)n - 1)

Thus F = A{[(1+i)n - 1]/i}

and, A = F[ i ]
(1+i)n - 1

Previous calculations (see notes for Lecture 2) showed that F = P(1+i)n , so P can be obtained
in terms of A, i and n from these equations by substitution, i.e.
P(1+i)n = A{[(1+i)n - 1]/i}

giving P = A [ (1+i)n - 1 ]
i(1+i)n

and from this it is easy to see that:

 A = P [ i(1+i)n ]
(1+i)n - 1
Example 2
Find the present and future values of $1,000 per year, over a period of 20 years at 10% compound
interest

Solution The equations given above can be used to carry out this calculation. Hence:

P = 1,000[(1.1)20 -1] = 1,000[6.7275-1]

0.1(1.1)20 0.67275

P = 1,000[8.5136] = $8,514

Having obtained the present worth, the future worth can easily be obtained from
F = 8,514(1.1)20 = 8,510(6.7275) = $57,275

3 Sinking Fund
3.1 A Sinking Fund is established to provide a known amount of capital in the future. Payments into
the fund, made annually, are known as Sinking Fund Payments. In the general case, we require
the Sinking Fund Payment $A, which will grow to a future sum $F, in n years time, with an
interest rate of i (see derivation above).
A = Fi
(1+i)n-l

Example 3
You want to have a capital sum of $100,000 to pay for your child to go to University in 14 years time.
How much do you have to pay into a Sinking Fund Account if this account earns 10% interest?

Solution Using the equation above. Putting n = 14 and i = 10%, we get:

A = 100,000 x 0.10 = $3,575

(1.10)14 -1

This means that if you pay a sum of $3,575 every year for 14 years into an account earning 10%
interest, at the end of the period the account will have $100,000 in it. (Note that 14 payments of
$3,575 would only amount to $50,050 without the effects of interest).

4 Capital Recovery
4.1 Many loans have to be repaid (or redeemed) by making equal annual payments over a given
period of time such that the payments cover accumulated interest first, with the balance going to
pay off the capital (or principal). A fixed rate of interest is applied to the outstanding balance of
the capital each year. The payments in this sort of schedule are known as Capital Recovery
Payments. A home loan mortgage is worked on this basis. The amount A of such payments for
a rate of interest i for n years to redeem a loan of P is given by:
A = P[ i(1+i)n ]
(1+i)n - 1

Example 4
A building can be insulated at a cost of $165,000 in order to reduce cooling costs by $26,000 per annum.
If the insulation has a useful life of 10 years, calculate whether the proposal is worthwhile,
assuming the required return on capital is 8% per annum. (The task in this instance is to provide
a solution by expressing the initial capital outlay as an equivalent annual expenditure, to
compare with the annual saving achieved using the insulation.)

Solution
The initial cost of the building insulation can be expressed as the equivalent of a constant amount
payable at the end of each of 10 years, using the expression shown above. Let this amount be A

A = 165,000{0.08(1.08)10}] = 165,000 { 0.1727 }

(1.08)10 - 1 2.159-1

= 165,000 x 0.149 = $24,588

Now, considering the problem as a whole:

Annual savings on cooling $26,000.00
Annual equivalent of initial cost -$24,589.87
Net annual value +$ 1,410.138

This is positive and so the project is worthwhile.

5 AMORTISATION
5.1 An Engineering project has a limited useful life for the purpose of economic analysis. The reason
for this is that physical deterioration, obsolescence or changing tastes and priorities will
eventually mean that the project facilities will be unable to serve the purpose for which they were
originally created. This period determines the length of time over which benefits can be obtained
from a project.

There is also a period over which payments are made for the gradual extinction of the debt incurred to
finance a project or during which the capital invested in the project must be recovered (as in a
Sinking Fund). This period is known as the amortisation period, and the process of recovery as
amortisation.

Examples of Range of Lives used in Economic Analysis

Engineering Asset Range (Years)

Dams, tunnels, docks, harbours 50 - 100

Buildings, roads, bridges 40 - 60
Outdoor steel structures, steel pipes 35 - 50
Underground electric cable 35 - 40
Overhead power lines, electric generators 30 - 35
Plant and equipment for power stations or manufacturing 25 - 30
Heating, and ventilating equipment 20 - 25
Portable tools and equipment 12 - 15
Road vehicles 5- 8