Lecture 8 Principles of

INTRODUCTION Engineering Economics

BES 213
Engineering
Economics
Define and explain annuity
including its application and
compute and calculate the
present and future values of
annuities using appropriate
formulas.
INTRODUCTION Principles of Eng. Economics

Time Value of Money

“The value of money changes over

time due to its potential earning
capacity. A dollar today is worth
more than a dollar in the future
because of its potential to earn
interest or be invested in profitable
ventures.”
ANNUITY 1.1. Definition and Terminologies
Annuity
• making payments for an item several times over a period of time
• sequence of equal payments at equal intervals is called annuity
• a series of equal payments made at regular intervals over a specific period.
• monthly payment on a house
Examples:
• Monthly payment on a car
Payment (A)
• the fixed amount paid or received in each period.
Interest Rate (i)
• the percentage charged or earned per period, usually expressed as an
annual percentage rate (APR).
Number of Periods (n)
• the total number of payments made during the annuity’s life (e.g., months, years).
Sinking Fund
• is fund or account into which annual deposits A are made in order to accumulate F
at t = n in the future
ANNUITY 1.1. Definition and Terminologies
Present Value of Annuity (P)
• the current worth of all future annuity payments, discounted at the given interest
rate.
• also known as discounting, determines the current worth of cash to be
received in the future.
Future Value of Annuity (F)
• the total value of annuity payments at the end of the period, including interest
earned.
Compounding
• the process of calculating interest on both the principal and previously
earned interest over multiple periods.
Payment interval or period
• time between consecutive payments
Term or Length of Annuity
• found by multiplying the number of payments by the payment period
ANNUITY 1.1. Definition and Terminologies
Number of payments per year for different payment intervals
ANNUITY 1.2. Types of Simple Annuities

In engineering economy, annuities are classified into four categories. These are:
(1) ordinary annuity, (2) annuity due, (3) deferred annuity, and (4) perpetuity.

1. Ordinary Annuity
• In ordinary annuity, the equal payments are made at the end of each
compounding period starting from the first compounding period.
ANNUITY 1.2. Types of Simple Annuities

Cash Flow Diagram of Ordinary Annuity

From the cash flow diagram shown above, the future amount F is the sum of
payments starting from the end of the first period to the end of the nth period.
Observe that the total number of payments is n and the total number of
compounding periods is also n. Thus, in ordinary annuity, the number of
payments and the number of compounding periods are equal.
ANNUITY 1.2. Types of Simple Annuities

Future amount of ordinary annuity, F

n
F = future value
1+i −1
1+i n −1 where
A = periodic payment (annuity amount) i
F=A
i i = interest rate per period
This factor is called equal-
n = number of periods
payment-series compound-
Derived Formulas: amount factor

Solving for A: Solving for i:

Rearrange to solve for i: Rearrange to solve for i:
F 𝐹 1+𝑖 𝑛 −1
A= = Fi
1+i n −1 𝐴 𝑖 1+i n
= +1
i A
Fi n
= 1+i −1 i is solved numerically.
A
𝑛
𝐹𝑖
1+𝑖 −1=
𝐴
ANNUITY 1.2. Types of Simple Annuities

Solving for n:
From previous formula: Natural Log Rules

𝑛
𝐹𝑖 • ln (mn) = ln m + ln n
1+𝑖 = +1
𝐴 • ln (m/n) = ln m - ln n
• ln mn = n ln m
Taking the natural logarithm on both sides:
• ln a = (log a) / (log e)
Fi • ln e = 1
n ln 1 + i = ln +1 • ln 1 = 0
A
Fi
ln +1
n = A
ln 1 + i
ANNUITY 1.2. Types of Simple Annuities

Present amount of ordinary annuity, P

1+𝑖 𝑛 − 1 𝑛
𝐴 1+𝑖 −1
𝐹 F 𝑖 𝐴 𝑖 1+𝑖 𝑛
−1
P= n OR P= n
= 𝑛 P= =𝐴 ÷ 1+𝑖 𝑛
1+i 1+i 1+𝑖 1+𝑖 𝑛 𝑖

