9/10/2023

Engineering Economics: Financial Decision

Making for Engineers
Seventh Edition

Chapter 3
Cash Flow Analysis

Copyright © 2022 Pearson Canada Inc. 3-2

Mrs Dashwood’s Annuity

• Mr John Dashwood and his avaricious wife, Fanny, are debating how
he can most cheaply discharge his obligations toward his half-sister,
Mrs Henry Dashwood, and her three daughters
• He first considers giving her a lump sum of £1,500; then, since £1,500
seems a lot to part with in one lump, he considers paying her an annual
sum of £100 – an annuity – for as long as she lives
• But, objects Fanny, although Mrs Dashwood is old, such an
arrangement will encourage her to cling to life for an unreasonable
time; and, should she survive for more than 15 years, her half-brother
will lose money by the arrangement
• It is clear from this discussion that Fanny Dashwood cannot have
studied “engineering” economics; for in fact, Mr Dashwood would save
money by the latter alternative, even if Mrs Henry Dashwood were to
live considerably longer than 15 years

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Mrs Dashwood’s Annuity, cont’d

• This is like a Lottery For Life problem (except the lottery
corporation gets to choose the amounts instead of you)
• Which would you choose: $1,000 a day for life, or $7 million
once?

Learning Goals (1 of 2)
3.1 Explain timing assumptions used in discrete or
continuous cash flow models.
3.2 Recognize key terminology related to discrete
compound interest factors, and the assumptions
required for their use.
3.3 Calculate a future amount given a present amount, and
vice versa.
3.4 Calculate an annuity given a future amount, and vice
versa.

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Learning Goals (2 of 2)
3.5 Calculate an annuity given an arithmetic gradient.
3.6 Calculate a present amount given a geometric gradient.
3.7 Analyze non‐standard annuities and gradients by
converting them to conform to the defined conversion
factors.
3.8 Calculate present worth of an infinitely long cash flow
series.

Key Summary: Course to date and coming soon

• Variables and parameters (puzzle pieces):
– Different kinds of interest rates
– Discount rates
– Costs and cost savings or revenues, now and in the future
– Different expected lives of the possible project/purchases
– Salvage value
– Taxes and tax savings
– How these escalate

• Analysis methods (ways to put the pieces together):

– Present worth analysis (Net Present Value)
– Equivalent uniform annual cost analysis
– Rate of return analysis
– Benefit-cost ratio analysis
– Payback period
– Cost-effectiveness analysis

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Introduction (1 of 1)
• Compound interest factors can be used to define
mathematical equivalence among certain common cash
flow patterns.
• This chapter:
– Explains how cash flow patterns are simplified
approximations of reality.
– Discusses discrete cash flow patterns and the compound
interest factors that relate them to each other.
– Discusses situations that are treated as though cash
flows continue indefinitely.

3.1 Timing of Cash Flows and Modelling (1 of 2)

• Engineers work with simple models of cash flow patterns.
• Most common type of model assumes:
– Cash flows occur at the end of conventionally defined
periods (months or years)
– Compounding of cash flows occur at the end of
conventionally defined periods (months or years)
• Models making the above assumption are called discrete
models

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3.1 Timing of Cash Flows and Modelling (2 of 2)

• Continuous models assume cash flows and their
compounding occur continuously over time.
• Cash flow models are usually an approximation
– Cash flows do not occur only at the ends of
conventionally defined periods.
– Cash flows are not actually continuous.

3.2 Compound Interest Factors for Discrete

Compounding (1 of 4)
• Compound interest factors are formulas that define
mathematical equivalence for specific common cash flow
patterns.

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3.2 Compound Interest Factors for Discrete

Compounding (2 of 4)
• Four discrete cash flow patterns commonly used:
1. Single disbursement (money spent) or receipt (money
received).
2. Set of equal disbursements/receipts over a sequence of
periods (annuity).
3. Set of disbursements or receipts that change by a constant
amount from one period to the next in a sequence of
periods (arithmetic gradient series).
4. Set of disbursements or receipts that change by a constant
proportion from one period to the next in a sequence of
periods (geometric gradient series).

