REN505 Project Management and

Engineering Economics
Dr. Tamer A. Mohamed
Cash Flow Analysis
Outline

3.1 Introduction
3.2 Timing of Cash Flows and Modelling
3.3 Compound Interest Factors for Discrete Compounding
3.4 Compound Interest Factors for Single Disbursements or
Receipts
3.5 Compound Interest Factors for Annuities
3.6 Compound Interest Factors for Arithmetic Gradient
Series
3.7 Compound Interest Factors for Geometric Gradient
Series
3.8 Non-standard Annuities and Gradients
3.9 Present Worth Computations when N → 
3.1 Introduction

 Compound interest factors can be used to

evaluate different patterns of cash flows.
3.2 Timing of Cash Flows and Modelling

 Timing of cash flows can be complicated and

irregular.
 Engineers typically work with simplified models
and assumptions.
 The most common is to assume that cash flows
and compounding of cash flows occur at the end
of conventionally defined periods (e.g. months or
years).
 Models that make this assumption are called
discrete models.
3.3 Compound Interest Factors for Discrete
Compounding

 Compound interest factors are formulas that

define mathematical equivalence for specific
common cash flow patterns.
 The factors facilitate cash flow analysis because
tables and spreadsheet functions can be used
instead of complicated formulas.
3.3 Compound Interest Factors for
Discrete Compounding, cont’d
 The four common patterns:
1.
1. Single Disbursement or Receipt
2.
2. Annuity
3.
3. Arithmetic Gradient Series
4.
4. Geometric Gradient Series
3.3 Compound Interest Factors for
Discrete Compounding, cont’d
 Discrete compounding models have several
assumptions:
1. Compounding periods are of equal length.
2. Each disbursement or receipt occurs at the end of a
period.
 A
A payment
payment at
at time
time 00 can
can be
be considered
considered to
to be
be at
at the
the end
end of
of time
time
period
period -1.
-1.

3. Annuities and Gradients coincide with the ends of

sequential periods (more later).
 3.4 Compound Interest Factors for Single
Disbursements or Receipts

 The single disbursement or receipt is the

most basic form of a cash flow.
 3.4 Compound Interest Factors for
Single Disbursements or Receipts,
cont’d
 The compound amount factor gives the future
amount, F, equivalent to a present amount P,
when the interest rate is i and the number of
periods until F is N:

F = P(1 + i)N = P (F/P, i, N)

 3.4 Compound Interest Factors for
Single Disbursements or Receipts,
cont’d
 The compound amount factor is written as:

(F/P, i, N) = (1 + i)N
 Practice Problem 3-1

• How much money will be in a bank account at the end of 2

years if £5000 is deposited today? The interest rate is 12%
compounded monthly.

Answer
F = P(F/P, i, N)
= 5000(F/P, 12%/12, 24) = 5000(F/P, 0.01, 24)
= 5000(1 + 0.01)24
= £6348.67
 3.4 Compound Interest Factors for
Single Disbursements or Receipts,
cont’d
 The present worth factor gives the present
amount, P, that is equivalent to the future
amount, F, when the interest rate is i and the
number of periods between F and P is N:

P = F/(1 + i)N = F (P/F, i, N)

 3.4 Compound Interest Factors for
Single Disbursements or Receipts,
cont’d
 The present worth factor is written as:

(P/F, i, N) = 1/(1 + i)N

 Practice Problem 3-2(a)

• What amount deposited today into an account bearing 12%

nominal interest will give £5000 at the end of two years?
Interest is compounded monthly.

Answer
1
P  F (P / F ,1%,24)  5000  3937.83
24
(1  0.01)
3.4 Compound Interest Factors for
Single Disbursements or Receipts,
cont’d
 All compound interest factors are relatively easy
to compute. However, you may often find tables
convenient.
 Appendix A at the back of the textbook lists
values for all compound interest factors for a
selection of interest rates for discrete
compounding periods.
 Practice Problem 3-3(b)

• (With interest tables) What amount deposited today into an account

bearing 12% nominal interest will yield £5000 at the end of two years?
Interest is compounded monthly.

