Engineering Economy (17HS6ICEEM)

UNIT - 1
INTRODUCTION: Engineering Decision- Makers, Engineering and Economics, Problem
solving and Decision making, Intuition and Analysis, Tactics and Strategy, Law of supply
and demand.

Engineers are planners and builders. They are also problem solvers, managers, and decision
makers. Engineering economics touches each of these activities. Plans and production must
be financed. Problems are eventually defined by monetory dimensions, and decisions are
evaluated by their monetary consequences. Much of the management function is directed
toward economic oiectives and is monitored by economic measures.

Engineering economics is closely aligned with conventional microeconomics, but it

has a history and a special flavor of its own. It is devoted to problem solving and decision
making at the operations level. It can lead to suboptirnization-a condition in which a solution
satisfies tactical objectives at the expense of strategic effectiveness—but careful attention to
the collection and analysis of data minimizes the danger.

An engineering economist draws upon the accumulated knowledge of engineenng and

econemics to identify alternative uses of limited resources and to select the prefered course of
action. Evaluations rely mainly on mathematical models and cost data, but judgment and
experience are pivotal inputs. Many accepted models are available for analyses of short-range
projects when the time value of money is not relevant, and of long-range proposals when
discounting is required for input data assumed to be known or subject to risk.

1.1 Engineering Decision- Makers:

The following questions might an engineer has to answer
• Which one of several competing engineering designs should be selected?
• Should the machine now in use be replaced with a new one?
• With limited capital available, which investment alternative should be funded?
• Would it be preferable to pursue a safer conservative course of action or to follow a riskier
one that offers higher potential returns?
• How many units of production have to be sold before a profit can be made? This area is
commonly called break-even analysis
• Among several proposals for funding that yield substantially equivalent worthwhile results
but have different cash flow pattern. Which is preferable?

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• Are the benefits expected from public service project large enough to make its
implementation costs acceptable?
Two characteristics of the questions above should be apparent. First, each deals with a choice
among alternatives; second, all involve economic considerations. Less obvious are the
requirements of adequate data and awareness of technological constraints to define the
problem and to identify legitimate solutions. These considerations are embodied in the
decision-making role of engineering economists to
1. Identify alternative uses for limited resources and obtain appropriate data
2. Analyze the data to determine the preferred alternative
The breadth of problems, depth of analysis, and scope of application that a practicing
engineer encounters vary widely.
Newly graduated engineers are regularly assigned to cost reduction projects and are
expected to be cost-conscious in all their opcration8. As they gain more experience, they
may become specialists in certain application areas or may undertake more general
responsibilities as managers. Beginners are usually restricted to short-range decisions for
low-budget operations, whereas engineering managers are confronted with policy
decisions that involve large sums and are influenced by many factors with long-range
consequences. Both situations arc served by the principles and practices of engineering
economics.
1.2 Engineering and Economics
In earlier days, engineers were mainly concerned with
• The design,
• Construction,
• Operation of machines,
• Structures and processes.
They gave less attention to the resources, human and physical, that produced the final
products. Many factors have since contributed to an expansion of engineering responsibilities
and concerns. Besides the traditional work with scientists to develop discoveries about nature
into useful products; engineers are now expected not only to generate novel technological
solutions but also to make skillful financial analyses of the effects of implementation. In
today’s close and tangled relations among industry the public, and government, cost and
value analyses are expected to be more detailed and inclusive (e.g., worker safety,
environmental effects, consumer protection, resource conservation) than ever before, Without

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these analyses, an entire project can easily become more of a burden than a benefit,
Most definitions of engineering suggest that the mission of engineers is to transform the
resources of nature for the benefit of the human race. The types of resources susceptible to
engineering enrichment indude everything from ores and crops to information and energy.
1.3 Problem solving and Decision making:
Problem solving
An engineering economist draws upon the accumulated knowledge of engineering and
economics to fashion and employ tools to identify a preferred course of action. The tools
developed so far are not perfect. There is still considerable debate about their theoretical
bases and how they should be used. This concern is wholesome because it promises improved
procedures, but the variety of analysis techniques can frustrate practitioners, especially
inexperienced ones.
There are many aspects to consider and many ways to consider them.The fundamental
approach to economic problem solving is to elaborate on the time-honored scientific
method.The method has link with two worlds a) Real world b) symblic word. The figure1.1
shows the detailed steps to be followed in problem solving process.

Figure1.1: Problem solving process

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1. Problems in engineering and managerial economy originate in the real world of economic
planning, management, and control
2. The problem is confined and clarified by data from the real world.
3. The information is combined with scientific principles supplied by the analyst to formulate
a hypothesis
4. The symbolic language aids the digestion of data.
5. By manulating and experimenting with the abstractions of the real world, the analyst can
simulate multiple configurations of reality.
6. The predicted behavior is converted back to reality for testing in the form of hardware,
designs, or commands.
7. If it is valid, the problem is solved, if not the cycle is repeated with added information.
Decision making
The standard decision making process is shown in the figure 1.2

Figure 1.2: decision making process

1. Recognize the problem

2. Define the goal or objective
3. Assemble relevant data
4. Identify feasible alternatives
5. Select the criterion to determine the best alternative
6. Construct a model
7. Predict each alternative’s outcomes or consequenses

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8. Choose the best alternative

9. Audit the results
1.3 Intuition and Analysis:
Generally engineers generally attack practical problems with solution deadlines instead of
engaging in esoteric issues for long-term enlightenment, their mission might appear relatively
simple. Engineering economic evaluations could even seem mundane, since they usually rely
on data from the marketplace and technology from the shelf-simply grab prices from a
catalog, plug them into a handy formula, and grind out an answer. Occasionally, such a
routine works. Spectacular workbench discoveries and overnight fortunes attest to the fact
that plungers sometimes win. There are also innumerable instances where rule-of-thumb,
skin-deep evaluat ions are absolutely unsatisfactory.
A decision made now is based on data from past performances and establishes a
course of action that will result in some future outcome. When the decision is shallow and the
outcomes are not of much consequence. A reflex response based upon intuition is feasible.
Instinctive judgments are often formalized by standard operating procedures (SOPs). In
economic analyses. SOPs often take the form of works heets for the justification of
investments. Such short-form justifications are typically limited to smaller investments, say,
less than Rs10, 000,00, that can be recaptured from savings generated by the investment
within 6 months or 1 year. These SOP forms represent collective intuition derived from
experience. They have a secure place in economic evaluations, but their use should be
tempered by economic principles and a continuing audit to verify that previous judgments are
appropriate for current decisions.

