Engineering Economic Analysis

FOURTEENTH EDITION

Donald G. Newnan
Chapter 4 San Jose State University

Ted G. Eschenbach
Equivalence for University of Alaska Anchorage

Repeated Cash Flows Jerome P. Lavelle

North Carolina State University

Neal A. Lewis
Fairfield University

Copyright Oxford University Press 2020 4-1

 Chapter Outline

 Uniform Series Compound Interest Formulas

 Cash Flows That Do Not Match Basic Patterns
 Economic Equivalence Viewed as a Moment
Diagram
 Relationships Between Compound Interest
Factors
 Arithmetic Gradient
 Geometric Gradient
 Spreadsheets for Economic Analysis
 Compounding Period & Payment Period Differ

Copyright Oxford University Press 2020 4-2

 Learning Objectives

 Solve problems using uniform series compound

interest formulas
 Use arithmetic & geometric gradients in
modeling economic analysis
 Understand why cash flows assume uniformity
 Use spreadsheet to model & solve economic
analysis problems

Copyright Oxford University Press 2020 4-3

 Vignette: Student Solar Power

Indiana State University (ISU) mechanical &

manufacturing engineering technology students
designed a photovoltaic system to make use of solar
energy in 2008.

 2-axis tracking system

 4 PV panels of 123 watts
each, life of 25 yrs..
 Most electrical parts
provided free by the
college CIM Lab.

Copyright Oxford University Press 2020 4-4

 Vignette: Student Solar Power

1. Panels were purchased by ISU 5 years ago. Is the

purchase cost a sunk cost?
2. How much difference due to a city’s longitude if same
panel installed there?
3. How important are latitude & yearly days of sunshine
in system economics?
4. What costs must be considered & how can they be
estimated over time?
5. How to compute the annual savings? Do panels
decline in efficiency each year?

Copyright Oxford University Press 2020 4-5

 Uniform Series Compound Interest
Formulas

A = end of period cash flow in a uniform series

A A A A

0 1 2 n-1 n

Examples:
 Automobile loans, mortgage payments, insurance
premium, rents, & other periodic payments
 Estimated future costs & benefits

Copyright Oxford University Press 2020 4-6

 Uniform Series Compound Interest
Formulas

Uniform Series Compound Amount Factor

(4-4)

Uniform Series Sinking Fund Factor

(4-5)

Sinking fund: separate fund into which one makes a uniform series of money
deposits (A) to accumulate a desires future sum (F) by the end of period 𝑛.

Copyright Oxford University Press 2020 4-7

 Example 4-1 Uniform Series
Compound Interest Formulas
$500 deposited in a credit union (pays 5%
compounded annually) at the end of each year for 5
years, how much do you have after the 5th deposit?
F=?

0 1 2 3 4 5
= 500(F/A, 5%, 5) = 500(5.526)
500 500 500 500 500
= $2763

Copyright Oxford University Press 2020 4-8

 Example 4-2 Uniform Series;
Multiple Cash Flows
Initial deposit = $685; $375 deposited monthly. Interest rate =
6%, monthly compounding. How much is saved after 48
months?

F = 375(F/A, 0.5%, 48) + 685(F/P, 0.5%, 48) = $21,156.7

Copyright Oxford University Press 2020 4-9

 Example 4-3

How much must Jim deposit at the end of each month to get
$1000 at year end? Bank pays 6% interest compounded
monthly.

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 Uniform Series Compound Interest
Formulas

Uniform Series Capital Recovery Factor

(4-6)

Uniform Series Present Worth Factor

(4-7)

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 Why the phrase “capital
recovery factor”
 Comes from asking the question:
 “How large does the annual return, A,
have to be to recover the capital P,
that is invested at time 0”

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 The Annuity Functions
See Appendix B

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 PE Exam Question
The total cost to construct a new highway is
$6,987,500. The annual debt service to retire a bond
in this amount over a 25-year period at 4% interest
is:

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 Example 4-4

A machine costs $5000 & lasts 5 years. If interest is 8%, how

much must be saved annually to recover the investment?

A A A A A

0 1 2 3 4 5
A  P ( A P , i, n)
 5000( A P ,8%,5)  5000(0.2505)  $1252.50
5000

Copyright Oxford University Press 2020 4-15

 To have $1M after 40 years in
account earning 6%

Your annual deposit must be

A. $6096
B. $25,000
C. $12,649
D. $6462
E. None of the above

Copyright Oxford University Press 2020 4-16

 To have $1M after 40 years in
account earning 6%

Your annual deposit must be

A. $6096
B. $25,000
C. $12,649
D. $6462
E. None of the above

Copyright Oxford University Press 2020 4-17

 Example 4-5

A machine costs $30,000, O&M = $2000/yr. Savings =

$10,000/yr. Salvage @ 5 yrs = $7000. i = 10%. PV = ??

