Fundamentals of Engineering Economic Analysis

Chapter 3
Interest and Time Value
of Money
CHAPTER OUTLINE
• Interest (Simple interest, compound
interest)
• Economic Equivalence
• Nominal and Effective Interest Rate
• Discrete Cash Flow and Discrete
Compounding Formulas
• Continuous Compounding Formulas
• Interest Calculation for Gradient Series
• Introduction to Life Cycle Costing
• Introduction to Financial and Economic
Analysis

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money

STUDENT LEARNING OBJECTIVE

From studying this chapter you will learn
• To understand the concept of simple interest and compound
interest
• To understand the concept of economic equivalence
• To derive the formula for compound interest
• To derive the formula for the discrete cash flow and discrete
compounding
• To derive the formula for continuous compounding and
continuous cash flow
• To derive the formula for gradient series (linear and
geometric)
• To solve the numerical problems of the discrete and
continuous compounding and gradient series
2.1 Time value of Money
Time value of money is defined as the time-dependent value of
money stemming both from changes in purchasing power of money
(inflation or deflation) and from the real earning potential of
alternative investments over time. Since money has the ability to
earn interest, its value increases with time. Hence it is the
relationship between interest and time.
Interest
Most of us are familiar in a general way with the concept of interest.
We know the money left in the savings account earns interest so that
the balance over time is greater than the sum of the deposits.
Whenever we go for any investment, we will have to consider the
following three factors:
(a) Liquidity
Once it is invested, it is not so easy to convert it to cash and when
needed immediately, we will not be able to spend on another project
or on other financial expenses. In other words, it is the reward for
not being able to use your money while you are holding the stock or
mortgage or promise.
(b) Risk premium
There is always a certain degree of risk associated with any
financial investment. For example, if you lend someone Rs 1,000, it
Er. Santosh K. Shrestha Er. Ishwar Adhikari
 Fundamentals of Engineering Economic Analysis

is not sure that you may get it back either because of his nature or
market scenario. The situation is worse in case when you are
making investment on businesses, shares etc. where you might also
loose your principal amount. It is common that most of the people
fear for investing, knowingly or unknowingly they are conscious
about risks associated with it. In other words, it is the reward for any
chance that you would not get your money back or that it will have
declined in value while invested.
(c) Inflation factor
Purchasing power of money goes down at a constant rate annually
and we call it inflation. The money we invested should at least earn
to cover the loss in its value due to inflation. In other words, it is the
compensation for decrease in purchasing power between the time
you invest it and time it is returned to you.
Every investor, because of these factors, looks for some return on
their investment and charges a cost of investment known as interest
rate. It is a percentage that is periodically applied and added to an
amount (or varying amounts) of money over a specified length of
time. When money is borrowed, the interest paid is the charge to the
borrower for the use of the lender’s property; when money is loaned
or invested, the interest earned is the lender’s gain from providing a
good to another. Interest, then may be defined as the cost of having
money available for use.

Elements of transaction involving interest

1. An initial amount of money that, in transaction
involving debt or investment, is called the Principal.
2. The interest rate that measures the cost or price of
money and that is expressed as a percentage per period
of time.
3. A period of time, called interest period that determines
how frequently interest is calculated.
4. A specified length of time that marks the duration of the
transaction and thereby establishes a certain number of
interest periods.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
5. A future amount of money that results from the
cumulative effects of the interest rate over a number of
interest periods.

Simple Interest: It uses fixed percentage of the principal (the

amount of money borrowed) i.e. if the total amount of interest
earned is directly proportional to the initial principal amount, then
the interest is said to be simple.
For a deposit of P dollars at a simple interest rate of i for N periods,
the total earned interest I would be I = (i*P) N
The total amount available at the end of N periods, F, thus would be
F = P+I = P (1+iN)
Compound interest: When the total time period is subdivided into
several interest periods (one year, half yearly, quarterly, monthly,
weekly); interest is credited at the end of each interest period, and is
allowed to accumulate from one interest period to next, then the
interest is said to compounded.

Derivation of compound interest formula (single cash flow)

(To find the single future sum (F) of the initial payment P)
During a given interest period, the current interest is determined as a
percentage of the total amount owed (i.e. principal plus the previous
accumulated interest)
For the 1st interest period,
Interest I1= i*P F

i%
0 N

P
Fig: 3.1Single cash flow diagram
Total accumulated amount at the end of 1st year
F1= P + I1 = P + i*P = P (1+i)
For the 2nd interest period
Interest I2= i* F1 = i* (1+i) Total accumulated amount at the end
of 2nd year

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 Fundamentals of Engineering Economic Analysis

F2 = F1+ I2 = P (1+i) + i * (1+i) P = P (1+i) 2

For the 3rd interest period
I3= F2 * i = P (1+i) 2 * i
Total accumulated amount at the end of 2nd year
F3 = F2+ I3 = P (1+i) 2+P (1+i) 2 * i = P (1+i) 3
Continuing,
If there is ‘N’ interest period
F= P (1+i) N

