PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

PE338 PRODUCTION ECONOMICS

AND FINANCIAL MANAGEMENT
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

DR. S. K. TIWARI
Department of Production & Industrial Engineering
Birla Institute of Technology, Mesra, Ranchi – 835215
Email: [email protected]

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

COURSE INFORMATION
 Course code: PE 338
 Course title: Production Economics and Financial Management
 Pre-requisite(s): Nil
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

 Co- requisite(s): Nil

 Crédits: 3 L: 3 T: 0
 Class schedule per week: 3
 Class: B. Tech
 Semester / Level: VI / Third
 Branch: Production and Industrial Engineering
 Name of Teacher: Dr. S. K. Tiwari

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

COURSE OBJECTIVES
This course enables the students to:
1) Acquire the knowledge of economics and financial management needed for
economic decision making.
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2) Explores the relationship, which exists between costs, revenue, output levels and
resulting profit.
3) Assess the best feasible investment proposal among the alternatives based on the
common index.
4) Conduct a replacement or retention study, as well as a depreciation review.
5) Develop the skills to analyze financial statements.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

COURSE OUTCOMES
After the completion of this course, students will be:

CO1: Evaluate the economic theories, cost concepts and pricing policies.
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CO2: Derive and use the engineering economy factors to account for the time value of
money.

CO3: Apply financial management concepts to project evaluation and capital funding
decisions.

CO4: Make replacement and retention decisions, as well as quantify capital asset
depreciation.

CO5: Recognize, quantify, and record the common business transactions, and analyze
financial statements using ratio analysis.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

SYLLABUS
Module 1: Economics, Cost and Pricing Concepts [8]
Economics and economy; Concept of firm, industry, and market; Economic theories, Demand
and supply, Theory of production, Interaction between economic theory and production; Cost
analysis - Cost concepts, Elements of costs, Cost estimation and indirect cost allocation,
Economies of scale and economies of scope; Cost-volume-profit relationship - Concept of
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contribution, p/v ratio, breakeven point, and margin of safety, Break-even analysis and the
financial decision-making; Price fixation, pricing policies and pricing methods.
Module 2: Principles of Money-Time Relationships [7]
Time value of money, Interest rate and rate of return, Inflation, Economic Equivalence, Simple
and compound interest, Minimum attractive rate of return (MARR), Cash flow diagrams,
Equivalence - Single payment in the future (P/F, F/P), Present payment compared to uniform
series payments (P/A, A/P), Future payment compared to uniform series payments (F/A, A/F),
Arithmetic gradient, Geometric gradient. Multiple compounding periods in a year, Continuous
compounding.
Module 3: Project Evaluation, and Capital Financing [8]
Project evaluation - Formulating alternatives, Present, future and annual worth method of
comparing alternatives, Rate of return, Incremental rate of return, Defining mutually
exclusive alternatives, Comparison of alternatives with unequal service life; Capital
Financing - MARR relative to the cost of capital; Debt-equity mix and weighted average cost of
capital; Cost of debt capital, equity capital and the MARR; Effect of debt-equity mix on
investment risk.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

SYLLABUS (continued…)

Module 4: Replacement Analysis, and Depreciation Methods [7]

Replacement and retention decisions - Reasons for replacement, Economic service life,
Evaluation of replacement involving excessive maintenance cost, decline in efficiency,
inadequacy and obsolescence; Depreciation of capital assets - Causes of depreciation,
Deprecation methods: Straight line, Declining and double declining balance, Units of
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production, and Sum of years digits methods.

Module 5: Accounting System, Statement, and Financial Analysis [10]
Accounting concepts and principles, Classification of accounts; Double entry system - Journal
and ledger entries; Financial statements – trading account, profit & loss account, balance sheet;
Financial ratios.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Books:
Text books:
1) L.T. Blank, A.J. Tarquin, Engineering Economy, McGraw-Hill. (T1)
2) G.J. Thusen, W.J. Fabrycky, Engineering Economy, Prentice-Hall, New York. (T2)
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3) N. Wilkinson, Managerial Economics: A Problem-Solving Approach, Cambridge University Press. (T3)

4) S.N. Maheshwari, S.K. Maheshwari, S.K. Maheshwari, An Introduction to Accountancy, Vikas Publishing, New
Delhi. (T4)

Reference books:
1) P. Chandra, Financial Management: Theory and Practice, McGraw Hill India. (R1)
2) W.G. Sullivan, E.M. Wicks, Engineering Economy, Pearson, New York. (R2)
3) D.G. Newnan, T.G. Eschenbach, J.P. Lavelle, Engineering Economic Analysis, Oxford University Press.
(R3)

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Module 2: Principles of Money-Time Relationships

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Time value of money, Interest rate and rate of return, Inflation, Economic Equivalence,
Simple and compound interest, Minimum attractive rate of return (MARR), Cash flow
diagrams, Equivalence - Single payment in the future (P/F, F/P), Present payment
compared to uniform series payments (P/A, A/P), Future payment compared to uniform
series payments (F/A, A/F), Arithmetic gradient, Geometric gradient. Multiple
compounding periods in a year, Continuous compounding.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Time Value of Money

 The Time Value of Money is an important concept in
financial management. It includes the concept of future
value and discounted value.
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 According to this concept, a sum of money owned in the

present has a greater value than the value of the same
sum received at a moment in the future.
 Because money can earn at a certain interest rate through
its investment for a period of time.
 Since money has earning power, this opportunity will earn
a return, so that after n years the original sum plus it
interest will be a larger amount then the same sum
received at that time.
 Therefore, time value of money may be defined as “a
relationship between money and that time”.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Interest Rate and Rate of Return

 Interest is the manifestation of the time value of money.
Computationally, interest is the difference between an
ending amount of money and the beginning amount.
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 If the difference is zero or negative, there is no interest.

 There are always two perspectives to an amount of interest
as shown in Figure (a) and (b):
a) Borrower’s perspective: Interest paid, and
b) Lender’s perspective : Interest earned.