3.2 Compound Interest Factors for Discrete

Compounding (3 of 4)
• Assumptions for discrete compounding:
1. Compounding periods are of equal length.
2. Each disbursement and receipt occurs at the end of a
period.
• Payment at time 0 considered to occur at the end of period
‐1.
3. Annuities and gradient coincide with the ends of
sequential periods

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3.2 Compound Interest Factors for Discrete

Compounding (4 of 4)
• See Appendix 3A
– mathematical derivations of six of the compound
interest factors.

3.3 Compound Interest Factors for Single

Disbursements or Receipts (1 of 5)
Figure 3.1

• General form of a single disbursement or receipt.

• A single receipt occurs at the end of period N.

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3.3 Compound Interest Factors for Single

Disbursements or Receipts (2 of 5)

• Compound amount factor gives future amount, F,

equivalent to a present amount P, interest rate is i and
the number of periods until F is N:

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

• (F / P, i, N) notation is read from left to right:

– “What is F, given P, i, and N”

3.3 Compound Interest Factors for Single

Disbursements or Receipts (3 of 5)

• The present worth factor gives the present amount, P,

that is equivalent to the future amount, F, when the
interest rate is i and the number of periods is N:

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

• (P / F, i, N) notation is read from left to right:

– “What is P, given F, i, and N”

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3.3 Compound Interest Factors for Single

Disbursements or Receipts (4 of 5)
• Basic use of compound amount interest factors is to:
– Convert a single cash flow that occurs at one point in
time to an equivalent cash flow at another point in time.
• Multiply the compound amount factor by P to determine
the future worth of a present value.
• Multiply the present worth factor by F to get the present
value of a future amount.

3.3 Compound Interest Factors for Single

Disbursements or Receipts (5 of 5)
• Compound interest factors are easy to compute.
• Appendix A lists values for compound interest factors
over a selection of interest rates and compounding
periods.

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Example 3.1 (1 of 4)
• How much money will be in a bank account at the end of
15 years if $100 is invested today, and the nominal
interest rate is 4%, compounded semiannually?

<see Excel examples>

Example 3.1 (2 of 4)
Answer
• Present amount given, future amount to be calculated.
• Use the compound amount factor (F / P, i, N)
• Choose i and N
– Since interest rate, i, is compounded semi‐annually,
number of compounding periods, N, is 30
– Interest rate, i, per 6‐month period is 2%

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Example 3.1 (3 of 4)
Answer (cont.)
F = 100 (F / P, 2%, 30)
= 100 (1 + 0.02)30
= $181.14
• Alternatively,
F = 100 (F / P, 2%, 30)
F = 100 (1.8114) (from Appendix A)
F = $181.14

Example 3.1 (4 of 4)
• Second solution is to calculate the effective yearly interest
rate and then compound over 15 years at this rate.
• Recall from equation (2.3)
ie = (1 + is)m ‐1
ie = (1 + 0.04/2)2 ‐1 = 0.0404
• Apply the effective yearly rate for each of 15 years
F = P (F / P, i, N)
= P (1+i)N = 100 (1 + 0.0404)15
= 181.14 [Balance will be $181.14]

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3.4 Compound Interest Factors for

Annuities (1 of 6)
• Annuity: series of uniform receipts or disbursements that
begin at end of period 1 and continue over N periods.
– Mortgage and lease payments are examples of annuities.

3.4 Compound Interest Factors for Annuities

(2 of 6)

• Sinking Fund Factor: (A/F, i, N)

• Gives the size, A, of a repeated receipt or disbursement
that is equivalent to a future amount, F, if the interest
rate is i and the number of periods is N.

i
( A / F , i, N ) 
(1  i ) N  1

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3.4 Compound Interest Factors for Annuities

(3 of 6)

Figure 3.2 Annuity over N Periods

3.4 Compound Interest Factors for

Annuities (3 of 6)
• Uniform Series Compound Amount Factor: (F/A, i, N)
• inverse of the sinking fund factor: (A/F, i, N)
• Gives the future value, F, that is equivalent to a series of
equal‐sized receipts or disbursements, A, when the
interest rate is i and the number of periods is N.