The factor in the bracket is called the Single Payment Compound

Factor
Functionally, (𝑭/𝑷, 𝒊%, 𝑵)

(To find the initial payment (P) of the single future sum (F))
P= F (1+i) - N
The factor in the bracket is called the Single Payment Present
worth factor
Functionally, 𝑷 = 𝑭 (𝑷/𝑭, 𝒊%, 𝑵)
Example3.1
Suppose you deposit Rs 1,000 in savings account that pays interest
at a rate of 8%, compounded annually. Assume that you don’t
withdraw the interest earned at the end of each period (year), but let
it accumulate. How much would you have at the end of year 3?

Solution F=?
Given: P = Rs 1,000, N=3 years, and i = 8% per year
F = P (F/P, i%, N)
F = Rs 1,000 (1+0.08)3 0 1 2 3
F = Rs 1,259.71 (Ans)
Rs 1,000
Example3.2
You have just purchased shares @Rs 100 per share. If you
expect the stock price to increase 20% per year, how long do
you expect to double its market price?

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 Interest and Time Value of Money
Solution
F =2 P
P (1+0.2) N = 2P
1.2N = 2
Taking log on both sides
N Log 1.2 = Log 2
N = Log 2/ Log 1.2 = 3.80 ≈ 4 years (Ans)

Example3.3
Mr. X deposits Rs 10,000 now in a bank which gives 8% interest
per year. He draws Rs 4,000 at the end of 2nd year. What will be the
remaining amount at the end of 5th year?
F=?
Solution 4,000

0
1 2 3 4 5

10,000

At the end of the 2nd year, the accumulated amount will be

10,000 (F/P, 8%, 2) = 10,000 (1+0.08)2 = Rs 11,664
After drawing 4000, the remaining deposit amount at the end of 2 nd
year will be,
11,664 – 4,000 = Rs 7,664
At the end of the fifth year the total accumulated amount will be
7,664 (F/P, 8%, 3) = 7,664 (1+0.08)3 = Rs 9,654.5 (Ans)

Alternatively
F = {10,000 (1.08)2 -4,000} (1.08)3
= Rs 9,654.5 (Ans)

RULE OF 72
Rule of 72 can determine approximately how long it will take for a
sum of money to ‘double’. The rule states that “to find the time it
takes for the present sum of money to grow by a factor of 2, we
divide 72 by the interest rate”
Er. Santosh K. Shrestha Er. Ishwar Adhikari
 Fundamentals of Engineering Economic Analysis

As in the previous example 3.2, 72/20 = 3.60 or roughly we can say

4 years

2.2 Economic Equivalence

Which option would you prefer?
 Receiving Rs. 20,000 today and Rs. 50,000 ten years from
now.
 Receiving Rs. 8,000 each year for the next ten years.
Calculations for determining the economic effects of one or more
cash flows are based on the concept of economic equivalence. The
time value of money and the interest rate helps to develop the
concept of economic equivalence which means that different sums
of money at different times are equal in economic value. For
example, if the interest rate is 6% per year, Rs 100 today (present
time) is equivalent to Rs 106 one year from today. If someone
offered you a gift of Rs 100 today or Rs 106 one year from today, it
would make no difference which offer you accept. In either case you
have Rs 106 one year from today. However, the two sums of money
are equivalent to each other only when the interest rate is 6% per
year. At a higher or lower interest rate, Rs 100 today is not
equivalent to Rs 106 one year from today.
Calculations for determining the economic effects of one or more
cash flows are based on the concept of economic equivalence.
Economic Equivalence refers to the fact that a cash flow- whether
single payment or a series of payment- can be converted to an
equivalent cash flow at any point in time. Economic Equivalence
exists between cash flows that have the same economic effect.

Example3.4
Suppose we invest Rs. 1000 at 12% annual interest for 5 years.
From Compound interest formula,
F= P (1+i) N, expresses the equivalence between present amount, P, and
future amount, F, for given interest, i, and number of interest
periods N.
F = Rs. 1000(1+0.12)5 = Rs. 1762.34

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
We can say that at 12% interest, Rs. 1000 received now is
equivalent to Rs. 1762.34 received in 5 years, and that we can trade
Rs. 1000 now for the promise of receiving Rs. 1762.34 in 5 years.