(a) Interest paid over time to lender (b) Interest earned over time by investor

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Interest Rate and Rate of Return (continued…)

 Borrower’s perspective:
 When a person or organization borrowed money (obtained a
loan) and repays a larger amount over a specific time period
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is known as interest paid. Mathematically, it is expressed

as:
Interest paid = Amount owed now – Principal amount

 When interest paid over a specific time unit is

expressed as a percentage of the principal, the result is
called interest rate. The time period for which interest
is paid may be longer (year) or shorter (month, week,
etc.). Mathematically, it is expressed as:

𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐩𝐩𝐩𝐩𝐩𝐩𝐩𝐩 𝐩𝐩𝐩𝐩𝐩𝐩 𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮 𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭

𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫 (%) = × 𝟏𝟏𝟏𝟏𝟏𝟏 %
𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Interest Rate and Rate of Return (continued…)

 Lender’s perspective:
 When a person or organization saved, invested, or lent
money and obtains a return of a larger amount over time
is known as interest earned. Mathematically, it is
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expressed as:
Interest earned = Total amount now – Principal amount
 Interest earned over a specific period of time is expressed
as a percentage of the original amount and is called rate
of return (ROR). The time period for which interest is
earned may be year, month, week, etc. Mathematically, it
is expressed as:
𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈𝐈 𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚𝐚 𝐩𝐩𝐩𝐩𝐩𝐩 𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮 𝐭𝐭𝐭𝐭𝐭𝐭𝐭𝐭
𝐑𝐑𝐑𝐑𝐑𝐑𝐑𝐑 𝐨𝐨𝐨𝐨 𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫𝐫 (%) = × 𝟏𝟏𝟏𝟏𝟏𝟏 %
𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏𝐏
Note: The numerical values and formulas used are the same for both perspectives, but
the interpretations are different.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Interest Rate and Rate of Return (continued…)

Illustration 1. An employee at LaserKinetics.com borrows

$10,000 on May 1 and must repay a total of $10,700 exactly
1 year later. Determine the interest amount and the interest
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rate paid.
Solution.
Here,
Principal amount = $10,000.
Amount after 1 year = $10,700.
Therefore,
Interest paid = $10,700 - 10,000 = $700.
And,
The interest rate paid for 1 year is:
$700
Percent interest rate = × 100% =7% per year.
$10,000

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Basic Terminology and Symbols

P = Value or amount of money at a time designated as the
present or time 0. Also P is referred to as present worth
(PW), present value (PV), net present value (NPV),
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discounted cash flow (DCF), and capitalized cost (CC).

F = Value or amount of money at some future time. Also, F is
called future worth (FW) and future value (FV).
A = Series of consecutive, equal, end-of-period amounts of
money. Also, A is called the annual worth (AW) and
equivalent uniform annual worth (EUAW).
n = Number of interest periods; years, months, days.
i = interest rate per time period; percent per year, percent per
month.
t = time, usually in periods such as years, months, days.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM

 Cash flow diagram is a graphical representation of cash flow
[i.e., inflow (receipts) and outflow (disbursement)] at a
different points in time that occur over the life of an
investment.
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 It provides the necessary information required for analyzing

and investment proposal.
 A cash flow diagram represents receipts received during a
period of time by an upward arrow [↑] (an increase in cash)
located at the end of the period. The arrow height may be
proportional to the magnitude of the receipts during the
period.
 Similarly, disbursements during a period are represented by
downward arrow [↓] (a decrease in cash).
 These arrows are placed on a Time Scale that spans all time
periods covered by the proposed investment.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

 Steps for making Cash Flow Diagrams:

1)Draw a time line
Always assume end-of-period cash flows
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Time
1 2 … … … n-1 n
0
One time
period

2)Show the cash flows (to approximate scale)

F = $100

1 2 … … … n-1 n
0
Cash flows are shown as directed arrows: + (up) for inflow & - (down) for outflow

P = $-80

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

 For example, consider ABC received a loan of ₹1,000 for 4

years from XYZ at an interest rate of 16% per annum.
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(a) ABC perspective (borrower) (b) XYZ perspective (lender)

 From Figure (a), it can be concluded that the borrower

receives ₹1,000 and this amount appears as a positive (+)
cash flow on the borrower’s cash flow diagram. Each year
the borrower pays ₹160 in interest; these amounts plus
repayment of ₹1,000 borrowed appears as negative (-) cash
flow.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

 However, from the lender’s perspective the cash flow is just

opposite to that of the borrower’s as shown in Figure (b).
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Note: It is to be noted that for every transaction there are two parties - borrower and lender.
Therefore, it is important to note that the cash flow directions in the cash flow diagrams
depend upon the point of view taken.
 When an investment alternative has both receipts and
disbursements occurring simultaneously, a net cash flow
may be calculated.
 Net cash flow is the arithmetic sum of the receipts (+) and
disbursements (-) that occurs at the same point in time.
 Let, ft is net cash flow at time t. Therefore, if ft is greater
than zero, the net cash flow is positive (+) i.e., receipt.
And, if ft is less than zero, the net cash flow is negative (-)
i.e., disbursement.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 2. Each year Exxon-Mobil expends large amounts of

funds for mechanical safety features throughout its worldwide
operations. Carla Ramos, a lead engineer for Mexico and Central
American operations, plans expenditures of $1 million now and each
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of the next 4 years just for the improvement of field-based pressure-

release valves. Construct the cash flow diagram to find the
equivalent value of these expenditures at the end of year 4, using a
cost of capital estimate for safety-related funds of 12% per year.
Solution:

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 2. Each year Exxon-Mobil expends large amounts of

funds for mechanical safety features throughout its worldwide
operations. Carla Ramos, a lead engineer for Mexico and Central
American operations, plans expenditures of $1 million now and each
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of the next 4 years just for the improvement of field-based pressure-

release valves. Construct the cash flow diagram to find the
equivalent value of these expenditures at the end of year 4, using a
cost of capital estimate for safety-related funds of 12% per year.
Solution:

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 3. An electrical engineer wants to deposit an amount P

now such that she can withdraw an equal annual amount of A1 =
$2000 per year for the first 5 years, starting 1 year after the deposit,
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and a different annual withdrawal of A2 = $3000 per year for the

following 3 years. How would the cash flow diagram appear if i = 8.5%
per year?
Solution:

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 3. An electrical engineer wants to deposit an amount P

now such that she can withdraw an equal annual amount of A1 =
$2000 per year for the first 5 years, starting 1 year after the deposit,
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and a different annual withdrawal of A2 = $3000 per year for the

following 3 years. How would the cash flow diagram appear if i = 8.5%
per year?
Solution:

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 4. A rental company spent $2500 on a new air compressor 7 years

ago. The annual rental income from the compressor has been $750. The $100
spent on maintenance the first year has increased each year by $25. The
company plans to sell the compressor at the end of next year for $150.
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Construct the cash flow diagram from the company’s perspective and indicate
where the present worth now is located.
Solution:
Let now be time t = 0. The incomes and costs for years - 7 through 1 (next
year) are tabulated below with net cash flow computed. Figure shows the net
cash flows (one negative, eight positive). Present worth P is located at year 0.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