Most decision makers informally set boundaries for routine responses to noncritical
problems of a personal and professional nature. Three possible parameters to identify routine
responses are shown in Figure.1.2.The level that separates an automatic decision from a
problem that requires more investigation among decision makers.
Since there are limits to a decision maker’s time and energy whereas the reservoir of
problems often seems infinite, guidelines are necessary to confine involvement. SOPs do save
time. An intuitive response is quick. Both draw upon experience to yield a reasonable
solution. However, handy answers may mask better solutions than could have been exposed
by analysis.

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1.4 Tactics and Strategy

Strategy and tactics historically are military terms associated with broad plans from the high
command and specific schedules from lower eche lons, respectively.
Strategy sets ultimate objectives, and the associated tactics define the multiple
maneuvers required to achieve the objectives. Strategic and tactical considerations have
essentially the same meaning for economic studies. There are usually several strategies
available to an organization. A strategic decision ideally selects the overall plan that makes
the best use of the organization’s resources in accordance with its long-range objectives. A
strategic industrial decision could be a choice from several different product designs to
develop or products to promote. In government, strategic evaluations could take the form of
benefit-cost analyses to select the preferred method of flood control or development of
recreational sites. The measure of merit for strategic alternatives is effectiveness-the degree
to which a plan meets economic targets.
A strategic plan can normally be implemented in a number of ways. For example,
each industrial design or product has tactical alternatives, such as which kind of machine to
employ or materials to use; tactics for flood control might involve choices among dams,
levees, dredging, etc. The relative values of tactical choices are rated according to their
efficiency- the degree to which an operation accomplishes a mission within economic
expectations.
The relationship between strategies and tactics offers some construct ive insights. The
effectiveness of each strategy is initially estimated from the effect it will have on system
objectives. It thus serves as a guide to the area in which tactics will produce the highest
efficiency. The actual effic iency of each tactic is determined from a study of the activities
required to conduct the tactical operation.An aerospace engine manufacturer is considenng
job shop automation. Two strategies, each with three apparent means of accomplishment, are
depicted in Figure. 1.3. Strategy 2 is to automate the impeller line, which will automate about
65 percent of the total shop. Strategy 1 is to automate both impeller and gear lines, which will
affect about 80 percent of the facility. The company has decided that the effectiveness
measure is the percentage of shop automation. The tactics shown in Figure. 1.3 represents
approaches to automation. DNC refers to centralized, integrated direct numerical control by
computer, CNC is local computer numerical control for each machine, and trace refers to
template tracing and duplication for multiple-part setups. The efficiency, or means by which
each approach is measured, in this case will be the dollar benefits from installing the new
equipment. In this case, we have a situation where the best dollar return is not realized by the
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most effective strategy. Possibly, the cost of automating the gear line is relatively higher than
for the impeller portion of the shop. The select ion of a tactic policy must be evaluated in
relation to the strategic objectives and the resources required for implementation.

Figure 1.3 Realtionship between Strategy and Tactics

Example 1: Planning a Trip
People use strategy and tactics in very simple ways every day without realizing it. For
example, if we are planning a trip from Bangalore to New Delhi, we need a strategy to get
there.
Strategy involves answering many questions, such as: How do we plan to travel (airplane,
boat, etc.)? What resources do we have? When do we need to get there?
If we decide to travel by airplane, the tactics of purchasing that plane ticket can be to:
• Call a travel agent
• Use the website of a specific airline
• Use a website that compares the rates of different airlines.

Law of supply and demand:

The demand and supply of a product are interdependent and they are sensitive with respect to
the price of that product. The interrelationships between them are shown in the figure 1.3

From the figure it is clear that when there is a decrease in the price of a product, the
demand for the product increases and its supply decreases. Also, the product is more in
demand and hence the demand of the product increases. At the same time, lowering of the
price of the product makes the producers restrain from releasing more quantities of the
product in the market. Hence, the supply of the product is decreased. The point of intersection

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of the supply curve and the demand curve is known as the equilibrium point. At the price
corresponding to this point, the quantity of supply is equal to the quantity of demand. Hence,
this point is called the equilibrium point.
Factors influencing demand
The shape of the demand curve is influenced by the following factors:
· Income of the people
· Prices of related goods
· Tastes of consumers
If the income level of the people increases significantly, then their purchasing power will
naturally improve. If, for instance, the price of television sets is lowered drastically its
demand would naturally go up. As a result, the demand for its associated product, namely
VCDs would also increase. Hence, the prices of related goods influences the demand of a
product.
Over a period of time, the preference of the people for a particular product may increase,
which in turn, will affect its demand. For instance, diabetic people prefer to have sugar-free
products. If the incidence of diabetes rises naturally there will be increased demand for sugar-
free products.The demand and supply curve is shown in the figure.1.3

Figure 1.3: Demand and supply curve.

Factors influencing supply
The shape of the supply curve is affected by the following factors:
· Cost of the inputs
· Technology

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· Weather
· Prices of related goods
If the cost of inputs increases, then naturally, the cost of the product will go up. In such a
situation, at the prevailing price of the product the profit margin per unit will be less. The
producers will then reduce the production quantity, which in turn will affect the supply of the
product. For instance, if the prices of fertilizers and cost of labour are increased significantly,
in agriculture, the profit margin per bag of paddy will be reduced. So, the farmers will reduce
the area of cultivation, and hence the quantity of supply of paddy will be reduced at the
prevailing prices of the paddy.
If there is advancement in technology used in the manufacture of the product in the long
run, there will be a reduction in the production cost per unit. This will enable the
manufacturer to have a greater profit margin per unit at the prevailing price of the product.
Hence, the producer will be tempted to supply more quantity to the market.
Weather also has a direct bearing on the supply of products. For example, demand for
woollen products will increase during winter. This means the prices of woollen goods will be
incresed in winter. So, naturally, manufacturers will supply more volume of woollen goods
during winter.
Again, take the case of television sets. If the price of TV sets is lowered significantly,
then its demand would naturally go up. As a result, the demand for associated products like
VCDs would also go up. Over a period of time, this will lead to an increase in the price of
VCDs, which would result in more supply of VCDs.

