Session - II - Time Value of Money

05/02/12
Blank & Tarquin: 5-th Edition Ch.

1 Authored by: Dr. Don Smith
Texas A&M University 1
ENGINEERING ECONOMY
SESSION_II
05/02/12
Blank & Tarquin: 5-th Edition Ch. 1
Authored by: Dr. Don Smith Texas A&M
University 2
1. Foundati ons: Overvi ew
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Interpol ate Factor Val ues
5. P/G and A/G Factors
6. Geometri c Gradi ent
7. Cal cul ate i
8. Cal cul ate n
9. Spreadsheets
05/02/12
SESSION II Secti on 1
ENGINEERING ECONOMY
05/02/12
University 4
2.1 Basi c Deri vati ons: F/P factor
F/P Factor To fi nd F gi ven P
P
0
F
n
N
.
To Fi nd F gi ven P
Compound forward i n ti me
05/02/12
University 5
2.1 Deri vati on by Recursi on: F/P factor
F
1
= P(1+i )
F
2
= F
1
(1+i )..but:
F
2
= P(1+i )(1+i ) = P(1+i )
2
F
3
=F
2
(1+i ) =P(1+i )
2
(1+i )

= P(1+i )
3
In general :
N
n
N
05/02/12
University 6
2.1 Present Worth Factor from F/P
Si nce
N
n
N
n} -n
(P/F,i%,n) = (1+i)
-n
05/02/12
University 7
2.1 P/F factor di scounti ng back i n
ti me
Di scounti ng back from the future
P
F
n
N
.
P/F factor bri ngs a si ngl e
future sum back to a speci fi c
poi nt i n ti me.
05/02/12
University 8
2.2 Exampl e- F/P Anal ysi s
Exampl e: P= $1,000;n=3;i =10%
What i s the future val ue, F?
0 1 2
3
P=$1,000
F = ??
i =10%/year
F
3
= $1,000[F/P,10%,3] = $1,000[1.10]
3
= $1,000[1.3310] = $1,331.00
05/02/12
University 9
2.2 Exampl e P/F Anal ysi s
Assume F = $100,000, 9 years from now.
What i s the present worth of thi s amount now
i f i =15%?
0 1 2 3
8 9
F
9
= $100,000
P= ??
i = 15%/yr
P
0
= $100,000(P/F, 15%,9) = $100,000(1/(1.15)
9
)
= $100,000(0.1111) = $11,110 at ti me t = 0
05/02/12
SESSION Secti on 2
ENGINEERING ECONOMY
05/02/12
University 11
2.2 Uni form Seri es Present Worth and
Capi tal Recovery Factors
Annui ty Cash Fl ow
$A per peri od
P = ??
0
..
n
1 2 3 .. ..
n-1
05/02/12
University 12
Desi re an expressi on for the
present worth P of a stream of
equal , end of peri od cash fl ows -
A
0 1 2 3
n-1 n
A = gi ven
P = ??
05/02/12
University 13
Wri te a Present worth expressi on
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
1
+ + + +
1
+ + + +
]
Term i nsi de the brackets i s a geometri c progressi on.
Mul t. Thi s equati on by 1/(1+i ) to yi el d a second
equati on
[1]
05/02/12
University 14
The second equati on
[2]
To i sol ate an expressi on for P i n terms of A, subtract
Eq [1] from Eq. [2]. Note that numerous terms wi l l
drop out.
2 3 1
1 1 1 1
..
1 (1 ) (1 ) (1 ) (1 )
n n
P
A
i i i i i
+
1
+ + + +
1
+ + + + +
]
05/02/12
University 15
Setti ng up the subtracti on
1 2 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
1
+ + + +
1
+ + + +
]
[1]
2 3 1
1 1 1 1
..
(1 ) (1 ) (1 ) (1 )
n n
P A
i i i i
+
1
+ + + +
1
+ + + +
]
[2]
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
1

1
+ + +
]
[3]
05/02/12
University 16
Si mpl i fyi ng Eq. [3] further
1
1 1
1 (1 ) (1 )
n
i
P A
i i i
+
1

1
+ + +
]
1
1
1
(1 )
n
A
P
i i
+
1

1
+
]
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
1
+

1
+
]
05/02/12
University 17
Thi s expressi on wi l l convert an
annui ty cash fl ow to an equi val ent
present worth amount one peri od to
the l eft of the fi rst annui ty cash fl ow.
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
1
+