(1  i ) N  1
( F / A, i, N ) 
i

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3.4 Compound Interest Factors for

Annuities (4 of 6)
• Multiply A by the uniform series compound amount
factor to get F, the future capital amount.
• Multiply F, the future value you want, by the sinking fund
factor to get A, the annual payment you need to make to
get that future amount.

3.4 Compound Interest Factors for

Annuities (5 of 6)
• The Capital Recovery Factor: (A/P, i, N)
• Gives the value, A, of the equal periodic payments or
receipts that are equivalent to a present amount, P, when
the interest rate is i and the number of periods is N.
• Easily derived from the sinking fund factor and the
uniform series compound amount factor:

i (1  i ) N
( A / P, i, N ) 
(1  i ) N  1

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3.4 Compound Interest Factors for Annuities

(6 of 6)

• The Series Present Worth Factor: (P/A, i, N)

• Gives the present amount, P, that is equivalent to an
annuity with disbursements or receipts in the amount A,
where the interest rate is i and the number of periods is
N.

(1  i ) N  1
( P / A,i,N ) 
i (1  i ) N

Close‐Up 3.1 Capital Recovery Formula

(1 of 1)

• Capital asset has an initial cost P, and a salvage value, S,

after N periods.
• An equivalent annual cost can be obtained using the
capital recovery factor and the sinking fund factor:
A = P(A/P, i, N) – S(A/F, i, N)
• With some algebra, we have the capital recovery
formula:
A = (P – S)(A/P, i, N) + Si
• A is often called the capital recovery cost.

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Practice Problem 1 (1 of 2)
• A supplier of lab equipment is looking at equipment
which will cost $71 000, have a useful life of 5 years and a
salvage value estimated at $8000.
a) If the cost of capital is 15% per year, what are the
equivalent annual costs (i.e., the annual capital recovery
costs) of purchasing the equipment?
b) If it produces extra profits of $23 000 per year, is it
justified?

Practice Problem 1 (2 of 2)
Answer:
a) A = (P − S)(A/P, i, N) + Si
= (71 000 − 8000)(A/P, 15%, 5) + 8000(0.15)
= 63 000(0.29832) + 1200 = $19 994 (capital recovery
cost)
b) Profits/year exceed capital recovery costs, so purchase is
justified.

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Example 3.4 (1 of 4)
• Clarence bought a condo for $188 000 in 2019. He made a
$28 000 down payment and negotiated a mortgage from
the previous owner for the balance. Clarence agreed to
pay $4,000 per month at 12% nominal interest,
compounded monthly. How long will it take him to pay
back the mortgage?

Example 3.4 (2 of 4)
Answer
• Clarence borrowed only $160 000, since he made a $28
000 down payment.
• The $4000 payments form an annuity over N months
where N is unknown.
Interest rate per month i = 12% nominal ÷ 12 months = 1%

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Example 3.4 (3 of 4)
Answer (cont.)
• Find the value of N such that:
 (1  i )N  1 
P  A  P / A, i , N   A  N 
 i (1  i ) 
Or
 i (1  i )N 
A  P  A / P, i , N   P  
 (1  i )  1 
N

• Where P = $160 000, A = $4000, and i = 0.01

Example 3.4 (4 of 4)
Answer (cont.)
 i (1  i )N 
A  P 
 (1  i )  1 
N

 0.01(1.01)N 
4000  160 000  
 (1.01)  1 
N

 (1.01)N 
2.5   
 (1.01)  1 
N

2.5 / 1.5  (1.01)N

N[In(1.01)] = In(2.5 / 1.5) N = 51.34 months

<see Excel Example 3.4 for manual solution>

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Practice Problem 2 (1 of 2)
• A Ford Mustang costs $17 000. It can be financed at 5.9%
for 48 months, with monthly compounding. How much
will the monthly payments be?

Practice Problem 2 (2 of 2)
Answer:
i = 0.059/12 = 0.00492 per month
A = P(A/P, i, N)
= $17 000(A/P, 0.00492, 48)
= $398.50

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Practice Problem 3 (1 of 2)
• What is the present worth of a series of 15 annual
payments of $1000 each, when the first payment is now
and the interest rate is 5%, compounded monthly?