Science is a field of study where the basic principles of different physical systems are
formulated and tested. Engineering is the application of science. It establishes varied
application systems based on different scientific principles.It is clear that price has a major
role in deciding the demand and supply of a product. Hence, from the organization’s point of
view, efficient and effective functioning of the organization would certainly help it to provide
goods/services at a lower cost which in turn will enable it to fix a lower price for its goods or
services.

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Module 1 (Part 2)
INTEREST AND INTEREST FACTORS: Interest rate, simple interest, Compound
interest, Cash- flow diagrams, Exercises and Discussion.

Interest: A fee paid for the use of another party's money. To the borrower it is the cost of
renting money, to the lender the income from lending it.

2.1 Interest rate

An interest rate is the rate at which interest is paid by borrowers for the use of money that
they borrow from a lender. Specifically, the interest rate (I/m) is a percent of principal (P)
paid a certain amount of times (m) per period (usually quoted per annum). For example, a
small company borrows capital from a bank to buy new assets for its business, and in return
the lender receives interest at a predetermined interest rate for deferring the use of funds and
instead lending it to the borrower. Interest rates are normally expressed as a percentage of the
principal for a period of one year.
2.2 Simple interest
The interest is said to simple, when the interest is charged only on the principal amount for
the interest period. No interest is charged on the interest amount accrued during the preceding
interest periods. In case of simple interest, the total amount of interest accumulated for a
given interest period is simply a product of the principal amount, the rate of interest and the
number of interest periods. It is given by the following expression.
IT = P  n i
Where
IT = total amount of interest
P = Principal amount
n = number of interest periods i = rate of interest
Simple interest reflects the effect of time value of money only on the principal amount.
2.3 Compound interest:
The interest is said to be compound, when the interest for any interest period is charged on
principal amount plus the interest amount accrued in all the previous interest periods.
Compound interest takes into account the effect of time value of money on both principal as
well as on the accrued interest also.

If an investor invests a sum of Rs. 100 in a fixed deposit for five years with an interest rate of
15% compounded annually, the accumulated amount at the end of every year will be as
shown in the following table 2.1

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Compound Amounts
(amount of deposit = Rs.
100.00)
Year Interes Compound
end t amount
(Rs.) (Rs.)
0 100.00
1 15.00 115.00
2 17.25 132.25
3 19.84 152.09
4 22.81 174.90
5 26.24 201.14

Table 2.1 Time value of money

The formula to find the future worth in the third column is
F = P (1 + i)n
where
P = principal amount invested at time 0, F = future amount,
i = interest rate compounded annually, n = period of deposit.

The maturity value at the end of the fifth year is Rs. 201.14. This means that the amount Rs.
201.14 at the end of the fifth year is equivalent to Rs. 100.00 at time 0 (i.e. at present). This is
diagrammatically shown in the following figure 2.1. This explanation assumes that the
inflation is at zero percentage.

Figure 2.1 Time value of money

Alternatively, the above concept may be discussed as follows: If we want Rs. 100.00 at the
end of the nth year, what is the amount that we should deposit now at a given interest rate, say
15%? A detailed working is shown in the following table 2.2

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Table 2.2 Present worth Amounts (rate of interest = 15%)

Compound
End of year Present worth amount
(n) after n year(s)
0 100
1 86.96 100
2 75.61 100
3 65.75 100
4 57.18 100
5 49.72 100
6 43.29 100
7 37.59 100
8 32.69 100
9 28.43 100
10 24.72 100

The formula to find the present worth in the second column is P =F(1 + i)n
From the table 2.2, it is clear that if we want Rs. 100 at the end of the fifth year, we should
now deposit an amount of Rs. 49.72. Similarly, if we want Rs. 100.00 at the end of the 10th
year, we should now deposit an amount of Rs. 24.72.Also, this concept can be stated as ,A
person has received a prize from a finance company during the recent festival contest. But the
prize will be given in either of the following two modes.
1. Spot payment of Rs. 24.72 or
2. Rs. 100 after 10 years from now (this is based on 15% interest rate compounded
annually).
If the prize winner has no better choice that can yield more than 15% interest rate
compounded annually, and if 15% compounded annually is the common interest rate paid in
all the finance companies, then it makes no difference whether he receives Rs. 24.72 now or
Rs. 100 after 10 years.
On the other hand, let us assume that the prize winner has his own business wherein he can
get a yield of 24% interest rate (more than 15%) compounded annually, it is better for him to
receive the prize money of Rs. 24.72 at present and utilize it in his business. If this option is
followed, the equivalent amount for Rs. 24.72 at the end of the 10th year is Rs. 212.45. This
example clearly demonstrates the time value of money.
2.4 Cash flow Diagrams:
The purpose of cash flow diagrams is to show the net amount of money received or spent
during various time periods for a project. The time periods are typically given in months or
years, depending on the scope of the project.

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Cash flow diagrams can be drawn from the perspective of the borrower or the lender. The
two perspectives make the diagram flip upside down, since a gain for the borrower is a loss
for the lender, and vice versa. For each time period, calculate the net amount of money
gained or lost during each time period.
Net cash flow = gains - losses = income - expenses
Gains or income include anything that gives the borrower money, such as taking out a loan,
receiving interest from an investment, receiving benefits from an operational system, etc.
Losses or expenses include any money leaving the borrower, such as loan payments, buying
equipment for cash, etc.
The cash flow diagram is a set of orthogonal arrows. The X axis is a timeline arrow pointing
to the right, labeled with the number of each time period (0, 1, 2, etc.). Each time period is
evaluated at the end of that time period, so pretend that all transactions in time period 2 are
accounted for at the end of time period 2. The end of Period 0 is the present time.A cash flow
diagram is shown in the figure 2.2

Figure 2.2: Cash flow diagram

Interest Formulas

While making investment decisions, computations will be done in many ways. To simplify all
these computations, it is extremely important to know how to use interest formulas more
effectively. Before discussing the effective application of the interest formulas for
investment-decision making, the various interest formulas are presented first.Interest rate can
be classified into simple interest rate and compound interest rate.
In simple interest, the interest is calculated, based on the initial deposit for every interest
period. In this case, calculation of interest on interest is not applicable. In compound interest,
the interest for the current period is computed based on the amount (principal plus interest up
to the end of the previous period) at the beginning of the current period.