1
+
]
/ %, P A i n factor
05/02/12
University 18
2.2 Capi tal Recovery Factor
A/P, i %, n
Gi ven the P/A factor
(1 ) 1
0
(1 )
n
n
i
P A for i
i i
1
+

1
+
]
(1 )
(1 ) 1
n
n
i i
A P
i
1
+
1
+
]
Sol ve for A i n terms of P
Yi el di ng.
A/P,i %,n factor
The present worth poi nt
of an annui ty cash fl ow i s
al ways one peri od to the
l eft of the fi rst A amount
05/02/12
ENGINEERING ECONOMY Fi fth Edi ti on
05/02/12
University 20
2.3 F/A and A/F Deri vati ons
Annui ty Cash Fl ow
0
..
N
$A per peri od
$F
Fi nd $A gi ven the
Future amt. - $F
05/02/12
University 21
2.3 Si nki ng Fund and Seri es Compound
amount factors (A/F and F/A)
Take advantage of what we al ready
have
Recal l :
Al so:
1
(1 )
n
P F
i
1
1
+
]
(1 )
(1 ) 1
n
n
i i
A P
i
1
+
1
+
]
Substi tute P and
si mpl i fy!
05/02/12
University 22
2.3 A/F Factor
By substi tuti on
we see:
Si mpl i fyi ng we
have:
Whi ch i s the
(A/F,i %,n) factor
1 (1 )
(1 ) (1 ) 1
n
n n
i i
A F
i i
1 1 +
1 1
+ +
] ]
(1 ) 1
n
A
i
i
F
1
1
+
]
05/02/12
University 23
2.3 F/A factor from the A/F Factor
Gi ven:
Sol ve for F i n
terms of A
(1 ) 1
n
i
A F
i
1
1
+
]
)
=A
(1 1
F
n
i
i
1
+
1
]
05/02/12
University 24
2.3 F/A and A/F Deri vati ons
Annui ty Cash Fl ow
0
..
N
$A per peri od
$F
Fi nd $F gi ven thethe
$A amounts
05/02/12
University 25
2.3 Exampl e 2.5
Formasa Pl asti cs has major
fabri cati on pl ants i n Texas and Hong
Kong.
It i s desi red to know the future worth
of $1,000,000 i nvested at the end of
each year for 8 years, starti ng one
year from now.
The i nterest rate i s assumed to be
14% per year.
05/02/12
University 26
2.3 Exampl e 2.5
A = $1,000,000/yr; n = 8 yrs, i = 14%/yr
F
8
= ??
05/02/12
University 27
2.3 Exampl e 2.5