Practice Problem 3 (2 of 2)
Answer:
• An effective annual interest rate must be calculated first:
ie = (1+0.05/12)12 −1 = 0.05116
P = 1000 + 1000(P/A, 5.116%, 14)
= 1000 + 1000 (9.82563) = $10 826

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Close‐Up 3.3 Linear Interpolation (1

of 2)

• Process of approximating a complicated function by a

straight line.
• Done to estimate the value of the independent variable
– Based on two sample pairs of independent and dependent
variables and an instance of the dependent variable

Close‐Up 3.3 Linear Interpolation (2 of 2)

Figure 3.3 – Actual shape of function, f, is not

known
– Estimate of the value of X* is
made by drawing a straight line
between (x1, y1) and (x2, y2)

x *  x1 y *  y 1

x2  x1 y 2  y 1
– Isolate for X* for linear
interpolation equation

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3.5 Conversion Factor for Arithmetic

Gradient Series (1 of 5)
• Arithmetic Gradient to Uniform Series Factor: (A/G,i,N)
– Gives the value of an annuity, A,
– That is equivalent to an arithmetic gradient series where
the constant increase in receipts or disbursements is G per
period,
– The interest rate is i
– The number of periods is N

3.5 Conversion Factor for Arithmetic

Gradient Series (2 of 5)
• Arithmetic gradient series is a:
– series of receipts or disbursements that’s starts at zero at
the end of the first period and then increases by a
constant amount from period to period.

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3.5 Conversion Factor for Arithmetic

Gradient Series (3 of 5)

Figure 3.4 Arithmetic Gradient Series of Receipts

Figure 3.5 Arithmetic Gradient Series of Disbursements

The first non‐zero cash flow of a gradient occurs at the end of the second compounding period,
not the first.

3.5 Conversion Factor for Arithmetic

Gradient Series (4 of 5)
Figure 3.6

The annuity, A’, is a base to which the arithmetic gradient, G, is added

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3.5 Conversion Factor for Arithmetic Gradient

Series (5 of 5)
– Arithmetic gradient annuity factor is:

1 N
( A / G, i, N )  
i (1  i ) N  1

– To determine the uniform base series equivalent to the

total cash flow, the base annuity, A′, must be included to
give the overall annuity:
Atot = A′ + G(A/G, i, N)

Example 3.6 (1 of 5)
• Susan Ng owns an eight‐year‐old Toyota Prius. She wants
to find the present worth of repair bills over the four
years that she expects to keep the car. Susan has the car
in for repairs every six months. Repair costs are expected
to increase by $50 every six months over the next four
years, starting with $500 six months from now, $550 six
months later, etc. What is the present worth of the repair
costs over the next four years if the interest rate is 12%
compounded monthly?

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Example 3.6 (2 of 5)
Answer
• There will be 8 repair bills over 4 years, so N = 8
• Base annuity payment, A′ = $500
• Arithmetic gradient of bills, G = $50
• Step 1: find Atot equivalent to the sum of the base annuity,
A′ = $500, and the arithme c gradient series with G = $50
over N = 8 periods
• Step 2: find the present worth of Atot using the series
present worth factor

Example 3.6 (3 of 5)
Answer (cont.)
• Find effective interest rate per 6 month period:

6
 0.12 
i 6 month   1   1  0.06152 or 6.152%
 12 

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Example 3.6 (4 of 5)
Answer (cont.)
• Step 1

Atot  A  G  A / G, i , N 
1 N 
 500  50   
 i (1  i )  1 
N

 1 8 
 500  50   
 0.06152 (1.06152)  1 
8

 659.39

Example 3.6 (5 of 5)
Answer (cont.)
• Step 2

P  Atot (P / A, i , N )
 (1  i )N  1 
 Atot  N 
 i (1  i ) 
 (1.6152)8  1 
 659.39  8 
 0.06152(1.06152) 
 4070.09
Present worth of repair costs is approximately $4070.09

<see Excel Example 3.6>

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3.6 Conversion Factor for Geometric Gradient

Series (1 of 6)
• Geometric Gradient to PW Conversion:(P/A, g, i, N)
– Gives the present worth, P,
– That is equivalent to a geometric gradient series where
the base receipt or disbursement is A, and where the
rate of growth is g,
– The interest rate is i,
– The number of periods is N