Example3.5
Suppose you are offered the alternative of receiving either Rs. 3000
at the end of 5 years or P Rs. today. There is no question that the
Rs. 3000 will be paid in full (no risk). Because you have no current
need for the money, you would deposit the P Rs. in an account that
pays 8% interest. What value of P would make you indifferent to
your choice between P Rs. today and the promise of Rs. 3000 at the
end of 5 years?
Solution
Our job is to determine the present amount that is economically
equivalent to $3000 in 5 years given the investment potential of 8%
per year.
Given: F = Rs. 3000, N = 5 years, i=8% per year.
P = F (1+i)-N = 3000 (1+0.08)-5 = Rs. 2042
• If P is anything less than Rs. 2042, you would prefer the
promise of Rs. 3000 in 5years to P Rs. today.
• If P were greater than Rs. 2042, you would prefer P.

Equivalence calculation: General Principles

Principle 1
Equivalence calculations made to compare alternatives requires a
common time basis.
 In example 3.5, if we had been given magnitude of each
cash flow and had been asked to determine their
equivalency, we should choose the reference point and find
the value of each cash flow at that point.
 For selecting the reference point, commonly present time
(present worth) or some point in future (future worth) is
used.
 The choice of point is chosen as per convenience.

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 Fundamentals of Engineering Economic Analysis

Example3.6
In example 3.5, we determined that, given an interest rate of 8% per
year, receiving Rs. 2042 today is equivalent to receiving Rs. 3000 in
5 years. Are these cash flows also equivalent at the end of year 3?
Solution
Here base period is 3 years.
In fig (a)
P = Rs. 2042, i=8% per year, N = 3 years
In fig (b)
F = Rs. 3000, i=8% per year, N = 2 years

Principle 2
Equivalence depends on interest rate
 The equivalence between two cash flows is a function of
both the cash flow pattern and the interest rate that operates
on those cash flows.
 Change in the interest rate will destroy the equivalence
between these two sums.

Example3.6
In example 3.5, we determined, at an interest rate of 8% per year,
receiving Rs. 2042 today is equivalent to receiving Rs. 3000 in 5
years. Are these cash flows equivalent at an interest rate of 10%?
Solution
Lets select base period N= 5 years.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
F = Rs. 2042 (1+0.1)5 = Rs. 3829
Since the amount is > Rs. 3000, change in interest rate destroys the
equivalence between two cash flows.

Principle 3
Equivalence Calculations may require the conversion of multiple
payment cash flows to a single cash flow.
Example3.7
Suppose that you borrow Rs. 1000 from a bank for 3 years at 10%
annual interest. The bank offers two options: (1) Repaying the
interest charges for each year at the end of that year and repaying
the principal at the end of 3 year. (2) Repaying the loan all at once
(including both interest and principal) at the end of year 3.
Option Year 1 Year 2 Year 3
End of year repayment of interest Rs. 100 Rs.100 Rs.1100
and principal repayment at end of
loan.
One end of loan repayment of 0 0 Rs. 1331
both principal and interest
Determine whether these options are equivalent, assuming the
interest rate for comparison is 10%?
Solution
Since we pay the principal after 3 years in either plan, the
repayment of principal can be removed from our analysis.

Since option 2 is already a single payment at n=3 years, it is

simplest to convert option 1 cash flow pattern to a single value at
n=3.
We must convert the three disbursement of option 1 to their
respective values at n=3.
F3 for $100 at n=1: Rs. 100 (1+0.10) 3-1 = Rs. 121
F2 for $100 at n=2: Rs. 100 (1+0.10) 3-2 = Rs. 110

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 Fundamentals of Engineering Economic Analysis

F1 for $100 at n=3: Rs. 100 (1+0.10)3-3 = Rs. 100

Total = Rs. 331

2.3 Nominal and Effective interest rate

If a financial institution uses a unit of time other than a year – a
month or a quarter (e.g. when calculating interest payments), the
institution usually quotes the interest rate on an annual basis.
Commonly this rate is stated as
r% Compounded M-ly
Where, r = the nominal interest rate per year
M = the compounding frequency or the number of
interest periods per year
r/M = the interest rate per compounding period.
Suppose that if a bank express the interest rate as “18%
compounded monthly”, we say that 18% is the nominal interest rate
or annual percentage rate (APR) and the compounding frequency is
monthly i.e. number of interest period per year is 12.
A nominal interest rate r may be stated for any time period – 1 year,
6 months, quarter, month, week day etc. Let us see the following
examples for expressing the nominal interest rate.
r = 12% compounded semiannually, M=2,
i.e.12%/2 (6% per 6 months)
r = 12% compounded quarterly, M=4,
i.e. 12%/4 (3% per 3 months)
r = 18% compounded monthly, M=12,
i.e. 18%/12 (1.5% per month)
r = 15%compunded weekly, M= 52
i.e.15%/52 (0.29% per week)
When M ∞, compounded continuously
Suppose that Rs 1,000 to be invested at a nominal rate of 12%
compounded semiannually.
The interest earned during first six months is 1,000* 0.12/2
= Rs 60
Total principal at the end of the first six months = Rs (1,000+60)
= Rs 1,060

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 Interest and Time Value of Money
Interest earned during the second six months is Rs 1,060*0.12/2
= Rs 63.60
Total interest at the end of 1 year = Rs 60+ Rs 63.60
= Rs 123.60
The effective annual interest rate for the entire year = 123.60/1,000
* 100 = 12.36%
The exact or the actual rate of interest earned on the principal
during one year is known as the effective interest (i). The effective
interest rates are always expressed on an annual basis unless
specifically stated otherwise.