Answer
From table: (P/F,1%,24) = 0.78757
P = F (P/F, 1%, 24)
= £5000(0.78757)
= £3937.85
3.5 Compound Interest Factors for Annuities

 Annuity: a series of N same-sized receipts or

disbursements that begin at the end of period 1
and continue to the end of period N
– Mortgage and loan payments are classical examples of
annuities.
3.5 Compound Interest Factors for
Annuities, cont’d
 The Sinking Fund Factor: (A/F, i, N)
 How much should be set aside each period in
order to meet a major financial need in the future
 3.5 Compound Interest Factors for
Annuities, cont’d
 (A/F, i, N) can be found by decomposing the series
of disbursements or receipts made at times 1, 2,
…, N and summing to produce a total future
value:

i
( A / F , i, N ) 
(1  i )  1
N
 Practice Problem 3-3

• You want to save £20 000 for a new car over the time you
are at university (5 years) by saving the same amount A
each month. You can get 7% compounded monthly. What
should you save each month?

Answer
i = 0.07/12 (= 0.00583 or 0.583%), N = 5  12 = 60
A = F(A/F, 0.583%, 60) = £20 000(0.01397) = £279.40
3.5 Compound Interest Factors for
Annuities, cont’d
 The Uniform Series Compound Amount
Factor: (F/A, i, N)
 Is used to compute the total amount saved at the
end of a regular savings plan
 3.5 Compound Interest Factors for
Annuities, cont’d
 (A/F, i, N) is the inverse of the sinking fund factor:

N
(1  i )  1
(F / A, i , N ) 
i
 Practice Problem 3-4

• A Ford Mustang costs £17 000. It can be financed at 5.9%

for 48 months, with monthly compounding. How much
will the monthly payments be?

Answer
i = 0.059/12 = 0.00492 per month
A = P(A/P, i, N) = £17 000(A/P, 0.00492, 48) = £398.50
3.5 Compound Interest Factors for
Annuities, cont’d
 The Capital Recovery Factor: (A/P, i, N)
 Is used to compute how much to be set aside
each period to repay a present use of money.
 3.5 Compound Interest Factors for
Annuities, cont’d
 (A/P, i, N) is easily derived from the sinking fund
factor and the uniform series compound amount
factor:

( A / P, i , N )  ( A / F , i , N )(F / P, i , N )
i (1  i )N

(1  i )N  1
 Practice Problem 3-5

• What is the present worth of a series of 15 annual

payments of £1000 each, when the first payment is now
and the interest rate is 5%, compounded yearly?
• This is an example of an annuity due  the payments of
an annuity are made at the start of each period rather than
at the end.
Practice Problem 3-5

 Method 1: Count the first payment as a present

worth and the next 14 payments as a regular
annuity:
P = 1000 + A(P/A, i, N) where
A = 1000, i = 5% and N = 14
P = 1000 + 1000(P/A, 5%, 14)
= 1000 + 1000(9.8986) = 1000 + 9898.6
= £10,898.60
 Practice Problem 3-5

 Method 2: Determine the

present worth of a standard P1  A( P / A, i, N ) = 1000(P/A,5%,15)
annuity at time 1 and then = 1000(10.380)
find its worth at time 0 (now).
The worth at time 1 is: = 10,380

P0  P1 (F/P, i, N )
• Then the present worth now
(time 0) is:  10 380(F/P,5%,1)  10 380 (1.05)
 10, 899
 Practice Problem 3-6

 What is the present worth of a series of 15 annual

payments of £1000 each, when the first payment
is now and the interest rate is 5%, compounded
monthly?
Answer
The method is as in the previous example, except an effective annual
interest rate must be calculated (Method 2):
i e  (1  0.05 / 12)12  1 = 0.05116
Practice Problem 3-7

 A new machine costing £8000 will reduce annual

production costs by £2100. The machine will
operate for 5 years, at which time it will have no
resale value. What rate of return is being earned
on this investment?
Restated: For what interest rate will a cash flow
of £2100 per year for 5 years be equivalent to a
present amount of £8000?
 Practice Problem 3-7, cont’d
Answer
Find i in: 2100(P/A, i, 5) = 8000
(P/A, i, 5) = P/A = 8000/2100 = 3.8095
where:
(1  i )N  1
(P / A, i , N ) 
i (1  i )N

which is not easy to solve for i.

