ECC 426 ENGINEERING ECONOMY

Prof.Dr. Cavit Atalar

#Section 2
1. Foundations: Overview
1. F/P and P/F Factors
2. P/A and A/P Factors
3. F/A and A/F Factors
4. Interpolate Factor Values
5. P/G and A/G Factors
6. Geometric Gradient
7. Calculate i
8. Calculate “n”
9. Spreadsheets
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CHAPTER II Section 3

P/G and A/G Factors

41
 GRADIENT FORMULAS
Sometimes the cash flows that occur in consecutive interest periods
are not the same amount (not an A value), but they do change in a predictable
way. These cash flows are known as gradients, and there are two general types:
arithmetic and geometric.
An arithmetic gradient is one wherein the cash flow changes (increases or
decreases) by the same amount in each period. For example, if the cash flow in
period 1 is $800 and in period 2 it is $900, with amounts increasing by $100 in
each
subsequent interest period, this is an arithmetic gradient G, with a value of
$100.
The equation that represents the present worth of an arithmetic gradient series
is:
P/G and A/G Factors
2.5 Arithmetic Gradient Factors

•In applications, the annuity cash flow pattern is

not the only type of pattern encountered
•Two other types of end of period patterns are
common
•The Linear or arithmetic gradient
•The geometric (% per period) gradient

•This section presents the Arithmetic Gradient

6
 2.5 Arithmetic Gradient Factors
•An arithmetic (linear) Gradient is a cash
flow series that either increases or
decreases by a constant amount over n
time periods.
•A linear gradient is always comprised of
TWO components:

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 2.5 Arithmetic Gradient Factors
•The Two Components are:
•The Gradient component
•The base annuity component
•The objective is to find a closed form
expression for the Present Worth of an
arithmetic gradient

8
2.5 Linear Gradient Example
A1+(n-1)G

A1+(n-2)G

Assume the following:

A1+2G

A1+G

0 1 2 3 n-1 N

This represents a positive, increasing arithmetic gradient

9
2.5 Example: Linear Gradient

•Typical Negative, Increasing Gradient:

G=$50

The Base Annuity

= $1500

10
2.5 Example: Linear Gradient

• Desire to find the Present Worth of this cash flow

The Base Annuity

= $1500

11
2.5 Arithmetic Gradient Factors

•The “G” amount is the constant arithmetic

change from one time period to the next.
•The “G” amount may be positive or
negative!
•The present worth point is always one time
period to the left of the first cash flow in the
series or,
•Two periods to the left of the first gradient
cash flow!
12
2.5 Derivation: Gradient Component Only

Focus Only on the gradient Component

(n-1)G

(n-2)G
“0” G

+2G

Removed Base annuity

0 1 2 3 n-1 N
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2.5 Present Worth Point…

The Present worth point of a linear

gradient is always:
 2 periods to the left of the “1G”
point or,
 1 period to the left of the very
first cash flow in the gradient
series.
DO NOT FORGET THIS!
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2.5 Present Worth Point…

$700
$600
$500
$400
$300
$200
$100

X0 1 2 3 4 5 6 7

The Present Worth Point of the

Gradient

15
2.5 Gradient Component

•The Gradient Component $600

$500
$400
$300
$200
$100

$0

X0 1 2 3 4 5 6 7

The Present Worth Point of the

Gradient

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2.5 Present Worth Point…

•PW of the Base Annuity is at t = 0

•PWBASE Annuity=$100(P/A,i%,7)

Base Annuity – A = $100

X0 1 2 3 4 5 6 7

The Present Worth Point of the

Gradient

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2.5 Present Worth: Linear Gradient

The present worth of a linear gradient is

the present worth of the two
components:
 1. The Present Worth of the Gradient
Component and,
 2. The Present Worth of the Base Annuity
flow
 Requires 2 separate calculations!

18
2.5 Present Worth: Gradient Component

The PW of the Base Annuity is simply

the Base Annuity –A{P/A, i%, n} factor
What is needed is a present worth
expression for the gradient component
cash flow.
We need to derive a closed form
expression for the gradient component.

19
2.5 Present Worth: Gradient Component

General CF Diagram – Gradient Part

Only
(n-1)G
(n-2)G
3G
2G
1G

0G

We want the PW at time t = 0 (2 periods to the left of 1G)

0 1 2 3 4 ……….. n-1 n

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2.5 To Begin- Derivation of P/G,i%,n

Next Step:
Factor out G and re-write as …..

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2.5 Factoring G out…. P/G factor

What is inside of the { }’s?

22
2.5 Replace (P/F’s) with closed-form

[1]

Multiply both sides by (1+i)

23
2.5 Mult. Both Sides By (n+1)…..

[2]

•We have 2 equations [1] and [2].

•Next, subtract [1] from [2] and work
with the resultant equation.

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2.5 Subtracting [1] from [2]…..

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2.5 The P/G factor for i and N

26
2.5 Further Simplification on P/G

Remember, the present worth point of any linear

gradient is 2 periods to the left of the 1-G cash
flow or, 1 period to the left of the “0-G” cash flow.