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The notations which are used in various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly, quarterly, semiannually or annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after period to/ from the amount
of deposit A1 at the end of period 1
Single-Payment Compound Amount
The objective is to find the single future sum (F) of the initial payment (P) made at time 0
after n periods at an interest rate i compounded every period. The cash flow diagram of this
situation is shown in Figure 2.3

Figure 2.3 Cash flow diagram for Single-Payment Compound Amount

The formula to obtain the single-payment compound amount is
𝑃(1 + 𝑖)𝑛
𝐹 = 𝑃(𝐹⁄𝑃, 𝑖, 𝑛)
Where (F/P, i, n) is called as single-payment compound amount factor.
Problem 1:A person deposits a sum of Rs. 20,000 at the interest rate of 18% compounded
annually for 10 years. Find the maturity value after 10 years.
Solution
P = Rs. 20,000
i = 18% compounded annually n = 10 years
= P(1 + i)n = P(F/P, i, n)
=20,000 (F/P, 18%, 10)
=20,000 x5.234 = Rs. 1, 04,680
The maturity value of Rs. 20,000 invested now at 18% compounded yearly is equal to
Rs. 1, 04,680 after 10 years.

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Single-Payment Present Worth Amount

Here, the objective is to find the present worth amount (P) of a single future sum (F) which
will be received after n periods at an interest rate of i compounded at the end of every interest
period.The corresponding cash flow diagram is shown in the following Figure 2.4

Figure 2.4 Cash flow diagram of single-payment present worth amount

The formula to obtain the present worth is
𝐹
𝑃= = 𝐹(𝑃⁄𝐹 , 𝑖, 𝑛)
(1 + 𝑖)𝑛

Problem 2: A person wishes to have a future sum of Rs. 1,00,000 for his son’s education
after 10 years from now. What is the single-payment that he should deposit now so that he
gets the desired amount after 10 years? The bank gives 15% interest rate compounded
annually.

Solution

F = Rs. 1,00,000

i = 15%, compounded annually n = 10 years

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

= 1,00,000 (P/F, 15%, 10)

= 1,00,000 ´x 0.2472

= Rs. 24,720
Q The person has to invest Rs. 24,720 now so that he will get a sum of Rs. 1,00,000
after 10 years at 15% interest rate compounded annually.

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Equal-Payment Series Compound Amount

In this type of investment mode, the objective is to find the future worth of n equal payments
which are made at the end of every interest period till the end of the nth interest period at an
interest rate of i compounded at the end of each interest period. The corresponding cash flow
diagram is shown in Figure 2.5

Figure 2.5 Cash flow diagram of equal-payment series compound amount.

In the above Figure
A = equal amount deposited at the end of each interest period
n= No. of interest periods i = rate of interest
F = single future amount
The formula to get F is
(1 + 𝑖)𝑛 − 1
𝐹=𝐴 = 𝐴(𝐹/𝐴, 𝑖%, 𝑛)
𝑖
Where (F/A, i, n) is termed as equal-payment series compound amount factor.
Problem 3: A person who is now 35 years old is planning for his retired life. He plans to
invest an equal sum of Rs. 10,000 at the end of every year for the next 25 years starting from
the end of the next year. The bank gives 20% interest rate, compounded annually. Find the
maturity value of his account when he is 60 years old.
Solution
A = Rs. 10,000
n = 25 years
i = 20%
F=?
The corresponding cash flow diagram is shown in the figure 2.6

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Figure 2.6 Cash flow diagram of equal-payment series compound amount.

(1 + 𝑖)𝑛 − 1
𝐹=𝐴
𝑖
=A (F/A, i, n)
=10,000(F/A, 20%, 25)
=10,000 x 471.981
= Rs. 47, 19,810
The future sum of the annual equal payments after 25 years is equal to Rs. 47,19,810.
Equal-Payment Series Sinking Fund
In this type of investment mode, the objective is to find the equivalent amount (A) that should
be deposited at the end of every interest period for n interest periods to realize a future sum
(F) at the end of the nth interest period at an interest rate of i.
The corresponding cash flow diagram is shown in the figure 2.7

Figure 2.7 Cash flow diagram of equal-payment series sinking fund.

Where (A/F, i, n) is called as equal-payment series sinking fund factor.

Problem 4: A company has to replace a present facility after 15 years at an outlay of Rs.
5,00,000. It plans to deposit an equal amount at the end of every year for the next 15 years at
an interest rate of 18% compounded annually. Find the equivalent amount that must be
deposited at the end of every year for the next 15 years.

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Solution
F = Rs. 5,00,000 n = 15 years
i = 18% A = ?
The corresponding cash flow diagram is shown in Figure 2.8.

Figure 2.8. Cash flow diagram of equal-payment series sinking fund.

𝑖
𝐴=𝐹 = 𝐹(𝐴⁄𝐹, 𝑖, 𝑛)
(1 + 𝑖)𝑛 − 1
=500000(A/F, 18%, 15)
=5,00,000 x 0.0164
=Rs 8200
The annual equal amount which must be deposited for 15 years is Rs. 8,200.

Equal-Payment Series Present Worth Amount

The objective of this mode of investment is to find the present worth of an equal payment
made at the end of every interest period for n interest periods at an interest rate of i
compounded at the end of every interest period.
The corresponding cash flow diagram is shown in Figure 2.9

Here,
P= Present worth
A=Annual equavalent worth
n= Duration
i= Interest rate
The formula to compute P is

(1 + 𝑖 )𝑛 − 1
𝑃=𝐴
𝑖(1 + 𝑖)𝑛
=A (P/A I, n)

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where (P/A, i, n) is called equal-payment series present worth factor

Figure 2.9 Cash flow diagram of equal-payment series present worth amount

Problem 5: A company wants to set up a reserve which will help the company to have an
annual equivalent amount of Rs. 10,00,000 for the next 20 years towards its employees
welfare measures. The reserve is assumed to grow at the rate of 15% annually. Find the
single-payment that must be made now as the reserve amount.