Relation between effective (i) and nominal (r) interest rate

𝐢 = (𝟏 + 𝐫/𝐌)𝐌-1, M is the compounding period per year.
As from the above example, the effective interest rate for 12%
compounded semi annually,
𝑖 = (1 + 𝑟/𝑀)𝑀 -1 = (1+0.12/2) 2 -1 = 12.36%
Alternatively
iN = (1+i)M -1, where, N = number of compounding periods.
i = interest rate per compounding period
M = compounding periods per year
Example 3.8
What is the effective interest rate of the nominal interest rate 9% per
year if the compounding is a) yearly b) quarterly c) monthly (d)
daily (e) continuously (N ∞)
Solution
For compounding yearly,
i = (1+0.09/1) 1 -1 = 0.09 = 9%
For compounding quarterly,
i = (1+0.09/4) 4 -1 = 0.09308= 9.308%
For compounding monthly,
i = (1+0.09/12) 12 -1 = 0.09380= 9.380%
For compounding daily,
i = (1+0.09/365) 365 -1 = 0.0941=9.41%
For compounding continuously,
i = (1+0.09/∞) ∞ -1 = er-1=e0.09 -1= 9.417%

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 Fundamentals of Engineering Economic Analysis

Example 3.9
A person deposits 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 of the deposit after 10 years.
Solution
P = Rs 5,000, N = 10 years, i=12%compounded quarterly
Interest period in a year = 4
Total interest period for 10 years = 40
i= 12%/4 = 3%
Using single payment compound amount factor
F = P (F/P, 3%, 40) = 5,000 (1+0.03)40 = Rs 16,310 (Ans).
Alternatively
iyear =(1+0.12/4)4 -1 = 12.5508% per year
N =10 years
F = 5,000 (F/P, 12.55%, 10) = 5,000 (1+0.125508)10
= Rs 16,310 (Ans)
2.4 Development of Interest formulas
As we begin to compare series of cash flows instead of single
payments, the required analysis becomes more complicated.
However, when patterns in cash flow transactions can be identified,
we can take advantage of these patterns by developing concise
expression for computing either present or future worth of the
series. We will classify the five major categories of cash flow
transactions; develop interest formulas for them and present several
working examples for them.
Types of Cash Flow
1. Single cash flow: the simplest case involves the
equivalence of a single present amount and its future worth.
The single cash flow formulas deal with the only two
amounts; a single present amount P and its future worth F.
1,000

Years
0 1 2 3 4 5

Fig: Single cash flow

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 Interest and Time Value of Money
(a) Equal (uniform) series: In this type, transactions are
arranged as a series of equal cash flows at regular intervals,
known as an equal payment series (uniform series) (fig: (b).
This describes the cash flows of the common installment
loan contract, which arranges repayment of the loan in equal
periodic installments.

1,000 1,000 1,000 1,000 1,000

0 1 2 3 4 5 Years

Fig: Equal (uniform) payment series

(b) Linear gradient series: While many transactions involve

series of cash flows, the amounts are not always uniform;
they may vary in some regular way. One common pattern of
variation occurs when each cash flow in a series increases
(or decreases) by a fixed amount. For example, A 10 year
loan repayment plan might specify a series of annual
payments that increase by Rs 1000 each year. This type of
cash flow pattern is called linear gradient series.
100+4G
100+3G
100+2G
100+G
100

0 1 2 3 4 5 Years
Fig: Linear Gradient series
(c) Geometric gradient series: Another kind of gradient series
is formed when the series in cash flow is determined, not by
a fixed amount like Rs 1,000, but by some fixed rate,
expressed as a percentage. For example, in a 10 year
financial plan for a project, the cost of particular raw
material might be budgeted to increase at a rate of 4% per
year. The curving gradient in the diagram of such a series

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 Fundamentals of Engineering Economic Analysis

suggests its name which is geometric gradient series.

However, we don’t deal with the formulas for geometric
gradient series.
100(1+g) 4
100(1+g) 3
100(1+g) 2
1 00(1+g)
100

Years
0 1 2 3 4 5

Fig: Geometric Gradient series

(d) Irregular Series: A series of cash flow may be irregular. It

doesn’t exhibit a overall regular pattern.
150
100 100
70
50

0 1 2 3 4 5 Years

Fig: Irregular series

Factor Notation
We will express the resulting compound interest factors in a
conventional notation that can be substituted in a formula to indicate
precisely which factor to use in solving an equation. In the
preceding examples the formula derived for the single cash flow as
. F= P (1+i) N In ordinary language, this tells us that to determine
what future amount F is equivalent to a present amount P, we need
to multiply P by a factor expressed as 1 plus the interest rate, raised
to the power given by the number of interest periods. The factor in
the functional form is expressed as: (F/P, i%, N) which is read as
“Find F, when P, i, and N given”. The factor notation is included for
each of the formulas derived in the following sections.