CASH FLOW DIAGRAM (continued…)

Illustration 4. A rental company spent $2500 on a new air compressor 7 years

ago. The annual rental income from the compressor has been $750. The $100
spent on maintenance the first year has increased each year by $25. The
company plans to sell the compressor at the end of next year for $150.
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Construct the cash flow diagram from the company’s perspective and indicate
where the present worth now is located.
Solution:
Let now be time t = 0. The incomes and costs for years - 7 through 1 (next
year) are tabulated below with net cash flow computed. Figure shows the net
cash flows (one negative, eight positive). Present worth P is located at year 0.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

SIMPLE INTEREST AND COMPOUND INTEREST

 Simple interest is calculated using the principal only, ignoring any
interest accrued in preceding interest periods. The total simple
interest earned may be found in the following manner.
 Let I represent the interest earned, P the principal amount, n the
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interest period, and i the interest rate. Then,

I = Pni
Illustration 5. GreenTree Financing lent an engineering company $100,000
to retrofit an environmentally unfriendly building. The loan is for 3 years at
10% per year simple interest. How much money will the firm repay at the end
of 3 years?
Solution: Given, P = $100,000
i = 10% per year
n = 3 years
Therefore,
Simple Interest = (P*i*n)/100 = 100,000*10*3/100 = $30,000
The firm will repay at the end of 3 years = $(100,000 + 30,000) = $130,000

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

SIMPLE INTEREST AND COMPOUND INTEREST(continued…)

 For compound interest, the interest accrued for each interest
period is calculated on the principal plus the total amount of
interest accumulated in all previous periods. Thus, compound
interest means interest on top of interest.
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 It reflects the effect of the time value of money on the interest also.
 Compound interest for one period is calculated as:

Compound interest = (principal + all accrued interest)(interest rate)

 However, compound interest It for time period t, it is calculated as:

𝒋𝒋=𝒕𝒕−𝟏𝟏

𝑰𝑰𝒕𝒕 = 𝑷𝑷 + � 𝑰𝑰𝒋𝒋 (𝒊𝒊)

𝒋𝒋=𝟏𝟏

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

SIMPLE INTEREST AND COMPOUND INTEREST(continued…)

Illustration 6. In illustration 5, compute the annual interest and total
amount due after 3 years.
Solution: Given, P = $100,000
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i = 10% per year

n = 3 years
Therefore,
Interest, year 1: 100,000(0.10) = $10,000.
Total due, year 1: 100,000 + 10,000 = $110,000.
Interest, year 2: 110,000(0.10) = $11,000.
Total due, year 2: 110,000 + 11,000 = $121,000.
Interest, year 3: 121,000(0.10) = $12,100.
Total due, year 3: 121,000 + 12,100 = $133,100.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

MINIMUM ATTRACTIVE RATE OF RETURN (MARR)

 The Minimum Attractive Rate of Return (MARR) is a
reasonable rate of return established for the evaluation and
selection of alternatives.
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 An investment is economically viable only if it is expected to

return at least the MARR.
 MARR is also referred to as the hurdle rate, cutoff rate,
benchmark rate, and minimum acceptable rate of return.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

INTEREST FORMULAS
FOR
DISCRETE COMPOUNDS AND DISCRETE PAYMENTS
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Single 1) Single-Payment Compound-Amount Factor (F/P, i, n).

Payment 2) Single-Payment Present-Worth Factor (P/F, i, n).
3) Equal-Payment Series Compound-Amount Factor or,
Uniform Series Compound-Amount Factor (F/A, i, n).
4) Equal-Payment Series Sinking-Fund Factor or, Sinking-Fund
Equal Factor (A/F, i, n).
Payment
5) Equal-Payment Series Capital Recovery Factor or, Capital
Recovery Factor (A/P, i, n).
6) Equal-Payment Series Present-Worth Factor or, Uniform
Series Present-Worth Factor (P/A, i, n).
7) Uniform-Gradient-Series Factor (A/G, i, n).
8) Geometric-Gradient-Series Factor (P/A, g’, n).

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Compound-Amount Factor (F/P, i, n)

 Let an amount P is invested now for n years at an interest rate of i
per year. Figure shows the cash flow diagram for this situation.
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Cash flow diagram for single-payment compound-amount factor (F/P, i, n)

 Since this transaction does not provide any payments until the
investment is terminated. It means that the interest earned is
added to the principal at the end of each annual interest period.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Compound-Amount Factor (F/P, i, n) (continued…)

 Table shows the calculation for the above situation for determining
the interest earned during each year as well as the total amount at
the end of each year for a period of n years.
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Year Amount at the beginning of Interest earned during Compound amount at the end of the year
the year the year

1 P Pi P + Pi = P(1+i)1

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

 The resulting factor, (1 + i)n, is known as the single-payment
compound-amount
⁞ ⁞ factor⁞ and is designated
⁞ as (F/P, i, n). ⁞
n P(1+i)n-1 P(1+i)n-1i P(1+i)n-1 + P(1+i)n-1i = P(1+i)n =F
 This factor may be used to find the future amount, F, of a present
principal amount, P. The relationship is:

F = P (1 + i)n ……..(1)

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Compound-Amount Factor (F/P, i, n) (continued…)

Illustration 7. Sandy, a manufacturing engineer, just received a
year-end bonus of $10,000 that will be invested immediately. With the
expectation of earning at the rate of 8% per year, Sandy hopes to take
the entire amount out in exactly 20 years to pay for a family vacation
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when the oldest daughter is due to graduate from college. Find the
amount of funds that will be available after 20 years and also draw
the cash flow diagram?

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Compound-Amount Factor (F/P, i, n) (continued…)

Illustration 7. Sandy, a manufacturing engineer, just received a
year-end bonus of $10,000 that will be invested immediately. With the
expectation of earning at the rate of 8% per year, Sandy hopes to take
the entire amount out in exactly 20 years to pay for a family vacation
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

when the oldest daughter is due to graduate from college. Find the
amount of funds that will be available after 20 years and also draw
the cash flow diagram?