Sol uti on:
The cash fl ow di agram shows the annual
payments starti ng at the end of year 1 and
endi ng i n the year the future worth i s desi red.
Cash fl ows are i ndi cated i n $1000 uni ts. The F
val ue i n 8 years i s
F = l 000(F/A,14%,8) =
1000( 13.23218) = $13,232.80 =
13.232 mi l l i on 8 years from now/
05/02/12
University 28
2.3 Exampl e 2.6
How much money must Carol deposi t every
year starti ng
,
l year from now at 5% per
year i n order to accumul ate $6000 seven
years from now?
05/02/12
University 29
2.3 Exampl e 2.6
Sol uti on
The cash How diagram from Carol's
perspective fits the A/F factor.
A= $6000 (A/F,5.5%,7) = 6000(0.12096)
= $725.76 per year
The A/F factor Value 0f 0.12096 was
computed using the A/F factor formula
05/02/12
ENGINEERING ECONOMY
05/02/12
University 31
2.4 Interpol ati on of Factors
Al l texts on Engi neeri ng economy wi l l provi de
tabul ated val ues of the vari ous i nterest
factors usual l y at the end of the text i n an
appendi x
Refer to the back of your text for those
tabl es.
05/02/12
University 32
2.4 Interpol ati on of Factors
Typi cal Format for Tabul ated Interest Tabl es
05/02/12
University 33
2.4 Interpol ati on (Esti mati on Process)
At ti mes, a set of i nterest tabl es may not
have the exact i nterest factor needed for an
anal ysi s
One may be forces to i nterpol ate between two
tabul ated val ues
Li near Interpol ati on i s not exact because:
The functi onal rel ati onshi ps of the i nterest
factors are non-l i near functi ons
Hence from 2-5% error may be present
wi th i nterpol ati on.
05/02/12
University 34
2.4 An Exampl e
Assume you need the val ue of the A/P factor
for i = 7.3% and n = 10 years.
7.3% i s most l i kel y not a tabul ated val ue i n
most i nterest tabl es
So, one must work wi th i = 7% and i = 8%
for n fi xed at 10
Proceed as fol l ows:
05/02/12
University 35
2.4 Basi c Setup for Interpol ati on
Work wi th the fol l owi ng basi c rel ati onshi ps
05/02/12
University 36
2. 4 i = 7.3% usi ng the A/P factor
For 7% we woul d observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL
N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 1.9672 0.5083 0.0724 13.8164 0.14238
A/P,7%,10) = 0.14238
05/02/12
University 37
2. 4 i = 7.3% usi ng the A/P factor
For i = 8% we observe:
COMPOUND PRESENT SINKING COMPOUND CAPITAL
N AMT. FACTOR WORTH FUND AMOUNT RECOVERY
F/P P/F A/F F/A A/P
10 2.1589 0.4632 0.0690 14.4866 0.14903
(A/P,8%,10) = 0.14903
05/02/12
University 38
2. 4 Esti mati ng for i = 7.3%
Form the fol l owi ng rel ati onshi ps
05/02/12
University 39
2.4 Fi nal Esti mated Factor Val ue
Observe for i i ncreasi ng from 7% to 8% the
A/P factors al so i ncreases.
One then adds the esti mated i ncrement to the
7% known val ue to yi el d:
05/02/12
University 40
2.4. The Exact Val ue for 7.3%
Usi ng a previ ousl y programmed spreadsheet
model the exact val ue for 7.3% i s:
05/02/12
ENGINEERING ECONOMY
05/02/12
University 42
2.5 Ari thmeti c Gradi ent Factors
In appl i cati ons, the annui ty cash fl ow pattern i s
not the onl y type of pattern encountered
Two other types of end of peri od patterns are
common
The Li near or ari thmeti c gradi ent
The geometri c (% per peri od) gradi ent
Thi s secti on presents the Ari thmeti c Gradi ent
05/02/12
University 43
An ari thmeti c (l i near) Gradi ent i s a cash fl ow
seri es that ei ther i ncreases or decreases by a
contestant amount over n ti me peri ods.
A l i near gradi ent i s al ways compri sed of TWO
components:
The Gradi ent component
The base annui ty component
The objecti ve i s to fi nd a cl osed form expressi on
for the Present Worth of an ari thmeti c gradi ent
05/02/12
University 44
2.5 Li near Gradi ent Exampl e
Assume the fol l owi ng:
0 1 2 3
n-1 N
A
1
+G
A
1
+2G
A
1
+n-2G
A
1
+n-1G
Thi s represents a posi ti ve, i ncreasi ng ari thmeti c gradi ent
05/02/12
University 45
2.5 Exampl e: Li near Gradi ent
Typi cal Negati ve, Increasi ng Gradi ent: G=$50
The Base Annui ty
= $1500
05/02/12
University 46
2.5 Exampl e: Li near Gradi ent
Desi re to fi nd the Present Worth of thi s cash
fl ow
The Base Annui ty
= $1500
05/02/12
University 47
The G amount i s the constant ari thmeti c
change from one ti me peri od to the next.
The G amount may be posi ti ve or negati ve!
The present worth poi nt i s al ways one ti me
peri od to the l eft of the fi rst cash fl ow i n the
seri es or,
Two peri ods to the l eft of the fi rst gradi ent cash
fl ow!
05/02/12
University 48
2.5 Deri vati on: Gradi ent Component
Onl y
Focus Onl y on the gradi ent
Component
A
1
+G
A
1
+2G
A
1
+n-2G
A
1
+n-1G
0 1 2 3
n-1 N
0 G
05/02/12
University 49
2.5 Present Worth Poi nt
The Present worth poi nt of a l i near
gradi ent i s al ways:
2 periods to the left of the 1G

point or,
1 period to the left of the very

first cash flow in the gradient
series.
05/02/12
University 50
0 1 2 3 4 5
6 7
$100
$200
$300
$400
$500
$600
$700
X
The Present Worth Poi nt of the
Gradi ent
05/02/12
University 51
2.5 Gradi ent Component
$0
$100
$200
$300
$400
$500
$600
X
Gradi ent
0 1 2 3 4 5
6 7
The Gradi ent Component
05/02/12
University 52
0 1 2 3 4 5
6 7
Base Annui ty A = $100
X
Gradi ent
PW of the Base Annui ty i s at t = 0
PW
BASE Annui ty
=$100(P/A,i %,7)
05/02/12
University 53
2.5 Present Worth: Li near Gradi ent
The present worth of a l i near gradi ent
i s the present worth of the two
components:
1. The Present Worth of the Gradient

Component and,
2. The Present Worth of the Base Annuity

flow
Requires 2 separate calculations!

