Lecture Notes in

Engineering Economics

Prepared by: Lucia Velasquez Ortega

 Table of Contents

Chapter I: Basic Economic Principles 1

1-01 Introduction
1-02 Reasons for Studying Engineering Economy
1-03 Important Application of Engineering Economy
1-04 Engineering Economy Technique
1-05 Basic Terms and Principles of Economics
Chapter II: Interest and Discount 10
2-01 Meaning of Interest
2-02 Simple Interest
2-03 Ordinary and Exact Simple Interest
2-04 Compound Interest
2-05 Continuous Compounding
2-06 Nominal Rate of Interest
2-07 Effective Rate of Interest
2-08 Present Value
2-09 Discount
2-10 Cash Flow Diagram
Chapter III: Annuities and Capitalized Cost 16
3-01 Meaning and Occurrence of Annuities
3-02 Types of Annuities
3-03 Ordinary Annuity
3-04 Formulas when each Payment is $A
3-05 Deferred Annuity
3-06 Annuity Due
3-07 Perpetuity
3-08 Capitalized Cost
3-09 Continuous Compounding for Discrete Payments
3-10 Continuous Compounding of Interest and Continuous Cash Flows
3-11 Summaries of Interest and Annuity Formulas
Chapter IV: Arithmetic and Geometric Gradient 25
4-01 Arithmetic Gradient
4-02 Derivation of Arithmetic Gradient Factors
4-03 Geometric Gradient
Chapter V: Financing any Enterprise 31
5-01 Methods of Financing
5-02 Working Capital
5-03 Types of Business Organization
5-04 Sole Proprietorship
5-05 Partnership
5.06 The Corporation
5-07 Dangers of the Corporation Form of Business Organization
5-08 Capitalization of a Corporation
5-09 Common Stock
5-10 Preferred Stock
5-11 Bonds
5-12 Classification of Bonds
5-13 Bond Amortization and Retirement
5-14 Value of a Bond
5-15 Derivation of the Formula for Value of a Bond
Chapter VI: Depreciation and Depletion 40
6-01 Depreciation
6-02 Types of Depreciation
6-03 Depreciation Cost
6-04 Determination of Depreciation Cost
6-05 Requirements for a Depreciation Method
6-06 Properties of the Different Depreciation Method
6-07 The Straight-Line Formula
6-08 The Sinking Fund Formula
6-09 Matheson Formula
6-10 Sum of the Years-Digits (SYD) Method
6-11 Service-Output Method
6-12 The Straight-Line plus Average Interest Formula
6-13 The Double Declining-Balance Method
6-14 Group and Composite Methods of Depreciation
6-15 Depletion
Chapter VII: Investment of Capital 53
7-01 The Profit Motive
7-02 Amount of Capital Required
7-03 Estimate of Income
7-04 Estimate of Expenses
7-05 Net Profit
7-06 Rate of Return
 7-07 Intangible Factors
7-08 Risks in the Investment of Capital
7-09 Basic Method for Investment Analysis
7-10 Explicit Reinvestment Rate of Return (ERR) Method
7-11 Annual Cost (AC) Method
7-12 Present Worth Cost (PWC) Method
7-13 Internal Rate of Return (IRR) Method
7-14 Payout Period Method
Chapter VIII: Comparison of Alternatives 61
8-01 Introduction
8-02 Fundamental Principle for Comparison of Alternatives
8-03 Methods of Comparison
8-04 Possibilities from Investing in excess of the Required Minimum
Chapter IX: Break-Even Analysis 65
9-01 Scope of Break-Even Analysis
9-02 Mathematical Expressions for Break-Even
9-03 Break-Even Chart
Chapter X: Public Economy: Benefit-Cost Analysis 69
10-01 Non-Profit Motive in Public Economy
10-02 Financing of Public Projects
10-03 Economic Analysis of Public Projects
10-04 The (B–C) Criterion
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

1-01 Introduction

Economics is one of the social sciences which consist of that body of knowledge
dealing with people and their assets or resources. Economics has also been defined as
the sum total of knowledge which treats of the creation and utilization of goods and
services for the satisfaction of human wants.

Engineering Economy is defined as that branch of economics which involves the

application of definite laws of economics, theories of investment and business
practices to engineering problems involving cost. Engineering Economy may also be
considered to mean the study of economic problems with the concept of obtaining
the maximum benefit at the least cost. Engineering economy also involves the study
of cost features and other financial data and their applications in the field of
engineering as basis for decision.

1-02 Reasons for Studying Engineering Economics

1) Engineers, as a group, have wrought immense changes in improving the economic

well-being of mankind through their inventions and their applications of scientific
principles to the varied problems of the industry. Seldom is there any phase of
daily life where engineers, at one time or another, have not done their share. In
the homes, in the highways, and in the factories the work of engineers are too
evident. In whatever they do, tremendous outlays of money have been expanded.
It will be readily admitted that the study of economics will benefit mankind due to
the more efficient use of wealth.

2) In the professional life of engineers, it is readily observed that the most successful
ones are those who gradually divorce themselves from the technical aspects of
engineering and who devote their time and efforts to financial problems related
to engineering work. Those engineers who ultimately become managers of their
own enterprise or those of others will finally realize that engineering does not
merely concern itself with technical aspects, but will ultimately lead to economic
considerations. At that time, their knowledge of engineering economy will assume
tremendous importance.

1-03 Important Applications of Engineering Economy

1) Seeking of new objectives for the applications of engineering.

2) Discovery of factors limiting the success of a venture or enterprise.
3) Analysis of possible investment of capital.
4) Comparison of alternatives as a basis for decision.
5) Determination of bases for decision.

luciavelasquezortega 1
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

Seeking of New Objectives: An important use of engineering economy is to seek new

objective for engineering application. Engineers all over the world are constantly
seeking new and wider applications of their technical knowledge for the benefit of
mankind. In this search, engineering economy provides basic principles and laws.
Companies usually conduct market surveys to learn what people need and want.
Traffic counts are made and statistics compiled by highway agencies to discover
present and future needs and to forecast trends in transportation.

Discovery of Factors: Knowing an objective, the next step is to determine ways and
means to attain such an objective. Engineering Economy seeks to discover so-called
limiting factors which may hinder the success of a project. Among the limiting factors,
there are some outstanding ones, called strategic factors, which if altered may be
made to insure the success of a venture. For instance, inadequacy of capital for a new
enterprise usually leads to failure, though in reality such an enterprise may be
worthwhile. This strategic factor may be removed by borrowing some capital or by
taking in more stockholders.

Investment of Capital: With the exception of a few cases, capital is invested to earn
profit for the owners of the capital. Engineering Economy enables engineers to
consider all aspects of the investment from both the technical and financial
viewpoints. Engineering Economy furnishes several patterns of analysis to determine
rate of return, annual costs and payout periods, which all serve as bases for decision.

Comparison of Alternatives: Most anything that has to be done can be accomplished

in many ways with satisfactory end results, but with varying expenditures. Usually the
alternative that will accomplish the objective with the least expense is the most
desirable. The principles of Engineering Economy point out the analysis of such
problems on a quantitative basis and enable decision makers to choose the right
decision. Likewise, qualitative factors involving risk or uncertainty are easier to
evaluate when principles of Engineering Economy are known and applied.

Bases for Decision: The work of engineers is fundamentally concerned with future
actions – on what to do, not on what has been accomplished. Decisions on future
actions are more valid and their chances for accuracy are improved when principles of
Engineering Economy are correctly applied. A working knowledge of Engineering
economy should improve the ability of an engineer to make correct decisions on all
technical matters involving cost.

1-04 Engineering Economy Technique

1) The economy analysis
2) The financial analysis
3) The intangible analysis

luciavelasquezortega 2
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

The economy analysis considers all factors affecting the economy of the project which
can be reduced to specific monetary values. It determines the initial cost of the
project, the costs for the operation and maintenance, the needed working capital, the
probable income the project will generate when operational, the rate of return on the
investment, and all other cost factors.

The primary purpose of the financial analysis is the determination of the methods and
sources of financing the project, either through equity capital or borrowed capital, or
a combination of both. It tries to discover the best methods of financing the project
to the extent of the amount obtained in the economy analysis. The financial analysis
follows the economy analysis since it is dependent upon the latter necessary data.

The intangible analysis determines all aspects of the project which cannot be reduced
to monetary values and considers the uncertainty and the risk inherent in the project.
Its scope includes the so-called judgment factor whose analysis depends upon the
judgment or responsible persons involved in the project.

All of these analyses should be made, studied and correlated with one another to form
a sound basis for the decision to implement the project or not. If these analyses are
all favorable, then a decision in favor of the proposal is not difficult to make.

BASIC TERMS AND PRINCIPLES OF ECONOMICS

1-05 Tangible and Intangible Factors

Tangible factors are those which can be express in terms of monetary values, while
intangible factors are those which are difficult or impossible to express definitely in
terms of monetary values. Intangible factors are also called irreducible factors.

1-06 Competition

Most economic laws are premised and stated for situations in which free or perfect
competition exists. Perfect competition occurs when a certain product is offered for
sale by many vendors or suppliers, and there is no restriction against other vendors
from entering the market. Buyers are free to buy from any vendor, and the vendors,
likewise, are free to sell to anyone.

1-07 Monopoly

Monopoly is the opposite of perfect competition. A perfect monopoly occurs when a

unique product or service is available only from a single supplier and entry of all other
possible suppliers is prevented. Under conditions of perfect monopoly, the single
vendor can control the supply and the price of the product or service.

luciavelasquezortega 3
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

1-08 Oligopoly

Oligopoly occurs when there are few suppliers and any action taken by anyone of
them will definitely affect the course of action of the others.

1-09 Price and Production

The price of a good or commodity is defined to be the amount of money or its

equivalent which is given in exchange for it. In a capitalist system, industry is based on
profit, and profit in turn is based on price. Goods that are in great demand and are
scarce command a high price relative to the cost of production and therefore will yield
a high profit. Producers of such goods will naturally exert all available means to
increase their output. On the other hand, goods that have little demand command a
low price in relation to the cost of production. Manufacturers of such goods will
decrease their production or, perhaps, cease manufacturing altogether.

Price therefore regulates production. If prices go up, production will increase. If prices
decrease, production will also decrease or cease.

1-10 Local and National Market

A market is defined to be a place where sellers and buyers come together. A limited
locality where certain goods such as those which are perishable are sold, is said to be
a local market. Certain goods sold all over the country are said to have a national
market. Goods that are exported to other countries are said to have a world market.

1-11 Consumer and Producer Goods

Consumer goods are those that are consumed or used directly by people, or are things
and services which serves to satisfy human needs. Examples: clothes, shoes, food,
houses, medical and dental services, barber and beauty services.

Producer goods are those which produce goods and services for human consumption,
such as lathes, generators, tools, ships, buses and airplanes. These are instrumental in
producing something or furnishing service for people.

1-12 Demand

Demand is the quantity of a certain commodity that is bought at a certain price at a

given place and time. It should not be confused with the quantity of commodity which
a person desires to purchase. Desire without actual purchase of the commodity does
not constitute demand.

1-13 Law of Demand

The law of demand may be stated as:

luciavelasquezortega 4
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

The demand for a commodity varies inversely as the price of the commodity,
though not proportionately.

It will be noted from Fig. 1-01 that when the price of a commodity is low, the demand
is great, for then more people will be able to afford the price of the commodity.
However, as the price increases, the demand decreases.

1-14 Elasticity of Demand

Elastic demand occurs when a decrease in selling price will cause a greater than
proportionate increase in the volume of sales. Goods are when considered luxuries
are said to have elastic demand, because a small decrease in cost will usually result in
a big increase in sales.

Inelastic demand occurs when a decrease in selling price will cause a less than
proportionate increase in sales. Goods which are classified as necessities usually have
inelastic demand, because even when a big decrease in selling price will not cause a
big increase in the volume of sales. For instance, a decrease in the price of rice to one-
half its current price will not cause people to eat twice as much as they are eating now.
Similarly, even should the price double, people cannot be expected to eat half as much
as they used to.

Unitary elasticity of demand occurs when the mathematical product of price and
volume of sales remains constants regardless of any change in price.

𝑃𝑉 = 𝐶

where, P = price of the product

V = volume of sales
C = a constant

luciavelasquezortega 5
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

1-15 Utility and Demand

Utility is defined to be the capacity of a commodity to satisfy human want. If the utility
of a certain good to a certain individual is great, his demand for that good will be great.
However, if a certain good has very small utility the demand will likewise be small.
Hence, the demand for a certain good varies directly as the utility.

1-16 Law of Diminishing Utility

An increase in the quantity of any good consumed or ocquired by an individual will

decrease the amount of satisfaction derived from that good.

The utility of a commodity decreases with an increase in the quantity available. If a

man has only one car, the utility of that car to him would indeed be great. However, a
second similar car would not have as much utility as the first. A third similar car would
practically have very little use.

To increase the utility of any commodity, it should be different from other similar
commodities. Thus, manufacturers of similar goods vary the style, the size, and the
use of the goods they manufacture.

1-17 Marginal Utility

The marginal utility of a commodity is the utility of the last unit of the same
commodity which is consumed or acquired. The last unit of similar commodities
consumed or acquired is called the marginal unit.
1-18 Supply
Supply is the quantity of a certain commodity that is offered for sale at a certain price
at a given place and time. A merchant may have more goods in his warehouse, but if
he only wishes to sell a certain quantity, then that quantity represents the supply.
Thus, unless a certain good is actually offered for sale, it does not constitute part of
the supply.
1-19 Law of Supply
The supply of a commodity varies directly as the price of the commodity,
though not proportionately.
As the price increases, the supply also increases. Likewise, as price decreases, the
supply will also decrease.

luciavelasquezortega 6
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

1-20 Law of Supply and Demand

The law may be stated as follows:
When free competition exists, the price of a product will be the value where
supply is equal to the demand.
Actually this is a combination of the laws of demand and supply. No sale exists if the
buyers and the sellers do not agree on a common price for the commodity. The price
is determined only when the demand is equal to the supply and a sale occurs.

1-21 Law of Diminishing Returns

This law was originally applied to agriculture, correlating the input of men, fertilizers,
and other variable factors to the output in crops or harvest. The law may be stated as:

When one of the factors of production is fixed in quantity or is difficult to

increase, increasing the other factors of production will result in a less than
proportionate increase in output.

In agriculture, increasing gradually the quantity of fertilizer for a fixed area of land will
result in an increase in output up to a certain extent, beyond which the output will
decrease or even become nil. Likewise, water is essential to the growth of rice, but too
much of it, as in flood, will kill the plants.

This law manifests itself also in many engineering problems. In running an engine, a
certain fuel-air ratio is needed to start the engine. As more fuel is fed, the power in
the engine will increase, but continued feeding will cause the engine to stop. In

luciavelasquezortega 7
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

maximizing profits, prices may be increased, but the amount of sales may decrease
resulting in low profit. Increasing the span between towers of a transmission line will
decrease the cost of the towers, but will increase the cost of the transmission wires or
cables, since larger wires are needed for longer spans. Increasing the span of bridges
will reduce the cost of abutments and piers, but will definitely increase the cost of the
superstructure. Increasing the speed of the conveyor system in an assembly line may
increase the output, but excessive speed will cause the piling up of unfinished goods
or will cause an increase in defective products.

1-22 Marginal Revenue and Marginal Cost

Marginal revenue is that amount received from the sale of an additional unit of a
product. Marginal cost is the additional cost of producing one more unit.

When free competition exists, the number of units produced that will give the
maximum profit is that for which the marginal revenue and marginal cost are equal.

1-23 Physical and Economic Efficiency

In the economic world, man always strives to gain more than he invests, whether it be
materials, money or energy. The farmer plants palay seeds to harvest rice. A business
man invests his money to make a profit. The effectiveness of the utilization is
measured by the well-known equation:

𝑂𝑢𝑡𝑝𝑢𝑡
𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝐼𝑛𝑝𝑢𝑡

Where physical units are involved, efficiency is measured by:

𝑂𝑢𝑡𝑝𝑢𝑡 𝑖𝑛 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑢𝑛𝑖𝑡𝑠

𝑃ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝐼𝑛𝑝𝑢𝑡 𝑖𝑛 𝑝ℎ𝑦𝑠𝑖𝑐𝑎𝑙 𝑢𝑛𝑖𝑡𝑠

This kind of efficiency can never exceed 100%. However, when money is the material,
effective utilization is measured by:

𝐼𝑛𝑐𝑜𝑚𝑒 𝑖𝑛 𝑚𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝑢𝑛𝑖𝑡

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝐶𝑜𝑠𝑡 𝑖𝑛 𝑚𝑜𝑛𝑒𝑡𝑎𝑟𝑦 𝑢𝑛𝑖𝑡

Unless the economic or financial efficiency exceeds 100%, the investment of capital,
from a strictly financial viewpoint is not recommended. A common measure of
financial efficiency is the so-called rate of return given by the formula:

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑

This is the most universally accepted measure of financial effectiveness. Another

measure of economic efficiency is the payout period.

luciavelasquezortega 8
CEng 5201 – Engineering Economics Chapter 1: Basic Economic Principles

𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑
𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

This ratio determines the number or years necessary to recover the amount of the
invested capital from the earnings of the investment.