P = –30,000 + (10,000 – 2000)(P/A, 10%, 5) + 7000(P/F, 10%, 5)

= –30,000 + (8,000)(3.791) + 7000(0.6209) = $4672

Copyright Oxford University Press 2020 4-18

 Example 4-6, Find Rate of Return

A machine costs $30,000, O&M = $2000/yr. Savings =

$10,000/yr. Salvage @ 5 yrs = $7000. ROR= ??

0 = −30,000 + (10,000 − 2000)(𝑃/𝐴, 𝑖, 5) + 7000(𝑃/𝐹, 𝑖, 5)

To solve with tabulated factors assume the interest rate

& see if the PW = 0

Copyright Oxford University Press 2020 4-19

 Example 4-6, Find Rate of Return

Try 15%
𝑃15 = −30,000 + (10,000 − 2000)(𝑃/𝐴, 15%, 5) + 7000(𝑃/𝐹, 15%, 5)
𝑃15 = −30,000 + (8000)(3.352) + 7000(. 4972) = $296.4

Try 18%
𝑃18 = −30,000 + (10,000 − 2000)(𝑃/𝐴, 18%, 5) + 7000(𝑃/𝐹, 18%, 5)
𝑃15 = −30,000 + (8000)(3.127) + 7000(. 4371) = −$1924.3

By interpolation, i = 15.4%

Copyright Oxford University Press 2020 4-20

formula
mini ta

ratform
a
 Interpolation

Interest Rate Present Worth

15% $296.40
a c
b i d 0 Using ratios, =
18% −$1924.30
𝑖 − 15% 0 − 296.40
=
18% − 15% −1924.30 − 296.40
𝑖 − 15% −296.4 296.4
= =
3% −2220.7 2220.7
3% × 296.4
𝑖 = 15% + = 15.4%
2220.7

Copyright Oxford University Press 2020 4-21

 Find the value of x using interpolation

Interest rate Value

2% 10.950
3% x
4% 12.006

A. 11.5
B. 11.464
C. 11.478
D. I don’t know

Copyright Oxford University Press 2020 4-22

 Find the value of x using interpolation

Interest rate Value

2% 10.950
3% x
4% 12.006

A. 11.5
B. 11.464 3% − 2% 𝑥 − 10.950
=
C. 11.478 4% − 2% 12.006 − 10.950
D. I don’t know

Copyright Oxford University Press 2020 4-23

 The firm invests $75,000 to save
$9000/year in energy costs for 15 yrs

What is the project’s rate of return?

A. 8.44%

B. 0.08%

C. 8%

D. 9.36%

E. I don’t know

Copyright Oxford University Press 2020 4-24

 The firm invests $75,000 to save
$9000/year in energy costs for 15 yrs

What is the project’s rate of return?

A. 8.44%

B. 0.08%

C. 8%

D. 9.36%

E. I don’t know

Copyright Oxford University Press 2020 4-25

 Example 4-7, Effective Rates

New car costs $15,732; 48 monthly payments of $398. What

is monthly interest rate? Effective annual rate?

Copyright Oxford University Press 2020 4-26

 Example 4-8

A student is borrowing $1000/yr for 3 years. The loan will be

repaid 2 years later at 15% interest rate. Find F.
1000 1000 1000
Year Cash Flow
1 +1000
0 1 2 3 4 5
2 +1000
3 +1000
4 0 F=?
5 -F

Copyright Oxford University Press 2020 4-27

 Example 4-8, Solution #1

A A A A A A

0 1 2 3 4 5 = 0 1 2 3 4 5 + 0 1 2 3 4 5 + 0 1 2 3 4 5

F3
F1 F2
F
𝐹 = 𝐹1 + 𝐹2 + 𝐹3
= 1000(𝐹/𝑃, 15%, 4) + 1000(𝐹/𝑃, 15%, 3) + 1000(𝐹/𝑃, 15%, 2)
= 1000(1.749) + 1000(1.521) + 1000(1.322) = $4592

Copyright Oxford University Press 2020 4-28

 Example 4-8, Solution #2
F3
A A A=100

0 1 2 3 4 5 = 0 1 2 3 4 5

F3
A A A=100

0 1 2 3 4 5 = 0 1 2 3 4 5
or

F F

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 Example 4-8, Solution #3

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 Example 4-9

What must be deposited in a saving account paying 15%

interest, to support 3 later withdrawals?