05/02/12
University 54
2.5 Present Worth: Gradi ent Component
The PW of the Base Annui ty i s si mpl y
the Base Annui ty A{P/A, i %, n} factor
What i s needed i s a present worth
expressi on for the gradi ent component
cash fl ow.
We need to deri ve a cl osed form
expressi on for the gradi ent
component.
05/02/12
University 55
2.5 Present Worth: Gradi ent Component
General CF Di agram Gradi ent Part Onl y
0 1 2 3 4 ..
n-1 n
1G
2G
3G
(n-2)G
(n-1)G
0G
We want the PW at ti me t = 0 (2 peri ods to the l eft of
1G)
05/02/12
University 56
2.5 To Begi n- Deri vati on of P/G,i %,n
( / , %, 2) 2 ( / , %, 2) ...
...+ [(n-2)G](P/F,i,n-1)+[(n-1)G])P/F,i,n)
P G P F i G P F i + +
Next Step:
Factor out G and re-wri te as ..
05/02/12
University 57
2.5 Factori ng G out. P/G factor
( / , %, 2) 2( / , %, 2) ...
...+ [(n-2)](P/F,i,n-1)+[(n-1)])P/F,i,n)
{
}
P G P F i P F i + +
05/02/12
University 58
2.5 Repl ace (P/F s) wi th cl osed-form
2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
1
+ + + +
1
]
Mul ti pl y both si des by (1+i )
[1]
05/02/12
University 59
2.5 Mul t. Both Si des By (n+1)..
1
1 2 n-2 n-1
1 2 n-2 n-1
P(1+i) =G ...
(1+i) (1+i) (1+i) (1+i)
1
+ + + +
1
]
[2]
We have 2 equati ons [1] and [2].
Next, subtract [1] from [2] and work wi th the
resul tant equati on.
05/02/12
University 60
2 3 n-1 n
1 2 n-2 n-1
P=G ...
(1+i) (1+i) (1+i) (1+i)
1
+ + + +
1
]
2. 5 Subtracti ng [1] from [2]..
1
1 2 n-2 n-1
1 2 n-2 n-1
P(1+i) =G ...
(1+i) (1+i) (1+i) (1+i)
1
+ + + +
1
]
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1
+
1
+ +
]
05/02/12
University 61
2.5 The P/G factor for i and N
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1
+
1
+ +
]
( / , %, ) P G i N factor
05/02/12
University 62
2.5 Further Si mpl i fi cati on on P/G
2
(1 ) 1
( / , %, )
(1 )
N
N
i iN
P G i N
i i
+
+
Remember, the present worth poi nt of any l i near
gradi ent i s 2 peri ods to the l eft of the 1-G cash
fl ow or, 1 peri od to the l eft of the 0-G cash
fl ow.
05/02/12
University 63
2.5 Extensi on The A/G factor
Some authors al so i ncl ude the
deri vati on of the A/G factor.
A/G converts a l i near gradi ent to an
equi val ent annui ty cash fl ow.
Remember, at thi s poi nt one i s onl y
worki ng wi th gradi ent component
There sti l l remai ns the annui ty
component that you must al so handl e
separatel y!
05/02/12
University 64
2.5 The A/G Factor
Convert G to an equi val ent A
( / , , )( / , , ) A G P G i n A P i n
How to do i t
05/02/12
University 65
2.5 A/G factor usi ng A/P wi th P/G
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1
+
1
+ +
]
(1 )
(1 ) 1
N
N
i i
i
1
+
1
+
]
(A/P,i ,n)
The resul ts fol l ow..
05/02/12
University 66
2.5 Resul tant A/G factor
(1 )
(1 ) 1
N
N
i i
i
1
+
1
+
]
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1
+
1
+ +
]
1
(1 ) 1
N
n
G
i i
1
1
+
]
A/G,i ,n =
05/02/12
University 67
2.5 Gradi ent Exampl e
Consi der the fol l owi ng cash fl ow
0 1 2 3
4 5
$100
$200
$300
$400
$500
Find the present worth if i = 10%/yr; n = 5 yrs
Present Worth Poi nt i s here!
And the G amt. = $100/peri od
05/02/12
University 68
2.5 Gradi ent Exampl e- Base
Annui ty
Fi rst, The Base Annui ty of $100/peri od
0 1 2 3
4 5
A = +$100
PW(10%) of the base annui ty = $100(P/A,10%,5)
PW
Base
= $100(3.7908)= $379.08
Not Fi ni shed: We need the PW of the gradi ent component
and then add that val ue to the $379.08 amount
05/02/12
University 69
2.5 The Gradi ent Component
0 1 2 3
4 5
$0
$100
$200
$300
$400
We desi re the PW of the Gradi ent Component at t = 0
P
G@t=0
= G(P/G,10%,5) = $100(P/G,10%,5)
05/02/12
University 70
2.5 The Gradi ent Component
0 1 2 3
4 5
$0
$100
$200
$300
$400
P
G@t=0
= G(P/G,10%,5) = $100(P/G,10%,5)
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1
+
1
+ +
]
Coul d substi tute n=5, i =10%
and G = $100 i nto the P/G
cl osed form to get the val ue
of the factor.
05/02/12
University 71
2.5 PW of the Gradi ent Component
P
G@t=0
= G(P/G,10%,5) = $100(P/G,10%,5)
Cal cul ati ng or l ooki ng up the P/G,10%,5
factor yi el ds the fol l owi ng:
P
t=0
= $100(6.8618) = $686.18 for the gradi ent
PW
P/G,10%,5)
G (1 ) 1
P=
i (1 ) (1 )
N
N N
i N
i i i
1 +
1
+ +
]
Sub. G=$100;i =0.10;n=5
6.8618
05/02/12
University 72
2.5 Gradi ent Exampl e: Fi nal Resul t
PW(10%)
Base Annui ty
= $379.08
PW(10%)
Gradi ent Component
= $686.18
Total PW(10%) = $379.08 + $686.18
Equal s $1065.26
Note: The two sums occur at t =0 and can be
added together concept of equi val ence
05/02/12
University 73
2.5 Exampl e Summari zed
0 1 2 3
4 5
$100
$200
$300
$400
$500
Thi s Cash Fl ow
Is equi val ent to $1065.26 at ti me 0 i f the i nterest
rate i s 10% per year!
05/02/12
University 74
2.5 Shi fted Gradi ent Exampl e: i = 10%
Consi der the fol l owi ng Cash Fl ow
0 1 2 3 4 5 6
7
1. Thi s i s a shi fted negati ve, decreasi ng
gradi ent.
2. The PW poi nt i n ti me i s at t = 3 (not t = o)
$600
$550
$500
$450
05/02/12
University 75
2.5 Shi fted Gradi ent Exampl e
0 1 2 3 4 5 6
7
$600
$550
$500
$450
The PW @ t = 0 requi res getti ng the PW @ t =3;
Then usi ng the P/F factor move PW