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
2.5 Discrete compounding and discrete cash flow
Interest formula relating a uniform (equal) series
(1) To Find F when A is given
Let’s consider the following cash flow as shown at the end of each
period.
F=?

A A A A A

0 1 2 3 N-1 N

P=? Fig 3.3: cash flow for uniform series

If the amount ‘A’ occurs at the end of each period for N periods and
i% is the interest rate per period, the Future worth (F) at the end of
the last (Nth) period is:
F = A {(1+i) N-1 + (1+i) N-2 + (1+i) N-3 + ………… + (1+i) 1 + 1}
The bracketed term comprise a geometric progression with common
ratio (1+i) -1
SN = a1 – baN (b≠1)
1-b

Where a1 = first term, b= common ratio, aN = last term

If we let b = (1+i) -1, a1= (1+i) N-1 and aN = 1, then

F=A {(1+i) N-1

} {1 - (1+i)-1}
- (1+i)-1 *1 /
F = A {(1+i) N -1/i}

Alternatively,
F=A (1+i) N-1+A (1+i) N-2+……. +A(1+i)+ A………………(1)
Multiplying both sides by (1+i)
F (1+i) = A (1+i) N + A (1+i) N-1 + ……….. + A (1+i) 2 + A
(1+i)……………… (2)
Subtracting equation (1) from equation (2), we get
F (1+i) – F = A (1+i) N –A
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 Fundamentals of Engineering Economic Analysis

F*i = A {1+i) N -1}

F = A {(1+i) N -1)/i}
The quantity in a bracket is called the uniform series compound
amount factor.
Functionally, F = A (F/A, i%, N)

Note: F (future worth) coincides with last annuity ‘A’

A (annuity) occurs at the end of each period
P (present worth) occurs at on the interest period before
the first ‘A’

Example 3.10
If a woman deposits Rs 15,000 at the end of each year for 10
continuous period years, how much money is accumulated at the
end of 10 years? i=10% compounded annually.
Solution
Given: A=Rs 15,000, N = 10 years, i=10% per year, F =?
F=?
i=10%
0 1 2 3 4 5 6 7 8 9 10

15000 15000 15000 15000 15000 15000 15000 15000 15000 15000

Using uniform series compound amount factor.

F = A (F/A, 10%, 10)
F = 15,000 {(1+0.1)10 -1)/0.1}
F = Rs 2, 39,061.36 (Ans)

(2) To Find P when A is given

Consider the cash flow diagram in fig: 3.3
We know, F= A [(1+i) N - 1] / i
Also, F= P (1+i) N
P (1+i) N = A [(1+i) N - 1] / i
P = A [(1+i) N - 1] /[ i * (1+i) N]
The quantity in a bracket is called the uniform series present worth
factor

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 Interest and Time Value of Money
Functionally, P = A (P/A, i%, N)

Example 3.11
How much money should you deposit now in a saving account
earning 10% interest rate compounded annually so that you may
make 8 end of year withdrawal of Rs 2000 each?
Solution
Given: A = Rs 2,000, N =8, i=10% per year
2000 2000 2000 2000 2000 2000 2000 2000

0 1 2 3 4 5 6 7 8

P =?

Using uniform series present worth factor

P= A (P/A, 10%, 8)
P = 2,000 [(1+0.1) 8 - 1] / [i * (1+0.1) 8]
P = Rs10, 669.85 (Ans)

(3) To Find A when F is given

We know, F = A {[(1+i) N -1]/i}
A = F [i / (1+i) N -1]
The quantity in a bracket is called the sinking fund factor
Functionally, A = F (A/F, i%, N)

Sinking fund is an interest bearing account into which a fixed sum is

deposited each interest period: it is commonly established for the purpose
of replacing fixed assets.

Example 3.12
Mr. Ramesh wants to have Rs 10, 00,000 for the studies of his
daughter after the period of 15 years. How much rupees does he has
to deposit each year for 10 continuous years in a saving account that
earns 8% interest annually. (TU, IOE-2061)

Solution
Given: F=Rs 10, 00,000, N =15, i=8% per year, A =?

