Tools for Engineering Economy

Calculation

time

Course Teacher
Dr. N. M. Golam Zakaria
Professor
Dept. of Naval Architecture & Marine Engineering
BUET, Dhaka-1000
1
 Tools for Engineering Economy
Calculation

• To integrate the related economic factor into the technical design

• To evaluate alternative design from different options

• To assess performance over life of the ship or any other project or

investment etc.
 Basic Concepts
Interest
Interest is a fee that is charged for the use of someone else's money.
The size of the fee will depend upon the total amount of money
borrowed and the length of time over which it is borrowed.
Whenever money is borrowed or invested, one party acts as the lender
and another party as the borrower. The lender is the owner of the
money, and the borrower pays interest to the lender for the use of the
lender's money. The reward or interest is fundamental to all economic
calculation.

Interest rate
If a given amount of money is borrowed for a specified period of
time (typically, one year), at certain percentage of the money is
charged as interest. This percentage is called the interest rate.
 Basic Concepts
Capital
Invested money and resources
Investment
The allocation of a capital for use in order to gain profit
Nominal IR
The interest rate per year without adjusting for the number of
compounding periods
Effective IR
The interest rate per year adjusting for the number of compounding
periods
Borrowed Capital
The capital borrowed from other sources
 Basic Concepts
Return
The result of productivity of capital, it is the difference between
income and expenses

Cash flow
A cash flow is the difference between total cash receipts (inflows) and
total cash disbursements (outflows) for a given period of time
(typically, one year).
Cash flows are very important in engineering economics because they
form the basis for evaluating projects, equipment, and investment
alternatives.
 Basic Concepts
:
The Simple Interest It is the amount earned by a unit of principal in a unit
of time , the principal which is the basic amount of money is regarded fixed
and the interest is calculated at the end of each time unit .
Interest = I = P . i . n
where, P = Principal , i = rate of interest , n = no. of years
After (n) years , the sum of money = P + I = P(1+i.n)

Compound Interest : It is the more usual situation in financial transactions,

the interest at the end of period of time is added to the principal for the next
period. Engineering economic analysis uses the compound interest scheme
exclusively, as it is most frequently practiced in the real world.
At the end of nth year S = P (1+i)n
 Simple and Compound interest rate
Problem: Suppose you deposit $1,000 in a bank savings account that pays
interest at a rate of 8% per year. Assume that you don't withdraw the interest
earned at the end of each period (year), but instead let it accumulate.
(a) How much would you have at the end of year three with simple interest?
(b) How much would you have at the end of year three with compound
interest?
Given: P = $1.000. N = 3 years. and i = 8% per year. Find: F.
(a) Simple interest: We calculate F as
 Simple and Compound interest rate
(b) Compound interest: Applying Equation for three-year, i= 8% case, we
obtain

The total interest earned is $259.71 which is ($ 259.71-$240)=$19.71 more

than that was accumulated under the simple-interest method. We can keep
track of the interest-accruing process more precisely as follows:
 Time Value of Money
Since money has the ability to earn interest, its value
increases with time., i.e., the value of money is
changeable by time

Most of us would rather be given one dollar today

than a promise of one in the near future

 The time value of money is judged by the running

rate of interest or the rate of inflation
 The Time Value of Money contd..

For instance, $100 today is equivalent to

F = $100(1+ 0.07)5 = $140.26
five years from now if the interest rate is 7% per year,
compounded annually. We say that the future worth of $100 is
$140.26 if i = 7% (per year) and n = 5 (years).

Since money increases in value as we move from the present

to the future, it must decrease in value as we move from the
present to past. Thus, the present worth of $140.26 is $100 if i =
7% (per year) and n = 5 years ago.
 Equivalence
Equivalence indicates that different amount of money at different
time periods are equivalent by considering the time value of money

Different sums of money at different times can be equal in

economic value

i.e. $100 today with i = 6% is equivalent to $106 in one year

Equivalence depends on the interest rate!