P = present value 1+𝑖 𝑛−1 𝑛

1+𝑖 𝑛−1 1
P=𝐴 ÷ 1+𝑖 =𝐴 × 𝑛
𝑖 𝑖 1+𝑖

1+𝑖 𝑛−1 1+𝑖 𝑛−1 This factor is called equal-

P=𝐴 where payment-series present-
𝑖 1+𝑖 𝑛 𝑖 1+𝑖 𝑛
worth factor
Derived Formulas:
Solving for i: Solving for n:
Solving for F: Rearrange to solve for n:
Rearrange to solve for F: Rearrange to solve for i:
F=P 1+i n Taking the natural logarithm:
n
F = P 1+i n
F ln
1
1+i = Pi
P 1− A
i is determined numerically n=
ln 1 + i
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
Illustrative Examples
1. How much did Grandpa accumulate by depositing PHP 1,500 at the end of each
quarter for 9 years if he got 8 percent interest compounded quarterly?
Solution: Given: A = 1,500; i = 0.08/4 = 0.02; n = (9) (4) = 36; F = ?
1 + 0.02 36 − 1 1.02 36 − 1
F = 1,500 = 1,500 = 77,991.55
0.02 0.02
F = PHP 77,991.55
2. Auto loan requires payments of PHP 300 per month for 3 years at a nominal
annual rate of 9% compounded monthly. What is the present value of this loan and
the accumulated value at its conclusion?
Solution: Given: A = 300; i = 0.09/12 = 0.0075; n = (12) (3) = 36; F = ?; P = ?
a. Accumulated value
1 + 0.0075 36 − 1 1.0075 36 − 1
F = 300 = 300 = 12,345.81
0.0075 0.0075
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
b. Present value
F 12,345.81 12,345.81
P= n = = = 9,434.042= PHP 9,434.042
1+i 1+0.0075 36 1.308645

3. Suppose that you buy a house for PHP 125,000.00, make a down payment of
PHP 25,000.00 and must pay off the remaining PHP 100,000.00 on time. If the
interest rate is 12 percent compounded monthly, and the term is 30 years, what
must your monthly payment be?
Solution: Given: P = 100,000; i = 0.12/12 = 0.01; j = 0.12; m = 12; n (term)
= 30; mn (length of annuity) = (12) (30) = 360, S = ?; R = ?

a. Accumulated Value/Future Value (F) using Nominal Rate – from previous slides
𝑚𝑛 12 30
j 0.12 360
S=P 1+ = 100,000 1 + = 100,000 1.01 = 3,594,964.10
𝑚 12
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
b. Periodic payment for each month for 30 years
1+𝑖 𝑛 −1 𝐹
F= 𝐴 ;𝐴 = 1+𝑖 𝑛 −1
𝑖
𝑖

3,594,964.10 3,594,964.10
A= = = 1,028.61
1 + 0.01 360 − 1 3,494.9641
0.01
A = PHP 1,028.61
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
4. Find the present value of an amount of PHP 240 per quarter for 12 years if the rate is
12 percent compounded quarterly.
Solution: Given: A = 240; i = 0.12/4 = 0.03; n = (12) (4) = 48; P = ?
F
Solving for P: P=
1+i n
n
1+i −1 1 + 0.03 48 − 1
F=𝐴 = 240
i 0.03
48
1.03 − 1
F = 240 = 240 104.4084 = 25,058.12
0.03
Solving for A:
F 25,058.12 25,058.12
P= n
= = = 6,064; A = PHP 6,064
1+i 1 + 0.03 48 4.1323
ANNUITY 1.2. Types of Simple Annuities

2. Annuity Due
• In annuity due, the equal payments are made at the beginning of each
compounding period starting from the first period.

As indicated in the
diagram, F1 is the sum of
ordinary annuity
of n payments. The future
amount F of annuity due
at the end of nth period is
one compounding period
away from F1. In
symbol, F = F1(1 + i).
Cash Flow Diagram of Annuity Due
ANNUITY 1.2. Types of Simple Annuities

Future amount of annuity due, F

𝑛 Note:
𝐴 1+𝑖 −1 Please refer to derivations of
𝐹 = 𝐹1 1 + 𝑖 = 1+𝑖
𝑖 formulas in the previous slides.