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 Fundamentals of Engineering Economic Analysis
Rs 10, 00,000
i =8%
1 2 3 4 5 6 7 8 14 15
0
A A A A A A A A A A

Discounting Rs. 10, 00,000 to the year 10

P = 10, 00,000 (P/F, 8%, 5)
= 10, 00,000 (1+0.08)-5 = Rs. 6, 80,583.197
Using the sinking fund factor
A = F (A/F, 8%, 10)
A = 6, 80,583.197 [i / (1+i) N -1]
A = 6, 80,583.197 [0.08 / (1.08)10 -1]
A = Rs 46,980.31 (Ans)

Example 3.13
How many deposits of Rs 25,000 each should Dr. Thakur make
each month so that the final accumulated amount will be Rs 10,
00,000 if the bank interest rate is 12% per year? (TU, IOE 2063)
Solution
Given: A = 25,000 per month, F = 10, 00,000, i =12% per year
Monthly interest rate,
im = (1+iyear)1/12 -1
im = (1+0.12)1/12 -1
im = 0.0094 = 0.94%
Using the uniform series compound amount factor
F = A (F/A, 0.94%, N)
10, 00,000 = 25,000 {((1+0.0094) N – 1)/ 0.0094}
0.376 = (1.0094) N -1
1.376 = (1.0094) N
Taking log on both sides
Log 1.376 = N Log 1.0094
N = 34, Dr. Thakur should make 34 deposits (Ans)

(4) To Find A when P is given

We know, P = A [(1+i) N - 1] / [i * (1+i) N]

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
A= P [i*(1+i) N] / [(1+i) N -1]
The quantity in a bracket is called the capital recovery factor
Functionally, A= P (A/P, i%, N)
Capital recovery is the annual equivalent of capital cost

Example 3.14
A man aged 40 years now had borrowed Rs, 5, 00,000 from a bank
for his further studies at the age of 20 years. Interest was charged at
11% per year compounded quarterly. He wished to pay loan in
semiannual equal installments with the first installment beginning 5
years after receiving the loan. He has just cleared the loan now.
What amount did he pay in each installment? (TU, IOE-2062)

Solution
Rs 5, 00,000

21 22 23 24 25 26 27 28 29 39 40
20

A
Given: P = Rs 5, 00,000, i=11%per compounded quarterly, N=20
years, A =?
Quarterly interest rate,
iq = 11%/4 = 2.75%
Semiannual interest rate
isemi = (1+iq)2 -1
isemi = (1+0.0275)2 -1
isemi = 5.57%
Using the single payment compound amount factor
F =5, 00,000 (F/P, 5.57%, 40) …………….. (1)
Using the uniform series compound amount factor
F = A (F/A, 5.57%, 30) …………………… (2)
Equating equation (1) and (2)
5, 00,000 (1+0.057)40 = A {((1+0.057)30 -1/ 0.057}
A = Rs 61,217.3 is the semiannual payment (Ans)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

Interest factor and symbols

To Given Factor Factor name Functional
find symbol
SINGLE CASHFLOW
F P (1+i)N Single payment {F/P, i%, N}
compound amount
P F 1/(1+i)N Single payment present {P/F, i%, N}
equivalent
UNIFORM SERIES
F A (1+i)N -1/ Uniform series {F/A, i%, N}
i compound amount
P A (1+i)N-1 Uniform Series present {P/A, i%, N}
i*(1+i)N worth
A F i Sinking fund {A/F, i%, N}
(1+i)N-1
A P i*(1+i)N Capital recovery {A/P, r%, N}
(1+i)N-1

2.6 Continuous compounding and continuous compounding

formulas
(a) Continuous compounding and discrete cash flow
The interest formula (for this) assumes, cash whenever it is
available, can usually be used profitably. Here cash flows
occurs at discrete interval (e.g. once per year) but it is
compounded continuously throughout the interval.
Let the nominal rate of interest per year be r, if the interest is
compounded continuously for M times and if the principal
amount is Rs 1 then the amount at the end of year will be
1 (1+r/M) M
= (1+r/M) M -1 …….. (1)
Let M/r = p, M= pr
Equation one becomes (1+1/p) pr = {(1+1/p) p} r
Here as M ∞, p ∞
As p lim ∞ (1+1/p)p = e

M lim ∞ (1+1/p)pr = er-1

i = er-1
er is equal to (1+i) (i= effective interest rate )

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
er = (1+i)
i= er -1
We have F = P (1+i) N
F = perN
F = P {F/P, r%, N}
(Continuously compounded compound amount factor for single
cash flow)
r% is used to denote the nominal rate and the use of continuous
compounding
Interest factors and symbols
To Given Factor Factor name Functional
find symbol
SINGLE CASHFLOW
F P erN Continuous compounding {F/P, r%, N}
compound amount
P F e-rN Continuous compounding {P/F,r%, N}
present equivalent
UNIFORM SERIES
F A erN-1 Continuous compounding {F/A, r%, N}
er -1 compound amount
P A erN-1 Continuous compounding {P/A, r%, N}
erN(er-1) present equivalent
A F er-1 Continuous compounding {A/F, r%, N}
erN-1 sinking fund
A P erN(er-1) Continuous compounding {A/P, r%, N}
erN-1 capital recovery
(b) Continuous compounding and continuous cash flow
Continuous cash flow means a series of cash flows occurring at
infinitesimally short interval. The interest formula could be applied
to companies having receipts and expenses that occur frequently
during each working day and interest is compounded continuously.
Let, Nominal interest per year = r
If there are p numbers of payment per year which amount to a
total of one unit per year, then F