Solution
A = Rs. 10,00,000 i = 15%
n = 20 years P = ?
The corresponding cash flow diagram is illustrated in Figure. 2.10

Figure 2.10: Cash flow diagram of equal-payment series present worth amount

(1 + 𝑖 )𝑛 − 1
𝑖 (1 + 𝑖 )𝑛

=A(P/A,i%,n)
= 10,00,000 (P/A, 15%, 20)
= 10,00,000 x 6.2593
= Rs. 62,59,300
The amount of reserve which must be set-up now is equal to Rs. 62, 59,300.

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Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent amount (A) which is
to be recovered at the end of every interest period for n interest periods for a loan (P) which is
sanctioned now at an interest rate of i compounded at the end of every interest period. Cash
flow diagram of equal-payment series capital recovery amount is shown in figure

Figure 2.11. Cash flow diagram of equal-payment series capital recovery amount.
In the above figure,

P= present worth (loan amount)

A=Annual equvallent worth
i= Interest rate
n= no. of interest periods
The formula to compute P is as follows
𝑖(1 + 𝑖)𝑛
𝐴=𝑃
(1 + 𝑖)𝑛 − 1

=P (A/P, i, n)
Where, (A/P, i, n) is called equal-payment series capital recovery factor.
Problem 6: A bank gives a loan to a company to purchase an equipment worth Rs. 10,00,000
at an interest rate of 18% compounded annually. This amount should be repaid in 15 yearly
equal installments. Find the installment amount that the company has to pay to the bank.

Solution
P = Rs. 10, 00,000
i = 18%
n = 15 years
A =?

11 | P a g e
 Engineering Economy (17HS6ICEEM)

The corresponding cash flow diagram is shown in the figure 2.12

Figure 2.12 cash flow diagram

𝑖(1 + 𝑖)𝑛
𝐴=𝑃
(1 + 𝑖)𝑛 − 1

=P (A/P, i, n)
= 10, 00,000 (A/P, 18%, 15)

= 10, 00,000 (0.1964)

= Rs. 1, 96,400
The annual equivalent installment to be paid by the company to the bank is Rs. 1, 96,400.

Uniform Gradient Series Annual Equivalent Amount

The objective of this mode of investment is to find the annual equivalent amount of a series
with an amount A1 at the end of the first year and with an equal increment (G) at the end of
each of the following n – 1 year with an interest rate i compounded annually.

The corresponding cash flow diagram is shown in the figure 2.13

Figure 2.13 Cash flow diagram of uniform gradient series annual equivalent amount.

12 | P a g e
 Engineering Economy (17HS6ICEEM)

The formula to compute A under this situation is

(1 + 𝑖)𝑛 − 1
𝐴 = 𝐴1 + 𝐺
𝑖(1 + 𝑖)𝑛 − 𝑖

=A1+G(A/G, I ,n)

where(A/G, i, n) is called uniform gradient series factor

Problem 7: A person is planning for his retired life. He has 10 more years of service. He
would like to deposit 20% of his salary, which is Rs. 4,000, at the end of the first year, and
thereafter he wishes to deposit the amount with an annual increase of Rs. 500 for the next 9
years with an interest rate of 15%. Find the total amount at the end of the 10 th year of the
above series.
Solution

A1= Rs 4000
G=Rs 500
i= 15%
n= 10 years
A= ?
F= ??

Figure 2.14 cash flow diagrams

(1 + 𝑖 ) 𝑛 − 1
𝐴 = 𝐴1 + 𝐺
𝑖(1 + 𝑖)𝑛 − 1

𝐴1 + 𝐺(𝐴⁄𝐺, 𝑖, 𝑛)

=4,000 + 500(A/G, 15%, 10)

13 | P a g e
 Engineering Economy (17HS6ICEEM)

=4,000 + 500 X 3.3832

=Rs. 5,691.60
This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of every year for
the next 10 years. The future worth sum of this revised series at the end of the 10th year is
obtained as follows:

F= A (F/A, i, n)
=A (F/A, 15%, 10)
=5,691.60(20.304)
Rs. 1, 15,562.25

At the end of the 10th year, the compound amount of all his payments will be
Rs.1, 15,562.25.
Problem 8: A person is planning for his retired life. He has 10 more years of service. He
would like to deposit Rs. 8,500 at the end of the first year and thereafter he wishes to deposit
the amount with an annual decrease of Rs. 500 for the next 9 years with an interest rate of
15%. Find the total amount at the end of the 10th year of the above series.
Solution:
A1=Rs 8500
G=-Rs 500
I=15%
N=10 Years
A=? F=?

The cash flow diagram is shown in the figure 2.15

Figure 2.15 Cash flow diagram

14 | P a g e
 Engineering Economy (17HS6ICEEM)

(1 + 𝑖 ) 𝑛 − 1
𝐴 = 𝐴1 + 𝐺
𝑖(1 + 𝑖)𝑛 − 1

𝐴 = 𝐴1 + 𝐺(𝐴⁄𝐺, 𝑖, 𝑛)
A=8500-500(A/G, i, n)
= 8500-500(A/G,15%, 10)
= 8500-500(3.3832)
Rs 6808.4

This is equivalent to paying an equivalent amount of Rs. 6,808.40 at the end of every year for
the next 10 years.
The future worth sum of this revised series at the end of the 10th year is obtained as follows:
F= A (F/A, i, n)
=A (F/A, 15%, 10)
=6,808.40(20.304)
=Rs. 1, 38,237.75

At the end of the 10th year, the compound amount of all his payments is Rs. 1, 38,237.75.

Effective Interest Rate

Let i be the nominal interest rate compounded annually. But, in practice, the compounding
may occur less than a year. For example, compounding may be monthly, quarterly, or semi-
annually. Compounding monthly means that the interest is computed at the end of every
month. There are 12 interest periods in a year if the interest is compounded monthly. Under
such situations, the formula to compute the effective interest rate, which is compounded
annually, is
Problem 6. A person invests a sum of Rs. 5,000 in a bank at a nominal interest rate of 12%
for 10 years. The compounding is quarterly. Find the maturity amount of the deposit after 10
years.
Solution
P = Rs. 5,000
n = 10 years
i = 12% (Nominal interest rate)
F=?

15 | P a g e
 Engineering Economy (17HS6ICEEM)

Method 1
No. of interest periods per year = 4
No. of interest periods in 10 years = 10 x4 = 40
Revised No. of periods (No. of quarters), N = 40
Interest rate per quarter, r = 12%/4
= 3%, compounded quarterly.