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Present-Worth Factor (P/F, i, n)

 From the single-payment compound-amount relationship [Equation
(1)], P can be determined as:
𝟏𝟏
𝑷𝑷 = 𝑭𝑭 = 𝑭𝑭(𝟏𝟏 + 𝒊𝒊)−𝒏𝒏 ……..(2)
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏

Cash flow diagram for single-payment present-worth factor (P/F, i, n)

 The resulting factor, (1 + i)-n, is known as the single-payment
present-worth factor and is designated as (P/F, i, n).

 This factor may be used to find the present worth, P, of a future

amount, F.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Present-Worth Factor (P/F, i, n) (Continued…)

Illustration 8. Houston American Cement factory will require an
investment of $200 million to construct. Delays beyond the
anticipated implementation year of 2012 will require additional
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money to construct the factory. Assuming that the cost of money

is 10% per year, compound interest, determine the following for
the board of directors of the Brazilian parent company
Votorantim Cimentos that plans to develop the plant.
a. The equivalent investment needed if the plant is built in
2015.
b. The equivalent investment needed had the plant been
constructed in the year 2008.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Single-Payment Present-Worth Factor (P/F, i, n) (Continued…)

BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

1/25/2024 Dr. S. K. Tiwari 36

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Equal-Payment Series Compound-Amount Factor (F/A, i, n)

 Let ‘A’ represents a series of ‘n’ equal payments as shown in
Figure. Then the future amount ‘F’ at the end of ‘n’ years at an
annual interest rate of ‘i’ per annum is calculated as:
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝐅𝐅 = 𝐀𝐀 𝟏𝟏 + 𝐀𝐀 𝟏𝟏 + 𝐢𝐢 +A 𝟏𝟏 + 𝐢𝐢 𝟐𝟐 +A 𝟏𝟏 + 𝐢𝐢 𝟑𝟑
⋯ +A 𝟏𝟏 + 𝐢𝐢 𝐧𝐧−𝟐𝟐
+A 𝟏𝟏 + 𝐢𝐢 𝐧𝐧−𝟏𝟏

……..(3)
Note: It is the sum of individual future amounts calculated
for each payment ‘A’ by compound amount factor.

Cash flow diagram for equal-payment series compound-amount factor (F/A, i, n)

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Equal-Payment Series Compound-Amount Factor (F/A, i, n) (Continued…)

 Now, to determine the equal-payment series compound-amount
factor, multiply the Equation (3) by (1+i). Therefore,

𝑭𝑭 𝟏𝟏 + 𝐢𝐢 = 𝐀𝐀 𝟏𝟏 + 𝐢𝐢 +A 𝟏𝟏 + 𝐢𝐢 𝟐𝟐 +A 𝟏𝟏 + 𝐢𝐢 𝟑𝟑
⋯ +A 𝟏𝟏 + 𝐢𝐢 𝐧𝐧−𝟏𝟏
+A 𝟏𝟏 + 𝐢𝐢 𝐧𝐧
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

……..(4)
 Now, by subtracting Equation (3) from Equation (4), we get:
𝐧𝐧
𝑭𝑭 𝟏𝟏 + 𝐢𝐢 − 𝑭𝑭 = −𝐀𝐀 + A 𝟏𝟏 + 𝐢𝐢

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

𝒐𝒐𝒐𝒐, 𝑭𝑭 = 𝑨𝑨 ……..(5)
𝒊𝒊
(𝟏𝟏+𝒊𝒊)𝒏𝒏 −𝟏𝟏
 The resulting factor, , is known as the equal-payment series
𝒊𝒊
compound-amount factor and is designated as (F/A, i, n).

 It is also known as Uniform-Series Compound-Amount Factor.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Equal-Payment Series Sinking-Fund Factor (A/F, i, n)

 From equal-payment series compound-amount factor, Equation
(5), we know that:

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏 𝒊𝒊

𝑭𝑭 = 𝑨𝑨 𝒐𝒐𝒐𝒐, 𝑨𝑨 = 𝑭𝑭 ……..(6)
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝒊𝒊 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

Cash flow diagram for equal-payment series sinking-fund factor (A/F, i, n)

𝒊𝒊
 The resulting factor, , is known as the equal-payment series
(𝟏𝟏+𝒊𝒊)𝒏𝒏 −𝟏𝟏
sinking-fund factor and is designated as (A/F, i, n).

 It is also known as Sinking-Fund Factor.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Equal-Payment Series Capital-Recovery Factor (A/P, i, n)

 From equal-payment series sinking-fund factor, Equation (6), we
know that:
𝒊𝒊 𝒏𝒏
𝒊𝒊
𝑨𝑨 = 𝑭𝑭 𝒐𝒐𝒐𝒐, 𝑨𝑨 = 𝑷𝑷(𝟏𝟏 + 𝒊𝒊)
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

From single-payment
compound-amount
factor, F = P (1 + i)n

𝒊𝒊(𝟏𝟏 + 𝒊𝒊)𝒏𝒏
𝒐𝒐𝒐𝒐, 𝑨𝑨 = 𝑷𝑷 ……..(7)
(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏
𝒊𝒊(𝟏𝟏+𝒊𝒊)𝒏𝒏
 The resulting factor, , is
(𝟏𝟏+𝒊𝒊)𝒏𝒏 −𝟏𝟏
known as the equal-payment series
capital-recovery factor and is
designated as (A/P, i, n).

 It is also known as Capital-Recovery Cash flow diagram for equal-payment

series capital-recovery factor (A/P, i, n)
Factor.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Equal-Payment Series Present-Worth Factor (P/A, i, n)

 From equal-payment series capital-recovery factor, Equation (7),
we know that:
𝒊𝒊(𝟏𝟏 + 𝒊𝒊)𝒏𝒏
𝑨𝑨 = 𝑷𝑷
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

𝒐𝒐𝒐𝒐, 𝑷𝑷 = 𝑨𝑨 ……..(8)
𝒊𝒊(𝟏𝟏 + 𝒊𝒊)𝒏𝒏

(𝟏𝟏+𝒊𝒊)𝒏𝒏 −𝟏𝟏
 The resulting factor, , is
𝒊𝒊(𝟏𝟏+𝒊𝒊)𝒏𝒏
known as the equal-payment series
present-worth factor and is
designated as (P/A, i, n).