0 1

P 1/p
Fig 3.4 Cash flow of Continuous compounding for 1 year
Er. Santosh K. Shrestha Er. Ishwar Adhikari
 Fundamentals of Engineering Economic Analysis

We have
F = A {(1+i) N-1/i}
F = A {(1+i)-1/i} (if N=1)
Future equivalent at the end of year 1
F = 1/p {(1+r/p) p -1 / r/p}
F= {(1+r/p) p -1/r}
AS F= P (1+r/p) p
P = (1+r/p) p -1
r (1+r/p)p
As lim (1+r/p) p = er
p ∞
Present equivalent of continuous one year cash flow
P = 1{er-1 / r(er)}
P = er-1/rer
(P/A, r%, N) = erN-1/rerN
Where A = amount flowing uniformly and continuously over
one year.
Interest factors and symbols
To Given Factor Factor name Functional
find symbol

F A erN-1/r Continuous compounding {F/A, r%, N}

compound
amount(continuous uniform
cash flow)
P A erN- Continuous compounding {P/A, r%, N}
1/rerN present
equivalent(continuous
uniform cash flow)
A F r/erN -1 Continuous compounding {F/A, r%,
sinking fund (continuous N}
uniform cash flow)
A P rerN/erN Continuous compounding {A/P, r%, N}
-1 present equivalent

Example 3.15
Suppose that Mr. Keshab has a present loan of Rs 1,000 and desired
to determine what equivalent uniform end of year payments, A,

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
could be obtained from it for 10 years if the nominal interest rate is
20% compounded continuously.
Solution
Here P = Rs 1,000, N=10 years, i=20%compounding continuously,
A=?
We know that,
A = P (A/P, r%, N)
= 1,000 {erN(er-1)/erN-1}
= 1,000 {e0.2*10 (e0.2-1)/e0.2*10-1}
= 1,000 {7.389 (0.221)/6.389
= Rs 256 (Ans)

Example 3.16
Calculate the future worth of the following cash flows deposited at
8% compounded continuously for five years (i) Rs 50,000 at the
beginning of each year (ii) Rs 50,000 at the end of each year. (TU,
IOE-2064)

F=?
Solution
(i)
0 1 2 3 4 5

50,000
Using Continuous compounding compound amount factor
F = A {F/A, r%, N}*er = A (erN-1/r) = 50,000 (e0.08*5-1/e0.08) *
e0.08 = Rs 3, 19,850 (Ans)
(ii) F=?

0 1 2 3 4 5

50,000

Using continuous compounding compound amount factor

F = A {F/A, r%, N) = 50,000 (erN-1/ er -1) = 50,000(e0.08*5-1/ e0.08 -1)
= Rs 2, 95,258 (Ans)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

2.7 Interest calculation for linear gradient series

An arithmetic gradient is a cash flow series that either increases or
decreases by a constant amount. The amount of increase or decrease
is the gradient (G). Formulas previously developed for uniform cash
flow series have earend amounts of equal value. In case of a
gradient series, each year end cash flow is different, so new
formulas must be derived. The cash flow at the end of year 1 is not
part of the gradient series, but is rather a base amount. This is
convenient because in actual applications, the base amount is
usually larger or smaller than the gradient increase or decrease.

A1 + (N-1) G
A1 + (N-2) G
A1 +4G
A1 +3G
A1 +2G
A1 +G
A1

0 1 2 3 4 5 N-1 N

Fig3.5: Increasing gradient series

0 1 2 3 4 5 N-1 N

A1 - (N-2) G

A1 -4G
A1 -3G
A1 - 2G
A1 A1 -G

Fig3.6: Decreasing gradient series

1. To find F when G is given

Let us consider the following cash flow

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
(N-1) G
(N-2) G
First cash
4G flow occurs
3G at the end of
2G period two
i.e. first cash
G flow is zero

0 1 2 3 4 5 N-1 N

Fig3.7: Cash Flow diagram for uniform Gradient series

The future equivalent, F, of the arithmetic sequence of cash flows

shown in fig 3.6 is
F = G (F/A, i%, N-1) + G (F/A, i%, N-2) + …………+ G (F/A, i%,
2) + G (F/A, i%, 1)
(1 + i) N −1 − 1 (i + i) N − 2 − 1
F = G [ + + ----------------- +
i i
(i + i ) 2 − 1 (i + i ) 1 − 1
+
i i