F= P(1 + r)N = 5,000(1 + 0.03)40

= Rs. 16,310.19

Method 2
No. of interest periods per year, C = 4
Effective interest rate, R = (1 + i/C )C – 1
= (1 + 12%/4)4 – 1
=12.55%, compounded annually.
F= P(1 + R)n
= 5,000(1 + 0.1255)10 = Rs. 16,308.91

16 | P a g e
 EE_Module_1_Problems

Engineering Economics
• 7 principles of EE
1. Among alternatives
2. Differences in future outcomes
3.Outcomes of feasible alternatives
4.Common unit of measurement
5.Selection preferred alternative
6.Uncertainity
7.Improvement/revisit the decision

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 EE_Module_1_Problems

• Interest and interest factors

Interest rate, simple / compound interest factors, Cash flow
diagrams, Numerical excercises.
Interest – is a rent paid for money borrowed.
Two types
1. Simple interest
2. Compound interest ---
a)Nominal interest rates

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 EE_Module_1_Problems

b)Effective interest rates

c)Continuous compounding

Problems

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 EE_Module_1_Problems

1. The rental cost of money is a loan of Rs. 1000 for

2months @ 10%. Use simple interest.
Solution : P=1000
i=10%
N=2/12 years
F=P(1+i.N)
=1000(1+0.1*0.167)
=1016.67
F=1000(1+0.1(31+28/365))=1016.16
2.What sum must be loaned at 8% simple interest to earn
rs.350 in 4years.
When N is a full year
I = P*i*N
350=P*0.08*4
P=350/(0.08*4)
P= 1093.75
i=8%
N=4
I=350
P=?

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 EE_Module_1_Problems

3.How long will it take rs.800 to yield rs.72 in simple interest

at 4%.
N=?
P=800
I=72
i=4%
I=P*i*N
72=800*0.04*N
N=2.25years
4.At what rate will 65.07 yield Rs. 8.75 in simple interest in 3
years 6 months?
i=?
P=65.07
I=8.75
N=3.6years
I=P*i*N
8.75=65.07*i*3.5
i=3.8%
5.How long will it take any sum to triple itself at 5% simple
interest rate? Asssume P=100
Answer : i=5%, I=300,N=60yrs

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 EE_Module_1_Problems

6. Determine the effective interest rate for a nominal

annual rate of 6% that is compounded
i)Semi-annually – n=2
ii)Quarterly n=4
iii)Monthly n=12
iv)Daily n=365
Ans: r=6%=0.06
1) i=(1+0.06/2)^2 -1
i=6.09%
ii) i=6.13%
iii)i=6.16%
iv)6.18%

7. A personal loan of Rs.1000 is made for a period of

18 months at an interest rate of 1 ½ percent per month
on the unpaid balance. If the entire amount owed is
repaid in a lump sum at the end of that time, determine
the effective annual interest rate.
Ans: P=1000

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 EE_Module_1_Problems

N=18 months
i= 1 ½ * 12=18%
i=(1+0.18/18)^18 - 1
i=19.61%
8. Find the compound amount of Rs.100 for 4yrs at 6%
compounded annually.
Ans: P=100
N=4 , i=6%
F=P(1+i)^n
=100(1+0.06)^4
F=126.24

9. A loan of Rs.2000 , interest rate is 10% per year. If

interest had not been paid each year but, had been
allowed to compound, how much interest would be due
to the lender as a lump sum at the end of 6yrs?
Ans: P=2000
i=10% , N=6

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 EE_Module_1_Problems

F=2000(1+0.1)^6
F=3543.12
Interest = F – P =3543.12-2000=1543.12
10. Accumulate a principle of Rs.1000 for
5yrs 9months at a nominal rate of 12% compounded
monthly. How much interest is earned?
Ans: P=1000 , N=69months , i=12%=1% per month
F=1000(1+0.01)^69
=1986.89
Notation and Cash flow Diagrams
A cash flow is the difference between
total cash inflows(receipts)and
cash outflow(expenditures) for a specified period of
time.
Interest formulas for Discrete Compounding and Cash
flows
There are 6 most common discrete compound interest
factors,
For Single Cash flows
1. Single payment compound amount P, F?

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 EE_Module_1_Problems

2. Single payment present worth F , P?

For Uniform series
1. Uniform series compound amount
2. Uniform series present worth
3. Equal payment series sinking fund
4. Equal payment series annual equivalent amount
5. Arithmetic gradient conversion factor (to uniform
series).

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 EE_Module_1_Problems

1. single payment compound amount

To find F , given P
1. A person deposits a sum of rs.20000 at the
interest rate of 18% compounded annually for
10yrs. Find the maturity value after 10yrs?
P=20000
i=18%
F=P(F/P,i%N)

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 EE_Module_1_Problems

F=P(1+i)^n
=20000(1+0.18)^10
F=1,04,680
2. A person deposits a sum of rs.10,000 in a bank at a
nominal rate of interest of 12% for 10yrs.Find the
maturity amount of the deposit after 10yrs. if the
compounding is done quarterly.
P=10,000
i=12%(compounded quarterly)
N=10
F=?
Method-1
No. of interest periods per year=4
No. of interest periods for 10yrs=10*4=40
Revised n=40
Rate of interest =12/4=3% =0.03

F=10,000(1+0.03)^40
F=32620.37
Method-2
R=(1+i/N)^n – 1
=(1+0.12/4) ^4 – 1
R=12.55%
Hence R replaces ‘i’ in the formula,
F=P(1+i)^n
=10000(1+0.1255)^10
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 EE_Module_1_Problems

F=32,620
3.Suppose that 10,000 is borrowed now at 15% interest
per annum. A partial repayment of 3000 is made four
yrs from now. The amount that will be remain to be
paid then is most nearly (a) 7000 (b)8050 (c)8500
(d)13000 (e)14490.
P=10,000
i=15%
N=4
F =P(1+i)^n
=10,000(1+0.15)^4
=17490
The amount to be paid is
=17490-3000=14490
2.Single Payment present worth
To find P given F
1. An investor has an option to purchase a land that will
be worth Rs.10,000 in 6yrs. If the value of land
increases at 8% each year,how much should the
investor be willing to pay now for this property.
F=10,000

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 EE_Module_1_Problems

N=6yrs
i=8%
P=?
P=F(P/F,i%N)
P=10,000(P/F,8%,6)
P=10,000/(1+0.08)^6
P=6302
2. If a person wishes to invest in a private bank that
pays rate of interest 11% but compounded
quarterly. So that he gets 10,00,000 for 10yrs from
now.
F=10 lakhs
i=11%
No. of interest period per year =4
Total no. of interest periods for 10yrs=4*10=40
Interest quarterly=0.11/4
P=F(P/F,0.11/4,40)
P=10,00,000/(1+0.11/4)^40
P=3,37,852.22

Cash flow diagrams for the problems solved on single

payment compound amount and present worth.