3
back to t=0
05/02/12
University 76
2.5 Shi fted Gradi ent Exampl e
The base annui ty i s a $600 cash fl ow for 3 ti me
peri ods
0 1 2 3 4 5 6
7
$600
$550
$500
$450
05/02/12
University 77
2.5 Shi fted Gradi ent Exampl e: Base
Annui ty
PW of the Base Annui ty: 2 Steps
A = -$600
0 1 2 3 4 5 6
7
P
3
=-600(P/A,10%,4)
P
3
P
0
P
0
=P
3
(P/F,10%,3)
P
0
= [-600(P/A,10%,4)](P/F,10%,3)
3.1699
0.7513
P
0-base annui ty
= -$1428.93
05/02/12
University 78
2.5 Shi fted Gradi ent Exampl e: Gradi ent
PW of Gradi ent Component: G = -$50
0 1 2 3 4 5 6
7
P
3
P
0
P
0
=P
3
(P/F,10%,3)
0G
1G 2G
3G
P
3-Grad
= +50(P/G,10%,4)
P
0-grad
= {+50(P/G,10%,4)}(P/F,10%,3)
4.3781
0.7513
=-$164.46
05/02/12
c
Hi l l
ENGINEERING ECONOMY
05/02/12
University 80
2.6 Geometri c Gradi ents
An ari thmeti c (l i near) gradi ent changes by a
fi xed dol l ar amount each ti me peri od.
A GEOMETRIC gradi ent changes by a fi xed
percentage each ti me peri od.
We defi ne a UNIFORM RATE OF CHANGE (%) for
each ti me peri od
Defi ne g as the constant rate of change i n
deci mal form by whi ch amounts i ncrease or
decrease from one peri od to the next
05/02/12
University 81
2.6 Geometri c Gradi ents:
Increasi ng
Typi cal Geometri c Gradi ent Profi l e
Let A
1
= the fi rst cash fl ow i n the seri es
0 1 2 3 4 ..
n-1 n
A
1
A
1
(1+g)
A
1
(1+g)
2
A
1
(1+g)
3
A
1
(1+g)
n-1
05/02/12
University 82
Decreasi ng
Typi cal Geometri c Gradi ent Profi l e
Let A
1
= the fi rst cash fl ow i n the seri es
A
1
A
1
(1-g)
A
1
(1-g)
2
A
1
(1-g)
3
A
1
(1-g)
n-1
0 1 2 3 4 ..
n-1 n
05/02/12
University 83
Deri vati on
Fi rst Major Poi nt to Remember:
A
1
does NOT defi ne a Base Annui ty/
There i s not BASE ANNUITY for a Geometri c
Gradi ent!
The objecti ve i s to determi ne the Present Worth
one peri od to the l eft of the A
1
cash fl ow poi nt
i n ti me
Remember: The PW poi nt i n ti me i s one peri od
to the l eft of the fi rst cash fl ow A
1
!
05/02/12
University 84
Deri vati on
For a Geometri c Gradi ent the fol l owi ng
parameters are requi red:
The i nterest rate per peri od i
The constant rate of change g
No. of ti me peri ods n
The starti ng cash fl ow A