Equivalence occurs when different cash flows at different times are

equal in economic value at a given interest rate
 Equivalence contd..
What are the equivalent amounts of $10,000 (today) at an interest rate of 10%
per year for the following cases?
a) 1 year from now (future)
b) 1 year before
Solution:
a) At interest rate of 10% per year, $ 10,000 (now ) will be equivalent to $
11,000 one year from now as shown below;
Amount accumulated at the end of one year = $ (10,000 X 1.10)
= $ 11,000
b) Similarly $ 10,000 now was equivalent to $ 9090.90 one year ago at interest
rate of 10% per year.
Thus due to the effect of time value of money, these amounts $ 9090.90 (one year before), $ 10,000

(today) and $ 11,000 (one year from now) are equivalent at the interest rate of 10% per year.
 Cash Flow Diagrams:
An Important Tool
 The graphical representation of the cash flows i.e. both cash
outflows and cash inflows with respect to a time scale is generally
referred as cash flow diagram.

 The cash flows are generally indicated by vertical arrows on the

time scale

 The cash outflows (i.e. costs or expense) are generally represented

by vertically downward arrows whereas the cash inflows (i.e.
revenue or income) are represented by vertically upward arrows.
 Cash Flow Diagrams:
An Important Tool contd..
 In the cash flow diagram, number of interest
periods is shown on the time scale. The
interest period may be a quarter, a month or a
year.
The cash flows generally occur at different
time intervals within an interest period, for
ease of calculation, all the cash flows are
assumed to occur at the end of an interest
period i.e. at the end of year (EOY).
 Cash Flow Diagrams:
An Important Tool contd..

time
Salvage
“Costs”
Operating & Income
Initial Capital Maintenance Replacement
Costs
Cost Costs

- Arrows up represent “income” or “profits” or “payoffs”

- Arrows down represent “costs” or “investments” or “loans”
- The “x axis” represents time, most typically in years
 Factors: How Time and
Interest Affect Money
• Single Payment Factors
A. F/P, P/F
The fundamental factor in engineering economy is the one that
determines the amount of money F accumulated after n periods
from a single present worth, P, with interest compounded one time
per period.
The single payment compound amount factor is used to compute
the future worth (F) accumulated after “n” years from the known
present worth (P) at a given interest rate ‘i’ per interest period. It
is assumed that the interest period is in years and the interest is
compounded once per interest period.
 The known present worth (P), unknown future worth (F) and the
total interest period ‘n’ years are shown in following Figure 1
P = given
i = given

0 1 2 n-2 n-1 n
F=?

Figure 1: Cash flow diagram for ‘known P’ and ‘unknown F’

The future worth (F1) accumulated at the end of year 1 i.e. 1st year is
given by;
F1 = P + P x i = P(1+i) (1)
The future worth accumulated at the end of year 2 i.e. F2 will be equal to
the amount that was accumulated at the end of 1st year i.e. F1 plus the
amount of interest accumulated from end of 1st year to the end of 2nd year
on F1 and is given by;
F2 = F1 + F1 x i = F1(1+i) (2)
 Single Payment Factors contd..
Putting the value of F1 from equation (1) in equation (2), the value of F2 is
given by;

F2 = F1(1+i) = P(1+i)(1+i) = P(1+i)2 (3)

Similarly, the future worth accumulated at the end of year 3 i.e. F3 is equal to
the amount that was accumulated at the end of 2nd year i.e. F2 plus the
amount of interest accumulated from end of 2nd year to the end of 3rd year
on F2 and is given by;

F3 = F2 + F2 X i = F2(1+i) (4)
 Single Payment Factors contd..
Putting the value of F2 from equation (3) in equation (4), the
value of F3 is given by;

F3 = F2(1+i) = P(1+i)2(1+i) = P(1+i)3 (5)

Similarly, the future worth accumulated at the end of year 4 i.e.