 It is also known as Uniform-Series

Present-Worth Factor.
Cash flow diagram for equal-payment
series present-worth factor (P/A, i, n)

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 9. Houston American Cement plant may generate a

revenue base of $50 million per year. The president of the
Brazilian parent company Votorantim Cimentos may have
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

reason to be quite pleased with this projection for the simple

reason that over the 5-year planning horizon, the expected
revenue would total $250 million, which is $50 million more
than the initial investment. With money worth 10% per year,
address the following question from the president: Will the
initial investment be recovered over the 5-year horizon with the
time value of money considered? If so, by how much extra in
present worth funds? If not, what is the equivalent annual
revenue base required for the recovery plus the 10% return on
money?

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BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 10. The president of Ford Motor Company wants to know the
equivalent future worth of a $1 million capital investment each year for 8 years,
starting 1 year from now. Ford capital earns at a rate of 14% per year.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

1/25/2024 Dr. S. K. Tiwari 44

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 10. The president of Ford Motor Company wants to know the
equivalent future worth of a $1 million capital investment each year for 8 years,
starting 1 year from now. Ford capital earns at a rate of 14% per year.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

1/25/2024 Dr. S. K. Tiwari 45

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Uniform-Gradient-Series Factor (A/G, i, n)

 In some cases, periodic payments do not occur in an equal series. They
may increase or decrease by a constant amount.
 For example, a series of payments that would be uniformly increasing is
$100, $125, $150, and $175 occurring at the end of the first, second, third,
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

and fourth years. Similarly, a uniformly decreasing series would be $100,

$90, $80, and $70 occurring at the end of the first, second, third, and
fourth years. In each case, an equal payment series provides the base with
a constant annual increase or decrease beginning at the end of the second
year. (n-1)G
(n-2)G
 In general, a uniformly increasing series
4G
of payments for n interest periods may be 3G
expressed as G, 2G,.., (n - 1)G, as shown 2G
in Figure, where G denotes the annual G
change in the magnitude of the
payments. 0 1 2 3 4 5 (n-1) n
 Let, G = Annual change or, gradient.
n = Number of years. Cash flow diagram for uniform-gradient-
series factor (A/G, i, n)
A = Equal annual payment.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Uniform-Gradient-Series Factor (A/G, i, n) (Continued…)

 The gradient series, G, 2G,…, (n - 1)G, can be represented as a sum of
identical components of size G as presented in Column 3 of Table. To find
the future amount, F, at time n that will result from the gradient series
displayed in Column 3, take each column of G values in Column 3 and
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find its future amount. Add these future amounts for all the columns of
G in Column 3. The total future amount can be represented as follows:

𝑭𝑭 = 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟏𝟏 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟐𝟐 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟑𝟑 + ⋯ + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝟐𝟐 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝟏𝟏

Gradient series and an equivalent set of series

End of Year Gradient Series Set of Series Equivalent to Gradient Series Annual Series
(1) (2) (3) (4)
0 0 0 0
1 0 0 A
2 G G A
3 2G G+G A
4 3G G+G+G A
⋮ ⋮ ⋮ ⋮
n-1 (n-2)G G+G+G+⋯+G A
n (n-1)G G+G+G+⋯+G+G A

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Uniform-Gradient-Series Factor (A/G, i, n) (Continued…)

𝑭𝑭 = 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟏𝟏 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟐𝟐 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝒏𝒏 − 𝟑𝟑 + ⋯ + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝟐𝟐 + 𝑮𝑮 𝑭𝑭⁄𝑨𝑨 , 𝒊𝒊, 𝟏𝟏

(𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟏𝟏 −𝟏𝟏 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟐𝟐 −𝟏𝟏 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟑𝟑 −𝟏𝟏 𝟏𝟏 + 𝒊𝒊 𝟐𝟐 − 𝟏𝟏

𝑭𝑭 = 𝑮𝑮 + 𝑮𝑮 + 𝑮𝑮 + ⋯ + 𝑮𝑮 +
𝒊𝒊 𝒊𝒊 𝒊𝒊 𝒊𝒊
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

(𝟏𝟏 + 𝒊𝒊)𝟏𝟏 −𝟏𝟏

𝑮𝑮
𝒊𝒊

𝑮𝑮
= (𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟏𝟏 +(𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟐𝟐 +(𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟑𝟑 + ⋯ + 𝟏𝟏 + 𝒊𝒊 𝟐𝟐 + 𝟏𝟏 + 𝒊𝒊 𝟏𝟏 + (𝒏𝒏 − 𝟏𝟏)
𝒊𝒊

𝑮𝑮 𝒏𝒏𝒏𝒏
= (𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟏𝟏 +(𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟐𝟐 +(𝟏𝟏 + 𝒊𝒊)𝒏𝒏−𝟑𝟑 + ⋯ + 𝟏𝟏 + 𝒊𝒊 𝟐𝟐 + 𝟏𝟏 + 𝒊𝒊 𝟏𝟏 + 𝟏𝟏 −
𝒊𝒊 𝒊𝒊

The bracketed terms constitute the equal payment series compound amount
factor for n years. Therefore,

𝑮𝑮 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏 𝒏𝒏𝒏𝒏 ……..(9)

𝑭𝑭 = −
𝒊𝒊 𝒊𝒊 𝒊𝒊

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Uniform-Gradient-Series Factor (A/G, i, n) (Continued…)

From Equation (6):
𝒊𝒊 𝑮𝑮 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏 𝒊𝒊 𝒏𝒏𝒏𝒏 𝒊𝒊
𝑨𝑨 = 𝑭𝑭 𝒏𝒏
= 𝒏𝒏
−
(𝟏𝟏 + 𝒊𝒊) −𝟏𝟏 𝒊𝒊 𝒊𝒊 (𝟏𝟏 + 𝒊𝒊) −𝟏𝟏 𝒊𝒊 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏
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From equal-payment
series sinking-fund factor,
𝒊𝒊
𝑨𝑨 = 𝑭𝑭
(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

𝒊𝒊 𝑮𝑮 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏 𝒊𝒊 𝒏𝒏𝒏𝒏 𝒊𝒊

𝑨𝑨 = 𝑭𝑭 𝒏𝒏
= 𝒏𝒏
−
(𝟏𝟏 + 𝒊𝒊) −𝟏𝟏 𝒊𝒊 𝒊𝒊 (𝟏𝟏 + 𝒊𝒊) −𝟏𝟏 𝒊𝒊 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

𝟏𝟏 𝒏𝒏
𝑨𝑨 = 𝑮𝑮 − ……..(10)
𝒊𝒊 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏

𝟏𝟏 𝒏𝒏
 The resulting factor, − , is called the uniform-gradient-series
𝒊𝒊 (𝟏𝟏+𝒊𝒊)𝒏𝒏 −𝟏𝟏
factor and is designated as (A/G, i, n).