1-24 Compromise between Perfection and Economy

Perfection is a human ideal worth striving for. However, in the practical world,
compromise from perfection is usually the rule. Complete quality control of all the
units produced by a factory is to be desired, but it will definitely increase the cost of
manufacturing, such that the goods are priced out of the market. It is desired that a
machine function properly as a physical unit, but it must also function properly as an
economic unit. For example, the perfect airplane that is crash-proof can be made but
it will not be able to lift itself off the ground.

luciavelasquezortega 9
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

2-01 Meaning of Interest

From the viewpoint of the borrower, interest is the amount of money paid for the use
of borrowed capital. For the lender, interest is the income produced by the money
which he has lent.
The charging of the interest is justified from the standpoint of the lender, because he
has to forego the use of his money during the time it is borrowed, and to compensate
him also for the risk which he has to take in lending his money. From the borrower’s
viewpoint, it is usually advantageous to borrow money if in so doing he will be able to
earn more than the interest which he has to pay.
2-02 Simple Interest
The interest on borrowed money is said to be simple interest if the interest to be paid
is directly proportional to the length of time the amount or principal is borrowed. The
principal is the amount of money borrowed and on which interest is charged. The rate
of interest is the amount earned by one unit of principal during a unit of time.
The formula for interest is
𝐼 = 𝑃𝑖𝑛
Where:I = total interest earned by the principal
P = amount of the principal
𝑖 = rate of interest expressed in decimal form
n = number of interest periods
The total amount F to be repaid is equal to the sum of the principal and the total
interest and is given by the formula:
𝐹 = 𝑃 + 𝐼 = 𝑃(1 + 𝑖𝑛)
2-03 Ordinary and Exact Simple Interest
Ordinary simple interest is computed on the basis of one banker’s year, which is
1 𝑏𝑎𝑛𝑘𝑒𝑟 ′ 𝑠𝑦𝑒𝑎𝑟 = 12 𝑚𝑜𝑛𝑡ℎ𝑠, 𝑒𝑎𝑐ℎ 𝑐𝑜𝑛𝑠𝑖𝑠𝑡𝑖𝑛𝑔 𝑜𝑓 30 𝑑𝑎𝑦𝑠
1 𝑏𝑎𝑛𝑘𝑒𝑟 ′ 𝑠𝑦𝑒𝑎𝑟 = 360 𝑑𝑎𝑦𝑠
Exact simple interest is based on the exact number of days, 365 for an ordinary year
and 366 days for a leap year. The leap years are those which are exactly divisible by 4,
but excluding the century years such as the years 1900, 2000, etc.
If d is the number of days in the interest period, then
𝑑
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠𝑖𝑚𝑝𝑙𝑒 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑖
360

luciavelasquezortega 10
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

Problem 1:
Determine the ordinary simple interest on $10,000 for 9 months and 10 days if the rate
of interest is 12%.
Problem 2:
Determine the ordinary and exact simple interest on $5,000 for the period from January
15 to June 20, 2003, if the rate of simple interest is 14%.
Problem 3:
Determine the exact and ordinary simple interest on $1,200 for the period from January
16 to November 26, 2012, if the rate of interest is 24%.
Problem 4:
A man borrows $10,000 from a loan firm. The rate of simple interest is 15%, but the
interest is to be deducted from the loan at the time the money is borrowed. At the end
of one year he has to pay back $10,000. What is the actual rate of interest?
Example 5:
A man borrows $6,400 from a loan association. In repaying this debt he has to pay $400
at the end of every 3 months on the principal and a simple interest of 16% on the
principal outstanding at that time. Determine the total amount he has paid after paying
all his debt.

2-04 Compound Interest

In compound interest, the interest earned by the principal is not paid at the end of
each interest period, but is considered as added to the principal, and therefore will
also earn interest for the succeeding periods. The interest earned by the principal
when invested at compound interest is much more than that earned by the same
principal when invested at simple interest for the same number of periods.
Using the same nomenclature as that for simple interest, the total amount due after
periods for compound interest is given by the formula
𝐹 = 𝑃(1 + 𝑖)𝑛
The factor (1 + 𝑖)𝑛 is called the “single payment compound amount factor” and is
designated by 𝑆𝑃𝐶𝐴𝐹 = (𝐹 ⁄𝑃, 𝑖% , 𝑛). Thus (1 + 𝑖)𝑛 = (𝐹 ⁄𝑃, 𝑖% , 𝑛) and the
formula is written
𝐹 = 𝑃(1 + 𝑖)𝑛 = 𝑃(𝐹 ⁄𝑃, 𝑖% , 𝑛)

luciavelasquezortega 11
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

Table 2-01: Derivation of Compound Interest Formula

Principal at
Interest Interest earned
beginning of Compound amount at the end of period
Period during period
period

1 𝑃 𝑃𝑖 𝑃 + 𝑃𝑖 = 𝑃(1 + 𝑖)

2 𝑃(1 + 𝑖) 𝑃(1 + 𝑖)𝑖 𝑃(1 + 𝑖) + 𝑃(1 + 𝑖)𝑖 = 𝑃(1 + 𝑖)2

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

... ... ... ...

n 𝑃(1 + 𝑖)𝑛−1 𝑃(1 + 𝑖)𝑛−1 𝑖 𝑃(1 + 𝑖)𝑛−1 + 𝑃(1 + 𝑖)𝑛−1 𝑖 = 𝑃(1 + 𝑖)𝑛

2-05 Continuous Compounding

If 𝑟 is the nominal annual interest rate and 𝑚 is the number of interest periods each
year, then the interest rate per interest period is = 𝑟⁄𝑚 , and the number of interest
period in years is 𝑚𝑛 . The single payment compound amount factor may be written
as
𝑟 𝑚𝑛
𝐹 = 𝑃 (1 + )
𝑚
Increasing m, the number of interest periods per year, without limit, it becomes very
large and approaches infinity and 𝑟⁄𝑚 approaches zero. This is the situation for
continuous compounding:
𝑟 𝑚𝑛
𝐹 = 𝑃 (1 + )
𝑚
lim 𝑚 → ∞
Set 𝑟⁄𝑚 = 𝑥 ; then 𝑛 = (1⁄𝑥 )𝑟 and 𝑚𝑛 = (1⁄𝑥 )𝑟𝑛 . As m approaches infinity, x
approaches zero. The equation becomes
1 𝑟𝑛
𝐹 = 𝑃 [(1 + 𝑥)𝑥 ]
lim 𝑥 → 0
1⁄𝑥
From the Calculus we have the limit (1 + 𝑥) = 2.7182 … . = 𝑒 , where e is the base
lim 𝑥 → 0
of natural logarithms. Thus, the equation becomes
𝐹 = 𝑃𝑒 𝑟𝑛
which is the continuous compounding single payment compound amount formula.
2-06 Nominal Rate of Interest
For compound interest, the rate of interest usually quoted is nominal rate of interest
which specifies the rate of interest and the number of interest periods per year. Thus,
a nominal rate of interest of 8% compounded quarterly means that there are 4 interest

luciavelasquezortega 12
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

periods each year, the rate per period being 8%/4 = 2% . In the formulas stated
above, in this case, 𝑖 = 0.02 .
2-07 Effective Rate of Interest
The effective rate of interest is the actual rate of interest on the principal for one year.
It is equal to the nominal rate if the interest is compounded annually, but greater than
the nominal rate if the number of interest periods per year exceeds one, such as for
interest compounded semi-annually, quarterly or monthly. To make this clear,
imagine $1.00 to be invested at the nominal rate of 8% compounded quarterly. This
amount will become after one year,
$1(1 + 0.02)4 = $1(1.0824) = $1.0824
Thus, the actual interest earned is $0.0824. This corresponds to an effective rate of
8.24% which is greater than the nominal rate of 8% compounded quarterly. In general,
if 𝐹1 is the amount $1 becomes after 1 year, 𝑛 the number of periods in one year, and
𝑖 the rate of interest per period, then the effective rate in decimal form is
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝐹1 − 1 = (1 + 𝑖)𝑛 − 1
2-08 Present Value
The principal P in the formula 𝐹 = 𝑃(1 + 𝑖)𝑛 may be considered as the value of the
compound amount F at present, or it is the amount which when investednow will
become F after n periods. P is called the present value of the amount F, and is given
by the formula
𝐹
𝑃 = 𝐹(1 + 𝑖)−𝑛 =
(1 + 𝑖)𝑛
The factor (1 + 𝑖)−𝑛 is called the “Single Payment Present Worth Factor” and is
designated by 𝑆𝑃𝑃𝑊𝐹 = (𝑃/𝐹, 𝑖%, 𝑛). Thus
1
(1 + 𝑖)−𝑛 = = (𝑃/𝐹, 𝑖%, 𝑛)
(1 + 𝑖)𝑛
and the equation becomes
𝐹
𝑃 = 𝐹(1 + 𝑖)−𝑛 = = 𝐹(𝑃/𝐹, 𝑖%, 𝑛)
(1 + 𝑖)𝑛
2-09 Discount
Discount on a negotiable paper is the difference between what it is worth in the
future and its present worth. Thus,
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 = 𝐹𝑢𝑡𝑢𝑟𝑒 𝑣𝑎𝑙𝑢𝑒 − 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒
For example, if a negotiable paper such as a bod can be sold for $100 six months from
now, but it is sold now for $95 at present then the discount is $5.00

luciavelasquezortega 13
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

The rate of discount is the discount on one unit of principal per unit time. If 𝑑 is the
rate of discount, then
𝑖
𝑑 =1− = 1 − (𝑃⁄𝐹 , 𝑖%, 1)
1+𝑖
For the equivalent rate of interest corresponding to a rate of discount 𝑖,
𝑑 𝑑
𝑖= =
1 − 𝑑 (𝑃⁄𝐹, 𝑖%, 1)
2-10 Cash Flow Diagram
Cash flow diagram is a graphical representation showing cash inflows and cash
outflows.

Problem 6:
If the sum of $12,000 is deposited in an account earning interest at the rate of 9%
compounded quarterly, what will it become at the end of 8 years?
Problem 7:
A man possesses a promissory note, due in 3 years hence, whose maturity value is
$6,700.48. If the rate of interest is 10% compounded semi-annually, what is the value
of this note now?
Problem 8:
What payment 𝑋 10 years from now, is equivalent to a payment of $1,000 six years
from now, if interest is 15% compounded (a) annually, (b) monthly?
Problem 9:

luciavelasquezortega 14
CEng 5201 – Engineering Economics Chapter 2: Interest and Discount

If you are investing your money, which is better: 12% compounded monthly or 12.5%
compounded annually? Compare the effective rates of the two alternatives.
Problem 10:
An advertisement of an investment firm states that if you invest $500 in their firm
today you will get $1,000 at the end of 4 ½ years. What nominal rate is implied if
interest is compounded (a) quarterly? (b) monthly? Determine also the effective rate
of interest in each case.
Problem 11:
Annual deposits were made in a fund earning 10% per annum. The first deposit was
$2,000 and each deposit thereafter was $200 less than the preceding one. Determine
the amount in the fund after the sixth deposit.
Problem 12:
A debt of $15,000 was paid for as follows: $4,000 at the end of 3 months, $5,000 at the
end of 12 months, $3,000 at the end of 15 months, and a final payment F at the end of
21 months. If the rate of interest was 18% compounded quarterly, find the final
payment F.

luciavelasquezortega 15
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

3-01 Meaning and Occurrence of Annuities

An annuity consists of a series of equal payments made at equal interval of time. It
occurs in the following instances:
1) Payment of a debt by a series of equal payments at equal intervals of time. This
occurs when goods are bought on the installment plan, the payments for which
are usually of equal amount paid periodically, usually monthly.
2) Accumulation of certain amount by setting equal amounts periodically. This occurs
when a person save equal amounts and deposits these periodically in a bank; when
equal amounts are set aside at equal intervals of time to take care of the
depreciation of equipment and to provide for their replacement at a definite
future time. Periodic deposits in a sinking fund, equal in amount, are also
annuities.
3) Substitution of a series of equal amounts periodically in lieu of a lump sum at
retirement of an individual.

3-02 Types of Annuities

Annuities in engineering economy are usually classified into four categories. These
are: (1) ordinary annuity, (2) deferred annuity, (3) annuity due, and (4) perpetuity.
An ordinary annuity is one where the equal payments are made at the end of each
payment period starting from the first period.
A deferred annuity is one where the payment of the first amount is deferred a certain
number of periods after the first period.
An annuity due is one where the payments are made at the start of each period,
beginning from the first period.
Perpetuity is an annuity where the payment periods extend forever or in which the
periodic payments continue indefinitely.

3-03 Ordinary Annuity

An ordinary annuity where each payment is unity (say $1.00) is illustrated in Figure 3-
01. The four essential elements of an ordinary annuity are:
1) The amounts of all payments are equal.
2) The payments are made at equal intervals of time.
3) The first payment is made at the end of the first period and all payments thereafter
are made at the end of the corresponding period.
4) Compound interest is paid on all amounts in the annuity.

luciavelasquezortega 16
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

Based on the latest accepted notations,

(𝑃⁄𝐴, 𝑖%, 𝑛) = 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 (𝑎𝑡 𝐴)𝑜𝑓 𝑡ℎ𝑒 $1.00 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
(𝐹 ⁄𝐴, 𝐼%, 𝑛) = 𝑓𝑢𝑡𝑢𝑟𝑒 𝑤𝑜𝑟𝑡ℎ (𝑎𝑡 𝐵) 𝑜𝑓 𝑡ℎ𝑒 𝑛 $1.00 𝑝𝑎𝑦𝑚𝑒𝑛𝑡𝑠
The present value, (𝑃⁄𝐴, 𝑖%, 𝑛), is the sum of the present values of each of the $1.00
payments. Thus,
(𝑃⁄𝐴, 𝑖%, 𝑛) = 1(1 + 𝑖)−1 + 1(1 + 𝑖)−2 + ⋯ + 1(1 + 𝑖)−𝑛
This is geometric progression whose first term is 1(1 + 𝑖)−1, last term is 1(1 + 𝑖)−𝑛 ,
and the common ratio is 1(1 + 𝑖)−1. From Algebra, the sum of the geometric
progression is
1(1+𝑖)−1 −1(1+𝑖)−𝑛 1(1+𝑖)−1
(𝑃⁄𝐴, 𝑖%, 𝑛) =
1−1(1+𝑖)−1

1(1+𝑖)−1 −1(1+𝑖)−𝑛 1(1+𝑖)−1 (1+𝑖)

(𝑃⁄𝐴, 𝑖%, 𝑛) = ∗ (1+𝑖)
1−1(1+𝑖)−1

1−(1+𝑖)−𝑛 1−(1+𝑖)−𝑛
(𝑃⁄𝐴, 𝑖%, 𝑛) = =
1+𝑖−1 𝑖
1−(1+𝑖)−𝑛 (1+𝑖)𝑛 −1
Thus, (𝑃⁄𝐴, 𝑖%, 𝑛) = =
𝑖 𝑖(1+𝑖)𝑛

The future worth, (𝐹 ⁄𝐴, 𝑖%, 𝑛), is obtained by summing up the future worth of the n
$1.00 payments.
(𝐹 ⁄𝐴, 𝑖%, 𝑛) = 1 + 1(1 + 𝑖)1 + ⋯ + 1(1 + 𝑖)𝑛−2 + 1(1 + 𝑖)𝑛−1
1−(1+𝑖)𝑛−1 (1+𝑖) 1−(1+𝑖)𝑛
(𝐹 ⁄𝐴, 𝑖%, 𝑛) = =
1−(1+𝑖) −𝑖

(1+𝑖)𝑛 −1
(𝐹 ⁄𝐴, 𝑖%, 𝑛) =
𝑖
1−(1+𝑖)−𝑛
Also, (𝐹 ⁄𝐴, 𝑖%, 𝑛) = (𝑃⁄𝐴, 𝑖%, 𝑛)(1 + 𝑖)𝑛 = (1 + 𝑖)𝑛
𝑖
(1+𝑖)𝑛 −1
(𝐹 ⁄𝐴, 𝑖%, 𝑛) =
𝑖

From the formulas above, we obtain the reciprocals

1 𝑖(1+𝑖)𝑛
(𝐴⁄𝑃, 𝑖%, 𝑛) = (𝑃 = (1+𝑖)𝑛 −1
⁄𝐴,𝑖%,𝑛)

luciavelasquezortega 17
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

1 𝑖
And (𝐴⁄𝐹, 𝑖%, 𝑛) = (𝐹 = (1+𝑖)𝑛−1
⁄𝐴,𝑖%,𝑛)

3-04 Formulas when each Payment is $A

Let A = amount of each payment of an ordinary annuity

P = present value of the n $A payments
F = future worth or accumulated amount of the n $A payments

𝑃 (1+𝑖)𝑛 −1
Then 𝑃 = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [ ]
𝑖(1+𝑖)𝑛

𝐹 (1+𝑖)𝑛 −1
𝐹 = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [ ]
𝑖

Problems on Annuity Factors

Determine the value of each of the following annuity.
𝑃
a) (𝐴 , 4%, 8)
𝐴
b) (𝑃 , 14.5%, 10)
𝐹
c) (𝐴 , 9.8%, 21)
𝐴
d) (𝐹 , 6.3%, 15)

Problems on Ordinary Annuity

1) A steam boiler is purchased on the basis of guaranteed performance. However, initial
tests indicate that the operating cost will be $400 more per year than guaranteed. If the
expected life is 25 years and money is worth 10%, what deduction from the purchase
price would compensate the buyer for the additional operating cost?
2) A one-bagger concrete mixer can be purchased with a down payment of $2,000 and
equal installments of $300 each paid at the end of every month for the next 12 months.
If money is worth 12% compounded monthly, determine the equivalent cash price of
the mixer.

