LECTURE 4

1-1
 Chapter 1 Revision

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 Rate of Return
Incase Ford Motor Company’s profits increased from 22 cents
per share to 29 cents per share in the April–June quarter
compared to the previous quarter, what was the rate of increase
in profits for that quarter?

Rate of increase = [(29 – 22)/22]*100

= 31.8%

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Actual vs Expected Return
At an interest rate of 8% per year, $10,000 today is equivalent to
how much
(a) 1 year from now and (b) 1 year ago?

• (a) Equivalent future amount

= 10,000 + 10,000(0.08)
= 10,000(1 + 0.08)
= $10,800
(b) Equivalent past amount: P + 0.08p = 10,000
1.08p = 10,000
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P = $9259.26 023
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 Rate of Return
Badger Pump Company invested $500,000 five years ago in
a new product line that is now worth $1,000,000. What rate
of return did the company earn
(a) on a simple interest basis and
(b) on a compound interest basis?

• Simple: 1,000,000 = 500,000 + 500,000(i)(5)

I = 20% per year simple
• Compound: 1,000,000 = 500,000(1 + i)5
(1 + i)5 = 2.0000
(1 + i) = (2.0000)0.2
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I = 14.87% 023
 Repayment
Companies frequently borrow money under an arrangement
that requires them to make periodic payments of only
interest and then pay the principal of the loan all at once.
A company that manufactures odor control chemicals
borrowed $400,000 for 3 years at 10% per year compound
interest under such an arrangement.

What is the difference in the total amount paid between this

arrangement (identified as plan 1) and plan 2, in which the
company makes no interest payments until the loan is due
and then pays it off in one lump sum?

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 Repayment
Borrowed $400,000 for 3 years at 10% per year
compound interest

• Plan 1: Interest Paid each Year , Principal paid at the end

interest paid each year = 400,000(0.10) = $40,000
Total paid = 40,000(3) + 400,000 = $520,000

• Plan 2: All paid at the end

total due after 3 years = 400,000(1 + 0.10)3 = $532,400

Difference paid = 532,400 – 520,000 = $12,400 05/10/2023 8

Engineering Economy

[2-1]
Time Value of Money
Single Cash Flow

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Project Cash Flows

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3
 The Five Types of Cash Flows
Cash flow transactions can be generally classified into five
general categories:
(1) Single cash flow

(2) Uniform series

(3) Linear gradient series

(4) Geometric gradient series, and

(5) Irregular series 05/10/2 12

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 Single Cash Flow
• The simplest case involves the equivalence of a single present
amount and its future worth

• Thus, the single-cash-flow formulas deal with only two

amounts: a single present amount P and its equivalent future
worth F

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Single Cash Flow

You have
P find F

You have
F find P

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 Equal (Uniform) Series
• Includes transactions arranged as a series of equal cash flows at
regular intervals, known as an equal payment series (or uniform
series)

• The equal-cash-flow formulas deal with the equivalence

relations P, F, and A (where A is the constant amount of the cash
flows in the series) Annuity

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 Linear Gradient Series
• A common pattern of variation occurs when each cash flow in
a series increases (or decreases) by a fixed amount

• A five-year loan repayment plan might specify, for example,

a series of annual payments that increase by $500 each year

• We call this type a linear gradient series because its cash flow
diagram produces an ascending (or descending) straight line

• In addition to using P, F, and A, the formulas employed in

such problems involve a constant amount G of the change in
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each cash flow 023
Linear Gradient Series

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023
 Geometric Gradient Series
• This type is formed when the series in a cash flow is
determined not by some fixed amount like $500, but by some
fixed rate, expressed as a percentage

• The curving gradient in the diagram is named the geometric

gradient series

• In the formulas dealing with such series, the rate of change is

represented by a lowercase g

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Geometric Gradient Series

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 Irregular (Mixed) Series
A series of cash flows may be irregular, in that it does not
exhibit a regular overall pattern

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 Single-Payment Factors
• We know that the amount of money F accumulated after n
years from a present worth P with interest compounded one
time per year is given by the following equation  F = P(1+i)n

• The factor (1+i)is called the single-payment compound

n

amount factor (SPCAF) and is usually referred to as the F/P

factor

• The factor P/F is known as the single-payment present worth

factor (SPPWF)
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 Single-Payment Factors
• Note that single payment means that only one payment or receipt is
involved

• A standard notation has been adopted for all the economic factors and is
always in the general form (X/Y,i,n)

• The letter X represents what is sought, while the letter Y represents

what is given

• For example, F/P means find F when P is given

• Thus, (F/P,6%,20) represents the factor that is used to calculate the

future amount F accumulated in 20 periods if the interest rate is 6% per22
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period. P is given 023
 Single-Payment Factors
Thus, (F/P,6%,20) represents the factor that is used to calculate the future
amount F accumulated in 20 periods if the interest rate is 6% per period.
P is given

The value of (P/F,5%,10)  P = F[1/(1+i)n] = 0.6139

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 Single-Payment Factors
Example
If you had $2,000 now and invested it at 10%, how much
would it be worth in eight years?

F = P(1+i)n = $2,000 × (1+0.1)8 = $4,287.18

Or
F = P(F/P,i,n) = 2,000(F/P,10%,8)

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 Single-Payment Factors
Example
• The office supplies for an engineering firm for different years were as follows:
Year 0: $600; Year 2: $300; and Year 5: $400

• What is the equivalent value in year 10 if the interest rate is 5% per year?

• Draw the cash flow diagram for the values $600, $300, and $400

• Use F/P factors to find F in year 10

• F = 600(F/P,5%,10) + 300(F/P,5%,8) + 400(F/P,5%,5) = 600×(1.6289) +

300×(1.4775) + 400×(1.2763) = $1931.11

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 Example

Decomposition and Superposition

• A company wishes to set aside money now to invest over the

next four years. The company can earn 10% on a lump sum
deposited now, and it wishes to withdraw the money in the
following increments:

• Year 1: $25,000
• Year 2: $3,000
• Year 3: No expenses
• Year 4: $5,000

• How much money must be deposited now to cover the

anticipated payments over the next 4 years?
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 Example
Decomposition and Superposition
• Apparently, one way to deal with an uneven series of cash
flows is to calculate the equivalent present value of each
single cash flow and to sum the present values to find P

• That is, the cash flow is broken into three components

(decomposition) and later all the three present values are
summed up (superposition)

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 Example
Decomposition and Superposition

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 Example
Decomposition and Superposition
• To see if the needed $28,622 is sufficient, let’s calculate the balance at the
end of each year

• If you deposit $28,622 now, it will grow to (1.10)($28,622), or $31,484, at the

end of year 1. From this balance, you pay out $25,000

• The remaining balance, $6,484, will again grow to (1.10)($6,484), or $7,132,

at the end of year 2. Now you make the second payment ($3,000) out of
this balance, which will leave you with only $4,132 at the end of year 2

• Since no payment occurs in year 3, the balance will grow to $(1.10)2($4,132),

or $5,000, at the end of year 4

• The final withdrawal in the amount of $5,000 will deplete the balance
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