Present amount of annuity due, P

−𝑛
𝐹 𝐴 1+𝑖 𝑛−1 𝐴 1− 1+𝑖
𝑃= = 1+𝑖 OR 𝑃= 1+𝑖
1+𝑖 𝑛 1+𝑖 𝑖𝑛 𝑖

Note: Please refer to derivations of formulas in the previous slides.

Number of periods, n
F
log +1
A 1+i
n=
log 1 + i
ANNUITY 1.2. Types of Simple Annuities

Illustrative Examples
1. An engineering firm sets aside $10,000 annually at the 2. A municipality plans to invest $50,000 at the
beginning of each year to cover future equipment beginning of each year into a fund for a bridge
maintenance costs for the next 8 years. The interest rate is maintenance project over 12 years. The investment
7% per year. How much should the firm set aside today to earns 6% interest annually. What will be the total
cover all future payments? amount available at the end of 12 years?
Solution: Given: A = 1,500; i = 0.07; n = 8; P = ? Solution: Given: A = 50,000; i = 0.06; n = 12; F = ?
𝐴 1− 1+𝑖 −𝑛 A 1+i n
−1
𝑃= 1+𝑖 F = F1 1 + i = 1+i
𝑖 i
−8 1 + 0.06 12 − 1
10,00 1 − 1 + 0.07 F = 50,000 1 + 0.06
𝑃= 1 + 0.07 0.06
0.07
10,00 1 − 1.07 −8 1.06 12 − 1
𝑃= 1.07 F = 50,000 1.06
0.07 0.06
10,00 1 − 0.5820 2.0122 − 1
𝑃= 1.07 F = 50,000 1.06
0.07 0.06
10,00 1 − 0.5820 1.0122
𝑃= 1.07 F = 50,000 1.06
0.07 0.06
10,00 0.4180 F = 50,000 16.87 1.06
𝑃= 1.07
0.07
P = 63,800.00 USD F = 894,000
ANNUITY 1.2. Types of Simple Annuities

3. A manufacturing company plans to accumulate $1,000,000 for the replacement of an

aging machine by depositing $75,000 at the beginning of each year in an account earning
5% annual interest. How many years will it take to reach the target?
Solution: Given: F = 1,000,000; A= 75,000; i = 0.05; n = ?
F
log +1
A 1+i
n=
log 1 + i
log 12.70 + 1
n=
1,000,000 log 1.05
log +1
75,000 1 + 0.05 log 13.70 1.14
n= n= = = 53.77 ≈ 54 𝑦𝑒𝑎𝑟𝑠
log 1 + 0.05 log 1.05 0.0212
1,000,000
log +1
78,750
n=
log 1.05
ANNUITY 1.2. Types of Simple Annuities

3. Deferred Annuity
• In deferred annuity the first payment is deferred a certain number of
compounding periods after the first.