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 EE_Module_1_Problems

Problems to be solved

1. A future amount F , is equivalent to Rs. 1500. Now when eight years

separates the amounts and the annual interest is 12%. What is the value of
F? Ans : 3713.9
2. Suppose you borrow Rs.8000 now, with the promise to repay the loan
principal plus accumulated interest in 4years at i=10% per year. How
much would you owe at the end of 4years? Ans: 11,713
3. A person wishes to have a future sum of Rs.10 lakhs for his daughter’s
engineering education in 15 years from now, what is the single payment

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 EE_Module_1_Problems

that he should deposit now. So, that he gets the desired amount after
10years? The banks gives 12% rate of interest compounded annually.
Ans: 3,21,973.3
4. A person wishes to have a future sum of Rs.1,00,000 for his son’s
marriage after 10years from now. What is the single payment that he
should deposit now. So, that he gets the desired amount after 10years?
The banks gives 15% interest rate compounded annually. Ans: 24,720

Probem 1 .

A person invests a sum of Rs.50,000 in a bank at a nominal interest rate of

18% for 15yrs. The compounding is monthly. Find the maturity amount of the
deposit after 15yrs.

P=50,000

i=18% = 18/12=1.5% (compounding monthly)

N=15 * 12=180

F=?

F=P(1+i)^n

F=50000(1+1.5/100) ^180

F=7,29,218.4

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 EE_Module_1_Problems

Prepared by Prof.Suman M, CSE, DSCE

 EE_Module_1_Problems

3. Series Compound amount factor (uniform series)

To find F, given A
1. A 45 year old person is planning for his retired life. He
plans to divert Rs. 30,000 from his bonus as investment
every year for the next 15yrs. The banks gives 10%

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 EE_Module_1_Problems

interest rate compounded annually. Find the maturity

value of his account when he is 60yrs old.
A=30,000 , N=15 , i=10% , F=?
F=A(F/A,i%N)
F=30,000[(1+0.1)^15 – 1 ] / 0.1
F=9,53,174

2. An automobile company recently advertised its car for a

down payment of Rs.1,50,000. Alternatively, the car can
be taken home by customers without making any
payment,but they have to pay an equal yearly amount of
Rs.25,000 for 15yrs at an interest rate of 18%
compounded annually.
Ans: Car value=P=1,50,000
A=25,000 , N=15 , i=18%
F=A(F/A,i%,N)
F=25000[(1+0.18)^15 – 1]/0.18
F=15,24,131.6

4. Sinking fund factor (Uniform series)

1. A person estimates an expenditure of Rs. 5 lakh for his
daughter’s wedding about 10yrs from now. He plans to
deposit an equal amount at the end of every year for the
next 10yrs at the rate of interest of 10% compounded
annually. Find the equivalent amount that must be
deposited at the end of every year for the next 10yrs.
F=5,00,000
N=10

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 EE_Module_1_Problems

A=? i=10%
A=500000(A/F,i%,N)
A=500000 * 0.1 / [(1+0.1)^10 – 1]
A=31,372.7 is the annual amount to be paid.

2.A company has to replace a present facility after 15yrs

at an outlay of Rs.5 L . If he plans to deposit an equal
amount at the end of every year for the next 15yrs at the
rate of interest of 18% compounded annually. Find the
equivalent amount that must be deposited at the end of
every year for the next 15yrs.
F=5,00,000 , N=15 , i=18% , A=?
A=F(i/(1+i)^n – 1 )
A=500000 (A/F,18%,15)
A=500000 * 0.0164
A=8200

5. Series Present Worth factor (Uniform series)

1. A company wants to set up an reserve which will help
the company to have an annual equivalent amount of
Rs.10,00,000 for the next 20yrs towards its employees
welfare measures.The reserve is assumed to grow at the
rate of 15% annually. Find the single payment that must
be made now as the reserve amount.
A=10,00,000 , N=20 , i=15% , P=?
P=A(P/A,i%,N)
P=[1000000(1+0.15)^20 – 1] / 0.15(1+0.15)^20
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 EE_Module_1_Problems

P=62,59,300

2. Suppose that installation of low-loss thermal windows in

your area is expected to save Rs.150 a year on your home
heating bill for next 18yrs. If you can earn 8% a year on
other investments, how much could you afford to spend
now for these windows?
A=150 , N=18 , i=8% , P=?
P=A(P/A,8%,18)
P=150 * (1+0.08)^18 – 1 / 0.08(1+0.08)^18
P=1405.8

6. Capital Recovery Factor (Uniform series)

1. A proposed product modification to avoid production
difficulties will require an immediate expenditure of
Rs.14,000 to modify certain dies. What annual savings
must be realised to recover this expenditure in 4yrs
with interest at 10% ?
i=10% , N=4 , P=14000
i ( 1 + i) n
A=P∗
( 1 + i) n − 1
0.1(1+0.1)4
A=14000 ∗ (1+0.1)4 − 1

A=4416.6

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 EE_Module_1_Problems

2. ICICI bank is offering Rs. 30 lakhs home loan to a

person to buy a new apartment at a interest rate of
7.5% compounded annually. This amount should be
repaid in 15yrs equal instalments. Find the annual
instalment amount the person has to pay to the bank.
P=30,00,000 N=15 i=7.5% A=?

i(1+i)n
A= P ∗ (1+i)n −1

0.075(1+0.075)15
A=3000000 ∗ (1+0.075)15 − 1
A=3,39,861 per annum

If the bank decides to compound the rate of interest

monthly rather than annually,how much less money
the person has to pay annually?
No. of interest periods per year = N=12
Total no. of interest periods n=12*15=180
Annual rate of interest=7.5%
Rate of interest per month = 0.075/12=0.00625
0.00625(1+0.00625) 180
A=3000000 ∗ (1+0.00625)180 − 1
A=27,810
He has to pay 3,39,861 – (27810*12)
=6141 less/year.