F4 is given by;

F4= F3(1+i) = P(1+i)3(1+i) = P(1+i)4 (6)

Thus the generalized formula for the future worth at the end of
‘n' years is given by;
F = P(1+i)n (7)
 Single Payment Factors contd..
F = P (1 + i)n, F/P (8)
Solving for P:
P = F[(1+i)-n ] , P/F (9)
(1+i)n is called the Compound amount CA, or the
F/P factor.
(1+i)-n is called the single payment present worth
factor, PF, or the P/F factor.
Both factors are for single payments.
 Standard Notation
Standard notation has been adopted for all factors, which
includes: two cash flow symbols, the interest rates and the
number of periods. It is always in the general form:

(X/Y, i, n)

X = what is sought

Y = what is given

i = interest rate, %

n = number of periods
 Example
Given: (F/P, 12%, 10)

Find: Translate the above, calculate F/P then check the table value, calculate
P/F

F the future worth is what is being sought ; P the present worth is that is
known

12% is the interest rate ; 10 is the number of time periods

(F/P, 12%, 10) = (1+i)n = (1+.12)10

(F/P, 12%, 10) = 3.105848 ; (F/P, 12%, 10) = 3.1058

P/F = 1/(F/P) = 1/3.105848

P/F = .3219732 ; P/F = .3220

 Single Payment Factors : CA & PW
F = ( CA – i % - N ) P = ( 1+ i )N x P
P = ( PW - i % - N ) F = 1 / ( 1+ i )N x F
CA = 1/PW
i = Interest rate of return , or discount rate
P = Present sum , Principal , Investment cost , or present worth of future money .
F = Future sum of money ,
N = Number of years,
CA is the single compound amount factor and it is the multiplier to convert
present sum into future sum

PW is the single present worth factor and it is the multiplier to convert future
sum into present sum (also called discounting factor)

The single payment is returning the borrowed capital to its initial value at once
after N years .
 Single Payment Factors : CA & PW
 The ‘present worth’ of F (which includes accumulated interest) is
exactly the same as P, i.e. they are effectively equivalent.

 CA is always greater than 1, PW is always less than 1.

 The present worth and compound amount factors only apply to

single future payments, not to a series
 Uniform Series Present Worth Factor (SPW):
The uniform-series present worth factor is used to determine the
present worth of a known uniform series. Let ‘A' be the uniform annual
amount at the end of each year, beginning from end of year ‘1' till end
of year ‘n' .

The known ‘A', unknown ‘P', and the total interest period ‘n' years are
shown in Fig. 2. This cash flow diagram refers to the case; if a person
wants to get the known uniform amount of return every year, how
much he has to invest now.

Figure 2: Cash flow diagram for ‘known A’ and ‘unknown P’

 Uniform Series Present Worth Factor (SPW):

The present worth (P) of the uniform series can be calculated by considering
each ‘A' of the uniform series as the future worth. Then by using the formula
in equation (9), the present worth of these future worth can be calculated and
finally taking the sum of these present worth values.

The present worth (P) of the uniform series is given by;

(10)
 Uniform Series Present Worth Factor (SPW):

(11)

(12)

The expression in the bracket is a geometric sequence with first term equal to (1+i)-1
and common ratio equal to (1+i)-1. Then the present worth (P) is calculated by
taking the sum of the first ‘n' terms of the geometric sequence (at i ≠ 0) and is given
by;
(13)

The simplification of equation (13) results in the following the expression;

(14)
 Uniform Series Present Worth Factor (SPW):
(14)

The factor within the bracket in equation (14) is known as uniform series present
worth factor (SPW). Thus if the value of ‘A' in the uniform series is known, then the
present worth P at interest rate of ‘i' (per year) can be calculated by multiplying the
uniform annual amount ‘A' with uniform series compound amount factor.

The present worth (P) of a uniform annual series of known ‘A' can also be
calculated in the following manner;

Dividing both sides of equation (10) by (1+i) results in the following equation;

(15)

Subtracting equation (15) from equation (10) results in the following expression;
(16)
Uniform Series Present Worth Factor (SPW):

(17)

(17)
 Capital recovery factor (CR):
The capital recovery factor is generally used to find out the uniform annual
amount ‘A' of a uniform series from the known present worth at a given
interest rate ‘i' per interest period.