3-05 Deferred Annuity

A deferred annuity where each payment is $1.00 is shown graphically in Fig. 3-02. It
will be noted that the first payment is made at a period later than the first. After the
first payment is made, all the succeeding payments are paid at the end of the periods
extending to the end of the annuity. It will be observed that in an annuity which has
been deferred k periods, the first payment is made at the end of (𝑘 + 1)period. At

luciavelasquezortega 18
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

𝑃
point B in Fig- 3-02 the present value of the annuity is (𝐴 , 𝑖%, 𝑛). At A, the present
𝑃
value, denoted by 𝑘| (𝐴 , 𝑖%, 𝑛) is given by the equation
𝑃 𝑃
𝑘| (𝐴 , 𝑖%, 𝑛) = (𝐴 , 𝑖%, 𝑛) (1 + 𝑖)−𝑘
𝑃 𝑃 𝑃
𝑘| (𝐴 , 𝑖%, 𝑛) = (𝐴 , 𝑖%, 𝑛) (𝐹 , 𝑖%, 𝑘)

If each payment is $A, then the present value of the deferred annuity is
𝑃 𝑃 𝑃
𝑘| (𝐴 , 𝑖%, 𝑛) = 𝐴 (𝐴 , 𝑖%, 𝑛) (𝐹 , 𝑖%, 𝑘)

The accumulated amount F is the same as that for an ordinary annuity.

Problems on Deferred Annuity

1) A lathe for a machine shop costs $60,000 if paid in cash. On the installment plan, a
purchaser should pay $20,000 down payment and 10 quarterly installments, the first
due at the end of the first year after the purchase. If money is worth 15% compounded
quarterly, determine the quarterly installment.
2) A man invests $10,000 now for the college education of his 2-year old son. If the fund
earns 14% effective, how much will the son get each year from his 18 th to the 22nd
birthday?

3-06 Annuity Due

Fig, 3-03 pictures an annuity consisting of n $1.00 payments, each paid at the
beginning of every period starting from the first. We will denote the present value and
𝑃̅ 𝐹̅
the future amount of such annuity by the symbols (𝐴 , 𝑖%, 𝑛) and (𝐴 , 𝑖%, 𝑛)
respectively.

luciavelasquezortega 19
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

Disregarding the first payment of $1.00, the remaining (𝑛 − 1) payments may be

considered to constitute an ordinary annuity. Hence,
𝑃̅ 𝑃
(𝐴 , 𝑖%, 𝑛) = 1 + (𝐴 , 𝑖%, 𝑛 − 1)
𝐹̅
The future amount, (𝐴 , 𝑖%, 𝑛), is derived by considering it as an ordinary annuity
extending for 𝑛 + 1 periods with the last payment omitted. Thus,
𝐹̅ 𝐹̅
(𝐴 , 𝑖%, 𝑛) = (𝐴 , 𝑖%, 𝑛 + 1) − 1

If each payment is $A, then the present value and future amount are, respectively,
𝑃̅ 𝑃
𝑃̅ = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [1 + (𝐴 , 𝑖%, 𝑛 − 1)]
𝐹̅ ̅
𝐹
𝐹̅ = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [(𝐴 , 𝑖%, 𝑛 + 1) − 1]

Problems on Annuity Due

1) A farmer bought a tractor costing $20,000 payable in 10 semi-annual payments, each
installment payable at the beginning of each period. If the rate of interest is 26%
compounded semi-annually, determine the amount of each installment.
2) A certain manufacturing plant is being sold and was submitted for bidding. Two bids
were submitted by interested buyers. The first bid offered to pay $200,000 each year
for 5 years, each payment being made at the beginning of each year. The second bidder
offered to pay $120,000 the first year, $180,000 the second year, and $270,000 each
year for the next 3 years. If money is worth 12% compounded annually, which bid
should the owner of the plant accept?

3-07 Perpetuity

luciavelasquezortega 20
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

It will be noted that the term (1 + 𝑖)−𝑛 in the previous formula becomes zero as n
approaches infinity or becomes indefinitely large. Hence, for perpetuity, the present
value is given by the formula
𝑃̅ 1
(𝐴 , 𝑖%, ∞) = 𝑖

For a perpetuity where the periodic payments are each equal to $A, the present
value is
𝐴
𝑃= 𝑖

Obviously the future amount is infinite.

3-08 Capitalized Cost

As a natural extension and application of perpetuity we have capitalized cost. The

capitalized cost of any structure or property (equipment, machinery, building, etc.) is
the sum of its first cost and the present worth of all costs for replacement, operation,
and maintenance for a long time or forever.
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑃𝑒𝑟𝑝𝑒𝑡𝑢𝑎𝑙 𝑀𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒
To derive the formulas for capitalized cost, let
CC = capitalized cost
FC = first cost of the structure
S = the amount needed to replace or maintain the property every k periods
X = the amount of principal invested at i% per period, the interest on which
will amount to S every k periods
Then,
Xi = interest on the amount X for each period
𝑆 = (𝑋𝑖)(𝐹/𝐴, 𝑖%, 𝑘)
and
𝑆 𝐴 𝑆
𝑋 = ( , 𝑖%, 𝑘) =
𝑖 𝐹 (1 + 𝑖)𝑘 − 1
𝑆
𝐶𝐶 = 𝐹𝐶 + 𝑋 = 𝐹𝐶 + (1+𝑖)𝑘 −1

If the property or structure costs $S to obtain and it will have to be replaced every k
periods for the same amount, then
𝑆 𝐴
𝐶𝐶 = 𝑆 + 𝑋 = 𝑆 + 𝑖 (𝐹 , 𝑖%, 𝑘)
𝑆 𝐴 𝑆 𝐴
𝐶𝐶 = 𝑖 [𝑖 + (𝐹 , 𝑖%, 𝑘)] = 𝑖 (𝑃 , 𝑖%, 𝑘)

luciavelasquezortega 21
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

𝑆
𝐶𝐶 = 1−(1+𝑖)−𝑘

3-09 Continuous Compounding for Discrete Payments

We observe that 𝑒 𝑟𝑛 in the formula for continuous compounding corresponds to

(1 + 𝑖)𝑛 for discrete compounding. Hence, 𝑒 𝑟 corresponds to (1 + 𝑖). From 𝑒 𝑟 = 1 +
𝑖 , we obtain 𝑖 = 𝑒 𝑟 − 1. Substituting this in the formula for present and future worth
of ordinary annuity,
𝑃 1−𝑒 −𝑟𝑛 𝑒 𝑟𝑛 −1
(𝐴 , 𝑖%, 𝑛) = = 𝑒 𝑟𝑛(𝑒 𝑟 −1)
𝑒 𝑟 −1

𝐹 𝑒 𝑟𝑛 −1
and ( , 𝑖%, 𝑛) =
𝐴 𝑒 𝑟 −1

3-10 Continuous Compounding of Interest and Continuous Cash Flows

We define continuous flow of funds to mean a series of payments made at infinitely

short intervals of time. This is equivalent to an annuity with infinitely short periods. In
this case, we consider interest to be compounded continuously. To derive the
formulas, let
r = nominal annual rate of interest
k = number of payments in one year which amount to a total of 1 unit per year
i = rate of interest per period = r/k
Using the formula for the present worth of the k payments at the beginning of the
year is
𝑟 𝑘 𝑟 𝑘
1 (1+𝑘) −1 (1+ ) −1
𝑘
𝑃= { } =
𝑘 𝑟 (1+ 𝑟)𝑘 𝑟 𝑘
𝑟(1+ )
𝑘 𝑘 𝑘

𝑟 𝑘
As k approaches infinity, the quantity (1 + 𝑘) approaches 𝑒 𝑟 as a limit. For
continuous uniform payment over one period, we obtain the value of the continuous
compounding present worth factor
𝑃 𝑒𝑟 − 1
( , 𝑟%, 1) =
𝐴̅ 𝑟𝑒 𝑟
where𝐴̅ is the amount flowing continuously over 1 year. For 𝐴̅ flowing each year over
n years,
𝑃 𝑒 𝑟𝑛 −1
(𝐴̅ , 𝑟%, 𝑛) = 𝑟𝑒 𝑟𝑛

which is called the continuous compounding present worth factor for continuous,
uniform payments.
Likewise, using formula for future amount

luciavelasquezortega 22
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

𝐹 𝑒 𝑟𝑛 − 1
( , 𝑟%, 𝑛) =
𝐴̅ 𝑟

3-11 Summaries of Interest and Annuity Formulas

For single payments:

𝐹
Given P, to find F: 𝐹 = 𝑃 (𝑃 , 𝑖%, 𝑛) = 𝑃(1 + 𝑖)𝑛
𝑃 1
Given F, to find P: 𝑃 = 𝐹 (𝐹 , 𝑖%, 𝑛) = 𝐹(1 + 𝑖)−𝑛 = 𝐹 [(1+𝑖)𝑛 ]

For uniform series (annuities):

𝐹 (1+𝑖)𝑛 −1
Given A, to find F: 𝐹 = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [ ]
𝑖
𝑃 (1+𝑖)𝑛 −1
Given A, to find P: 𝑃 = 𝐴 (𝐴 , 𝑖%, 𝑛) = 𝐴 [ ]
𝑖(1+𝑖)𝑛

𝐴 𝑖
Given F, to find A: 𝐴 = 𝐹 ( , 𝑖%, 𝑛) = 𝐹 [(1+𝑖)𝑛 ]
𝐹 −1

𝐴 𝑖(1+𝑖)𝑛
Given P, to find A: 𝐴 = 𝑃 (𝑃 , 𝑖%, 𝑛) = 𝑃 [(1+𝑖)𝑛−1]
𝐴 𝐴 𝐴 𝐴
Given (𝑃 , 𝑖%, 𝑛)and (𝐹 , 𝑖%, 𝑛), to find 𝑖 : 𝑖 = (𝑃 , 𝑖%, 𝑛) − (𝐹 , 𝑖%, 𝑛)

For continuous compounding (single payments):

𝐹
Given P, to find F: 𝐹 = 𝑃 (𝑃 , 𝑟%, 𝑛) = 𝑃𝑒 𝑟𝑛
𝑃
Given F, to find P: 𝑃 = 𝐹 (𝐹 , 𝑟%, 𝑛) = 𝐹𝑒 −𝑟𝑛

For continuous compounding (annuities)

𝐹 𝑒 𝑟𝑛 −1
Given A, to find F: 𝐹 = 𝐴 (𝐴 , 𝑟%, 𝑛) = 𝐴 [ 𝑒 𝑟 −1 ]
𝑃 𝑒 𝑟𝑛 −1
Given A, to find P: P= 𝐴 (𝐴 , 𝑟%, 𝑛) = 𝐴 [𝑒 𝑟𝑛(𝑒 𝑟 −1)]

𝐴 𝑒 𝑟 −1
Given F, to find A: 𝐴 = 𝐹 (𝐹 , 𝑟%, 𝑛) = 𝐹 [𝑒 𝑟𝑛−1]
𝐴 𝑒 𝑟𝑛 (𝑒 𝑟 −1)
Given P, to find A: A= 𝑃 (𝑃 , 𝑟%, 𝑛) = 𝑃 [ ]
𝑒 𝑟𝑛 −1

For continuous compounding, continuous uniform cash flows

𝐹 𝑒 𝑟𝑛 −1
Given 𝐴̅, to find F: 𝐹 = 𝐴̅ (𝐴̅ , 𝑟%, 𝑛) = 𝐴̅ [ ]
𝑟
𝑃 𝑒 −1𝑟𝑛
Given 𝐴̅, to find P: P= 𝐴̅ (𝐴̅ , 𝑟%, 𝑛) = 𝐴̅ [ 𝑟𝑒 𝑟𝑛 ]
𝐴 ̅ 𝑟
Given F, to find 𝐴̅: 𝐴̅ = 𝐹 (𝐹 , 𝑟%, 𝑛) = 𝐹 [𝑒 𝑟𝑛−1]

luciavelasquezortega 23
CEng 5201 – Engineering Economics Chapter 3: Annuities and Capitalized Cost

𝐴̅ 𝑟𝑒 𝑟𝑛
Given P, to find 𝐴̅: 𝐴̅ = 𝑃 (𝑃 , 𝑟%, 𝑛) = 𝑃 [𝑒 𝑟𝑛−1]

Problems on Perpetuity and Capitalized Cost

1) If money is worth 8% compounded quarterly, compare the present value of the
following:
a) An annuity of $1,000 payable quarterly for 50 years.
b) An annuity of $1,000 payable quarterly for 100 years
c) A perpetuity of $1,000 payable quarterly.
2) It costs $50,000 at the end of each year to maintain a section of the road going to Dire
Dawa. If money is worth 10%, how much would it pay to spend immediately to reduce
the annual cost to $10,000?
3) To maintain a bridge, $5,000 will be required at the end of 3 years and annually
thereafter. If money is worth 8%, determine the capitalized cost of all the future
maintenance.
4) A manufacturing plant installed a new boiler at a total cost of $150,000 and is estimated
to have a useful life of 10 years. It is estimated to have a scrap value at the end of its
useful life of $5,000. If interest is 12% compounded annually, determine its capitalized
cost.
5) The capitalized cost of a piece of equipment was found to be $142,000. The rate of
interest used in the computations was 12%, with a salvage value of $10,000 at the end
of a service life of 8 years. Assuming that the cost of perpetual replacement remains
constant, determine the original cost of the equipment.
6) Compare the capitalized costs of the following penstocks for a hydro-electric plant with
interest at 10%.
Timber Steel
First cost $50,000 $80,000
Estimated life 10 years 30 years
Scrap value $2,000 None
Annual maintenance $1,200 $200

luciavelasquezortega 24
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

4-01 Arithmetic Gradient

It frequently happens that the cash flow series is not of constant amount A. Instead,
there is a uniformly increasing series as shown.

Cash flows of this form may be resolved into two components:

Note that by resolving the problem in this manner, the first cash flow in the arithmetic
gradient series becomes zero. This is done so that G is the change from period to period,
and because the gradient (G) series normally is used along with a uniform series (A). We
already have an equation for P’, and we need to derive an equation for P”. In this way,
we will be able to write
𝑃 𝑃
𝑃 = 𝑃′ + 𝑃" = 𝐴 (𝐴 , 𝑖%, 𝑛) + 𝐺 (𝐺 , 𝑖%, 𝑛)

4-02 Derivation of Arithmetic Gradient Factors

The arithmetic gradient is a series of increasing cash flows as follows:

luciavelasquezortega 25
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

The arithmetic gradient series may be thought of as a series of individual cash flows

The value of F for the sum of the cash flows: 𝐹 = 𝐹 𝐼 + 𝐹 𝐼𝐼 + ⋯ + 𝐹 𝐼𝐼𝐼 + 𝐹 𝐼𝑉 , or

𝐹 = 𝐺(1 + 𝑖)𝑛−2 + 2𝐺(1 + 𝑖)𝑛−3 + ⋯ + (𝑛 − 2)𝐺(1 + 𝑖)1 + (𝑛 − 1)𝐺 (4-1)
Multiply Equation (4-1) by (1 + 𝑖) and factor out G, or
(1 + 𝑖)𝐹 = 𝐺[(1 + 𝑖)𝑛−1 + 2(1 + 𝑖)𝑛−2 + ⋯ + (𝑛 − 2)(1 + 𝑖)2 + (𝑛 − 1)(1 + 𝑖)1 ] (4-2)
Rewrite Equation (4-1) to show other terms in the series,
𝐹 = 𝐺[(1 + 𝑖)𝑛−2 + ⋯ + (𝑛 − 3)(1 + 𝑖)2 + (𝑛 − 2)(1 + 𝑖)1 + (𝑛 − 1)] (4-3)
Subtracting Equation 4-3 from Equation 4-2, we obtain
𝐹 + 𝑖𝐹 − 𝐹 = 𝐺[(1 + 𝑖)𝑛−1 + (1 + 𝑖)𝑛−2 + ⋯ + (1 + 𝑖)2 + (1 + 𝑖)1 + 1] − 𝑛𝐺 (4-4)
In the derivation of the equation for the future amount of ordinary annuity, the terms
inside the brackets of Equation (4-4) were shown to equal the series compound amount
factor:
(1+𝑖)𝑛 −1
[(1 + 𝑖)𝑛−1 + (1 + 𝑖)𝑛−2 + ⋯ + (1 + 𝑖)2 + (1 + 𝑖)1 + 1] =
𝑖

Thus, Equation 4-4 becomes

(1+𝑖)𝑛 −1
𝑖𝐹 = 𝐺 [ ] − 𝑛𝐺
𝑖

Rearranging and solving for F, we write

𝐺 (1+𝑖)𝑛 −1
𝐹= 𝑖[ 𝑖
− 𝑛] (4-5)

Multiplying Equation 4-5 by the single payment present worth factor gives
𝐺 (1+𝑖)𝑛 −1 1
𝑃=𝑖[ − 𝑛] [(1+𝑖)𝑛]
𝑖

(1+𝑖)𝑛 −𝑖𝑛−1
𝑃 = 𝐺[ ]
𝑖 2 (1+𝑖)𝑛

𝑃 (1+𝑖)𝑛 −𝑖𝑛−1
(𝐺 , 𝑖%, 𝑛) = [ ] (4-6)
𝑖 2 (1+𝑖)𝑛

Equation (4-6) is the arithmetic gradient present worth factor. Multiplying Equation (4-
5) by the sinking fund factor, we have

luciavelasquezortega 26
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

𝐺 (1+𝑖)𝑛 −1 𝑖 (1+𝑖)𝑛 −𝑖𝑛−1

𝐴=𝑖[ − 𝑛] [(1+𝑖)𝑛 −1] = 𝐺 [ ]
𝑖 𝑖(1+𝑖)𝑛 −𝑖

𝐴 (1+𝑖)𝑛 −𝑖𝑛−1 1 𝑛
(𝐺 , 𝑖%, 𝑛) = [ ] = [ 𝑖 − (1+𝑖)𝑛 −1] (4-7)
𝑖(1+𝑖)𝑛 −𝑖

Equation (4-7) is the arithmetic gradient uniform series factor.