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 11. A local university has initiated a logo-licensing program with the
clothier Holister, Inc. Estimated fees (revenues) are $80,000 for the first year with
uniform increases to a total of $200,000 by the end of year 9. Determine the gradient
and construct a cash flow diagram that identifies the base amount and the gradient
series.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

1/25/2024 Dr. S. K. Tiwari 50

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 11. A local university has initiated a logo-licensing program with the
clothier Holister, Inc. Estimated fees (revenues) are $80,000 for the first year with
uniform increases to a total of $200,000 by the end of year 9. Determine the gradient
and construct a cash flow diagram that identifies the base amount and the gradient
series.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 12. Neighboring parishes in Louisiana have agreed to pool road tax
resources already designated for bridge refurbishment. At a recent meeting, the
engineers estimated that a total of $500,000 will be deposited at the end of next year
into an account for the repair of old and safety-questionable bridges throughout the
area. Further, they estimate that the deposits will increase by $100,000 per year for
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only 9 years thereafter, then cease. Determine the equivalent (a) present worth and
(b) annual series amounts, if public funds earn at a rate of 5% per year.

1/25/2024 Dr. S. K. Tiwari 52

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 12. Neighboring parishes in Louisiana have agreed to pool road tax
resources already designated for bridge refurbishment. At a recent meeting, the
engineers estimated that a total of $500,000 will be deposited at the end of next year
into an account for the repair of old and safety-questionable bridges throughout the
area. Further, they estimate that the deposits will increase by $100,000 per year for
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

only 9 years thereafter, then cease. Determine the equivalent (a) present worth and
(b) annual series amounts, if public funds earn at a rate of 5% per year.

1/25/2024 Dr. S. K. Tiwari 53

BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

1/25/2024 Dr. S. K. Tiwari 54

 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Geometric-Gradient-Series Factor (P/A, g’, n)

 In some situations, annual payments increase or decrease, not by a
constant amount but by a constant percentage.
 If g is used to designate the percentage change in the magnitude of the
payment from one year to the next, the magnitude of the tth payment is
related to payment F1 as:
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𝑭𝑭𝒕𝒕 = 𝑭𝑭𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)𝒕𝒕−𝟏𝟏 , 𝒕𝒕 = 𝟏𝟏, 𝟐𝟐, ⋯ , 𝒏𝒏. ……..(11)

 When g is positive the series will increase, as illustrated in Figure. When

g is negative the series will decrease.
 To derive an expression for the present amount, P,
the relationship between F1 and Ft given by
Equation (11) can be used, together with the
single-payment present-worth factor of Equation
(2) as:

(𝟏𝟏 + 𝒈𝒈)𝟎𝟎 (𝟏𝟏 + 𝒈𝒈)𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)𝒏𝒏−𝟏𝟏

𝑷𝑷 = 𝑭𝑭𝟏𝟏 𝟏𝟏
+ 𝑭𝑭𝟏𝟏 𝟐𝟐
+ ⋯ + 𝑭𝑭𝟏𝟏
(𝟏𝟏 + 𝒊𝒊) (𝟏𝟏 + 𝒊𝒊) (𝟏𝟏 + 𝒊𝒊)𝒏𝒏
Cash flow diagram for geometric-
gradient-series factor

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Geometric-Gradient-Series Factor (P/A, g’, n) (Continued…)

By multiplying each term by (1+g)/(1+g) and simplify:

𝑭𝑭𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)𝟐𝟐 (𝟏𝟏 + 𝒈𝒈)𝒏𝒏

𝑷𝑷 = 𝟏𝟏
+ 𝟐𝟐
+ ⋯+
(𝟏𝟏 + 𝒈𝒈) (𝟏𝟏 + 𝒊𝒊) (𝟏𝟏 + 𝒊𝒊) (𝟏𝟏 + 𝒊𝒊)𝒏𝒏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

Let,
𝟏𝟏 (𝟏𝟏 + 𝒈𝒈)
= ……..(12)
′
(𝟏𝟏 + 𝒈𝒈 ) (𝟏𝟏 + 𝒊𝒊)
(𝟏𝟏 + 𝒊𝒊)
⇒ 𝒈𝒈′ = − 𝟏𝟏 ……..(13)
(𝟏𝟏 + 𝒈𝒈)
where g’ is the growth-free rate, and substitute for each term:

𝑭𝑭𝟏𝟏 𝟏𝟏 𝟏𝟏 𝟏𝟏
𝑷𝑷 = 𝟏𝟏
+ 𝟐𝟐
+ ⋯+
(𝟏𝟏 + 𝒈𝒈) (𝟏𝟏 + 𝒈𝒈𝒈) (𝟏𝟏 + 𝒈𝒈𝒈) (𝟏𝟏 + 𝒈𝒈𝒈)𝒏𝒏

The term within the brackets constitute the equal-payment series present-
worth factor for n years. Therefore,

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Geometric-Gradient-Series Factor (P/A, g’, n) (Continued…)

𝑭𝑭𝟏𝟏 (𝟏𝟏 + 𝒈𝒈𝒈)𝒏𝒏 −𝟏𝟏
𝑷𝑷 = ……..(14)
(𝟏𝟏 + 𝒈𝒈) 𝒈𝒈𝒈(𝟏𝟏 + 𝒈𝒈𝒈)𝒏𝒏
(𝟏𝟏+𝒈𝒈′)𝒏𝒏 −𝟏𝟏
 The resulting factor, , is called the geometric-gradient-series factor and is
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝒈𝒈′(𝟏𝟏+𝒈𝒈′)𝒏𝒏
designated as (P/A, g’, n).

 Further, Equation (14) can be reduced by putting the value of g’ to:

𝒏𝒏
𝑭𝑭𝟏𝟏 𝟏𝟏 + 𝒈𝒈
𝑷𝑷 = 𝟏𝟏 − ……..(15)
(𝒊𝒊 − 𝒈𝒈) 𝟏𝟏 + 𝒊𝒊

Cases:

1) When g’ > 0 i.e., i > g: The geometric-gradient-series is a positive series.

2) When g’ < 0 i.e., i < g: The geometric-gradient-series is a negative series.
3) When g’ = 0 i.e., i = g: In this case the value of (P/A, g’, n) will be n.
𝒏𝒏
i.e., 𝑷𝑷 = 𝑭𝑭𝟏𝟏
(𝟏𝟏+𝒈𝒈)

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Illustration 13. A coal-fired power plant has upgraded an emission control valve.
The modification costs only $8000 and is expected to last 6 years with a $200
salvage value. The maintenance cost is expected to be high at $1700 the first year,
increasing by 11% per year thereafter. Determine the equivalent present worth of
the modification and maintenance cost at 8% per year.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

Solution.