The cash flow diagram is shown in Fig. 3. This cash flow diagram indicates, if
a person invests a certain amount now, how much he will get as return by an
equal amount each year.

Figure 3: Cash flow diagram for ‘known P' and ‘unknown A'
 Capital recovery factor (CR):
Recalling equation (17), the expression for the uniform annual amount
(A) can be written as follows;

(18)

The factor within bracket in equation (18) is known as the capital

recovery factor (CR). Thus the uniform annual amount ‘A' at interest
rate of ‘i' (per year) can be determined by multiplying the known
present worth ‘P' with the capital recovery factor.

It may be noted here that the expressions for uniform series present
worth factor and capital recovery factor are derived with present worth
‘P' located one interest period before the occurrence of first ‘A' of the
uniform series.
 CR & SPW
Uniform annual amount (A) to be balanced against present value
or investment .

A = ( CR - i % - N ) P
P = ( SPW - i % - N ) A
CR = (i (1+ i )n/ [(1+ i )n - 1 ]
SPW = 1/CR , A = P x CR

CR is the capital recovery factor

SPW is the series uniform present worth factor (annuity factor)
The vertical arrows represent total cash flow during the time unit .
The capital recovery factor is the percentage returning annually of the capital
 CR & SPW ; application
 A common application of CR is in installment buying , by finding the
periodic amount (A) that will repay the debt (P) in (N) years at an
interest rate i % .

 Conversely , if you have opportunity to buy a facility that promised

to return (A) dollars per year for (N) years , you can find how much
can be paid for it.

 SPW is numerically equal to the sum of the individual annual

present worth factors over the life of the investment, so is useful for
dealing with uniform cash flows, which can be used for many marine
problems, at least in preliminary evaluations.
 Sinking Fund Factor(SF):
The sinking fund factor is used to calculate the annual amount ‘A' of a
uniform series from the known future sum ‘F'. The cash flow diagram
is shown in Fig. 4.
This cash flow diagram indicates that, if a person wants to get a known
future sum at the end of ‘n' years at interest rate of ‘i' per year, how
much he has to invest every year by an equal amount.

Figure 4 Cash flow diagram for ‘known F' and ‘unknown A'
 Sinking Fund Factor(SF):

From the above equations, the expression for the uniform annual amount (A)
can be written as follows;

(19)
 Sinking Fund Factor(SF):
The expression for the uniform annual amount (A) can be written as
follows;

(19)

The factor within bracket in equation (19) is known as sinking fund

factor (SF). Thus one can find out the annual amount ‘A' of a uniform
series by multiplying the future worth ‘F' with the sinking fund factor.

The derivation of expressions for both uniform series compound

amount factor and sinking fund factor is based on the fact that, the
future sum ‘F' occurs at the same time as the last ‘A' of the uniform
series.
 Uniform Series Compound Amount
Factor(SCA):
The uniform series compound amount factor is used to determine the
future sum (F) of a known uniform annual series with uniform amount
‘A'. The cash flow diagram is shown in Fig. 5. This cash flow diagram
states that, if a person invests a uniform amount at the end of each year
continued for ‘n' years at interest rate of ‘i' per year, how much he will
get at the end of ‘n' years.

Figure 5 Cash flow diagram for ‘known A' and ‘unknown F'
 Uniform Series Compound Amount Factor
(SCA):

(19)

(20)

The factor within bracket in equation (20) is known as uniform series

compound amount factor (SCA). Hence the future worth ‘F' can be
computed by multiplying the uniform annual amount ‘A' with the uniform
series compound amount factor.
 SF & SCA
Uniform annual amount (A) to be balanced with a single future amount (F) .