Problem 4-01:
A man has purchased a new automobile. He wishes to set aside enough money in a bank
to pay the maintenance on the car for the first five years. It has been estimated that the
maintenance cost of an automobile is as follows:
Year Maintenance Cost
1 $120
2 $150
3 $180
4 $210
5 $240
Assume the maintenance costs occur at the end of each year and that the bank pays 5%
interest. How much should the car owner deposit in the bank now?
Problem 4-02
On a certain piece of machinery, it is estimated that the maintenance expense will be as
follows:
Year Maintenance Cost
1 $100
2 $200
3 $300
4 $400
What is the equivalent uniform annual maintenance cost for the machinery if 6% interest
is used?
Problem 4-03:
A textile mill in India installed a number of new looms. It is expected that initial
maintenance costs and expenses for repairs will be high but will then decline for several
years. The projected cost is:
Maintenance and
Year
Repair Cost (rupees)
1 24,000
2 18,000
3 12,000
4 6,000
What is the projected equivalent annual maintenance and repair cost if interest is 10%?

luciavelasquezortega 27
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

Problem 4-04:
Compute the value of P in the diagram. Use a 10% interest rate.

4-03 Geometric Gradient

In the preceding section, we saw that the arithmetic gradient is applicable where the
period-by-period change in a cash receipt or payment is a uniform amount. There are
other situations where the period-by-period change is a uniform rate, g. For example,
if the maintenance costs for an automobile are $100 the first year and they increase at
a uniform rate, g, of 10% per year, the cash flow for the first five years would be as
follows:
Year Cash Flow
1 100.00 = $100.00
2 100.00 + 10%(100.00) = 100(1 + 0.10)1 = $110.00
3 110.00 + 10%(110.00) = 100(1 + 0.10)2 = $121.00
4 121.00 + 10%(121.00) = 100(1 + 0.10)3 = $133.10
5 133.10 + 10%(133.10) = 100(1 + 0.10)4 = $146.41

From the table, we can see that the maintenance cost in any year is
$100(1 + 𝑔)𝑛−1
luciavelasquezortega 28
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

Stated in a more general form,

𝐴𝑛 = 𝐴1 (1 + 𝑔)𝑛−1 (4-8)
Where:
g = uniform rate of cash flow increase/decrease from period to period, that is,
the geometric gradients
A1 = value of cash flow at Year 1 ($100 in the example)
An = value of cash flow at any Year n
Since the present worth Pn of any cash flow An at interest rate I is
𝑃𝑛 = 𝐴𝑛 (1 + 𝑖)−𝑛 (4-9)
We can substitute Equation 4-7 into Equation 4-9 to get
𝑃𝑛 = 𝐴1 (1 + 𝑔)𝑛−1 (1 + 𝑖)−𝑛
This may be rewritten as
𝑛
−1
1 + 𝑔 𝑥−1 (4-10)
𝑃 = 𝐴1 (1 + 𝑖) ∑( )
1+𝑖
𝑥=1

The present worth of the entire gradient series of cash flows may be obtained by
expanding Equation 4-10
𝑛
−1
1 + 𝑔 𝑥−1 (4-11)
𝑃 = 𝐴1 (1 + 𝑖) ∑( )
1+𝑖
𝑥=1

In the general case, where 𝑖 ≠ 𝑔, Equation 4-10 may be written as follows:

1+𝑔 1+𝑔 2
𝑃 = 𝐴1 (1 + 𝑖)𝑛−1 + 𝐴1 (1 + 𝑖)−1 ( 1+𝑖 ) + 𝐴1 (1 + 𝑖)−1 ( 1+𝑖 ) + ⋯ +
1+𝑔 𝑛−1
𝐴1 (1 + 𝑖)−1 ( 1+𝑖 ) (4-12)
1+𝑔
Let 𝑎 = 𝐴1 (1 + 𝑖)−1 and = ( 1+𝑖 ) . Equation 4-12 becomes

luciavelasquezortega 29
CEng 5201 – Engineering Economics Chapter 4: Arithmetic and Geometric Gradient

𝑃 = 𝑎 + 𝑎𝑏 + 𝑎𝑏 2 + ⋯ + 𝑎𝑏 𝑛−2 + 𝑎𝑏 𝑛−1 (4-13)

Multiply Equation 4-13 by b:
𝑏𝑃 = 𝑎𝑏 + 𝑎𝑏 2 + 𝑎𝑏 3 + ⋯ + 𝑎𝑏 𝑛−1 + 𝑎𝑏 𝑛 (4-14)
Subtract Equation 4-14 from Equation 4-13
𝑃 − 𝑏𝑃 = 𝑎 − 𝑎𝑏 𝑛
𝑃(1 − 𝑏) = 𝑎 − 𝑎𝑏 𝑛
𝑎 − 𝑎𝑏 𝑛
𝑃=
(1 − 𝑏)
Replacing the original values for a and b, we obtain
1+𝑔 𝑛 1+𝑔 𝑛
1−( ) 1−( )
−1 1+𝑖 1+𝑖
𝑃 = 𝐴1 (1 + 𝑖) [ 1+𝑔 ] = 𝐴1 [ 1+𝑔 ]
1−( ) (1+𝑖)−( )(1+𝑖)
1+𝑖 1+𝑖

1−(1+𝑔)𝑛 (1+𝑖)−𝑛
𝑃 = 𝐴1 [ ]
1+𝑖−1−𝑔

1−(1+𝑔)𝑛 (1+𝑖)−𝑛
𝑃 = 𝐴1 [ ] (4-15)
𝑖−𝑔

where 𝑖 ≠ 𝑔
The expression in the brackets of Equation 4-15 is the geometric series present worth
factor where 𝑖 ≠ 𝑔.
𝑃 1−(1+𝑔)𝑛 (1+𝑖)−𝑛
(𝐴 , 𝑔, 𝑖, 𝑛)) = [ ] (4-16)
𝑖−𝑔

In the special case where 𝑖 = 𝑔, Equation 4-15 becomes

𝑃 = 𝐴1 𝑛(1 + 𝑖)−1
𝑃
(𝐴 , 𝑔, 𝑖, 𝑛)) = [𝑛(1 + 𝑖)−1 ] where 𝑖 = 𝑔 (4-17)

Problem 4-05:
The first-year maintenance cost for a new automobile is estimated to be $100, and it
increases at a uniform rate of 10% per year. Using an 8% interest rate, calculate the
present worth of cost of the first 5 years of maintenance.

luciavelasquezortega 30
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

5-01 Methods of Financing

Funds for financing an engineering or any business enterprise may be clssified into: (1)
equity, and (2) borrowed or debt capital. Equity capital is owned by the investors in
the enterprise and they exect to earn profit from their investment. However, there is
no obligation to pay them when there is no profit. When funds are borrowed, the
borrower is supposed to pay interest and to repay the principal on a specific date,
whether or not the operation of the enterprise have been profitable or not. Loans are
fixed obligations, and failure to repay them on time leads to embarrasment or
foreclosure of the property pledged as collateral.
5-02 Working Capital
Working or circulating capital includes all those funds which are required to make the
enterprise a going concern. There are two kinds of working capital: initial and regular
working capital. Initial working capital is the amount needed at the beginning of
operations and permits the enterprise to begin functioning before it receives any
income from the sales of its products or service. Regular working capital is what is
needed when operation have been in progress for sufficient time and have been
normalized. It is usually less than the initial working capital.
5-03 Types of Business Organization
The three principal types of business organizations are:
1) The individual ownership or sole proprietorship (Sole Proprietorship)
2) The partnership (PLC – Private Limited Company / Share Company)
3) The corporation (Branch / Multinational Company)
In recent years, due to the immensity or complexity of many engineering projects, two
or more large corporations together with some individuals group together to form
what is called a sydicate or complex. An aggrupation of several corporations engaged
in different lines of business, but under the controlof a central manageent is called
conglomerate.
5-04 Sole Proprietorship
The sole proprietorship or individual ownership is the simplest form of business
organization, wherein the business is owned entirely by one person who is responsible
for the operation. All profits that are obtained from the business are his alone, but he
must also bear all the losses should they be incurred.
Advantages of the Sole Proprietorship: The owner of a single proprietorship enjoys
the following advantages:
1) It is easy to organize. It is subject to fewer legal restrictions that the other types of
business organizations.

luciavelasquezortega 31
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

2) The sole owner has full possession of all the profits that accrue to the business. He
does not have to share the profit to anyone.
3) Full control of the business resides under one owner.
4) It is flexible because it is not necessary to request permission from the government
for the performance of any legal act.
5) The affairs of the business are free from the scrutiny of anyone except the owner
himself. All affairs of the organization may be kept secret.
Disadvantages of the sole Proprietorship: The points to consider against a sole
proprietorship are the following:
1) It is difficult to raise large amounts of capital in forming or expanding the business.
2) It is relatively difficult for the owner to obtain long term loans, because of the
uncertainty of the life of the enterprise.
3) The life of the organization depends on the life of the owner. In case of his death,
the business has to be entirely reorganized by his heirs.
4) The sole owner has no partner whom he can consult in deciding important
matters.
5) The most important and critical disadvantage is the unlimited liability of the owner
for his debts, in case of bankruptcy. The sole owner’s liabilities do not end with his
investment in the business, but even extend to his own personal properties.
5-05 Partnership
A partnership is an association of two or more persons for the purpose of engaging in
a business for profit.
Advantages of Partnership: Some of the advantages enjoyed by the partners are the
following:
1) Two or more or persons with different talents or abilities may group together for
their common welfare. An engineer may associate with a capable salesman and
together the business may be more successful than if owned by one man only.
2) More capital may be obtained by the partners pooling their resources together.
3) It is relatively easy to form compared to the formation of a corporation.
4) The partners directly share in the profits and this serves as an incentive for them
to exert their best for their common benefit.
5) It is also a flexible form of organization, without the need for permission from
anyone in the pursuance of legal acts.
Disadvantages of the Partnership: The partnership form of business organization has
some serious disadvantages. These are:
1) The amount of capital is definitely limited by the resources of the partners.
2) It is difficult to obtain capital in large amounts, particularly through long-term
loans.

luciavelasquezortega 32
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

3) The life of the partnership is limited to the lives of the partners. In case one of the
partners dies or ceases to be connected with the enterprise for any reason, the
business has to be reorganized.
4) The partners may have serious disagreements among themselves, which may end
the partnership.
5) In cases where the partners have equal or nearly equal shares in the business,
there is usually divided authority.
6) At least one of the partners is liable for all the liabilities of the enterprise in case
of bankruptcy. This is the most serious disadvantage.
Formation of the Partnership: A partnership is usually formed by the voluntary
agreement of the partners either verbally or in writing. To prevent misunderstanding
among the partners, the common practice is to have in writing all points on which the
partners have agreed in a form called the articles of co-partnership. The contract
among the partners usually states the relations between the partners on matters
relating to the proportion in which profits or losses are shared, their investments, the
rights and duties of each partner, and provisions for the withdrawal of any partner or
the dissolution of the partnership.
To be more specific, the partnership contract will contain the following provisions:
1) The name, location, and nature of the business.
2) The names of the partners, and the duties and rights of each.
3) Amount to be invested by each partner. This provision must include a procedure
for valuing any non-cash assets invested or withdrawn by any partner.
4) Procedure for sharing profits or losses.
5) Withdrawals to be allowed each partner.
6) Provisions for insurance on the lives of the partners, naming the partnership or the
surviving partners as beneficiaries.
7) The accounting period to be used.
8) Provision for audit by certified public accountants.
9) Provision for settlement of disputes.
10) Provision for dissolution of the partnership.
5-06 The Corporation
A corporation is a distinct legal entity, separate from the individuals who own it, and
which can engage in practically any business transaction which a real person could do.
It is considered the most important type of business organization and may have
perpetual life if desired. Since it is a legal entity, it may sue or be sued in its own name.
Advantages of the Corporation: Some of the advantages of a corporation over the
sole proprietorship or the partnership are the following:
1) It enjoys perpetual life. The corporation does not die with the death of anyone
member even of all the members.
luciavelasquezortega 33
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

2) The stockholders of the corporation are only liable to the extent of their
investment. In case of bankruptcy, the personal properties of any stockholder
cannot be attached for the debts of the corporation. This is the most important
advantage.
3) It is relatively easier to obtain large amounts of capital for its expansion, due to its
perpetual life and non-dependence on the lives of the stockholders.
4) The ownership in the corporation is readily transferred.
5) The best managerial talent is obtained by the hiring of competent executives.
Disadvantages of the Corporation: Some of the disadvantages of a corporation are as
follows:
1) The activities of a corporation are limited to those stated in its charter.
2) It is relatively complicated in formation and administration.
3) There is a greater degree of governmental control as compared to the other types
of business organizations.
4) Due to manipulation of the controlling stockholders the minority stockholders are
sometimes exploited.
5) Double taxation. The corporation pays an income tax on its earnings. Furthermore,
when its net income is distributed to the owners in the form of cash dividends,
these dividends are considered personal income of the stockholders and are again
subject to tax.
5-07 Dangers of the Corporation Form of Business Organization
It may be well to consider the dangers attendant to the formation of corporations. The
corporation has been stated as the best form of business organization, but there are
abuses and dangers which should be weighed in its formation. Some of these are:
1) Dishonesty of the Promoters. There have been cases where certain person have
taken the initiative in forming corporations where their only interest is in the
promotion fees which they can collect after the formation of the corporation and
not in the enterprise itself.
2) Dishonesty of the Management. The officers of the corporation may be dishonest,
and their only aim may be to enrich themselves at the expense of the stockholders
by paying themselves unreasonably large salaries, and by employing their relatives
and paying them salaries far in excess of their capabilities or the value of the job
they are holding.
3) Watering of Stock. The stocks of a corporation are said to be watered if the
amount of stocks issued is far in excess of the actual value of the assets of the
corporation. The watered stocks which do not represent any assets often go to the
dishonest officers of the corporation, earn the same dividends as the other stocks,
to the detriment of the stockholders.

luciavelasquezortega 34
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

4) Absentee Ownership: In the sole proprietorship and partnership forms of business

organizations, the sole owner or the partners take an active hand in the
administration of the enterprise. In the corporation, however, most of the
stockholders may know nothing of the affairs of the business, because they are
not employed in the enterprise. Usually a stockholder is satisfied if he gets a large
annual dividend, without his knowing that these dividends may have been
obtained through the payment of low wages to its workers or by some other
means.
5-08 Capitalization of a Corporation
A corporation is capitalized through the sale of shares of stock. There are two principal
types of capital stock: common stock and preferred stock. There are many varieties
which exist within these classes relative to income, control, and other matters. If only
one class of stock is issued it is usually common stock, although it is sometimes called
capital stock.
5-09 Common Stock
Common stock represents the ownership of stockholders who have a residual claim
on the assets of the corporation after all other claims have been settled. No return is
guaranteed on the investment of common stockholders.
Common stockholders, as owners of the corporation, have certain legal rights, among
which are the following:
1) To call and hold meetings, usually upon the request of a majority of the
stockholders.
2) To vote at stockholders’ meetings.
3) To elect the members of the board of directors who will manage the affairs of the
corporation.
4) To amend the charter of the corporation subject to government approval.
5) To prepare and amend the by-laws of the corporation.
6) To inspect the books of the corporation.
7) To receive dividends when such are declared.
8) To share the remaining assets, if any, when the corporation is dissolved.
5-10 Preferred Stock
Preferred stock also represents ownership, and it possesses the same rights as
common stock, but in addition, it enjoys certain preferences, not possessed by
common stock.
Preferred stock has priority over common stock in the receipts of dividends, and it is
usually guaranteed a fixed annual dividend, regardless of the amount of the earnings
of the corporation. In case the corporation is dissolved, the owner of the preferred
stock has priority over the assets before the common stockholders. However, due to

luciavelasquezortega 35
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

a guaranteed dividend on the preferred stock, the preferred stockholders usually have
no right to vote in meetings.
5-11 Bonds
A bond is a certificate of indebtedness of a corporation usually for a period not less
than 10 years, and guaranteed by a mortgage on certain assets of the corporation or
its subsidiaries.
Bonds are issued when there is need for more capital such as for expansion of the
plant or the services rendered by the corporation. Bonds represent indebtedness, and
in return for the money borrowed the corporation agrees to pay interest at a
stipulated rate and at specified periods in addition to the payment of the loan at the
time or maturity or prior to that date. Because of the guarantee existing behind the
bond, it represents a more stable investment than either a common or preferred
stock. However, the bondholder has no voice in managing the affairs of the
corporation, and is not given any share in the profits of the corporation.
The par value of the bond is the amount stated on the bond. The bond rate is the rate
of interest quoted on the bond.
5-12 Classification of Bonds
Bonds are classified into several ways. Bonds may be classified according to the
method of payment of interest, as to the security behind the bond, and in many
other ways.
According to the method of paying interest, bonds are classified into:\
1) Registered Bonds. In all registered bonds, the owner’s name is recorded in the
books of the corporation, and interest is paid periodically to the owners without
their asking for it.
2) Coupon Bonds. These are bonds to which are attached coupons indicating the
interest due and the date when such interest is to be paid. The owner can collect
the interest due by surrendering the same to the officers of the corporation or
cashing it at specified banks.

