Lecture # 6
Engineering Economics (MS-291)
Chapter 2
Factors: How Time and Interest Affect Money
Dr. Muhammad Ullah
Assistant Professor
School of Management Sciences GIKI
Recap
• Costs
– Fixed vs. Variable
– Private vs. Social Cost
– Prospective vs. Sunk Cost
– Opportunity Cost
• Product Life Cycle
Contents
• Single-Payment Compound Amount Factor (SPCAF)
• Single-Payment Present Worth Factor (SPPWF)
• Uniform Series Present Worth Factor (USPWF)
• Capital Recovery Factor (CRF)
• Uniform Series Compound Amount Factor (USCAF)
• Sinking Fund Factor (SFF)
Single-Payment Compound Amount Factor
If an amount is invested at time the amount accumulated after a year is given as;
At the end of 2nd year, the accumulated amount is given by;
Similarly;
Single Payment Compound Amount
Factor (SPCAF), also factor
Generalized formula for calculating future values is given by;
Single Payment Present Worth
Factor, factor
In book, the notation is;
Quick Check
• A person deposits Rs. 5000 into an account which pays interest at a rate of 10% per year.
The amount in the account after 5 years is closest to:
(A) Rs. 2,792 (B) Rs. 9,000 (C) Rs. 8,050 (D) Rs. 12,165
Cash Flow Diagram
𝑭 =?
𝒊=𝟏𝟎 %
Solution Using Formula 0 1 2 3 4 5
𝐹 =𝑃 (1+𝑖)𝑛
P= - 5000
¿ 5000(1+0.10) 5
= 8,052.5
Example
• After graduation, Mr. Saad Hassan, an Electrical Engineer is planning to
go on vacation to London in five years time. This trip will cost him Rs.
500,000. How much, does he need to deposit today at the rate of 10% in a
saving account to have Rs. 500,000 at the end of five years?
Cash Flow Diagram
Solution Using Formula 500,000
𝑃 = 𝐹 ( 1+𝑖 )− 𝑛 𝒊=𝟏𝟎 %
−5
¿ 500,000 ( 1+ 0.10 ) 0 1 2 3 4 5
= 310,450
P= ?
Factor Notation
• This notations includes two cash flows symbols, interest rate and number of periods
• General form is: (X/Y, i, n) which means calculating “X” from “Y”. i.e. X is required and
Y is given, “i” is interest rate and “n” is number of periods.
Calculating Future Values
Solution Using Formula Cash Flow Diagram Solution Using Factor
𝐹 =𝑃 (1+𝑖)𝑛 𝑭 =? 𝐹 =𝑃 (𝐹 / 𝑃 , 𝑖 , 𝑛)
𝒊=𝟏𝟎 %
¿ 5000(1+0.10) 5 0 1 2 3 4 5 ¿ 5000(𝐹 / 𝑃 ,10 % , 5)
= 8,052.5 ¿ 5000(1.6105)
P= - 5000 ¿ 8,052.5
Calculating Present Values
Cash Flow Diagram
Solution Using Formula 500,000
Solution Using Factor
𝑃=𝐹 ( 1+𝑖 )− 𝑛 𝒊=𝟏𝟎 % 𝑃=𝐹 (𝑃 / 𝐹 , 𝑖 , 𝑛)
¿ 500,000(𝑃 / 𝐹 ,10 % , 5)
0 1 2 3 4 5
−5
¿ 500,000 ( 1+ 0.10 )
= 310,450 ¿500,000(0.6209)
P= ?
¿ 310,450
Compounding
• Compounding is the process of converting present values “P” into a future amount “F”
• Compounding increase your amount as it’s being compounded.
• Compound factors
Discounting
• Discounting is the process of converting a future amount “F” into present amount “P”.
• Discounting decrease your amount as it’s being discounted.
Discounting Compounding
13
Uniform Series/ Annuities
• Practically, we do not face Single Payments mostly.
• Instead, we have cash flows such as home mortgage payments, fixed lease payments and
monthly insurance payments.
• Annuity is an equal periodic (e.g. monthly, quarterly or annual) series of cash flows.
• It may be equal ‘annual deposit, equal annual withdrawals, equal annual payments, or
equal annual receipts.
• Most important point is equal periodic cash flows.
A Typical Uniform Series and its Present Worth
Present Worth of Uniform Series
Uniform Series Present Worth Factor (USPWF)
is Uniform Series Present Worth Factor (USPWF). It is represented by
Example: P/A Factor
An engineer believes that by modifying the structure of a certain water treatment plant, his
company would save Rs. 50,000 per year. At an interest rate of 10% per year, how much
could the company afford to spend now to just break even over a 6 year project period?
P = A(P/A, i, n)
P = Rs. 50,000(P/A,10%,6)
P = Rs. 50,000 (4.3553)
P = Rs. 217,765
Capital Recovery Factor (CRF or A/P Factor)
is called Capital Recovery Factor.
It calculates the equivalent uniform annual worth over years for a given
in year 0, when the interest rate is .
Application: Calculating loan installment
Example 2.3: CRF or A/P Factor
Q: How much money should you be willing to pay now for a guaranteed $600 per year for
9 years starting next year, at a rate of return of 16% per year?
Solution # 1
Example 2.3: Using Tables
Q: How much money should you be willing to pay now for a guaranteed $600 per year for
9 years starting next year, at a rate of return of 16% per year?
Solution # 2
Solution
Example: Calculating P from A
“Make your best deal with us on a new automobile and we’ll change your oil for free for as
long as you own the car!” If you purchase a car from this dealership, you expect to have
four free oil changes per year during the five years you keep the car. Each oil change would
normally cost you $30. If you save your money in a mutual fund earning 2% per quarter,
how much are the oil changes worth to you at the time you buy the car?
Given:
Cost of an oil change = $30
Quarterly interest rate = 2%
Deal validity = 5 years
Total Oil Changes = 20
Solution
Example: Calculating A from P
Q: You borrow $15,000 from a bank to purchase a used car. The interest rate on your loan is
0.25% per month and you will make a total of 36 monthly payments. What is your monthly
payment?
Solution # 1
Q: Will the initial investment be recovered over the 5-year horizon with the time value of
money considered? If so, by how much extra in present worth funds?
Give: Initial Investment = 200M
Since ; the answer is NO.
Solution # 2
Q: If not, what is the equivalent annual revenue base required for the recovery plus the 10%
return on money?
In order to break-even, the cement
factory would need an annual revenue
of at least;
Sinking Fund Factor and Uniform Series Compound Amount Factor
• So far, we calculated and factors.
=> Relationship between uniform series and present values
• Now it is time to calculate and factors.
=> Relationship between uniform series and future values
Sinking Fund Factor
factor relationship is given by;
Since
Sinking Fund Factor
Uniform Series Compound Amount Factor
and Factors: Notation and Equations
What is Sinking Fund?
• A sinking fund is established by an economic entity (e.g. an organization) by setting
aside (portion of) revenue over a period of time to fund a future capital expense, or
repayment of a long-term debt.
• Example: Sinking Fund for Bond repayment
Example: Sinking Fund Factor
An engineering firm has to pay Rs. 1,000,000 for the replacement of production plant by
the end of fifth year from now. The market rate of interest is 10% per year. How much the
company should deposit annually in a saving account to have exactly Rs. 1,000,000 by the
end of fifth year?
Solution:
Thank You
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