3.6 Conversion Factor for Geometric

Gradient Series (2 of 6)
Figure 3.7

Cash flow showing gradient series for receipts with positive growth

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3.6 Conversion Factor for Geometric

Gradient Series (3 of 6)
Figure 3.8

Cash flow showing gradient series for receipts with negative growth

3.6 Conversion Factor for Geometric

Gradient Series (4 of 6)
• A series of cash flows that increase or decrease by a
constant percentage each period.
• The present worth of the series is:

A A(1  g ) A(1  g ) N 1
P   
(1  i ) (1  i ) 2 (1  i ) N

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3.6 Conversion Factor for Geometric

Gradient Series (5 of 6)
• Need what is called a growth adjusted interest rate which
can be defined as i°:

1 i 1 1 g
i   1 so that 

1 g 1 i 1 i

• Used as follows:
(1  i  ) N  1  1 
( P / A, g , i, N )    
i (1  i  ) N  1  g 
( P / A,i  ,N )

(1  g )

3.6 Conversion Factor for Geometric

Gradient Series (6 of 6)
1. i > g > 0: i° is positive  use tables or formula

2. g < 0: i° is positive  use tables or formula

3. g > i > 0: i° is negative  must use formula

 A 
4. g = i > 0: i° = zero P N 
 1 g 

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Example 3.8 (1 of 4)
• Emery’s company, Dry‐All, produces control systems for
drying grain. Proprietary technology has allowed Dry‐All
to maintain steady growth in the US market in spite of
numerous competitors. Company dividends, all paid to
Emery, are expected to rise at a rate of 10 percent per
year over the next 10 years. Dividends at the end of this
year are expected to total $110,000. If all dividends are
invested at 10% interest, how much will Emery
accumulate in 10 years?

(see Example 3.8 in ch. 3)

Example 3.8 (2 of 4)
Answer
• Calculate the growth adjusted interest rate:

1 i
i0  1
1 g

1.015
i0  1
1.0025

i 0  0.01247

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Example 3.8 (3 of 4)
Answer (cont.)
• Since g = i, the present worth is given by:

 A 
P N 
 1 g 

 110 000 
P  10  
 1.1 

P  1000 000

Example 3.8 (4 of 4)
Answer (cont.)
• Future worth of $1 000 000 after 10 years:
F = 1 000 000 (F/P, 10%,10)
= 1 000 000 (2.5937)
= 2 593 700
• Emery will accumulate $2 593 700 in dividends and
interest

<see Excel Example 3.8>

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3.7 Non‐Standard Annuities and

Gradients (1 of 1)
• If payment period and compounding period are not the
same, formulas given in this chapter cannot be applied
directly.
• Three methods for dealing with this situation:
1. Treat each cash flow in the annuity or gradient individually.
2. Convert the non‐standard annuity or gradient to standard
form by changing the compounding period.
3. Convert the non‐standard annuity form by finding an
equivalent standard annuity for the compounding period.

3.8 Present Worth Computations

When N∞
• Used for long‐lived projects
– When it is reasonable to model the cash flows as if they
will continue indefinitely.
• Present worth of an infinitely long series = capitalized value
• The capitalized value formula is: P = A ÷ i

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Example 3.11 (1 of 2)
• The town of South Battleford is considering building a bypass
for truck traffic around the downtown commercial area. The
bypass will provide merchants and shoppers with benefits
that have an estimated value of $5 million per year.
Maintenance costs will be $1.25 million per year. If the
bypass is properly maintained it will provide benefits for a
very long time. The actual life of the bypass will depend on
factors, such as future economic conditions, that connaot be
forecast at this time. It is therefore reasonable to model the
flow of benefits as though they will continue indefinitely. If
the interest rate is 10 percent, what is the present worth of
the potential project?

Example 3.11 (2 of 2)
Answer
P=A÷i
A = 5 000 000 – 1 250 000 = 3 750 000
P = 3 750 000/0.1
P = 37 500 000
Present worth of benefits net of maintenance costs =
$37,500,000

<see Excel Example 3.11>

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Reality and the Assumed Uniformity of a, G, and g

• We define and start with an A (uniform annual cost), a G

(uniform annual gradient), and a g (uniform annual rate of
increase) for three reasons:
1. It is easier to start with simple models
2. These model cash flows are convenient for bounding the
problems often encountered in engineering economic analysis
3. Not enough is known about the future and so it is
approximated through uniform series and gradients

Analysis in Excel allows us to easily account for non-uniform series,

so it isn’t necessary to constrain oneself to using these equations. If
you want to use equations, though, it’s necessary to make
uniformity assumptions as required by the equations.