According to the security behind the bonds, the classification is as follows:

1) Mortgage Bonds. These are bonds whose security is a mortgage on certain
specified assets of the corporation. If the corporation fails to pay the bond value
on the date of maturity, title to the property is transferred to the bondholders,
who may take possession and sell the same to reimburse the amounts they have
invested.
2) Collateral Trust Bonds. In such types of bonds, the corporation pledges securities
which it owns, such as the stocks or bonds of one of its subsidiaries. In case of

luciavelasquezortega 36
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

default in the payment of the bond value at maturity the bondholders have to
depend on the assets of the subsidiary for redemption of their investment. Usually
however the issuing corporation includes a guaranty involving its properties to
enhance the value of the bond to prospective investors.
3) Equipment Obligations Bonds. These bonds refer primarily to bonds whose
guaranty is a lien on railroad equipment, such as freight and passenger cars,
locomotives, and other railroad equipment.
4) Debenture Bonds. These are bonds without any security behind them except a
promise to pay by the issuing corporation. These bonds may only be issued by large
and well-known firms, whose record of achievement is known to the public.
5) Joint Bonds. Sometimes two or more corporation issue bonds which are
guaranteed jointly and severally by them. Such bonds are called joint bonds. Each
of the issuing corporations is liable for the entire bond issue in case of default.
5-13 Bond Amortization and Retirement
Bonds represent debt, and therefore some provision must be made for its repayment
at some future time. The amount necessary to redeem or retire bonds may be done
in three ways.
1) The corporation may issue another set of bonds equal to the amount of bonds due
for redemption. This method in effect is borrowing from Peter to pay John, and
will cause the corporation to be perpetually in debt.
2) The corporation may set up a sinking fund into which payments are made
periodically and usually of equal amounts. The amounts deposited, together with
the interests they earn at maturity date equal to the amount of the bonds to be
retired. The bondholders are then paid the par value of their bonds. The
corporation, however, must, in addition to the amount set aside for the bond
retirement, pay periodically the interest on the bonds. To determine the amount
of the periodic payment, let
A = amount of the periodic payment, part of which will pay for bond
retirement, the balance for periodic interest.
F = the amount of the bond issue, which will be repaid at maturity date.
n = the number of periods until the bonds are retired.
i = rate of interest on the bonds per periods.
In this case, the total periodic payment will be
𝐴 𝐴
𝐴 = 𝐹𝑖 + 𝐹 ( , 𝑖%, 𝑛) = 𝐹 ( , 𝑖%, 𝑛)
𝐹 𝑃
𝐴 𝐴
Since 𝑖 + (𝐹 , 𝑖%, 𝑛) = (𝑃 , 𝑖%, 𝑛)

3) Usually the interest on the bonds is more than the interest on the sinking fund set
up by the company. In such a case, it is more economical to retire the bonds

luciavelasquezortega 37
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

annually in order that the corporation may take advantage of the higher bond rate.
The corporation may therefore float or issue callable or serial bonds. These bonds
permit repayment of the principal on certain bonds before maturity. The callable
bonds to be retired on a definite date are usually determined by lot, while those
for serial bonds are indicated on the bond issue, and bonds are retired according
to a certain schedule where the serial number of the bonds to be retired at specific
dates is stated.
In retiring a bond issue where a sinking fund is set up for such a purpose, the
company prepares an amortization schedule which shows the method of repaying
the principal and interest. In general, amortization is defined to be any method of
repaying a debt, the principal and interest included, usually by a series of equal
payments at periodic intervals of time.
The periodic payments made to amortize a bonded debt are used to pay the
interest already due and to redeem a certain number of the bonds. The periodic
payments cannot be kept equal, but are to be kept as nearly equal as possible.
Fractions of a bond cannot be retired. For example, if the denomination of the
bonds is $100 and if $842.10 is available for redeeming the bonds, then 8 bonds
are redeemed, not 8.42 bonds; if $875.31 is available, 9 bonds are redeemed.
5-14 Value of a Bond
The value of a bond is defined to be the present worth of all the amounts the
bondholder will receive through his possession of the bond. The bondholder will
receive two types of payments which are:
1) A single payment which the owner will receive at the date of maturity of the bond,
which is usually equal to the par value of the bond, and
2) The periodic payment for interest on the bond until it is redeemed by the issuing
corporation.
5-15 Derivation of the Formula for Value of a Bond
Let Vn = value of the bond n periods before redemption
F = par value of the bond
C = amount paid to the bondholder at maturity of the bond which is usually equal
to F
n = number of periods prior for redemption
i = actual rate of interest on the amount invested in the bond, usually called
yield

luciavelasquezortega 38
CEng 5201 – Engineering Economics Chapter 5: Financing any Enterprise

From Figure 4-01, it is clear that the periodic interest payments on the bonds form an
ordinary annuity, each payment being Fr. The present value of n such payments is
𝑃
𝐹𝑟(𝐴 , 𝑖%, 𝑛). The single payment C at the maturity date of the bond is therefore
𝑃 𝑃
𝑉𝑛 = 𝐶 ( , 𝑖%, 𝑛) + 𝐹𝑟 ( , 𝑖%, 𝑛)
𝐹 𝐴
𝐶 (1+𝑖)𝑛 −1
𝑉𝑛 = (1+𝑖)𝑛 + 𝐹𝑟 [ ]
𝑖(1+𝑖)𝑛

In solving the above formula for the rate of interest I, interpolation methods are
usually employed due to the difficulty of direct solution.

Problems on Amortization of an Interest Bearing Debt

A debt of $5,000 with interest at 6% payable quarterly will be discharged, interest
included, by equal payments at the end of each 3 months for 2 years. Construct the
amortization schedule.
Problems on Amortization of Bonded Debts
A corporation sells $100,000 worth of 10-year callable bonds in $500 denomination,
which are to be redeemed in ten annual payments, as nearly equal as possible. The
bond rate is 8% compounded annually. Prepare an amortization schedule.
Problems on Bond Value
1) A bond with a par value of $1,000 and with a bond rate of 9% payable annually is to
be redeemed at $1,050 at the end of 6 years from now. If it is sold now, what should
be the selling price to yield 8%?
2) A bond with a par value of $1,000 and with a bond rate of 10% payable annually is
sold now for $1,080. If the yield is to be 12%, how much should the redemption price
be at the end of 8 years?

luciavelasquezortega 39
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

6-01 Depreciation

Depreciation is defined as the decrease in the value of a property, such as machinery,

equipment, building or other structure, due to the passage of time.

Excluded from this definition are the properties whose values increase with time, such
as antiques, paintings of the masters, rare stamps, rare coins, and in most cases, land.

Depreciation must always be included in the cost of production of any product or the
rendering of any service where equipment is used for the following reasons:

1) To provide for the replacement of the equipment either at the end of its physical
or economic life or at the time when its operation no longer results in a satisfactory
profit.
2) To provide for the maintenance of capital to replace the decrease in the value of
equipment caused by physical or functional causes.

6-02 Types of Depreciation

Decreases in the value of property with the passage of time are due mainly to the
following:

1) Physical depreciation caused by the following:

a) Deterioration due to the effects of various chemical and mechanical factors on
the materials composing the property. Included in this are rusting of metal
parts, decay of wooden parts of a structure, and the discoloration and cracking
of plastic parts.
b) Wear and tear due to abrasion, friction between moving parts of equipment,
impact, vibration, or fatigue of the materials in the property. It is determined
by use rather than by age. Sudden physical damage to a property due to
accidents and disasters, such as fire, flood, earthquake, tidal waves and other
unforeseen acts of nature are excluded from the determination of decrease in
value.
2) Functional depreciation which is due to a decrease in the demand for the function
of the equipment for which it was designed. Such depreciation is caused by the
following:
a) Inadequacy of the equipment.
b) Obsolescence caused by the invention of more efficient equipment and
machines to perform the same task.
c) Changes in methods of production.
d) Changes in styles and designs of the goods produced on the equipment.
e) Transfer of population due to various causes.
3) Changes in the price levels of similar property. If price levels rise during the life of
a property, even if the original investment has been recovered through proper

luciavelasquezortega 40
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

depreciation procedure, the recovered capital will be insufficient to provide as

identical replacement. Thus, it is the capital that has depreciated, and not the
property.

6-03 Depreciation Cost

The depreciation cost depends upon the physical or economic life of the equipment
and its first cost.

The physical life of equipment is the length of time during which it is capable of
performing the function for which it is designed and manufactured.

The economic life of equipment is the length of time during which it will operate at a
satisfactory profit. Thus, even though the equipment can still perform its function, but
if it can only operate at a loss, then it is considered economically dead. Replacement
is in order.

The life of any property is usually difficult to determine accurately. In many cases, the
determination of life is dependent to a great extent upon the experience of the men
managing the enterprise in the use of similar equipment. For purposes of taxation, the
U.S. International Revenue Service prepared a list of equipment with their
corresponding lives. (Refer to Table 5-02).

The first cost of any property includes the original purchase price, freight and
transportation charges to the site, installation expenses, and initial taxes and permits
to operate, and all other expenses needed to put the equipment into operation.

The amount to be recovered, equal to the depreciation cost, is the difference between
the first cost and the salvage value of the equipment.

Salvage value, sometimes called second-hand value, is defined to be the amount for
which the equipment or machine can be sold as second hand. It implies that the
machine can still perform its function.

Scrap or junk value is the amount the equipment can be sold for, when disposed-off
as junk. This implies that the equipment cannot be used anymore for the function for
which it was designed.

6-04 Determination of Depreciation Cost

The methods often used to determine the annual depreciation cost are the following:

1) Straight-Line Formula
2) Sinking Fund Formula

luciavelasquezortega 41
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

3) Matheson Formula: This is also known by other names like: Constant Percentage
Method, Fixed Percentage Method, declining Balance Method, or Diminishing
Balance Method.
4) Sum of the Years-Digits Method (SYD Method)
5) Service-Output or Production-Units Method

Other methods formulated in recent years are:

6) Straight-Line Plus Average Interest Formula

7) Double-Rate Declining-Balance Method
8) Operating Day Method
9) Retirement Method
10) Annual Inventory Method

6-05 Requirements for a Depreciation Method

A depreciation method should fulfill the following requirements:

1) Payments to the depreciation fund should be equal to the loss in value due to
depreciation.
2) The method should be simple.
3) Prior to its adoption, approval of the method should be secured from the Internal
Revenue Office.
4) To be satisfactory, the actual value of the equipment should, at all times, be equal
to the book value. It will be necessary from time to time to check the actual value
against the book value, and in case the two values are not in agreement,
adjustment should be made.

6-06 Properties of the Different Depreciation Method

The Straight-Line Formula

1) It is simple and is more widely used than any other method.

2) It does not need annuity tables or computing machines for using it.
3) It gives a uniform annual charge.
4) It is acceptable to the Internal Revenue Office.
5) It does not take into account the interest or profit earned on the accumulated
depreciation fund. Likewise, operation and maintenance costs are disregarded.

The Sinking Fund Formula

1) It is also relatively simple, though it will require the use of annuity tables in the
absence of the electronic calculator.
2) It also gives a uniform annual charge.
3) A sinking fund is created in which funds accumulate for replacement purposes.

luciavelasquezortega 42
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

4) All amounts in the sinking fund earn interest.

5) Usually the company uses the amount accumulated in its operations, and
therefore the amount in the fund is assumed to earn a certain profit or interest.
6) It is generally the method used for economy study purposes.

The Matheson Formula

1) The basic assumption for this method is that the annual cost of depreciation is a
constant percentage of the salvage value at the beginning of the year.
2) The annual depreciation charges, different each year, decrease from year to year,
greater during the first year and least in the last year of life of the property.
3) With this formula, however, a property can never depreciate to zero value.

The Sum of the Years-Digits (SYD) Method

1) It provides very rapid depreciation during the early years of life of the property,
and therefore enables faster recovery of capital.
2) It is easier to use than the Matheson Formula.
3) Properties can be depreciated to zero value.
4) The basic assumption for the method is that the value of the property decreases
at a decreasing rate.

The Service-Output Method

1) Depreciation during any year is charged on the basis of actual service rendered or
actual units produced by the property during the year.
2) The depreciation cost per unit is constant and gives low depreciation expense
during periods of little production. Theoretically, if the property is idle during any
year no depreciation is charged.
3) It is difficult to apply because one has to estimate not only the economic life span,
but also the total amount of service or units the property will render or produce
during its life.
4) It is used in certain cases for computing the depreciation of public utility
equipment like taxis, buses, commercial planes, etc.

The Straight-Line plus Average Interest Formula

1) It is an approximate method, because it adds and subtracts amounts which do not

occur at the same point in time.
2) The method closely approximates the true equivalent annual cost in certain cases
but a poor approximation in others.
3) The recovery of capital in on a straight-line basis, that is, an equal amount is
recovered each year.

luciavelasquezortega 43
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

4) Depreciation cost computed by this method is low. The error is considerable when
the rate of interest is high and the life period is long.

The Double-Rate Declining-Balance Method

1) The depreciation cost in any year is a constant ratio of the book value at the
beginning of the year.
2) The book value for this method can never become zero.
3) The salvage value, if any, does not enter into the computations.

The Operating Day Method

This is confined to assets where the major factor in depreciation is wears and tears
arising from use. The depreciation cost to be charge daily depends upon the number
of units produced during the day – the greater the production, the higher the
depreciation cost will be. This method may be considered an extension of the service-
output method, which is applied on annual basis.

The Retirement Method

A change is made in the investment account when the property is retired or replaced.
At this time the full initial book value of the asset is taken out of the capital account.
This sum diminished by the salvage value is charged to current expenses. Any
expenses for repairs or replacement or worn-out parts made during the life of the
equipment are charged directly to current expenses and are never included in the
capital account.

The Annual Inventory Method

This method involves the write-off of annual depreciation determined by officers of

the company who possess the required experience and technical knowledge. In this
respect the year-end book value of the asset may be more responsive to the actual
conditions obtained during the year.

6-07 The Straight-Line Formula

In this method the loss in value is considered to be directly proportional to the age of
the property. No interest is assumed to be paid on the amounts set aside in the
depreciation fund.

We shall adopt the following symbols:

n = useful life of the property in years
m = age of the property at any time less than or equal to n (𝑚 ≤ 𝑛)
d = annual cost of depreciation
𝐷𝑚 = accrued or total depreciation up to m years

luciavelasquezortega 44
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

𝐶0 = original or first cost of the property

𝐶𝑚 = book value of the property at the end of n years
𝐶𝑛 = book value at the end of life, n years, (salvage or scrap value, as the case may
be)
Then,
𝐶0 −𝐶𝑛 𝑚
𝑑= 𝐷𝑚 = 𝑚𝑑 = (𝐶0 − 𝐶𝑛 ) 𝑛 𝐶𝑚 = 𝐶0 − 𝐷𝑚
𝑛

6-08 The Sinking Fund Formula

In this method it is assumed that a sinking fund is established in which funds will
accumulate for replacement purposes and will bear interest. The total depreciation
which has occurred up to any given time is assumed to equal the amount in the sinking
fund at that time.