A = ( SF - i % - N ) F
F = ( SCA - i % - N ) A
SF is the sinking fund factor = i / [(1+ i )n - 1 ]

SF is also called the equal-payment-series sinking-fund factor and a sinking

fund is an interest-bearing account into which a fixed sum is deposited each
interest period; it is commonly established for the purpose of replacing fixed
assets.
SCA is the series uniform compound amount factor = 1 / SF , A = F. SF
If we want to accumulate at a determined future date a certain amount of
cash (F) by regular banking (A) , the product of (F) by SF yields the value of (A) .
Sinking Fund and Series Compound amount
factors (A/F and F/A)
 Example
A student deposits $1000 in a savings account that pays interest
at the rate of 6% per year, compounded annually. If all of the
money is allowed to accumulate, how much money will the
student have after 12 years?
Solution:
We wish to solve for F, given P, i, and n.
Thus,
 Example
An engineer who is planning his retirement has decided that he
will have to withdraw $10 000 from his savings account at the
end of each year. How much money must the engineer have in the
bank at the start of his retirement, if his money earns 6% per year,
compounded annually, and he is planning a 12-year retirement
(i.e., 12 annual withdrawals)?

Solution:
A is given, P unknown, i=6%, N=12 years
 Example
How much do you need to deposit today (P) to withdraw $25,000 at
n=1, $3,000 at n= 2, and $5,000 at n=4, if your account earns 10%
annual interest?
Solution:
Example
Example
 Example
You are saving up money to make a 20% down payment on a
$100,000 house when you graduate in 4 years. You plan to invest
$A at the end of each summer in a money market account
earning 6.5%/year. Find A.
Solution:
Example
 Gradient Factors
Engineering Economic problems frequently
involve disbursements or receipts that
increase or decrease each year (i.e.
equipment maintenance)

If the increase/decrease is the same every

year this is called a uniform arithmetic
gradient.

A GEOMETRIC gradient changes by a fixed

percentage each time period.
 Arithmetic Gradient Factors
Some cash flows, the expenditure or the income increases or decreases
by same amount. The cash flow involving such payments or receipts is
known as uniform gradient series.
For example, if the cost of repair and maintenance of a piece of
equipment increases by same amount every year till end of its useful life,
it represents a cash flow involving positive uniform gradient.
Similarly if the profit obtained from an investment decreases by an equal
amount every year for a certain number of years, it indicates a cash flow
involving negative uniform gradient.
Figure: Cash flow diagram involving a positive uniform gradient
( a positive gradient of 1000)

Figure: Cash flow diagram involving a negative uniform gradient

( a negative gradient of 2000)
Arithmetic Gradient Factors

Increasing Gradient Series (G>0)

Decreasing Gradient Series (G<0)

 Derivation of Arithmetic Gradient Factors

 The present worth, future worth and the equivalent uniform

annual worth of the uniform gradient can be derived using the
compound interest factors.

 The generalized cash flow diagram involving a positive uniform

gradient with base value ‘A1' and the gradient ‘G' can be split
into two cash flows; one having the uniform series with
amount ‘A1 ' and the other having the gradient series with
values in multiples of gradient amount ‘G'.

 This gradient series is also known as the arithmetic gradient

series as the expense or the income increases by the uniform
arithmetic amount ‘G' every year.
Example: if you purchase a used car with a 1-year warranty, you might expect to pay the
gasoline and insurance costs during the first year of operation. Assume these cost
$2500; that is, $2500 is the base amount. After the first year, you absorb the cost of
repairs, which can be expected to increase each year. If you estimate that total costs will
increase by $200 each year, the amount the second year is $2700, the third $2900, and
so on to year n , when the total cost is 2500+( n - 1)200.
The cash flow diagram is shown below. Note that the gradient ($200) is first observed
between year 1 and year 2, and the base amount ($2500 in year 1) is not equal to the
gradient. Define the symbols G for gradient and CFn for cash flow in year n as
follows.