1
05/02/12
University 85
2.6 Geometri c Gradi ents: Starti ng
P
g
= The A
j
s ti me the respecti ve (P/F,i ,j)
factor
Wri te a general present worth rel ati onshi p to
fi nd P
g
. 2 1
1 1 1 1
1 2 3
(1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
A A g A g A g
P
i i i i
+ + +
+ + + +
+ + + +
Now, factor out the A1 value and rewrite as..
05/02/12
University 86
1 2 1
1
2 3
1 (1 ) (1 ) (1 )
...
(1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i
1
+ + +
+ + + +
1
+ + + +
]
(1)
(1+g)
Multuply both sides by to create another equation
(1+i)
1 2 1
1
2 3
(1+g) (1+g) 1 (1 ) (1 ) (1 )
...
(1+i) (1+i) (1 ) (1 ) (1 ) (1 )
n
g
n
g g g
P A
i i i i
1
+ + +
+ + + +
1
+ + + +
]
(2)
Subtract (1) from (2) and the resul t i s..
05/02/12
University 87
1
1
1+g (1 ) 1
1
1+i (1 ) 1
n
g
n
g
P A
i i
+
1
+
_

1
+ +
,
]
Sol ve for P
g
and si mpl i fy to yi el d.
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
05/02/12
University 88
2.6 Geometri c Gradi ent P/A factor
Thi s i s the (P/A,g,i ,n) factor and i s val i d i f g
not equal to i .
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
05/02/12
University 89
2.6 Geometri c Gradi ent P/A factor
Note: If g = i we have a di vi si on by 0
undefi ned.
For g = i we can deri ve the cl osed form PW
factor for thi s speci al case.
We substi tute i for g i nto the Pg rel ati onshi p to
yi el d:
05/02/12
University 90
2.6 Geometri c Gradi ent: i = g Case
g 1
1 1 1 1
P =A ...
(1+i) (1+i) (1+i) (1+i)
_
+ + + +