 Practice Problem 3-7, cont’d
Answer (cont’d)
Compound interest factor tables may not be available for all
combinations of i and N
From before: (P/A, i, 5) = 3.8095
From tables: (P/A, 10%, 5) = 3.7908
(P/A, 9%, 5) = 3.8897
The interest rate we are looking for must be between 9% and
10%.
 Practice Problem 3-7, cont’d
Answer (cont’d)
(P/A, 10%, 5) = 3.7908  (x1, y1) = (0.10, 3.7908)
(P/A, 9%, 5) = 3.8897  (x2, y2) = (0.09, 3.8897)

Want to find i: (x*, y*) = (i, 3.8095)

 Practice Problem 3-7, cont’d
Answer (cont’d)
By interpolation…
 y *  y1 
x*  x1  ( x2  x1 ) 
 y2  y1 
 3.8095  3.7908 
 0.10  (0.09  0.10) 
 3.8897  3.7908 
 0.09811
 9. 8%
Figure 3.3 Linear Interpolation
3.6 Conversion Factor for Arithmetic Gradient
Series

 Arithmetic Gradient to Uniform Series Factor:

(A/G, i, N)
 A series of N receipts or disbursements that
increase by a constant amount from period to
period.
 Cash flows: 0G, 1G, 2G, ..., (N – 1)G at the end
of periods 1, 2, ..., N
3.6 Conversion Factor for
Arithmetic Gradient Series, cont’d
 Cash flows for arithmetic gradient with base
annuity:
A', A’ + G, A‘ + 2G, ..., A‘ + (N – 1)G at the end
of periods 1, 2, ..., N where A’ is the amount of
the base annuity
3.6 Conversion Factor for
Arithmetic Gradient Series, cont’d
 The annuity equivalent to an arithmetic gradient
series is A = G(A/G, i, N)
 If there is a base cash flow A', the base annuity A'
must be included to give the overall annuity: Atot
tot
= A' + G(A/G, i, N)
 Note that A' is the amount in the first year and G
is the uniform increment starting in year 2.
Figure 3.6 Arithmetic Gradient
Series with Basic Annuity
Practice Problem 3-8

 A lottery prize pays £1000 at the end of

the first year, £2000 the second, £3000 the
third, etc., for 20 years. If there is only one
prize in the lottery, 10 000 tickets are sold,
and you can invest your money elsewhere
at 15% interest, how much is each ticket
worth, on average?
 Practice Problem 3-8, cont’d
Answer
Method 1: First find annuity value of
prize and then find present value of
annuity.
Method 2: Find P–1 with A' = 0, G = 1000
and N = 21. Then find P0.
 Practice Problem 3-8, cont’d
Answer
Method 1
A' = 1000, G = 1000, i = 0.15, N = 20
A = A' + G(A/G, i, N) = 1000 + 1000(A/G, 15%, 20)
= 1000 + 1000(5.3651) = 6365.10
Now find present value of annuity:
P = A (P/A, i, N) where A = 6365.10, i = 15%, N =
20
P = 6365.10(P/A, 15, 20)
= 6365.10(6.2593) 39,841.07
=

Since 10,000 tickets are to be sold, on average each

 Practice Problem 3-8, cont’d
Answer
Method 2
Find P1 with A' = 0, G = 1000 and N = 21.
Then find P0.
3.7 Conversion Factor for Geometric Gradient
Series

 A series of cash flows that increase or decrease

by a constant proportion each period
 Cash flows: A, A(1 + g), A(1 + g)22, …, A(1 + g)N–
N–
11
at the end of periods 1, 2, 3, ..., N
 g is the growth rate, positive or negative
percentage change
 Can model inflation and deflation using
geometric series
3.7 Conversion Factor for
Geometric Gradient Series, cont’d
 Geometric Gradient to Present Worth Conversion
Factor:
 (P/A, g, i, N)
 The present worth of the series, where A is the
base amount and g is the growth rate.
A A(1  g ) A(1  g )N 1
P  
2
(1  i ) (1  i ) (1  i )N
3.7 Conversion Factor for
Geometric Gradient Series, cont’d
 Before we may get the factor, we need what is
called a growth adjusted interest rate:

 1 i 1 1 g
i   1 so that 
1 g  1 i
1 i
 3.7 Conversion Factor for
Geometric Gradient Series, cont’d
(1  i  )N  1 1 
(P / A, g, i , N )   
  N 1 g
i (1  i )  
(P/A,i ,N)

( 1  g)

1. i > g > 0: i° is positive  use tables or formula

2. g < 0: i° is positive  use tables or formula
3. g > i > 0: i° is negative must use formula
4. g = i > 0: i° = 0   A 
P  N 
1 g 
Figure 3.7 Geometric Gradient
Series for Receipts with Positive
Growth
Figure 3.8 Geometric Gradient
Series for Receipts with Negative
Growth
Practice Problem 3-9
 Suppose that the salary of an engineer during the
coming year is expected to be £128 000. It is
expected to increase by 12% per year over the
following four years, when she would retire and
receive a pension. She has just been in a bad
accident and will be unable to work again, so a
judge is estimating the lump sum amount that the
insurance company must pay to the engineer now
in order to replace her salary. The interest rate is
taken to be 10%, compounded yearly, during this
period. What is the present worth now of the
earnings over the next five years?
 Practice Problem 3-9, cont’d

Answer
N = 5, g = 0.12, i = 0.10, A = 128 000
Find the growth adjusted interest rate:

P = A(P/A, g, i, N) = 128 000(4.7138) = £603,366

The present worth of the next five year’s salary is £603,366.
 3.9 Present Worth Computations When
N

 The model is reasonable for long-lived projects

 P in this case called the capitalized value
 The capitalized value formula is: P = A/i

(1  i )N  1
P  lim A(P / A, i , N )  A lim  
N  N   i (1  i )N

A

i
Practice Problem 3-10

 A £500,000 gift was bequeathed to a city for the

construction and continued maintenance of a
small music hall. Annual maintenance for a hall
is estimated at £15,000.
 In addition, £25,000 will be needed every 10
years for painting and major repairs.
 How much will be left for the initial construction
costs after funds are allocated for continuous
upkeep? Interest is 6% per annum.
 Practice Problem 3-10, cont’d
Answer
Amount left = £500 000  (capitalized cost of perpetual upkeep) =
£500 000  A/i
where A = annual disbursement
A = 15,000 + 25,000(A/F, 6%, 10) = 15,000 + 25 000(0.07587)
= 16,896.75
Amount left = 500,000  (16,896.75)/0.06 = £218 387.50
The amount left for constructing the hall is £218 388.
Capital Recovery Formula

 Consider a capital asset (e.g., a robot in a factory,

delivery truck). It has an initial cost is P, and a
salvage value, S, after N periods.
 An equivalent annual cost can be obtained using
the capital recovery factor and the sinking fund
factor: A = P(A/P, i, N) – S(A/F, i, N)
 Capital Recovery Formula , cont’d
 With some algebra, we have the capital recovery
formula:

A = (P – S)(A/P, i, N) + Si
• A is often called the capital recovery cost
Practice Problem 3-11

 A supplier of laboratory equipment is looking at

a mobile demonstration unit which will cost
£71 000. It will have a useful life of 5 years and
the salvage value at that time is estimated at
£8000.
a) If the cost of capital is 15% per year, what are the
equivalent annual costs (i.e., the annual capital
recovery costs) of purchasing the equipment?
b) If the mobile demonstration unit is estimated to
produce extra profits of £23 000 per year, is it
economically justified?
 Practice Problem 3-11

Answer
a) A = (P − S)(A/P, i, N) + Si

= (71 000 − 8000)(A/P, 15%, 5) + 8000(0.15)

= 63 000(0.29832) + 1200 = £19 994

The equivalent annual costs (capital recovery costs) are £19 994.

b) Since the savings per year exceed the equivalent annual costs, the
purchase is justified.