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Illustration 13. A coal-fired power plant has upgraded an emission control valve.
The modification costs only $8000 and is expected to last 6 years with a $200
salvage value. The maintenance cost is expected to be high at $1700 the first year,
increasing by 11% per year thereafter. Determine the equivalent present worth of
the modification and maintenance cost at 8% per year.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

Solution.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Illustration 14. The announcement of the HAC cement factory states that the $200
million (M) investment is planned for 2012. Most large investment commitments
are actually spread out over several years as the plant is constructed and
production is initiated. Further investigation may determine, for example, that the
$200 M is a present worth in the year 2012 of anticipated investments during the
next 4 years (2013 through 2016). Assume the amount planned for 2013 is $100 M
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

with constant decreases of $25 M each year thereafter. As before, assume the time
value of money for investment capital is 10% per year to answer the following
questions.
a) In equivalent present worth values, does the planned decreasing investment
series equal the announced $200 M in 2012?
b) Given the planned investment series, what is the equivalent annual amount that
will be invested from 2013 to 2016?
c) What must be the amount of yearly constant decrease through 2016 to have a
present worth of exactly $200 M in 2012, provided $100 M is expended in 2013?

Solution.

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

INTEREST FORMULAS
FOR
CONTINUOUS COMPOUNDS AND DISCRETE PAYMENTS
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

Single 1) Single-Payment Compound-Amount Factor [F/P, r, n].

Payment 2) Single-Payment Present-Worth Factor [P/F, r, n].
3) Equal-Payment Series Compound-Amount Factor or,
Uniform Series Compound-Amount Factor [F/A, r, n].
4) Equal-Payment Series Sinking-Fund Factor or, Sinking-Fund
Equal Factor [A/F, r, n].
Payment
5) Equal-Payment Series Capital Recovery Factor or, Capital
Recovery Factor [A/P, r, n].
6) Equal-Payment Series Present-Worth Factor or, Uniform
Series Present-Worth Factor P/A, r, n].
7) Uniform-Gradient-Series Factor [A/G, r, n].
8) Geometric-Gradient-Series Factor [P/A, g’, n].

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 PE338 PRODUCTION ECONOMICS AND FINANCIAL MANAGEMENT

Relationship Between Effective Rate of Interest and

Nominal Rate of Interest
 The nominal or annual rate of interest is expressed on an annual basis and is determined by
multiplying the actual or effective interest rate per interest period by the number of
compounding periods per year.
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

 For example, when the actual or effective rate of interest is 3% interest compounded each
six-month period, the annual or nominal interest is quoted as 6 % per year compounded
semiannually. For an effective rate of interest of 1.5% compounded at the end of each three-
month period, the nominal interest is quoted as 6% per year compounded quarterly.
 The relationship between effective interest rate and nominal interest rate is as follows:
𝒓𝒓 𝒍𝒍.𝒎𝒎
𝒊𝒊 = 𝟏𝟏 + − 𝟏𝟏 ……..(16)
𝒎𝒎

𝒓𝒓 𝒄𝒄
𝒊𝒊 = 𝟏𝟏 + − 𝟏𝟏 where, c = l.m ……..(17)
𝒎𝒎

where,
r = nominal interest rate per year.
i = effective interest rate in the time interval.
l = length of the time interval (in years).
m = reciprocal of the length of the compounding period (in years).

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For Example:
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

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CONTINUOUS COMPOUNDING
There are certain cases where the compounding period is infinite number of times per year. In
these cases, the effective annual interest rate for continuous compounding is derived from
Equation (16) with l =1 as:
𝒓𝒓 𝒎𝒎
𝒊𝒊𝒂𝒂 = lim 𝟏𝟏 + − 𝟏𝟏 Continuous compounding is present when the
𝒎𝒎
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝒎𝒎→∞ duration of CP, the compounding period,

becomes
But since infi nitely small and m , the number of times
𝒓𝒓 𝒎𝒎 𝒓𝒓 𝒎𝒎/𝒓𝒓 𝒓𝒓 interest is compounded per period, becomes
𝟏𝟏 + = 𝟏𝟏 + infi nite.
𝒎𝒎 𝒎𝒎 Businesses with large numbers of cash fl ows
each day consider the interest to be
continuously
and 𝒎𝒎/𝒓𝒓
𝒓𝒓 compounded for all transactions.
lim 𝟏𝟏 + = 𝒆𝒆 = 𝟐𝟐. 𝟕𝟕𝟕𝟕𝟕𝟕𝟕𝟕
𝑚𝑚→∞ 𝒎𝒎
then 𝒓𝒓 𝒎𝒎/𝒓𝒓 𝒓𝒓
𝒊𝒊𝒂𝒂 = lim 𝟏𝟏 + − 𝟏𝟏
𝒎𝒎→∞ 𝒎𝒎
= 𝒆𝒆𝒓𝒓 − 𝟏𝟏
Therefore, when interest is compounded continuously,

𝒊𝒊𝒂𝒂 = 𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆𝒆 𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂𝒂 𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊𝒊 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏 ……..(18)

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Single-Payment Compound-Amount Factor [F/P, r, n]

From Equation (1):
𝑭𝑭 = 𝑷𝑷(𝟏𝟏 + 𝒊𝒊)𝒏𝒏
∵ 𝒊𝒊 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

∴ 𝑭𝑭 = 𝑷𝑷𝑷𝑷𝒓𝒓𝒓𝒓 ……..(18)

The resulting factor, 𝒆𝒆𝒓𝒓𝒓𝒓 , is called the Single-Payment Compound-Amount Factor for
continuous compounding and is designated [F/P, r, n].

Single-Payment Present-Worth Factor [P/F, r, n]

From Equation (18):

𝑭𝑭 = 𝑷𝑷𝑷𝑷𝒓𝒓𝒓𝒓

𝟏𝟏 ……..(19)
⇒ 𝑷𝑷 = 𝑭𝑭 𝒓𝒓𝒓𝒓 = 𝑭𝑭𝑭𝑭−𝒓𝒓𝒓𝒓
𝒆𝒆
The resulting factor, 𝒆𝒆−𝒓𝒓𝒓𝒓 , is called the Single-Payment Present-Worth Factor for continuous
compounding and is designated [P/F, r, n].