,
1
(1 )
g
nA
P
i
+
For the case i = g
05/02/12
University 91
2.6 Geometri c Gradi ents: Summary
P
g
= A
1
(P/A,g,i,n)
1
(1 )
g
nA
P
i
+
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
g not = to
i
Case: g =
i
05/02/12
University 92
2.6 Geometri c Gradi ent: Notes
The geometri c gradi ent requi res knowl edge of:
A
1
, i , n, and g
There exi st an i nfi ni te number of combi nati ons
for i , n, and g: Hence one wi l l not fi nd tabul ated
tabl es for the (P/A, g,i ,n) factor.
You have to cal cul ated ei ther from the cl osed
form for each probl em or appl y a pre-
programmed spreadsheet model to fi nd the
needed factor val ue
No spreadsheet bui l t-i n functi on for thi s factor!
05/02/12
University 93
2.6 Geometri c Gradi ent: Exampl e
Assume mai ntenance costs for a parti cul ar
acti vi ty wi l l be $1700 one year from now.
Assume an annual i ncrease of 11% per year
over a 6-year ti me peri od.
If the i nterest rate i s 8% per year, determi ne
the present worth of the future expenses at ti me
t = 0.
Fi rst, draw a cash fl ow di agram to represent
the model .
05/02/12
University 94
2.6 Geometri c Gradi ent Exampl e (+g)
g = +11% per peri od; A1 = $1700; i = 8%/yr
0 1 2 3 4 5
6 7
$1700
$1700(1.11)
1
$1700(1.11)
2
$1700(1.11)
3
$1700(1.11)
5
PW(8%) = ??
05/02/12
University 95
2.6 Sol uti on
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = 11%
i= 8%
N= 7
P/A,g,i,n factor is 7.04732
First Amt= 1,700.00 $
P. Value = 11,980.44 $
P = $1700(P/A,11%,8%,7)
Need to cal cul ate the P/A factor from the
cl osed-form expressi on for a geometri c gradi ent.
From a spreadsheet we see:
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
05/02/12
University 96
2.6 Geometri c Gradi ent ( -g )
Consi der the fol l owi ng probl em wi th a negati ve
growth rate g.
0 1 2 3
4
g = -10%/yr; i = 8%; n = 4
A
1
= $1000
$900
$810
$729
P
0
=??
We si mpl y appl y a g val ue = -0.10
05/02/12
University 97
2.6 Geometri c Gradi ent (-g val ue)
Eval uate:
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
1
1
1
1
g i
n
g
g
i
P A
i g
1
+
_
1

