Engineering Economics: Financial

Decision Making for Engineers

Seventh Edition

Chapter 3
Cash Flow Analysis

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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.

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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.
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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.

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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).

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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.
• See Spreadsheet Savy feature for Chapter 3
– Excel and other spreadsheet programs that can be
used as alternatives to compound interest factors.

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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”

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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.

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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 …

(see Example 3.1 in ch. 3)

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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

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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.

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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

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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.

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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

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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?

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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.
Due to …

(see Example 3.4 in ch. 3)

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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 )N
− 1 
• Where P = $160 000, A = $4000, and i = 0.01

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 Example 3.4 (4 of 4)

Answer (cont.)
 i (1 + i )N 
A = P 
 (1 + i )N
− 1 
 0.01(1.01)N 
4000 = 160 000  
 (1.01)N
− 1 
 (1.01)N 
2.5 =  
 (1.01)N
− 1 
2.5 / 1.5 = (1.01)N
N[In(1.01)] = In(2.5 / 1.5) N = 51.34 months

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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?

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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?

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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

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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
= 2
x2 − x1 y − y 1
– Isolate for X* for linear interpolation
equation

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Close-Up 3.4 Bonds (1 of 3)

• Bonds are investments that provide an annuity and a

future value in return for a payment today.
• Par or face value:
– Amount for which a bond can be redeemed after a
certain period of time.
• Coupon rate:
– They pay the bearer an annuity, usually semi-
annually, calculated as a percentage of the face
value.

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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)

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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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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

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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.
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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, Aʹ, must be
included to give the overall annuity:
Atot = Aʹ + G(A/G, i, N)

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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 repair …

(see Example 3.6 in ch. 3)

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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, Aʹ = $500
• Arithmetic gradient of bills, G = $50
• Step 1: find Atot equivalent to the sum of the base
annuity, Aʹ = $500, and the arithmetic gradient series
with G = $50 over N = 8 periods
• Step 2: find the present worth of Atot using the series
present worth factor
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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)8
− 1 
= 659.39

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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

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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

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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

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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 )
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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 …

(see Example 3.8 in ch. 3)

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Example 3.8 (2 of 4)

Answer
• Calculate the growth adjusted interest rate:
1+ i
i =
0
−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

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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

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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.
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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 …

(Example 3.11 in ch. 3)

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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

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Summary (1 of 2)

• 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

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Summary (2 of 2)

• How to analyze non-standard annuities and

gradients
• Present Worth Computations when N →∞

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