3000
Year Cash Flow 2000 2000
0 -P
1 0 0 1 2 3 4
2 +2000
3 +3000
4 +2000 P=?

Copyright Oxford University Press 2020 4-31

 Example 4-9, Solution #1

3k 3k
2k 2k 2k 2k
0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4 + 0 1 2 3 4

P1 P2 P3

P = P1 + P2 + P3
= 2000(P/F,15%,2) + 3000(P/F,15%,3) + 2000(P/F,15%,4)
= 2000(0.7561) + 3000(0.6575) + 2000(0.5718) = $4628

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 Example 4-9, Solution #2

3k F F1 F2 2k
2k 2k 3k
2k F3

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4 + 0 1 2 3 4

F = F1 + F2 + F3
= 2000(F/P,15%,2) + 3000(F/P,15%,1) + 2000
= 2000(1.322) + 3000(1.150) + 2000 = $8094
3k
2k 2k F
P = F(P/F,15%,4)
0 1 2 3 4 = 0 1 2 3 4
= 8094(0.5718) = $4628
P P

Copyright Oxford University Press 2020 4-33

 Example 4-9, Solution #3

3k 3k
2k 2k 2k 2k 2k 2k 2k 1k
0 1 2 3 4 1 2 3 4 = 1 2 3 4 + 1 2 3 4

P P1 P1

P = P1 (P/F,15%,1)
= [2000(P/A,15%,3) + 1000(P/F,15%,2)](P/F,15%,1)
= [2000(2.283) + 1000(0.7561)](0.8696) = $4628

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 Example 4-9, Solution #4

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 Relationships Between
Compound Interest Factors

Single Payment
(4-8)

Uniform Series

(4-9)

(4-10)

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 Relationships Between
Compound Interest Factors

Uniform Series
(4-11)

(4-12)

(4-13)

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 Arithmetic Gradient
A+4G
A+3G
A+2G
4G
A+G 3G
A A A A A A 2G
G

0 1 2 3 4 5 = 0 1 2 3 4 5 + 0 1 2 3 4 5

Examples:
Operating & maintenance costs
Salary packages

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 Arithmetic Gradient

Notation:
G = a fixed amount increment or decrement per time period
(n-1)G
(n-2)G

2G
G
0
0 1 2 3 n-1 n

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 Arithmetic Gradient
Arithmetic gradient present worth
1 + 𝑖 − 𝑖𝑛 − 1
𝑃=𝐺
𝑖 1+𝑖
Present valeu of
Gradient

Arithmetic gradient uniform series

1 + 𝑖 − 𝑖𝑛 − 1
𝐴=𝐺
𝑖 1+𝑖 −𝑖

Copyright Oxford University Press 2020 4-40

 Example 4-11

240
210
180 120
150 90
120 A=120 60
30
0 1 2 3 4 5 = 0 1 2 3 4 5 + 0 1 2 3 4 5

Year Cash Flow

𝑃 = 120(𝑃⁄𝐴, 5%, 5) + 30(𝑃⁄𝐺, 5%, 5)
1 120 = 120 4.329 + 30 8.237
2 150 = $766
value
3 180 Future
i =
Stin
= S

766
4 210 p =

P(Ite("
F =

0 05)" F =
P(FP ein)
,

= 36(1
+ .

or

5 240
F
05)5
F =
76611 .

F =

Copyright Oxford University Press 2020 4-41

i '

to to Go no to the
!

·
!
is s o '
Always starts
on
and
year
Gradient

&
 Example 4-12

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4
100
100 200
200 100 100 100 100
300
300
400

Year Cash Flow 𝐴 = 100 + 100(𝐴⁄𝐺, 6%, 4)

1 100 = 100 + 100 1.427 = $242.70
2 200
3 300
4 400

Copyright Oxford University Press 2020 4-42

 Example 4-13
A=24,000
24000
18000
12000
6000

0 1 2 3 4 = 0 1 2 3 4 + 0 1 2 3 4

6000
Year Cash Flow 12000
18000
1 24000
2 18000
3 12000
4 6000

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 Example 4-14

0 1 2 3 4 5 6 7 = 0 1 2 3 4 5 6 7 + 0 1 2 3 4 5 6 7

25 50
75
150 175
200 225 A=150

P P3
𝑃 = 150(𝑃⁄𝐴, 10%, 4) + 25(𝑃⁄𝐺, 10%, 4)
Year Cash Flow = 150 3.170 + 25 4.378
4 150 = $584.95
5 175 𝑃 = 𝑃 (𝑃⁄𝐹, 10%, 3)
6 200 = 584.95 0.7513
7 225 = $439.47

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 Reality & Assumed Uniformity of A,
G, & g

 Most future costs & benefits won’t be uniform

 Even so uniformity usually assumed
 Simpler models are easier to use
 Tabulated factors & spreadsheet annuity
functions assume uniformity
 Engineering economy used in decision-making at
feasibility & preliminary analysis stages
 Not enough is known for estimates to be more
detailed

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 Geometric Gradient

Notation:
g = a constant growth rate (+ or -) per period
A1 = cash flow at period 1

A1(1+g)n-1
A1(1+g)n-2
A1 (1+g)2
A1(1+g) 1 − (1 + 𝑔) (1 + 𝑖)
A1 𝑃=𝐴
𝑖−𝑔

0 1 2 3 n-1 n

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 Example 4-15 Geometric Gradient

At 8% interest find the PW of maintenance costs that are

$100 the first year & then increasing at 10% per year until
the end year 5.