Using the same symbols as those for the Straight-Line Formula, the formulas for this
method are:
𝑖 (1+𝑖)𝑚 −1
𝑑 = (𝐶0 − 𝐶𝑛 ) [(1+𝑖)𝑛 −1] 𝐷𝑚 = (𝐶0 − 𝐶𝑛 ) [ (1+𝑖)𝑛 −1 ]

𝐶𝑚 = 𝐶0 − 𝐷𝑚
Derivation of the above formulas

Figure 6-01 shows the periodic payments to the sinking fund, each equal to d, which
are paid at the end of every period. The n payments constitute an ordinary whose
accumulated amount for n periods is the total depreciation for n periods, 𝐶0 − 𝐶𝑛 .
Hence, by formula for finding future amount of ordinary annuity

𝐹 1
𝐶0 − 𝐶𝑛 = 𝑑 [𝐴 , 𝑖%, 𝑛] 𝑑 = (𝐶0 − 𝐶𝑛 ) [𝐹 ]
,𝑖%,𝑛
𝐴

The total depreciation up to the end of m years is 𝐷𝑚 . Again, by formula for finding
future amount of ordinary annuity
𝐹
𝐹 ,𝑖%,𝑚
𝐷𝑚 = 𝑑 [𝐴 , 𝑖%, 𝑚] = (𝐶0 − 𝐶𝑛 ) [𝐴𝐹 ]
,𝑖%,𝑛
𝐴

luciavelasquezortega 45
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

As before, the book value at the end of m years is

𝐶𝑚 = 𝐶0 − 𝐷𝑚
6-09 Matheson Formula

This method assumes that the annual cost of depreciation is a fixed percentage of the
book value at the beginning of the year. In addition to the previous symbols for the
Straight-Line Formula, let
k = ratio of the depreciation in any one year to the book value at the beginning of
that year. This is constant throughout the life of the property.
The formulas are:
𝑚 𝐶𝑚 𝑛 𝐶
𝑘 =1− √ = 1 − √ 𝐶𝑛 𝑑𝑚 = 𝑘𝐶𝑚−1
𝐶0 0

𝐶𝑚 = 𝐶0 (1 − 𝑘)𝑚 𝐶𝑛 = 𝐶0 (1 − 𝑘)𝑛
The formulas are derived in Table 6-01

Table 6-01: Derivation of Formulas

Book value at Depreciation Book value at the end
Year
beginning of the year during the year of the year
1 𝐶0 𝑘𝐶0 𝐶1 = 𝐶0 (1 − 𝑘)
2 𝐶0 (1 − 𝑘) 𝑘𝐶1 𝐶2 = 𝐶0 (1 − 𝑘)2
3 𝐶0 (1 − 𝑘)2 𝑘𝐶2 𝐶3 = 𝐶0 (1 − 𝑘)3
... ... ... ...
m 𝐶0 (1 − 𝑘) 𝑚−1
𝑘𝐶𝑚−1 𝐶𝑚 = 𝐶0 (1 − 𝑘)𝑚
... ... ... ...
n 𝐶0 (1 − 𝑘) 𝑛−1
𝑘𝐶𝑛−1 𝐶𝑛 = 𝐶0 (1 − 𝑘)𝑛

From the formula above, we obtain

𝑚 𝐶𝑚 𝑛 𝐶
1−𝑘 = √ = √ 𝐶𝑛
𝐶0 0

Hence,
𝑚 𝐶𝑚 𝑛 𝐶
𝑘 = 1− √ = 1 − √ 𝐶𝑛
𝐶0 0

6-10 Sum of the Years-Digits (SYD) Method

The steps in the method are:
1) Determine the sum of the years (∑ 𝑌𝑒𝑎𝑟𝑠) of the life of the property. If n is the
life of the property in years, and noting that the digits 1,2,3, . . . (𝑛 − 1), 𝑛 form an
arithmetic progression, then
𝑛
(∑ 𝑌𝑒𝑎𝑟𝑠) = (𝑛 + 1)
2

luciavelasquezortega 46
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

2) Determine the loss in value due to depreciation, 𝐶0 − 𝐶𝑛 .

3) The respective annual depreciation charges are:
𝑛
For the first year, (𝐶0 − 𝐶𝑛 )
∑ 𝑌𝑒𝑎𝑟𝑠
𝑛−1
For the second year, (𝐶0 − 𝐶𝑛 )
∑ 𝑌𝑒𝑎𝑟𝑠
... ... ... ...
2
For the (n-1)th year, (𝐶0 − 𝐶𝑛 )
∑ 𝑌𝑒𝑎𝑟𝑠
1
For the nth year, (𝐶0 − 𝐶𝑛 )
∑ 𝑌𝑒𝑎𝑟𝑠
For any year m, ≤ 𝑛 , the annual depreciation charge is
2(𝑛−𝑚+1)
𝑑𝑚 = (𝐶0 − 𝐶𝑛 ) 𝑛(𝑛+1)

Note that the annual depreciation charge gradually decreases as the property gets
older. The depreciation for the first year is n time the depreciation charge for the last
year n.

6-11 Service-Output Method

In this method it is assumed that the total depreciation that has taken place is directly
proportional to the quantity of the output of the property up to that time. This method
has the advantages of making the unit cost of depreciation constant and giving low
depreciation expense during periods of little production. In actual practice its
application is difficult due to the uncertainty in the estimate of the economic life of
the property and its total output during that life. Let

T = total units of output produced during the life of the property

m = age in years of the property at any time
𝑄𝑚 = total units of output during year m
𝐷𝑚 = depreciation charge during year m
𝐶0 = original cost of the property
𝐶𝑛 = book value at the end of life, n years
The depreciation per unit of output is
𝐶0 −𝐶𝑛 𝑄𝑚
𝑑1 = 𝐷𝑚 = 𝑄𝑚 𝑑1 = (𝐶0 − 𝐶𝑛 )
𝑇 𝑇

6-12 The Straight-Line plus Average Interest Formula

For this method it is assumed that the amount of capital recovered each year is on a
straight-line basis, as shown in Figure 6-02. The investment is recovered each year by
(𝐶0 −𝐶𝑛 )
an amount equal to . Thus, the annual interest charges are not equal, and we
𝑛
have to determine the average annual interest cost in order to have equal annual
costs.

luciavelasquezortega 47
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

We derive the interest formula as follows:

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑦𝑒𝑎𝑟 = 𝐶0 𝑖 + (𝐶0 − 𝐶𝑛 )𝑖
𝐶0 −𝐶𝑛
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑 𝑜𝑓 𝑡ℎ𝑒 𝑙𝑎𝑠𝑡 𝑦𝑒𝑎𝑟 𝑛 = 𝐶𝑛 𝑖 + ( )𝑖
𝑛

The average of these interests is,

1 𝐶0 −𝐶𝑛 𝑛+1 𝑖
𝑖𝑎𝑣𝑒 = 2 {𝐶0 𝑖 + (𝐶0 − 𝐶𝑛 )𝑖 + 𝑖} = (𝐶0 − 𝐶𝑛 ) ( ) 2 + 𝐶𝑛 𝑖
𝑛 𝑛

Thus, the annual cost (AC) is the sum of the annual depreciation plus the average
interest.
𝐶0 −𝐶𝑛 𝑛+1 𝑖
𝐴𝐶 = + (𝐶0 − 𝐶𝑛 ) ( ) 2 + 𝐶𝑛 𝑖
𝑛 𝑛

The first term in the right member of the above formula represents the recovery of
the capital, the second term the interest on that part of the investment which
depreciates, and the last term is the interest on that part of the capital which does not
depreciate; the average value.
6-13 The Double Declining-Balance Method

In this method the depreciation during any year is a constant ratio of the book value
1
at the beginning of the year. If the useful life is n years, the straight-line rate is 𝑛 and
2
the double-rate declining balance rate is 𝑛 . The depreciation charge is computed by
2
multiplying the unamortized value at the beginning of each year by . Consequently,
𝑛
the salvage value is not used in the computations.

The book value at the end of any year is calculated as follows:

2 2
𝐶1 = 𝐶0 − 𝐶0 (𝑛) = 𝐶0 (1 − 𝑛)

2 2 2 2
𝐶2 = 𝐶1 − 𝐶1 (𝑛) = 𝐶1 (1 − 𝑛) = 𝐶0 (1 − 𝑛)

⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯⋯

luciavelasquezortega 48
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

2 𝑚
𝐶𝑚 = 𝐶0 (1 − 𝑛)
2
The depreciation expense in any year m is 𝑛 times the book value at the beginning of
year m.
2 2 2 2𝐶0 2 𝑚−1
𝑑𝑚 = 𝐶𝑚−1 (𝑛) = 𝐶0 (1 − 𝑛) (𝑛 − 1) (𝑛) = (1 − 𝑛)
𝑛

6-14 Group and Composite Methods of Depreciation

The methods explained in previous articles are called unit or item depreciation
because they consider the write-off on only one asset at a time. However, in large
companies, assets are usually grouped into classes and the depreciation charge is
computed for the entire class, not for each individual asset. An advantage in grouping
assets together and depreciating them as a unit is that no capital gain or loss is
computed at the time a single asset is retired. The cost of a single asset is removed
from the group account and the gain or loss is determined only at the time when the
last asset is retired.

The group depreciation method consists of the computation of a single annual

depreciation charge for a group of similar assets using their average life. When an
asset in the group is retired, the method requires the calculation of a new value of the
depreciation charge for the remaining assets. Ay of the previous methods for
computing the depreciation charge can be used.
The appropriate group depreciation rate is determined by the equation:
1
𝐺𝑟𝑜𝑢𝑝 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑔𝑟𝑜𝑢𝑝

and is applied to the total first cost of the assets.

If the class consists of dissimilar assets, the depreciation computed is termed
composite depreciation. For this method, annual depreciation is computed for each
asset on a straight-line basis, and the total annual depreciation for the group is related
to the total first cost to give the depreciation rate. The formulas for this method are:
𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
𝐶𝑜𝑚𝑝𝑜𝑠𝑖𝑡𝑒 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑓𝑖𝑟𝑠𝑡 𝑐𝑜𝑠𝑡

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑚𝑝𝑜𝑠𝑖𝑡𝑒 𝑙𝑖𝑓𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑛𝑛𝑢𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

6-15 Depletion

Certain natural resources such as mines, quarries, oil and gas wells, and timber lands
are called “wasting” or “depleting” assets due to the gradual extraction of the
contents of such properties. To provide for the recovery of capital invested in such
assets, a depletion fund is provided. The annual charge set aside in the fund is called
depletion cost rather than depreciation cost.

luciavelasquezortega 49
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

It is usual practice to return annually a part of the investment of each investor instead
of accumulating a depletion fund. The yearly amount paid to an investor consists of
two parts: part of capital invested and the dividends or profit of the investor.

The theoretical depletion charge for a year is usually determined by two methods:

1) The Unit or Factor Method: This is similar to the service-output method of

depreciation discussed in article 5-06 and 5-11. The depletion charge depends
upon the initial cost of the property and number of units in the property.
The depletion cost during any year m is calculated as
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦
𝑑𝑚 = (𝑈𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑑𝑢𝑟𝑖𝑛𝑔 𝑦𝑒𝑎𝑟)
𝑇𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑖𝑛 𝑝𝑟𝑜𝑝𝑒𝑟𝑡𝑦
This depletion cost, of course, varies each year depending upon the production
during the year.
2) The Percentage or depletion Allowance Method: This allows a fixed percentage
of the gross income received during a year to be the depletion charge.
Consequently, the total depletion charges may exceed the initial cost of the
property. However, it is required that for any year the depletion charge should not
exceed 50% of the net taxable income for that year obtained by deducting all
expenses excluding depletion from the gross income. Some of the fixed
percentages allowed for certain natural resources are:
Maximum Percentage of
Natural Resource
Gross Income
Gravel, sand, clay 5%
Coal, sodium chloride 10
Gold, silver, copper, iron ore 15
Oil and gas wells 22
Sulfur, cobalt, lead, nickel, zinc, etc. 22

Problems on Depreciation
1) The original cost of a certain piece of equipment is $150,000 and it is depreciated by
a 10% sinking fund method. Determine the annual depreciation charge if the book
value of the equipment after 10 years is the same as if it had been depreciated at
$14,000 each year by straight-line formula.
2) A certain company makes it a policy that for any new piece of equipment the annual
depreciation cost should not exceed 10% of the original cost at any time with no
salvage or scrap value. Determine the length of service life necessary if the
depreciation method used is (a) the straight-line formula, (b) the sinking fund formula
at 8%, and (c) the SYD method.

luciavelasquezortega 50
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

3) A contractor imported a bulldozer for his job, paying $150,000 to the manufacturer.
Freight and insurance charges amounted to $18,000; custom’s, broker’s fees and
arrastre services, $8,500; taxes, permits, and other expenses, $25,000.
If the contractor estimates the life of the bulldozer to be 10 years with a salvage value
of $20,000, determine the book value at the end of 6 years, using the (a) straight-line
formula, (b) sinking fund formula at 8%, (c) Matheson formula and (d) SYD method.
4) A civil engineer bought a gantry crane for erecting tall buildings. The first cost of the
gantry crane was $250,000. Brokerage, bank, arrastre fees, customs duties, permits,
etc. total $120,000. At the end of 10 years, he expects to sell it for $50,000. Prepare
a depreciation schedule for each of the following methods: (a) straight-line formula,
(b) sinking fund formula at 12%, (c) Matheson formula, and (d) SYD method.
5) Determine the year-end book value for the gantry crane in Problem 4 by the Double-
Rate Declining-Balance method.
6) An asphalt and aggregate mixing plant having a capacity of 50 cu. m. every hour costs
$200,000. It is estimated to process 800,000 cu. m during its life. During a certain year
it process 60,000 cu. m. if its scrap value is $20,000, determine the total depreciation
during the year and the depreciation cost chargeable to each batch of 50 cu. m. using
the production-units method.
7) A company purchased a machine for $30,000, used it for 5 years and then sold it for
$10,000. If capital is worth 8%, determine the annual cost of depreciation and interest
using the following: (a) sinking fund depreciation and interest on first cost, (b)
straight-line depreciation plus average interest.
8) The Allied Plastic Company has four plastic injection machines that cost $15,000,
$18,000, $22,000 and $25,000. These machines have an expected service life of 12
years with estimated salvage values at that time of $2,500, $3,000, $4,500 and $5,000.
Determine the annual depreciation by the group depreciation method.
9) The XYZ Company maintains records of its production machines on a composite basis.
The data for 4 machines is shown in the table below.
Machine First Cost Salvage Value Service Life
A $55,000 $10,000 15
B $52,000 $8,000 11
C $40,000 $6,000 10
D $38,000 $5,000 10

Compute (a) the composite life of the machines, and (b) the composite depreciation
rate.

luciavelasquezortega 51
CEng 5201 – Engineering Economics Chapter 6: Depreciation and Depletion

10) The TUV Machine Company owns three different models of lathes whose data are
indicated in the table below.
Model Number First Salvage Expected
Number Owned Cost Value Life
A 12 $25,000 $5,000 8
B 6 $12,000 $2,000 10
C 4 $15,000 $3,500 12

One-half of the lathes of each model will be sold after 8 years and the remainder will
be replaced after 12 years. Compute the total annual straight-line depreciation
charges using (a) the group depreciation method, and (b) the composite depreciation
method. (c) Compute the total annual depreciation charges for each method, and
compute the composite life based on depreciation.
Problems on Depletion
11) To develop an oil well containing 2,000,000 barrels of oil required an initial investment
of $30,000,000. In a certain year, 400,000 barrels of oil were produced from this well.
Determine the depletion charge during the year.
12) The total gross income of the oil company in Problem 11 is $34,000,000 for the
particular year, and the taxable income after taking all deductions, except for
depletion, is $14,100,000. Determine the allowable depletion allowance for the year.
13) During the month of August, a mining company has a gross income of $3,200,000 from
the production of nickel. All expenses, excluding depletion expenses for this month,
amount to $2,600,000. If the fixed depletion rate for nickel is 22%, what is the
depletion charge allowance for this month?

luciavelasquezortega 52
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

7-01 The Profit Motive

In general, people invest capital in an enterprise for the purpose of obtaining profit.
Profit is defined as the excess of income over expenses. Profit cannot be guaranteed,
unlike interest on money which must be paid to the owner of the capital whether the
business succeeds or fails. The success of a business is measured by the amount of
profit it makes.
Engineers in industry are often requested to make financial studies to determine
whether capital should be invested in a new product or enterprise. In his studies, he
must consider each of the following: (a) amount of capital required, (b) the expected
annual income, (c) the estimated annual expenses, (d) the net profit, (e) the rate of
return on the investment, (f) the effects of intangible factors on the investment, and
(g) the possible risks, their nature and their effects on the investment. Each of these
will be considered.
7-02 Amount of Capital Required
The total amount of capital needed for a new enterprise will consist, in general, of the
development cost, the promotion cost, the construction cost, and the circulating or
working capital. Thus,
𝐴𝐶𝑅 = 𝐷𝐶 + 𝑃𝐶 + 𝐶𝐶 + 𝑊𝐶 (7-01)
Where:
ACR = amount of capital required
DC = development cost
PC = promotion cost
CC = construction cost
WC = working capital
Development Cost: This is the sum of all the costs incurred by the originators of the
project up to the time that the project is accepted by the promoters of the project.

Promotion Cost: Promotion cost is the sum of all necessary expenses to organize the
business enterprise and its financing until the time construction of the buildings and
installation of machinery and equipment is complete.

Construction Cost: Construction cost includes all those expenses which will be
incurred in the actual construction of the plant including the procurement of all
machinery and equipment ready for operation.

Working Capital: Working capital includes those funds which are necessary to make
the project a going concern. Initial working capital enables the project to begin
functioning. Regular working capital is the amount needed to keep the enterprise
going once it has started. Regular working capital is usually less than the initial working
capital.

luciavelasquezortega 53
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

7-03 Estimate of Income

Income from enterprise can be obtained through: (1) the sale of finished products, and
(2) through a decrease in operating expenses. If income is to be obtained from the sale
of goods or the rendering of service, the analyst must take into account (a) the kind of
goods or services, (b) the quantity which can be sold, and (c) the selling price.

The analysis for the kind of goods to be sold must include a study of all possible designs
of the products, the quality of the product as to materials and workmanship, and other
details which enhance its sales appeal. After decision has been made, it will usually be
difficult to make changes.

7-04 Estimate of Expenses

After knowing the amount of capital required and the probable income from the
enterprise, the next step is to determine, as accurately as possible, the expenses
incurred in running the business. If the product to be manufactured is new in the
market, the company can easily set the selling price to such an extent that a
satisfactory profit margin will be earned.