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 EE_Module_1_Problems

3. A company 3yrs ago borrowed 40,000 to pay for a

new machine tool, agreeing to repay the loan in 100
monthly payments at an annual nominal interest rate of
12% compounded monthly. The company now wants
to pay off the loan. How much would this payment be,
assuming no penalty costs for early payout?
P=40,000 i=12% =12/12=1% N=100months A=?
i(1+i)n
A= P ∗ (1+i)n −1

0.01(1+0.01)100
A=40000 ∗ (1+0.01)100 − 1
A=634.6
F=P(F/P,1%,36)
=P(1+i)^n
=40000 (1+0.01)^36
F=57230.75
The worth of 40000 for 3yrs is 57,230.75 and installement
payed for 3yrs = 634.6*36=22845.6
The pay off amount = 57320.75 – 22845.6 = 34385.2

7.Arithmetic Gradient Conversion Factor ( Uniform series)

To find annual equivalent amount of a series with an
amount A1 @ end of first year and with an equal
increment (G ) at the end of (n-1) yrs with i% interest.

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 EE_Module_1_Problems

1. Assume that an endowment was originally set up to

provide a Rs. 10000 as first payment with payments
decreasing by 1000 each year during the 10 year
endowment life. What constant annual payment for
10yrs would be equivalent to the original endowment
plan if i=8% ?
A1=10,000 , i=8% , G=1000 , N=10

1 n
A = A1 + G [ i − (1+i)n −1 ]

1 10
A = 10000 − 1000 [ 0.08 − (1+0.08)10− 1 ]

A=10000 – 3871.31
A=6128.69

2. A person is planning for his retired life. He has 10

more yrs of service. He would like to deposit 20% of
his salary, which is Rs.4000 at the end of 1st year and
thereafter he wishes to deposit the amount with an
annual increase of Rs.500 for the next 9yrs with an
interest rate of 15%. Find the total amount at the end
of the 10th year of above series.
A1=4000 , G=500 , i=15% , N=10 , A=? , F=?
1 n
A = A1 + G [ i − (1+i)n −1 ]

1 10
A = 4000 + 500 [ 0.15 − (1+0.15)10− 1 ]

A=4000+500(3.3832)
A=5,691.60
F=A(F/A,15%,10)
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 EE_Module_1_Problems

F=5691.60 * 20.304
F=1,15,562.25

3. A film star is at the height of his carrier. He wants to

invest Rs. 10 lakhs from the end of this year and
follow it up with 9 lakhs, 8 lakhs and so on for the
next five yrs, when his income would go on
diminishing. Find the maturity amount 6 yrs later if a
film producer agrees to pay him 15% rate of
interest,compounded annually.
A1=10,00,000 i=15% N=6 G=100000 F=? A=?
A=A1 – G (A/G,15%,6)
A=1000000 – 100000(2.09719)
A=7,90,281

F=A(F/A,15%,6)
F=7,90,281 (8.75374) from discrete series table
F=69,17,914

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 EE_Module_1_Problems

Problems to be solved
1. A person deposits a sum of Rs.1,00,000 in a bank for his son’s
education who will be admitted to a professional course after
6yrs. The bank pays 15% interest rate, compounded
annually.Find the future amount of the deposited money at the
time of admitting his son in the professional course.
Ans: F=2,31,306
2. A person needs a sum of Rs. 2,00,000 for his daughter’s marriage
which will take place 15yrs from now. Find the amount of money
that he should deposit now in a bank if the bank gives 18%
interest,compounded annually.Ans: P=16703.2
3. A person who is now 35yrs old is planning for his retired life. He
plans to invest an equal sum of Rs. 10,000 at the end of every
year for the next 25yrs. The banks gives 20% interest rate
compounded annually. Find the maturity value of his account
when he is 60yrs old. Ans: F=47,19,810
4. A woman wishes to have Rs. 1,00,000 in her retirement savings
plan after working for 25yrs. She will accomplish this by
depositing Rs. A each year in a savings acoount that earns 6% per
year. How much must she save each year. Ans : A=1822
5. A financial institution introduces a plan to pay a sum of
Rs.15,00,000 after 10yrs at the rate of 18% compounded
annually. Find the annual equivalent amount that a person should
invest at the end of every year for the next 10yrs to receive
Rs.15,00,000 after 10yrs from the institution.Ans:A=63771.96
6. A person wants to give scholarship to poor students of Rs.25,000
every year. He wants to deposit a lumpsum in the bank which
makes him receive the required amount every year for next 20yrs.
The reserve is assumed to grow annually at the rate of 9%. Find
the single payment that must be made now as the reserve amount?
Ans: P=2,28,213

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 EE_Module_1_Problems

7. It is estimated that a certain piece of equipment car save Rs.6000 per year
in labour and materials costs. The equipment has an expected life to 5yrs.
If the company must earn a 20% rate of return on such investments,how
much could be justified now for the purchase of this piece of equipment?
Draw a cash flow diagram. Ans:P=17,943.7
8. If Rs.25000 is deposited now into a savings account that earns 12% per
year, what uniform annual amount could be withdrawn at the end of each
year for 10yrs so that nothing would be left in the account after the tenth
withdraw? Ans : A=4422.5
9. A bank gives a loan to a company to purchase an equivalent worth
Rs.10,00,000 at an interest rate of 18% compounded annually. This amount
should be repaid in 15yearly equal instalments. Find the instalment amount
that the company has to pay to the bank.
Ans: A=1,96,400
10. A person is planning for his retired life. He has 10 more yrs of service. He
would like to deposit 20% of his salary, which is Rs.10,000 at the end of
1st year and thereafter he wishes to deposit the amount with an annual
increase of Rs.2000 for the next 9yrs with an interest rate of 20%. Find the
total amount at the end of the 10th year of above series.
Ans : A=16147.7 and F=419173.01

Prepared by Prof.Suman M, CSE, DSCE