+
,
1

1
1
1
]
For a negati ve g
val ue = -0.10
303: Use "g" 667: use f-bar
Geometric Gradients
"E" or g or f-bar = -10%
i= 8%
N= 4
P/A,g,i,n factor is 2.87637
First Amt= 1,000.00 $
P. Value = 2,876.37 $
05/02/12
ENGINEERING ECONOMY
05/02/12
University 99
2.7 When the i rate i s unknown
A cl ass of probl ems may deal wi th al l of the
parameters know except the i nterest rate.
For many appl i cati on-type probl ems, thi s can
become a di ffi cul t task
Termed, rate of return anal ysi s
In some cases:
i can easi l y be determi ned
In others, tri al and error must be used
05/02/12
University 100
2.7 Exampl e: i unknown
Assume on can i nvest $3000 now i n a venture
i n anti ci pati on of gai ni ng $5,000 i n fi ve (5)
years.
If these amounts are accurate, what i nterest
rate equates these two cash fl ows?
0 1 2 3
4 5
$3,000
$5,000
F = P(1+i )
n
5,000 = 3,000(1+i )
5
(1+i )
5
= 5,000/3000 = 1.6667
05/02/12
University 101
2.7 Exampl e: i unknown
Assume on can i nvest $3000 now i n a venture
i n anti ci pati on of gai ni ng $5,000 i n fi ve (5)
years.
If these amounts are accurate, what i nterest
rate equates these two cash fl ows?
0 1 2 3
4 5
$3,000
$5,000
(1+i )
5
= 5,000/3000 = 1.6667
(1+i ) = 1.6667
0.20
i = 1.1076 1 = 0.1076 = 10.76%
05/02/12
University 102
2.7 For i unknown
In general , sol vi ng for i i n a ti me val ue
formul ati on i s not strai ght forward.
More often, one wi l l have to resort to some
form of tri al and error approach as wi l l be shown
i n future secti ons.
A sampl e spreadsheet model for thi s probl em
fol l ows.
05/02/12
University 103
2.7 Exampl e of the IRR functi on
=IRR($D7:$D12)
05/02/12
ENGINEERING ECONOMY
05/02/12
University 105
2.8 Unknown Number of Years
Some probl ems requi re knowi ng the number of
ti me peri ods requi red gi ven the other
parameters
Exampl e:
How l ong wi l l i t take for $1,000 to doubl e i n
val ue i f the di scount rate i s 5% per year?
Draw the cash fl ow di agram as.
0 1 2 . . . . .
. . n
P = $1,000
F
n
= $2000
i = 5%/year; n i s unknown!
05/02/12
University 106
Sol vi ng we have..
0 1 2 . . . . .
. . n
P = $1,000
F
n
= $2000
F
n=?
= 1000(F/P,5%,x): 2000 = 1000(1.05)
x
Sol ve for x i n cl osed form
05/02/12
University 107
Sol vi ng we have..
(1.05)
x
= 2000/1000
Xl n(1.05) =l n(2.000)
X = l n(1.05)/l n(2.000)
X = 0.6931/0.0488 = 14.2057 yrs
Wi th di screte compoundi ng i t wi l l take 15
years to amass $2,000 (have a l i ttl e more that
$2,000)
05/02/12
University 108
2.8 No. of Years NPER functi on
From Excel one can formul ate as:
=NPER(C23,C22,C20,C21)
05/02/12
ENGINEERING ECONOMY
05/02/12
University 110
2.9 Basi c Sensi ti vi ty Anal ysi s
Sensi ti vi ty anal ysi s i s a procedure appl i ed to a
formul ated probl em whereby one can assess the
i mpact of each i nput parameter rel ati ng to the
output vari abl e.
Sensi ti vi ty anal ysi s i s best performed usi ng a
spreadsheet model .
The procedure i s to vary the i nput parameters
wi thi n certai n ranges and observe the change on
the output vari abl e.
05/02/12
University 111
By proper model i ng, one can perform what-i f
anal ysi s on one or more of the i nput parameters
and observe any changes i n a targeted output
(response) vari abl e
Commerci al add-i n packages are avai l abl e that
can be l i nked to Excel to perform such an
anal ysi s
Speci fi cal l y: Pal i sade Corporati on s TopRank
Excel add-i n i s most appropri ate.
05/02/12
University 112
When you bui l d your own model s, devi se an
approach to permi t varyi ng at l east one of the
i nput parameters and store the resul ts of each
change i n the output vari abl ethen pl ot the
resul ts.
If a smal l change i n one of the i nput
parameters represents a si gni fi cant change i n
the output vari abl e then
That i nput vari abl e i s sensi ti ve
05/02/12
University 113
If an i nput parameter i s deemed sensi ti ve
then some effort shoul d go i nto the esti mati on
of that parameter
Because i t does i nfl uence the response (output)
vari abl e.
Less sensi ti ve i nput parameters may not have
as much effort requi red to esti mate as those
i nput parameters do not have that much i mpact
on the targeted response vari abl e.
05/02/12
University 114
When you bui l d your own model s, devi se an
approach to permi t varyi ng at l east one of the
i nput parameters and store the resul ts of each
change i n the output vari abl ethen pl ot the
resul ts.
If a smal l change i n one of the i nput
parameters represents a si gni fi cant change i n
the output vari abl e then
That i nput vari abl e i s sensi ti ve
05/02/12
SESSION II Summary
c
Graw
Hi l l
ENGINEERING ECONOMY
05/02/12
University 116
Chapter Summary
Thi s chapter presents the fundamental ti me
val ue of money rel ati onshi ps common to most
engi neeri ng economi c anal ysi s cal cul ati ons
Deri vati ons have been presented for:
Present and Future Worth- P/F and F/P
Annui ty Cash fl ows P/A, A/P, F/A and A/F
Gradi ents P/G, A,G and P/A,g,i ,n
05/02/12
University 117
Chapter Summary
One must master these basi c ti me val ue of
money rel ati onshi ps i n order to proceed wi th
more meani ngful anal ysi s that can i mpact
deci si on maki ng.
These rel ati onshi ps are i mportant to you
professi onal l y and i n your personal l i ves.
Master these concepts!!!
05/02/12
SESSION II End of Sl i de Set
ENGINEERING ECONOMY

Session - II - Time Value of Money

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05/02/12

Blank & Tarquin: 5-th Edition Ch.

2 periods to the left of the 1G

1 period to the left of the very

1. The Present Worth of the Gradient

2. The Present Worth of the Base Annuity

Requires 2 separate calculations!

Then usi ng the P/F factor move PW

The starti ng cash fl ow A

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