P=G(P/G,i,n)
27
2.5 Extension – The A/G factor

Some authors also include the

derivation of the A/G factor.
A/G converts a linear gradient to an
equivalent annuity cash flow.
Remember, at this point one is only
working with gradient component
There still remains the annuity
component that you must also handle
separately!

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2.5 The A/G Factor

Convert G to an equivalent A

How to do it…………

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2.5 A/G factor using A/P with P/G

The results follow…..

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 2.5 Resultant A/G factor

(A/G,i,n) =

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2.5 Gradient Example

• Consider the following cash flow

$500
$400
$300
$200
$100

0 1 2 3 4 5
Present Worth Point is here!
And the G amt. = $100/period

Find the present worth if i = 10%/yr; n = 5 yrs

32
2.5 Gradient Example- Base Annuity

• First, The Base Annuity of $100/period

A = +$100

0 1 2 3 4 5

•PW(10%) of the base annuity = $100(P/A,10%,5)

•PWBase = $100(3.7908)= $379.08
•Not Finished: We need the PW of the gradient component
and then add that value to the $379.08 amount

33
 2.5 Focus on the Gradient Component
$400
$300
$200
$100
$0

0 1 2 3 4 5

We desire the PW of the Gradient

Component at t = 0

PG@t=0 = G( P/G,10%,5 ) = $100( P/G,10%,5 )

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2.5 The Set Up
$400
$300
$200
$100
$0

0 1 2 3 4 5

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

Could substitute n=5, i=10%
and G = $100 into the P/G
closed form to get the value
of the factor.

35
2.5 PW of the Gradient Component

PG@t=0 = G(P/G,10%,5) = $100(P/G,10%,5)

P/G,10%,5) Sub. G=$100;i=0.10;n=5

6.8618

Calculating or looking up the P/G,10%,5 factor yields the following:

Pt=0 = $100(6.8618) = $686.18 for the gradient PW

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2.5 Gradient Example: Final Result

• PW(10%)Base Annuity = $379.08

•PW(10%)Gradient Component= $686.18

•Total PW(10%) = $379.08 + $686.18

•Equals $1065.26
•Note: The two sums occur at t =0 and can
be added together – concept of equivalence

37
2.5 Example Summarized

This Cash Flow… $500

$400
$300
$200
$100

0 1 2 3 4 5

Is equivalent to $1065.26 at time 0 if the interest rate

is 10% per year!

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 2.5 Shifted Gradient Example: i = 10%

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

1. This is a “shifted” negative, decreasing

gradient.
2. The PW point in time is at t = 3 (not t = o)

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2.5 Shifted Gradient Example

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The PW @ t = 0 requires getting the PW @ t =3;

•Then using the P/F factor move PW3 back to t=0

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2.5 Shifted Gradient Example

• Consider the following Cash Flow

0 1 2 3 4 5 6 7

$450
$500
$550
$600

•The base annuity is a $600 cash flow for 3 time

periods

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2.5 Shifted Gradient Example: Base
Annuity

• PW of the Base Annuity: 2 Steps

0 1 2 3 4 5 6 7

P3=-600(P/A,10%,4)
P0=P3(P/F,10%,3)
P3

P0 A = -$600
3.1699 0.7513
P0= [-600(P/A,10%,4)](P/F,10%,3)

P 0-base annuity = -$1428.93

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2.5 Shifted Gradient Example: Gradient
• PW of Gradient Component: G = -$50

0 1 2 3 4 5 6 7

P3-Grad = +50(P/G,10%,4)

P0=P3(P/F,10%,3)
P3

P0 0G 3G
1G 2G
4.3781 0.7513
=-$164.46
P0-grad = {+50(P/G,10%,4)}(P/F,10%,3)

44
CHAPTER II

Geometric Gradient

80
GEOMETRIC GRADIENT
•An arithmetic (linear) gradient changes by a fixed dollar amount
each time period.
•A GEOMETRIC gradient changes by a fixed percentage each
time period.
•We define a UNIFORM RATE OF CHANGE (%) for each time period
•Define “g” as the constant rate of change in decimal form by
which amounts increase or decrease from one period to the next
Case: g = i
v
2.6 Geometric Gradients: Increasing

• Typical Geometric Gradient Profile

•Let A1 = the first cash flow in the series

0 1 2 3 4 …….. n-1 n

A1 A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1
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7,000(1-0,788/0.03)(0.5718)= 7,000(0,2117/0.03)(0.5718)=
7,000(7.56)(0.5718)= 49,400 (0.5718)= 28,247
References

[1] Leland Blank and Anthony Tarquin (2011)Engineering Economy 7.th Edition,
McGraw Hill
[2] Leland Blank and Anthony Tarquin (2018)Engineering Economy 8.th Edition,
McGraw Hill
[3] William G. Sullivan, Elin M. Wicks and C. Patrick Koelling (2018) Engineering
Economy 17.th Edition, Pearson