G constant arithmetic change in cash flows from one time period to the next; G may be
positive or negative.
The total present worth PT for a series that includes a base amount A and conventional
arithmetic gradient must consider the present worth of both the uniform series defined
by A and the arithmetic gradient series. The addition of the two results in PT.

where PA is the present worth of the uniform series only, PG is the present worth of
the gradient series only, and the + or - sign is used for an increasing ( +G ) or decreasing
( -G ) gradient, respectively.

The corresponding equivalent annual worth AT is the sum of the base amount series
annual worth AA and gradient series annual worth AG , that is,
Three factors are derived for arithmetic gradients: the P/G factor for present
worth, the A/G factor for annual series, and the F/G factor for future
worth.
The arithmetic gradient present worth factor, or P/G factor, may be
expressed in two forms:
Alternative Derivation of Arithmetic Gradient Factors

+
Arithmetic Gradient Factors
(21)

(22)

(23)

(24)
 Arithmetic Gradient Factors
(25)

The expression in the bracket is a geometric sequence with first term

equal to 1/(1+i) and common ratio equal to 1/(1+i). Thus equation
(25) is rewritten by taking sum of the first ‘n' terms of the geometric
sequence (at i ≠ 0) and is given by;

(26)

(27)
 Arithmetic Gradient Factors
Recalling equation (19) & (27)

(28)

The resulting factor is called the uniform-gradient series factor and

is designated (A/G, i, n)
Geometric Gradient Series
Geometric Gradient Series

(29)
 Derivation of Geometric Gradient Series
Consider the cash flows due to some expenses or incomes is being
increased by a constant percentage in the successive time periods i.e. in
successive years. Such kind of cash flow is known as geometric
gradient series. The generalized cash flow diagram involving geometric
gradient series with expense or receipt ‘C' at the end of year ‘1' and
geometric percentage increase ‘g' is shown in following Figure.
 Geometric Gradient Series
The present worth (P) of the geometric gradient series can be
calculated by considering each amount as the future worth and
then taking sum of these present worth values.

(30)

(31)

Dividing both sides of the equation (31) by (1+i)

(32)

Multiplying both sides of the equation (32) by (1+g)

(33)
 Geometric Gradient Series
Subtracting equation (30) to (33) results in the following expressions

(34)

(35)

The expression in equation (35) is valid when g ≠ i. When ‘g' is equal to ‘i' then right
hand side of the equation (35) takes the indeterminate form of 0/0. In this case the
expression for the present worth ‘P' can be obtained by applying L'Hospital's rule as
follows;

(36)

Then the expression for the present worth ‘P' is given as follows;
i=g
(37)
 Example:
An engineer is planning for a 15-year retirement. In order to
supplement his pension and offset the anticipated effects of
inflation, he intends to withdraw $5000 at the end of the first
year, and to increase the withdrawal by $1000 at the end of each
successive year. How much money must the engineer have in his
savings account at the start of his retirement, if money earns 6%
per year, compounded annually?

C = 5000
g = 1000/5000 = 0.2
i = 0.06
uniform gradient banaite hobe age

P/A
 Example:
Airplane ticket price will increase 8% in each of the next four
years. The cost at the end of the first year will be $180.
How much should be put away now to cover a students
travel home at the end of each year for the next four years?
Assume 5%.

 1  (1  g ) n (1  i )  n 
P  A 
 ig 
 1  (1.08) 4 (1.05)  4    0.11928 
 180   180   $715.67
 .05  .08    0.03 
S
U
M
M
A
R
Y
 Use of Basic Interest Relationships
 Interest relationships make allowances for the time value of
money and the life of the investment and may be used to convert
an investment (e .g. cost of a ship) into an annual amount which,
when added to the annual operating costs, may be used to
determine the necessary level of income to give any required rate
of return
 Alternatively, where annual cash flows are known, the
relationships can convert them into present worths, which may be
added together to give Net Present Worths (or Values) (NPV), for
comparison with the amount of the investment.
 For an investment to be worthwhile, the present worth of the cash
flows of income minus expenditure should be greater than the
investment, taking inflows as positive, and outflows as negative,
i.e . NPV should be positive,