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Equal-Payment Series Present-Worth Factor [P/A, r, n]

From Equation (8):
(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏
𝑷𝑷 = 𝑨𝑨
𝒊𝒊(𝟏𝟏 + 𝒊𝒊)𝒏𝒏
Putting 𝒊𝒊 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝟏𝟏 − 𝒆𝒆−𝒓𝒓𝒓𝒓
𝑷𝑷 = 𝑨𝑨 ……..(20)
𝒆𝒆𝒓𝒓 − 𝟏𝟏
𝟏𝟏−𝒆𝒆−𝒓𝒓𝒓𝒓
The resulting factor, 𝒆𝒆𝒓𝒓 −𝟏𝟏
, is called the Equal-Payment Series Present-Worth Factor for
continuous compounding and is designated [P/A, r, n].

Equal-Payment Series Capital-Recovery Factor [A/P, r, n]

From Equation (20):
𝟏𝟏 − 𝒆𝒆−𝒓𝒓𝒓𝒓
𝑷𝑷 = 𝑨𝑨
𝒆𝒆𝒓𝒓 − 𝟏𝟏
𝒆𝒆𝒓𝒓 − 𝟏𝟏
𝑨𝑨 = 𝑷𝑷 ……..(21)
𝟏𝟏 − 𝒆𝒆−𝒓𝒓𝒓𝒓
𝒆𝒆𝒓𝒓 −𝟏𝟏
The resulting factor, 𝟏𝟏−𝒆𝒆−𝒓𝒓𝒓𝒓
, is called the Equal-Payment Series Capital-Recovery Factor for
continuous compounding and is designated [A/P, r, n].

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Equal-Payment Series Sinking-Fund Factor [A/F, r, n]

From Equation (6):
𝒊𝒊
𝑨𝑨 = 𝑭𝑭
(𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏
Putting 𝒊𝒊 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝒆𝒆𝒓𝒓 − 𝟏𝟏
𝑨𝑨 = 𝑭𝑭 𝒓𝒓𝒓𝒓 ……..(22)
𝒆𝒆 − 𝟏𝟏
𝒆𝒆𝒓𝒓 −𝟏𝟏
The resulting factor, 𝒆𝒆𝒓𝒓𝒓𝒓 −𝟏𝟏
, is called the Equal-Payment Series Sinking-Fund Factor for
continuous compounding and is designated [A/F, r, n].

Equal-Payment Series Compound-Amount Factor [F/A, r, n]

From Equation (22):
𝒆𝒆𝒓𝒓 − 𝟏𝟏
𝑨𝑨 = 𝑭𝑭 𝒓𝒓𝒓𝒓
𝒆𝒆 − 𝟏𝟏
𝒆𝒆𝒓𝒓𝒓𝒓 − 𝟏𝟏
𝑭𝑭 = 𝑨𝑨 𝒓𝒓 ……..(23)
𝒆𝒆 − 𝟏𝟏
𝒆𝒆𝒓𝒓𝒓𝒓 −𝟏𝟏
The resulting factor, 𝒆𝒆𝒓𝒓 −𝟏𝟏
, is called the Equal-Payment Series Compound-Amount Factor for
continuous compounding and is designated [F/A, r, n].

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Uniform-Gradient Series Factor [A/G, r, n]

From Equation (10):
𝟏𝟏 𝒏𝒏
𝑨𝑨 = 𝑮𝑮 −
𝒊𝒊 (𝟏𝟏 + 𝒊𝒊)𝒏𝒏 −𝟏𝟏
Putting 𝒊𝒊 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝟏𝟏 𝒏𝒏
𝑨𝑨 = 𝑮𝑮 𝒓𝒓 − 𝒓𝒓𝒓𝒓 ……..(24)
𝒆𝒆 − 𝟏𝟏 𝒆𝒆 − 𝟏𝟏
𝟏𝟏 𝒏𝒏
The resulting factor, 𝒆𝒆𝒓𝒓 −𝟏𝟏
−
𝒆𝒆𝒓𝒓𝒓𝒓 −𝟏𝟏
, is called the Uniform-Gradient Series Factor for continuous
compounding and is designated [A/G, r, n].

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Geometric-Gradient Series Factor [P/A, g’, n]

From Equation (13):
(𝟏𝟏 + 𝒊𝒊)
′
𝒈𝒈 = − 𝟏𝟏
(𝟏𝟏 + 𝒈𝒈)
Putting 𝒊𝒊 = 𝒆𝒆𝒓𝒓 − 𝟏𝟏
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

𝒆𝒆𝒓𝒓
∴ 𝒈𝒈𝒈 = − 𝟏𝟏 ……..(25)
(𝟏𝟏 + 𝒈𝒈)

The remaining formula will be same.

Therefore,

𝑭𝑭𝟏𝟏 (𝟏𝟏 + 𝒈𝒈𝒈)𝒏𝒏 −𝟏𝟏

𝑷𝑷 = ……..(26)
(𝟏𝟏 + 𝒈𝒈) 𝒈𝒈𝒈(𝟏𝟏 + 𝒈𝒈𝒈)𝒏𝒏

(𝟏𝟏+𝒈𝒈′)𝒏𝒏 −𝟏𝟏
The resulting factor, , is called the geometric-gradient-series factor for
𝒈𝒈′(𝟏𝟏+𝒈𝒈′)𝒏𝒏
continuous compounding and is designated [P/A, g’, n].

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ECONOMIC EQUIVALENCE
 Definition: Combination of interest rate (rate of return) and time value
of money to determine different amounts of money at different points
in time that are economically equivalent.
 How it works: Use rate i and time t in upcoming relations to move
BIRLA INSTITUTE OF TECHNOLOGY, MESRA – Ranchi

money (values of P, F and A) between time points t = 0, 1, …, n to make

them equivalent (not equal) at the rate i.
 Example:
Different sums of money at different times may be equal in economic
value at a given rate.
$110

0
1
Rate of return = 10%per year

$100 now

$100 now is economically equivalent to $110 one year from now, if the $100 is
invested at a rate of 10% per year.

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Reference:
1) G.J Thusen, W.J. Fabrycky, Engineering Economy, Prentice-Hall, New York.
2) W.G Sullivan, E.M. Wicks, Engineering Economy, Pearson, New York.
3) Blank & Tarquin, Engineering Economy, McGraw-Hill.

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