1 − (1 + 𝑔) (1 + 𝑖)
𝑃=𝐴
𝑖−𝑔

1 − (1 + 10%) (1 + 8%)
= 100
8% − 10%

= $480.42

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 Spreadsheets for Economic Analysis

1. Constructing tables of cash flows

2. Using annuity functions for P, F, A, n, or i
 PV, FV, PMT, NPER, RATE
3. Block functions to find NPV or IRR
4. Making graphs
5. Conducting what-if analysis

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 Spreadsheet Annuity Functions
(introduced in Chapter 3)
Excel Functions Purpose

PV(RATE,NPER,PMT,[FV],[TYPE]) Find P

FV(RATE,NPER,PMT,[PV],[TYPE]) Find F

PMT(RATE,NPER,PV,[FV],[TYPE]) Find A

NPER(RATE,PMT,PV,[FV],[TYPE]) Find n

RATE(NPER,PMT,PV,[FV],[TYPE],[GUESS]) Find i

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 Build Amortization Table

 Borrow $4000
 N = 5 years
 i = 10%
 Equal annual payments
 A=

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 Amortization Table

4000 Amount borrowed

5 N
10% i
$1,055.19 payment
Balance
Period Interest Principal Due
0 4000.00
1 400.00 655.19 3344.81
2 334.48 720.71 2624.10
3 262.41 792.78 1831.32
4 183.13 872.06 959.26
5 95.93 959.26 0.00
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 Spreadsheet Block Functions

Excel Functions Purpose

NPV (i, CF1:CFn) To find net present value of a range of cash
flows (from period 1 to n) at a given interest
rate
IRR (CF0:CFn, [guess]) To find internal rate of return from a range of
cash flows (from period 0 to n)

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 NPV & IRR are Block Functions for
Cash Flow Tables

 Assume 1 cash flow per period

 Equal length periods
 Interest rate for that period
 Not restricted to any pattern
 0 must not be left as blank cell for cash flows
 NPV (net present value) is a Present Worth
 Periods 1 to N  The first cell is NOT period 0 !
 IRR (internal rate of return) is interest rate
 PW at IRR = 0
 Periods 0 to N  The first cell IS period 0 !
 Assumptions for period 0 are different, arbitrary, &
critical.

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 Use the NPV Function

First calculate the NPV of the

positive cash flows

=NPV(A1, B5:B9) = 216.47

Notice that this returns a positive

number

PW = B4+NPV(A1,B5:B9)
= $16.47

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 NPV, Different Cash Flows

With different cash flows,

We cannot use the PV function.
Must use NPV function.

PW = B4 + NPV(A1, B5:B9)
= $12.25

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 Another NPV Advantage
200/year
100/year

0 1 2 3 4 5 6 7 8 9 10
i = 10%
P

Remember that NPV will discount the first cash flow, so start at year 1
& include it’s zero value.

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 There is no G function in Excel
Use the NPV function

i =14% 400
280 340
100 160 220

0 1 2 3 4 5 6

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 IRR: =IRR(CF1:CF2)

What is the IRR?

=IRR(B4:B9) = 6.91%

At this rate the PW of the

cash flows is 0.

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 Example 4-15 Geometric Gradient

Spreadsheet
approach

Note use of the

data block; cells
in Column B use
cell referencing,
are copied

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 1st cost = $750,000. 1st year net revenue = $225,000, increasing either
(a) $25,000 per yr. or (b) decreasing 10% per yr. or (c) increase by
$25,000 for 1 yr. then decrease by 10% per yr. MARR = 12%; n = 5 yrs.
Find PW & IRR for each scenario.

Example 4-16
Gradients

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 Example 4-17 Compounding Period &
Payment Period Differ
On Jan. 1, deposit $5000 that pays 8% nominal annual interest,
compounded quarterly. Withdraw in 5 equal yearly sums, beginning
December 31 of the first year. How much is withdrawn each year?

Compute equivalent A for each quarter

A = P(A/P, i, n) = 5000(A/P, 2%, 20) = 5000(0.0612) = $306
For each 1-year time period,
W = A(F/A, i, n) = 306((F/A,2%,4) = 306(4.122) = $1260

Copyright Oxford University Press 2020 4-61