Aside from the expenses for direct materials and direct labor, careful consideration
must be given to certain items of overhead such as depreciation, taxes, and allowance
for waste in the manufacturing process. Regarding depreciation, it is considered wise
management to assume a shorter write-off period for certain properties. The write-
off period is the time within which the original cost of equipment is written off through
deposits in the depreciation fund. The policy of having short write-off periods has been
found wiser than uncertainly long periods.

The allowance for waste materials in the manufacturing process is often expressed as
a percentage of the actual amount of materials that goes into the finished product.
Careful attention should be devoted to waste materials for they represent in certain
industrial operations a large amount of overhead. By-products may be obtained from
the waste materials which command a good price in the market. Notable among these
are the manufacture of insulation boards from sugar cane bagasse, wall boards from
sawdust in lumber processing, laminated doors using waste lumber in the interior of
doors, and many others.

7-05 Net Profit

The net profit calculated for a new enterprise is the difference between the estimated
income and the estimated expenses. If the project studies indicate a net profit,
decision should be deferred until after the rate of return on the investment has been
evaluated, and the risk attendant to the project has been assessed.

luciavelasquezortega 54
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

7-06 Rate of Return

The rate of return on the capital invested is given by the formula

𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (7-02)

The rate of return is a measure of the financial efficiency of the investment. To justify
the investment of capital, it is conservatively estimated that a rate of return equivalent
from 20% to 25% of the investment is adequate. Uncertainties in the estimated
income and expenses may reduce this down to as low as 15%, which is usually
considered sufficient. If the rate of return is acceptable, management should analyze
the intangible factors and risk attendant to the investment.

7-07 Intangible Factors

Not all factors involved in an economy study can be evaluated precisely in terms of
monetary values. Such factors are intangible factors, and in certain cases will affect,
to a large extent, the decision to invest.

An example of the effect of intangible factors is the following. An economy of the air-
conditioning of a movie houses may yield a rate of return of only 5%, but if the other
movie houses existing in the vicinity are already air-conditioned or are intending to do
the same, it may be wise to invest in air-conditioning if the owner wishes to stay in the
business. Thus, in this case the insufficiency of the rate of return is offset by the
probable closing of the movie house if it is not air-conditioned due to people no longer
patronizing the movie house. Examples such as this abound in highly competitive
businesses. Intangible factors may indicate larger losses if investment is not made.

7-08 Risks in the Investment of Capital

It cannot be denied that in all forms of capital investment that risk will always be
present. However, the fact that business is risky should not deter one from investing
if he knows all the facts about the business. Among the risks which have to be
considered are:

1) Risks due to changes in physical environment: Among these are the effects of
floods, droughts, tidal waves, storms, earthquakes, and other natural causes. Fires
also affect all kinds of industries. In most cases of this nature, the risk may be
lessened by adequate insurance. The loss may also involve the destruction of
valuable records, and statistics have shown that most companies which lose their
records during catastrophes are unable to reopen.
2) Changing demand: A manufacturer who believes that there will be perpetual
demand for his product is unusual, for it is well-known that human wants are very
subject to change. People may no longer desire to buy the product due to changes

luciavelasquezortega 55
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

in style, the introduction of new materials, devices or inventions, and other

factors.
3) Reduction in prices: The price which was used in the economy study may have
been the current price at the time, but the selling price may be reduced suddenly
due to the introduction of new and more efficient methods of manufacture, the
sudden onset of serious depression, and other causes. The prices of imported raw
materials may suddenly increase due to strikes in shipping or the factories abroad
supplying the raw materials.
4) Risks due to war: War suddenly break out. If this should happen, a newly
established industry may find itself wiped out. The enterprise may be destroyed
by the ravages of war.
5) Personal risks: Human life is destructible. Without warning, workers in a factory
may die due to fire, explosions, or accidents. The mining, lumber and construction
industries are full of hazards. Such risks may however be covered by adequate
insurance of workers and personnel employed. Another type of personal risk,
which sometimes occurs in a partnership, is the dishonesty of one or more of the
partners. They may abscond with some or all of the capital which may never be
recovered.
Besides the above-mentioned risks, one also has to consider some factors affecting
risk, which are:
1) The estimates obtained in the economy study may be erroneous to such an extent
that the conclusions from them may be misleading. Not enough care may have
been employed in gathering data.
2) The type of business is also a factor affecting risk. For example, the oil industry is
full of risks, but due to possible huge returns from the investment, people are
encouraged to invest their money. To offset this factor, one should depend on the
past history of similar enterprises.
3) The type of plant, machinery, and equipment to be adopted is also a factor to be
considered. Industries using highly specialized and expensive equipment are more
risky than those needing standard equipment.
4) One should also consider the length of time that will elapse before the business
will begin to earn profit.
Many industries lose or at most break-even during the first few years. It is also wise
to bear in mind that unless the capital invested is recovered that there is actually no
profit.

luciavelasquezortega 56
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

7-09 Basic Method for Investment Analysis

Investment analyses employ several methods for making economy studies to

determine the feasibility of investing capital in a proposed venture. The most widely
used methods are:

1) Explicit reinvestment rate of return (ERR) method

2) Annual cost (AC) method
3) Present worth cost (PWC) method
4) Internal rate of return (IRR) method
5) Payout period method

7-10 Explicit Reinvestment Rate of Return (ERR) Method

It is easy to calculate the rate or return by this method when there is a simple lump
sum investment and uniform savings or returns at the end of each period during the
life of the project. The pattern for this method is as follows:

Required capital investment = C

Annual income = G
Annual expenses:
Operation and maintenance = 𝑂 + 𝑀
(This includes expenses for direct materials, direct labor, and overhead,
including property taxes, but excluding depreciation.)
𝑖
Depreciation: 𝐷 = (𝐶0 – 𝐶𝑛 ) [(1+𝑖)𝑛−1]
Net profit before income taxes: 𝑃𝑏 = 𝐺 − (𝑂 + 𝑀 + 𝐷) (7-03)
𝑃𝑏
Annual rate of return on required investment before income taxes = (100%)
𝐶

If this rate of return is greater than or equal to the minimum acceptable rate of return
(MARR), then investment of capital in the project is, in most cases, justified.

7-11 Annual Cost (AC) Method

This method is similar to the ERR method with the exception that a minimum required
profit (MRP) on the invested capital is included as a cost. The pattern for this method
is outlined below.
Required investment = C
Annual income = G
Annual expenses:
Operation and maintenance = 𝑂 + 𝑀
(This includes expenses for direct materials, direct labor and overhead,
including property taxes, but excluding depreciation.)
𝑖
Depreciation: 𝐷 = (𝐶0 – 𝐶𝑛 ) [(1+𝑖)𝑛−1]

luciavelasquezortega 57
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

Minimum required profit: 𝐶𝑖

Excess annual income over annual expenses = 𝐺 − (𝑂 + 𝑀 + 𝐷 + 𝐶𝑖 ) (7-04)
If this excess is zero or positive, then the investment of capital in the project is justified.
It must be remembered that profit is included as an element of cost.
7-12 Present Worth Cost (PWC) Method

In applying this method the present worth of all cash flows for investments, receipts,
and disbursements are calculated for some base or beginning time called the present.
The criterion for this method in order that a project to be economically feasible is that
the present worth of the net cash flows should be equal to or greater than zero. The
present worth considering all cash flows during the life of the project is given by:

𝑃𝑊 = [𝐺 − (𝑂 + 𝑀)]1 (1 + 𝑖)−1 + [𝐺 − (𝑂 + 𝑀)]2 (1 + 𝑖)−2 + ⋯ + [𝐺 − (𝑂 +

𝑀)]𝑛 (1 + 𝑖)−𝑛 + 𝐶𝑛 (1 + 𝑖)−𝑛 − 𝐶 (7-05)

This method is very flexible because it can be used for any type of economy study,
even though the annual revenues and costs are not the same, or even occur at
irregular intervals.

7-13 Internal Rate of Return (IRR) Method

The internal rate of return is a rate which relates the positive and negative cash flows
of a project. Receipts are considered positive (+), and disbursements negative (-). The
principle of the method is illustrated in Figure 6-01.

An initial investment 𝐷0 is made at the beginning of the first year. The net receipts R
reduce the net amount of the investment, while the disbursements or investments D
tend to increase the capital investment. There is a certain rate of return which will
exactly reduce the worth of the investment to zero at the end of the time period. The
computed rate of interest or profit rate, 𝑖, which will satisfy either of Eqs. (6-06) or (6-
07) below is the internal rate of return. These equations give the relationship among
the positive and negative cash flows. The reference point for Eq. (6-06) is at the end
of the nth year.

luciavelasquezortega 58
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

−𝐷0 (1 + 𝑖)𝑛 + 𝑅1 (1 + 𝑖)𝑛−1 + 𝑅2 (1 + 𝑖)𝑛−2 − 𝐷3 (1 + 𝑖)𝑛−3 + 𝑅4 (1 + 𝑖)𝑛−4 +

⋯ + 𝑅𝑛−1 (1 + 𝑖)1 + 𝑅𝑛 = 0 (7-06)

Considering the present worth of all cash flows of the beginning of the first year, the
equation is

−𝐷0 + 𝑅1 (1 + 𝑖)−1 + 𝑅2 (1 + 𝑖)−2 − 𝐷3 (1 + 𝑖)−3 + 𝑅4 (1 + 𝑖)−4 + ⋯ + 𝑅𝑛−1 (1 +

𝑖)−(𝑛−1) + 𝑅𝑛 (1 + 𝑖)−𝑛 = 0 (7-07)

7-14 Payout Period Method

This method determines the number of years within which the invested capital can be
recovered out of the net incoming cash flow. It does not consider the possible earnings
from reinvested capital during the payout period. Its most serious defect, however, is
that it does not take into consideration the economic life of the physical asset. Its use
alone is not recommended except as a supplement to the other four methods
previously discussed. In applying this method, the net incoming cash flow must include
all taxes. Thus, denoting by T the annual income tax, we have

𝑛 𝐶−𝐶
𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑖𝑛 𝑦𝑒𝑎𝑟𝑠 = 𝐺−(𝑂+𝑀+𝑇) (7-08)

Problem 1:
It is estimated that insulation of steam pipes in a factory will reduce the fuel bill by as
much as 20%. The cost of the insulation is $90,000 installed and the annual cost of taxes
and insurance is 5% of the initial cost. Without insulation, the annual fuel bill is
$180,000. If the insulation is worthless after 6 years use, and a minimum return of 12%
is desired, would it be worthwhile to invest in the insulation?
Problem 2:
An existing machine in a factory has an annual maintenance cost of $40,000. A new and
more efficient machine will require an investment of $90,000 and is estimated to have
a salvage value of $30,000 at the end of 8 years. Its annual expenses for maintenance
and upkeep, etc. total $22,000. If the company expects to earn 12% on its investment,
will it be worthwhile to purchase the new machine using the (a) present-worth method?
(b) rate of return method?
Problem 3:
A project capitalized for $50,000 invested in depreciable asset will earn a uniform,
annual income of $19,849 in 10 years. The costs for operation and maintenance total
$9,000 a year, and taxes and insurance will cost 4% of the first cost each year. If the
company expects its capital to earn 12% before income taxes, is the investment
worthwhile?

luciavelasquezortega 59
CEng 5201 – Engineering Economics Chapter 7: Investment of Capital

Example 4:
An economic study of a proposed light oil recovery plant to recover light oils from a gas
manufacturing firm has the following data:
a) Total investment = $800,000
b) Total annual expenses = $403,600
c) Average annual sales = 730 𝑡𝑜𝑛𝑠 of light oils and derivatives
d) A local chemical firm guarantees to purchase 20 tons monthly of benzene, one of
the light oils, at a price of $500 per ton.
e) Paint factories guarantee 30 tons monthly purchases of light oil derivatives. The
factories import their present supply at an average cost of $700 per ton.
f) The balance of oils can be sold to a drug, rubber, plastic, and other companies at
$750 per ton.
Determine (a) the annual net profit; (b) the recovery period of the investment. (c) Will
you recommend such a project? Give your reasons.

luciavelasquezortega 60
CEng 5201 – Engineering Economics Chapter 8: Comparison of Alternatives

8-01 Introduction
In the fundamental rules for investing capital, the question which we sought to answer
was: Should capital be invested in a certain enterprise? It is however, well-known that
in most problems of capital investment that two or more alternatives present
themselves for consideration. In this chapter, we will seek to discuss the basic rules
and governing factors to be analyzed in a wise choice between several alternatives.
The question therefore is: Knowing what ought to be done, what is the best alternative
to be chosen in order that the investment will have optimum efficiency. Knowing what
to do has been decided. What we only seek is how this must be done in the best
possible manner.
8-02 Fundamental Principle for Comparison of Alternatives
In reaching a decision on which alternative to choose from among several possibilities,
the fundamental principle is:
That alternative should be chosen which will produce satisfactory results and
which, at the same time, will require the least amount of capital, unless there are
other reason which will indicate that another alternative requiring a bigger
investment of capital is the better choice.
If it exists, the ideal alternative to choose is that one requiring the least first cost, with
greatest income, least operating expenses, and greatest rate of return. However, one
should not lose sight of the fact that, assuming capital is available; an additional
investment may result in greater plant capacity, bigger reduction in the wholesale
prices of materials, bigger revenue, less operating expenses, and better competitive
position.
8-03 Methods of Comparison
There are many methods for the comparison of alternatives, but only the four most
widely used methods will be considered. These are:
1) Present Worth Cost Method
2) Rate of Return on the additional investment method
3) Minimum annual cost method
4) Capitalized cost method
Present Worth Cost (PWC) Method: In comparing alternatives by this method,
determine the present worth of all the amounts invested for each alternative within
the given time horizon. In the analysis, one must include the present worth of all
operation and maintenance expenses, replacement, and other out-of-pocket costs.
The alternative with the least present worth is the most logical choice, unless certain
intangible factors mitigate against it.
Rate of Return on the Additional Investment Method: This method assumes that
unlimited capital is available, and therefore an alternative requiring a bigger

luciavelasquezortega 61
CEng 5201 – Engineering Economics Chapter 8: Comparison of Alternatives

investment may be adopted provided the rate of return on the additional investment
justifies the bigger outlay of capital. Unless intangible factors indicate otherwise, the
more expensive alternative should be chosen, provided that the rate of return on the
additional investment exceeds the prevailing or current rate of return on the capital.
Suppose, for instance, that a certain company is presently obtaining a rate of return
of 10%, and it finds that between two alternatives it may choose from that the one
requiring bigger capital outlay will give a rate of return on the additional investment
of 20%, then unless other factors indicate otherwise, the alternative requiring more
capital should be chosen, It is however, assumed that the company has the additional
investment available from its funds.
This method is widely used and is probably the best among the several methods
available. Rate of return is universally understood, and is usually the best measure of
financial efficiency of any investment.
Minimum Annual Cost Method: It is the policy of most businessmen and most
companies to think in terms of annual income, annual expenses, and annual profit.
One has only to read the financial reports of companies to note that comparisons of
financial items are made on a yearly basis. The minimum annual cost method appears
to fit admirably the situation of comparing alternatives. This method in effect states
that:
The alternative which results in the least annual cost should be chosen.
Thus, in applying this method, all that one has to do is to determine the annual cost of
each of the several alternatives and to choose that one with the least annual cost.
However, unless more computations are made, the actual rate of return on each
investment, nor the rates of return on each increment of investment will not be
known.
Capitalized Cost Method: Capitalized cost is widely used in comparing alternatives
where the structures have long lives. As previously defined, capitalized cost of any
asset is the sum of its first cost and the present worth of all costs for replacement,
operation and maintenance for a long time or forever. In this method all that is
required to compare alternatives is to determine the capitalized cost for each and to
choose that one with the least capitalized cost.
However, this method may be criticized on the ground that most assets never last
forever; the large amounts for capitalized cost are usually misleading for they do not
indicate what actually may be very small annual differences among the alternatives,
and furthermore the rate of return on each invesment is not determined unless more
computations are made.

luciavelasquezortega 62
CEng 5201 – Engineering Economics Chapter 8: Comparison of Alternatives

8-04 Possibilities from Investing in excess of the Required Minimum

Investing capital more than the least required may result in three possibilities which
are:
1) The rate of return on the larger invested capital may exceed that on the minimum
required. This indicates that the additional investment earns a greater rate of
return compared with the least amount required. It therefore appears that if
increasing the amount invested will yield a greater rate of return that capital
invested should be increased. If this line of reasoning is pursued one would,
however, not lose sight of the fact that, in general, capital is limited and that
greater risk accompanies bigger investment. Economy studies are basically
forecasts of future events and the possibility always exists that there may be
errors in the assumptions or that future events may nullify whatever advantage
will be obtained from investing larger capital.
2) The rate of return on the larger investment may be less than that on the minimum
required. In this case, the best policy is to adopt the alternative requiring the least
amount of capital.
3) The rate of return on the larger investment may equal that on the least amount
of capital required. If this happens it is clear that the best alternative is the one
requiring the least investment.