In the diagram below,

the first payment was
made at the end of
the kth period
and n number of
payments was made.
The n payments form
an ordinary annuity
Cash Flow Diagram of Deferred Annuity
ANNUITY 1.2. Types of Simple Annuities
Future amount of deferred annuity, F where: A = Periodic payment
1+𝑖 𝑛−1 𝑑 i = Interest rate per period
𝐹=𝐴 1+𝑖
𝑖 n = Number of payment periods
Present amount of deferred annuity, P d = Deferral period (number of
−𝑛 periods before payments start)
1− 1+𝑖 −𝑑
𝑃=𝐴 1+𝑖
𝑖
Periodic Payment for a Deferred Annuity, A
𝑃
𝐴= −𝑛
1− 1+𝑖 −𝑑
1+𝑖
𝑖 Number of Periods for a Deferred Annuity, n
OR
P i
F ln 1 − A
𝐹 ln i +1 1+i −d
𝐴= A 1+i d OR n=
1+𝑖 𝑛−1 𝑑 n= ln 1 + i
1+𝑖 ln 1 + i
𝑖
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
Illustrative Examples
1. A civil engineer is saving for a bridge 2. A wastewater treatment plant will need new filtration
maintenance project. The project will need systems in 8 years. The engineer plans to deposit
₱200,000 per year for 10 years, starting 5 years ₱50,000 annually into a reserve fund for 12 years, with
from now. If the interest rate is 6% annually, what is the first deposit starting after 8 years. The fund earns 5%
the present value of this deferred annuity? annually. What will be the future value of the fund at the
end of the deposits?
Solution: Given: A = 200,000; i =
0.06; n = 10; d = 5 years; Solution: Given: A = 50,000; i = 0.05; n = 12; d= 8; F=?
P=? 1+𝑖 𝑛−1 𝑑
𝐹=𝐴 1+𝑖
1− 1+𝑖 −𝑛 𝑖
−𝑑
𝑃=𝐴 1+𝑖
𝑖 1 + 0.05 12 − 1 8
F = 50,000 1 + 0.05
0.05
1 − 1 + 0.06 −10 −5
P = 200,000 1 + 0.06 1.05 12 − 1 8
0.06 F = 50,000 1.05
1 − 1.06 −10 0.05
P = 200,000 1.06−5 1.7959 − 1
0.06 F = 50,000 1.4775
1 − 0.5584 0.05
P = 200,000 1.06−5
0.06 F = 50,000 15.918 1.4775 ≈ ₱1,175,630
P = 200,000 7.36 0.7473 ≈ ₱1,099,990.00
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
3. A hydrologist is planning a flood control project that requires ₱5,000,000 in 20 years. If
the government deposits ₱100,000 annually, starting after 5 years, into a trust fund
earning 4% annually, how many years will it take to reach the target fund?
Solution: Given: F = 5,000,000; A=100,000; i = 0.04; ?; d= 5; n=?
F
ln i +1
A 1+i d
n=
ln 1 + i
5,000,000
ln 0.04 + 1
100,000 1 + 0.04 5
n=
ln 1 + 0.04
5,000,000
ln 121,670 0.04 + 1
n=
ln 1 + 0.04
ln 1.643 + 1
n= ≈ 24.8 𝑦𝑒𝑎𝑟𝑠
ln 1.04
ANNUITY 1.2. Types of Simple Annuities
4. Perpetuity
• Perpetuity is an annuity where the payment period extends forever, which means
that the periodic payments continue indefinitely.

There is no definite future in perpetuity,

thus, there is no formula for the future
amount.
Present amount of perpetuity, P
𝐴
Cash Flow Diagram of Perpetuity 𝑃=
𝑖
Future amount of perpetuity, F A = Pi
There is no definite future in perpetuity, thus,
𝐴
there is no formula for the future amount. i=
𝑃
ANNUITY 1.2. Accumulated and Present Value
of the Annuity
Illustrative Examples
1. A renewable energy company has installed a wind 3. A mechanical engineering company is evaluating an
turbine that generates revenue from electricity sales. investment in industrial machinery that generates
The company expects to receive ₱500,000 per year ₱750,000 annually in cost savings indefinitely. If the
indefinitely. If the required rate of return on investments machine was purchased for ₱12,500,000, what is the
in renewable energy is 8% per year, determine the implied rate of return on the investment?
present value of this perpetual cash flow.
Solution: Given: P = 12,500,000; A = 750,000; i=?
Solution: Given: A=500,000; i = 0.08; ?; P=?

𝐴 𝐴 750,000
𝑃= 500,000 i= = = 0.06 = 6%
𝑖 𝑃= = ₱ 6,250,000 𝑃 12,500,000
0.08

2. A civil engineering firm wants to set up an infrastructure

maintenance fund to cover annual maintenance expenses of
a bridge indefinitely. If the present value of the fund is
₱20,000,000 and it earns 6% per year, how much should be
withdrawn annually to maintain the bridge?
Solution: Given: P = 20,000; i = 0.06; ?; A= ?

A = Pi A = 20,000) 0.06 = ₱1,200,000

ANNUITY