Lecture # 8

Engineering Economics (MS-291)

Chapter 2
Factors: How Time and Interest Affect Money

Dr. Maazullah Khan

PhD, MSc, MBA
Associate Professor of Practice
Department of Management Sciences GIKI
Recap
•  Single-Payment
[Compounding]
[Discounting]

• Uniform Series /Annuities
and  Capital Recovery Factor
----- sinking fund factor

 
8% 2.1589
0.3%  𝑥
1% 8.3% f 0.2085

9% 2.3674
Moving from Uniform Series to Gradient
• We started with single-payments. Factors: F/P, P/F
• We moved to uniform series/ Annuities. Factors: P/A, A/P, F/A and A/F
• Now its time to tackle “Arithmetic” or  “Geometric” Gradient Series
Arithmetic Gradient
• An arithmetic gradient series is a cash flow series that either increase or decrease by a
constant amount each period.
• The amount of change (increase or decrease) is called the gradient.
• Gradient series can be both: cash inflows or cash outflows.
• Let suppose that an engineer predicts that the cost of operating the plant will increase by
Rs. 50,000 each year until the plant become obsolete. The cash flow series of operating
the plant involves a constant gradient, which is Rs. 50,000 per year.
Example: Arithmetic Gradient
• Let suppose, You bought a used bike with one year warranty.
• The cost of using bike during first year is only the petrol expense that is estimated to be
$2,500.
• From second year, you have to pay $200 per year for repair and maintenance. This cost
will increase by $200 each year.
• What will be the amount in 2nd year?
Arithmetic Gradient
Typical Arithmetic Gradient Cash Flow
PT = ?

i = 10%
0 1 2 3 4 5

400
450
Amount in year 1 500
is base amount 550
600

This diagram = this base amount plus this gradient

PA = ? PG = ?
i = 10% i = 10%

+
0 1 2 3 4 5
0 1 2 3 4 5

Amount 400 400 400 400 400

50
in year 1 100
PA = 400(P/A,10%,5) PG = 50(P/G,10%,5) 150
is base 200
amount  𝑷 𝑻 =𝑷 𝑨 + 𝑷 𝑮=𝟒𝟎𝟎( 𝑷 / 𝑨 ,𝟏𝟎 % , 𝟓)+𝟓𝟎( 𝑷 / 𝑮 ,𝟏𝟎 % ,𝟓)
Converting Arithmetic Gradient to A
  Arithmetic gradient can be converted into equivalent A value using
i = 10% i = 10%
0 1 2 3 4 5 0 1 2 3 4 5

G
2G A=?
3G
4G

General equation when base amount is involved is

A = base amount + G(A/G,i,n)

For decreasing gradients,

0 1 2 3 4 5
change plus sign to minus
4G
3G
2G   A = base amount -
G
Summation of Arithmetic Gradient
•  
can be easily calculated from factor. is something that we should take care of. [Next slide]

Alternatively;
 Conversion of in
Future Value of Arithmetic Gradient
•  Multiply by factor;
Example: Arithmetic Gradient
The present worth of $400 in year 1 and amounts increasing by $30 per year
through year 5 at an interest rate of 12% per year is closest to:

(A) $1532 (B) $1,634 (C) $1,744 (D) $1,829

Solution:
PT = ? PT = 400(P/A,12%,5) + 30(P/G,12%,5)
i = 12% = 400(3.6048) + 30(6.3970)
0 1 2 3 4 5 Year = $1,633.83
Answer is (B)
400
430 The cash flow could also be converted into an A
460
490 (uniform series) value as follows:
G = $30 520
A = 400 + 30(A/G,12%,5)
= 400 + 30(1.7746)
= $453.24
Solution: (a)
Solution: (b)
Geometric Gradients
Geometric gradients change by the same percentage each period
Cash flow diagram for present worth
of geometric gradient  There are no tables for geometric factors

Use following equation for

Pg = ?
  𝟏+ 𝒈 𝒏
1 2 3 4 n
𝑷 𝒈= 𝑨 𝟏
𝟏− (𝟏+𝒊 )
𝒊−𝒈
0
A1  where: A1 = cash flow in period 1
A 1(1+g)1
A 1(1+g)2 g = rate of increase
Note: g starts between If ,
periods 1 and 2 A 1(1+g)n-1

Note: If g is negative, change signs in front of both g values

Geometric Gradient
 If
,
Eq. 2.31 implies;
Example: Geometric Gradient

Find the present worth of $1,000 in year 1 and amounts increasing by 7%

per year through year 10. Use an interest rate of 12% per year.

(a) $5,670 (b) $7,333 (c) $12,670 (d) $13,550

Pg = ? Solution:
i = 12%
1 2 3 4 10 𝑃
  𝑔=1000 [1 −(1+0.07/1+0.12)10]/(0.12− 0.07)
= $7,333
0
1000
1070 Answer is (b)
1145
g = 7%

1838 To find A, multiply Pg by (A/P,12%,10)

Example 2.11
 Calculating and for know Cash Flows

 Calculator

 Excel

 Linear Interpolation
Problem # 2.45
Acme Bricks, a masonry products company, wants to have $600,000 on hand before it
invests in new conveyors, trucks, and other equipment. If the company sets aside $80,000
per year in an account that increases in value at a rate of 15% per year, how many years will
it be before Acme can purchase the equipment?

Solution
600,000 = 80,000(F/A,15%,n)
(F/A,15%,n) = 7.50
Interpolate in the 15% interest table or use a spreadsheet function. By spreadsheet, n = 5.4
years.

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 Interpolation

 
5 6.7424
x 0.7576
1 n 7.500 2.0113
years
6 8.7537

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 Thank You

Any Questions?
Email: maazullah@giki.edu.pk

Teaching Assistant: Ms. Sabahat Orakzai

sabahat@giki.edu.pk
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin [ISBN-
10: 0073376302] and accompanying PowerPoint slides

• Videos from Dragon’s Den are copy righted. We are using it only for educational
purposes.

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