Problem 1:
To remedy the traffic situation at a busy intersection in a City, two plans are being
considered. Plan A is to build a complete cloverleaf costing $9,200,000 which would
provide for all needs during the next 30 years. Maintenance costs are estimated to be
$2,000 a month for the first 15 years and $3,500 for the second 15 years.
Plan B is to build a partial cloverleaf at a cost of $6,500,000 which would be sufficient
for the next 15 years. At the end of 15 years, the cloverleaf will completed at an
estimated cost of $7,500,000. Maintenance would cost $1,400 a month during the first
15 years and $3,500 a month for the second 15 years.
If money is worth 8%, which of the two plans would you recommend?
Problem 2:
A gasoline driven pump and an electric power pump are being considered for use in a
mine for a period of 10 years. The date available are:
Gasoline Electric
First cost $12,000 $25,000
Life in years 5 years 10 years
Salvage value $1,000 $2,000
Annual operating cost $3,200 $1,800

luciavelasquezortega 63
CEng 5201 – Engineering Economics Chapter 8: Comparison of Alternatives

Annual repairs $600 $400

Annual taxes (% of the first cost) 3% 3%
If money is worth 12% compounded annually, which would you recommend on the
basis of annual cost?
Problem 3:
To augment its water requirements, a city plans to build an aqueduct which will pass
through 600 m of tunnel in a nearby mountain. Two possible alternatives are being
considered. Alternative A will require a full capacity tunnel, 3.2 m in diameter.
Alternative B proposes to build a half-capacity tunnel, 2.3 m in diameter which will be
adequate for 20 years, and then build a second parallel half-capacity tunnel.
The full-capacity tunnel can be built now for $3,500,000, while the first half-capacity
tunnel can be built for $2,500,000. Due to increasing costs, it is expected that the
second half-capacity tunnel can be built 20 years hence for $3,800,000. To repair the
tunnel lining every 10 years will require $9.00per square meter for the full capacity
tunnel and $10.00 per square meter for the half-capacity tunnel.
Due to greater friction losses in the smaller tunnels, it is estimated that pumping costs
will be $20,000 each year for the first 20 years, and $40,000 each year when the second
half-capacity tunnel is operational.
If money is worth 10% compounded annually, determine the capitalized cost of the two
alternatives.

luciavelasquezortega 64
CEng 5201 – Engineering Economics Chapter 9: Break-Even Analysis

9-01 Scope of Break-Even Analysis

Industry is faced with certain situations where two or more methods are applicable to
a certain operation and are related by a common variable. Break-even analysis in this
case will involve the determination of the break-even cost, which is the cost at which
all the methods will be equal. Below this cost, one method will be more economical,
and above this cost the other will prove to be better one economically.
Investment of capital, production of goods, and the rendering of service are usually
done for obtaining profit. In all situations, production output can be varied under
certain conditions. Related to such output are fixed and variable costs, previously
explained. At a certain level of production, the total income will just equal the total
expenses, resulting in no profit. This level of production where the total income is
equal to the total expenses is called the break-even point. Below this break-even
point, a loss will result for the enterprise, and above this a profit will be realized. It is
the responsibility of management to know at all times the value at which break-even
occurs, and to see to it that production exceeds this value, if profit is to be realized.
9-02 Mathematical Expressions for Break-Even
Based on certain assumptions, the relations among income, costs, and profit may be
expressed mathematically. These assumptions are:
1) All units produced are sold at a constant price per unit.
2) There is no income other than from operations.
3) The variable costs are directly proportional to production rate from zero to 100%
capacity.
4) Fixed costs are constant regardless of the number of units produced.
Based on these assumptions, we obtain the equation
𝐺𝑃 = 𝑛𝑆 − (𝑛𝑉 + 𝐹) = 𝑛(𝑆 − 𝑉) − 𝐹 (9-01)
Where:
𝐺𝑃 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑎𝑛𝑛𝑢𝑎𝑙𝑙𝑦
𝑆 = 𝑛𝑒𝑡 𝑠𝑎𝑙𝑒𝑠 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝑉 = 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡
𝐹 = 𝑎𝑛𝑛𝑢𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
If the profits tax 𝑡 is considered, the net profit NP may be obtained from the equation
𝑁𝑃 = 𝐺𝑃(1 − 𝑡) (9-02)
At the break-even point, 𝐺𝑃 = 0, and from Eq. (8-01)
𝐹 𝐹
𝑛 = 𝑆−𝑉 = 𝑉 (9-03)
𝑆(1− )
𝑆

luciavelasquezortega 65
CEng 5201 – Engineering Economics Chapter 9: Break-Even Analysis

𝑛𝑉+𝐹 𝐹
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 = =𝑉+𝑛 (9-04)
𝑛

Usually, a plant operates at its maximum efficiency or at minimum cost when

production is at 100% of capacity. However, the total profit may be greater if the plant
can operate above 100% capacity, since profit is cumulative, even though the profit
per unit produced is less. Thus, if
𝑛′ = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑝𝑟𝑜𝑑𝑢𝑐𝑒𝑑 𝑎𝑏𝑜𝑣𝑒 100% 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦
𝑉 ′ = 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑓𝑜𝑟 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑖𝑛 𝑒𝑥𝑐𝑒𝑠𝑠 𝑜𝑓 100% 𝑐𝑎𝑝𝑎𝑐𝑖𝑡𝑦
𝐺𝑃 = (𝑛 + 𝑛′)𝑆 − (𝑛𝑉 + 𝑛′ 𝑉 + 𝐹)
𝐺𝑃 = 𝑛(𝑆 − 𝑉) + 𝑛′(𝑆 − 𝑉′) − 𝐹 (9-05)
𝑛𝑉+𝑛′ 𝑉 ′ +𝐹
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 = (9-06)
𝑛+𝑛′

Again, if the profits tax is included, the net profit is

𝑁𝑃 = 𝐺𝑃(1 − 𝑡) (9-02)
In certain cases, a manufacturer will sell a portion of his production at a certain sales
price S and the remaining production at a lower prices S’ because the demand at the
price S, is not sufficient to take all the production. This practice is called “dumping”.
In many cases the excess production is exported to other countries. If
𝑛 = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑎𝑡 𝑎 𝑝𝑟𝑖𝑐𝑒 𝑆
𝑛" = 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑 𝑎𝑡 𝑝𝑟𝑖𝑐𝑒 𝑆′
Then
𝐺𝑃 = 𝑛𝑆 + 𝑛"𝑆′ − (𝑛𝑉 + 𝑛"𝑉 + 𝐹)
𝐺𝑃 = 𝑛(𝑆 − 𝑉) + 𝑛"(𝑆 ′ − 𝑉) − 𝐹 (9-07)
And
𝑁𝑃 = 𝐺𝑃(1 − 𝑡) (9-02)
At the break-even point,
𝑛𝑉+𝑛"𝑉+𝐹
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 = 𝑛+𝑛"
𝐹
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑢𝑛𝑖𝑡 𝑐𝑜𝑠𝑡 = 𝑉 + 𝑛+𝑛" (9-08)

9-03 Break-Even Chart

Break-even analysis is conveniently represented on a break-even chart, which
indicates the graphs of fixed costs, variable costs, and expected income from sales for
different production levels. The break-even point is the quantity of production at
which the curve for total income intersects the curve for total costs. When provision
for dividends to stockholders is shown on this chart, the point which indicates the sales

luciavelasquezortega 66
CEng 5201 – Engineering Economics Chapter 9: Break-Even Analysis

volume at which the enterprise will be able to pay these dividends is called the
“unhealthy point”.
When two methods of production are to be compared, the break-even cost is
similarly located on a break-even chart by noting the intersection of the total
expenses for each method.
Figure 8-01 is an example of a break-even chart. The fixed cost, variable cost, and
income are plotted against output, either in percent capacity, units or peso volume.
The line FF’ represents the fixed cost of production, usually assumed to remain
constant from zero to 100% capacity. The line FV indicates the variation in variable
cost. It actually represents the total of all production costs since it is drawn from point
F, which is also the starting point of the fixed cost line. The gross income from the sales
of products is represented by line OI. The intersection of the income and variable cost
lines is the point at which total cost is exactly equal to the total income. At this
production capacity, no profit or loss will result. If production and sales exceed this
value, a profit will result; otherwise, when the rate or production is less than the value
at the break-even point, a loss will result. It is clear that break-even charts indicate the
relationship between income and costs for all rates of production.

Example 1:
A company has a production capacity of 200 units per month and its fixed costs are
$20,000 a month. The variable cost per unit is $300, and each unit can be sold for $450.
Economy measures are instituted to reduce the fixed costs by 10% and the variable
costs by 20%.Determine the old and new break-even points. Draw the break-even chart.

luciavelasquezortega 67
CEng 5201 – Engineering Economics Chapter 9: Break-Even Analysis

Problem 2:
A firm has the capacity to produce 1,000,000 units of a product per year. At present, it
is able to produce and sell only 600,000 units yearly at a total income of $7200,000.
Annual fixed costs are $250,000 and the variable costs per unit are $0.70.
a) Calculate the firm’s annual profit or loss for this production.
b) How many units should be sold annually to break-even?
c) If the firm can increase its sales to 80% of full capacity, what will its profit or loss be,
assuming that its income and variable costs per unit remain constant?
d) Draw a break-even chart indicating the above results on the chart.
Problem 3:
A shoe manufacturer produces a pair of shoes at a labor cost of $8.50 and materials
cost of $23.50. The fixed charges on the business are $10,125 a month and the variable
costs are $2.50 a pair. If the shoes sell to retailers for $48.00 a pair, how many pairs
must be produced and sold each month for the manufacturer to break-even?

luciavelasquezortega 68
CEng 5201 – Engineering Economics Chapter 10: Public Economy: Benefit-Cost Analysis

10-01 Non-Profit Motive in Public Economy

In general, most private organization and corporations exist for profit. The principal
motive of economy studies for private projects is the maximizing of profits. Analysis
of several alternatives is made to determine which one will contribute the maximum
net profit. No expenditure is justified unless it can be considered as an acceptable
investment.
On the other hand, government or public organizations spend money to create an
advantage for the public or a segment of it. For example, the benefits to be derived
from the construction of a highway may consist of savings in time consumed because
of higher speeds, in reduction of accidents because the highway is built in accordance
with highway standards, in lesser maintenance and repair costs of vehicles because
the surface is smooth, and in shorter distances because the route is direct. Likewise,
expenditures for other projects like bridges, waterworks, dams, airports, libraries,
schools, flood controls, and all other public works projects cause benefits to the
people. The basic purpose of government organizations is to provide a benefit needed
by the people.
10-02 Financing of Public Projects
With the exception of self-liquidating projects, the basic source of capital needed for
public projects is taxes. It is reasonable to expect that public funds obtained from taxes
should be invested with a financial efficiency at least equal to that which a private
person would earn with those funds.
10-03 Economic Analysis of Public Projects
Several methods are applicable in analyzing the several alternatives available for
public works. Among these are:
1) Annual Cost Method
2) Rate of Return Method
3) Benefit-Cost Ratio Method
These methods are explained below relative to Highway Economic Analysis.
Annual Cost Method
The annual cost of a highway system is determined by the following formula:
𝐶 = 𝐴 + 𝑂 + 𝑀 + 𝐶𝑑 + 𝐶𝑟 (10-01)
Where:
C = the total investment per kilometer
A = the average annual cost of administration and management
O = the average annual highway operation cost
M = the average annual highway maintenance cost
Cd = the avergae annual depreciation cost

luciavelasquezortega 69
CEng 5201 – Engineering Economics Chapter 10: Public Economy: Benefit-Cost Analysis

r = rate of return on the investment

For economic analysis, the total annual cost of owning and operating of different
alternatives are compared. The alternative with the least annual cost will be the best
choice.
Rate of Return Method
In this method, an alternative which would promise the highest rate of return on the
investment will be the best choice. In general, the rate of return is obtained for traffic
data for the next 5 years. The rate of return may be expressed as
𝑂+𝐴−𝑀
𝑟= (100) (10-02)
𝐶

Where:
r = rate of return in percent
O = savings in annual labor, vehicle time, and operating costs
A = annual savings in costs of accidents
M = additional maintenance cost per annum
C = capital cost of improvements
Benefit-Cost (B/C) Ratio Method
The comparative worth of highway projects is expressed by the ratio of annual
benefits which happen to the owners. When the project involves disadvantages to the
owners, these are called disbenefits. Costs are the anticipated expenditures for
construction, maintenance, operation, and other costs. For public projects, it is
convenient to think of the public as the owners, and the national government as the
one which incurs the costs.
When quantifying the B/C ratio, the analyst must know that benefits include all the
advantages, minus the disadvantages, to the users, and that costs mean all the
expenditures, minus any savings, that will be incurred by the government. A plan with
many valuable benefits may also include some inescapable disadvantages to the user,
in which case they must be regarded as negative benefits and subtracted. Thus,
𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠−𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐵𝑒𝑛𝑒𝑓𝑖𝑡 − 𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 = (10-03)
𝐶𝑜𝑠𝑡𝑠

Another way of expressing this ratio is

𝐴𝑛𝑛𝑢𝑎𝑙 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝑓𝑟𝑜𝑚 𝑖𝑚𝑝𝑟𝑜𝑣𝑒𝑚𝑒𝑛𝑡𝑠
𝐵𝑒𝑛𝑒𝑓𝑖𝑡 − 𝐶𝑜𝑠𝑡 𝑅𝑎𝑡𝑖𝑜 = (10-04)
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝑜𝑓 𝑖𝑚𝑝𝑟𝑜𝑣𝑒𝑚𝑒𝑛𝑡𝑠

The procedure for a benefit-cost economy study, like that for a rate of return solution,
involves two sets of computations. First, the benefit-cost ratios for each alternative
are found, and those plans that fail to attain a B/C ratio of unity are rejected. Next,
the B/C ratio for each increment of added investment is computed, each plan being
compared against the preceding acceptable plan. The alternative that reaches the

luciavelasquezortega 70
CEng 5201 – Engineering Economics Chapter 10: Public Economy: Benefit-Cost Analysis

prescribed B/C ratio (usually 1.0) on both the total and increment of investment is the
most acceptable on the basis of the assumed interest rate.
10-04 The (𝑩– 𝑪) Criterion
As stated above,
𝐵 = 𝑛𝑒𝑡 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 = 𝑎𝑙𝑙 𝑡ℎ𝑒 𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒𝑠, 𝑙𝑒𝑠𝑠 𝑡ℎ𝑒 𝑑𝑖𝑠𝑎𝑑𝑣𝑎𝑛𝑡𝑎𝑔𝑒𝑠 𝑡𝑜 𝑡ℎ𝑒 𝑢𝑠𝑒𝑟
𝐶 = 𝑛𝑒𝑡 𝑐𝑜𝑠𝑡𝑠 = 𝑎𝑙𝑙 𝑑𝑖𝑠𝑏𝑢𝑟𝑠𝑒𝑚𝑒𝑛𝑡𝑠, 𝑙𝑒𝑠𝑠 𝑎𝑛𝑦 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 𝑡𝑜 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑜𝑟
For a project to be acceptable, the difference between the net benefits and net costs
must be positive, that is, the benefits must exceed the costs. It is obvious that if 𝐵 <
𝐶, then the project should not be implemented.
Where several alternatives are to be compared by this criterion, the quantity (𝐵 − 𝐶)
is calculated for each alternative, and the one with the maximum value is selected.

Problem 1:
To increase accessibility to some beautiful scenery along the National Highway in a city,
a new highway is being proposed for construction. The initial cost is expected to be
$9,600,000, with annual maintenance cost of $36,000. Every three years, minor
improvements costing $20,000 are expected to be made. It is estimated that income
from tourists from foreign countries will be $1,200,000 annually. Using a planning
horizon of 30 years and interest rate of 10%, determine if the highway should be
constructed. Analyze by (a) the (B – C) criterion, and (b) the B/C method.

Problem 2:
A government project has the following estimates:
Annual benefits = $500,000
Annual disbenefits = $450,000
Annual costs = $350,000
Annual savings = $340,000
a) Calculate the B/C ratio
b) Mistakenly treating disbenefits as costs and savings as benefits, determine the B/C
ratio
c) Calculate the B – C.

Problem 3:
Determine the annual benefit x for alternative B to have the same benefit-cost ratio as
alternative A, assuming a minimum attractive rate of return of 2%.

luciavelasquezortega 71
CEng 5201 – Engineering Economics Chapter 10: Public Economy: Benefit-Cost Analysis

Alternative A B
Cost $5,400 $7,300
Salvage Value $400 $600
Annual Benefit $1,500 X
Life (years) 10 10

Problem 4:
To avoid double handling of cargo and to enable larger ships to dock at the piers of a
coastal city, it becomes necessary to dredge the harbor to a sufficient depth. Dredging
is estimated to cost $4,000,000, but it will decrease shipping and cargo handling costs
by $1.50 per ton. The port is presently processing 800,000 tons of cargo per year, but
this is expected to increase by 60,000 tons each year for the next 20 years. Maintenance
costs of the harbor are currently $500,000 a year, increasing $70,000 each year. If the
harbor is dredged, maintenance will cost $600,000 and increased by $50,000 per year
each year. Funding for the project is available at 8% interest. Determine the feasibility
of the project using B/C analysis and assuming a time horizon of 20 years.
Problem 5:
Data for two alternatives are given in the table below. Determine the cost X of
alternative B so that the two alternatives will be equally desirable. Assume an interest
rate of 11%. Use the benefit-cost ratio analysis.
Alternative A B
Cost $9,500 $X
Salvage value $1,000 $1,600
Annual benefit $2,800 $3,700
Life (years) 6 12

luciavelasquezortega 72