Close‐Up 3.4 Bonds and Bond Pricing

• A Bond is a way for firms or governments to borrow money
from others. For the buyer:
• When Bonds are purchased, the fixed items are:
• Face Value (e.g., $1000)
 Amount paid out when the bond matures
• A nominal interest rate (e.g., 8% semi-annually)
 Sometimes called “coupon rate”
 The amount of interest paid out to the bond holder per
compounding period
• The purchase price can vary depending on the current market interest
rate as the present worth of a bond is determined from the fixed values
above (the interest paid out per compounding period and the final face
value paid out in the future).
• We will discuss different ways firms can borrow money later on.

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Close‐Up 3.4 Bonds (2 of 3)

• How to calculate the worth of a bond today at an interest
rate, i:
– Present worth of face value (F) + present worth of
coupons (A)

Close‐Up 3.4 Bonds (3 of 3)

• If money can earn 12% compounded annually, a bond
maturing on 15 years with a face value of $5000 and a
coupon rate of 7% is today worth:
P = 5000(P/F,6%,30) + (5000 x 0.07/2) (P/A, 6%,30)
= 5000(0.17411) + 175(13.765)
= 3279.43
• The bond is worth about $3279 today.

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Bond Pricing Example • See Excel

example

• A 15‐year municipal bond was issued 5 years

ago. Its coupon interest rate is 8%. Interest
payments are made semi‐annually. Its face
value is $1,000.
• If the current market interest rate is 12.36%,
what should the price of the bond be?

Bond Pricing Example • See Excel

example
• The first five years are past, and there are 20 more semi‐
annual payments. The coupon interest rate is the nominal
annual rate. Half of that is 4%. 4% x $1,000 = $40 is paid at
the end of each 6‐month period.
• The price of the bond is the present worth of cash flows
that will be received if the bond is purchased. The cash
flows are:
– $40 at the end of each of the 20 semi‐annual periods
– The face value of $1,000 paid at the end of period 20.
• The market, or effective, annual interest rate must be
converted to a semi‐annual rate:
– (1+i)^2 = 1+i(a) = 1.1236
– i=6% effective semi‐annual interest rate
• PW = 40 (P/A, 6%, 20) + 1000 (P/F, 6%, 20) = $770.60

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Opportunity Cost
Opportunity cost is the net benefit (the textbook sometimes uses 'return') of
your next best alternative.
Example 1:
If I go and get a waffle cone at Rain or Shine, and I pick London Fog (because it's amazing) over Strawberry,
the monetary cost is the same, but my opportunity cost is the enjoyment of Strawberry ice cream, which I don't
get by eating London Fog.

London Fog has a higher net benefit, because it has a higher benefit and the same cost. In this case, we can’t
monetize the net benefit because the benefit isn’t measurable: we just know it’s higher for London Fog (as
evidenced by the choice made).

Example 2:
You need to install a new server. You have two options: modify and install an old server that you have in
inventory for $5,000. Alternatively, you could buy and install a new server for $8,000. The old server could be
sold off for $2,000.

If you install the new server, it will cost $8,000 minus $2,000 for selling the old server = $6,000 cost.
If you install the old server, it will cost $5,000.
Installing the old server is the best option. The opportunity cost is the net benefit of the next best alternative,
which is a cost of $6,000.

Notice that you need to include all the benefits and costs of the next best
alternative.

Summary
• Modelling patterns of cash flows that enable comparisons of
the worth of projects.
• Four basic patterns of discrete cash flows:
1. Flows at a single point
2. Flows that are constant over time
3. Flows that grow or decrease at a constant arithmetic rate
4. Flows that grow or decrease at a constant geometric rate
• How to analyze non‐standard annuities and gradients
• Present Worth Computations when N →∞
• How bonds work
• What opportunity cost is

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