G NG
F= [(1+i) N-1 + (1+i) N-2 + ……………. + (1+i) 2 + (1+i) 1 + 1] -
i i
G [ (1 + i ) − 1] − NG
N

F=
i i i
The quantity in the bracket is called the Gradient to Future
equivalent factor
G NG
Functionally, (F/G, i%, N) -
i i

2. To find A when G is given

G (1 + i) N − 1 NG
F=[ [ ]−
i i i
(i + i) − 1 G (1 + i ) N − 1 NG
N

A[ ]= [ ]−
i i i i
Er. Santosh K. Shrestha Er. Ishwar Adhikari
 Fundamentals of Engineering Economic Analysis

1 N
A = G[ − ]
i (1 + i ) N − 1
The quantity in the bracket is called the Gradient to uniform series
factor
Functionally, G (A/G, i%, N)

3. To find P when G is given

G (1 + i) N − 1 NG
F= [ ]−
i i i
G (1 + i) N − 1 NG
P (1+i) = [
N
]−
i i i
(1 + i) N − 1 G NG 1
 P=[ ] - *
i(1 + i) N i i (1 + i ) N
1 (1 + i ) N N
P=G( [ ]− )
i i (1 + i ) N
i (1 + i ) N
G (1 + i ) N − Ni − 1
P= [ ]
i2 (1 + i ) N
The quantity in the bracket is called the Gradient to present
equivalent factor
Functionally, G (P/G, i%, N)

Example 3.17
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 there after 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
10th year of the above service.

Solution
G = Rs 500, i=15%, N =10 years, F =?

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money

1 2 3 4 5 6 7 8 9 10
0

4,000
4,500
5,000
5,500 6,000
6,500
7,000 7,500
8,000
= 8,500

0 1 2 3 4 5 6 7 8 9 10

4,00 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000 4,000
0

0 1 2 3 4 5 6 7 8 9 10
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500

Using uniform series and Gradient to future equivalent factor

F = FA + FG
F = A (F/A, 15%, 10) + G (F/G, i%, 10)
(1 + i) N − 1 G (1 + i ) N − 1 NG
F= A [ ]+ [ ]−
i i i i
(1 + 0.15 ) − 1 500 (1 + 0.15 )10 − 1 10 * 500
10

= 4,000 ]+ [ ]−
0.15 0.15 0.15 0.15
= Rs 1, 15,562 (Ans)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

Example 3.18
Ram and Shayam have just opened two saving accounts. The
accounts earn 10% annual interest. Ram wants to deposit Rs.1, 000
in his account at the end of the 1st year and increase this amount by
Rs.300 for each of the following 5 years. Shayam wants to deposit
an equal amount each year for next 6 years. What should be the size
of the Shayam’s annual deposit so that the two accounts would have
equal balance at the end of 6 years?

Solution
Given: G = Rs.300, i=10%, N =6 years

Ram’s Cash flow

1 2 3 4 5 6
0
1,000
1,300
1,600
=
1,900
2,200
= 2,500

0 1 2 3 4 5 6

1,000 1,000 1,000 1,000 1,000 1,000

+
0 1 2 3 4 5 6

300
600
900
1,000
1,200
Using Gradient to uniform series conversion factor
A = A +G (A/G, 10%, 6)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
1 N
= 1,000+ G[ − ]
i (1 + i ) N − 1
1 6
= 1,000 + 300[ − ]
0.1 (1 + 0.1)6 − 1
= 1,000+ 300(2.2236)
= Rs. 1,667.08 (Ans)

Alternatively
P = 1,000(P/A, 10%, 6) + 300(P/G, 10%, 6)
= 1,000 (4.3553) +300 (9.6842)
= Rs.7, 260.56
A = P (A/P, 10%, 6)
= Rs. 1,667.02 (Ans) this is Shayam’s annual contribution.

Example: 3.19
Suppose that one has cash flows as follows.
End of year Net Cash Flow
1 -8000
2 -7000
3 -6000
4 -5000
Calculate the Present equivalent at i=15%

Solution
1 2 3 4
0
5,000
7,000 6,000
8,000
P =?

=
0 1 2 3 4

8,000 8,000 8,000 8,000

-

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

3,000
2,000
1,000
0
1 2 3 4
Using Gradient to present equivalent conversion factor
= 8,000 (P/A, 15%, 4) – 1000 (P/G, 15%, 4)
= 8,000 [(1+0.15)4-1/ (1+0.15)4 *0.15] – 1,000/0.152[
(1 + 0.15) 4 − 4*0.15 − 1
(1 + 0.15) 4
= 22,864 - 3,786
= Rs 19,078 (Ans)
Example 3.20
Consider the cash flow as below:
End of year Net Cash Flow
1 200,000
2 175,000
3 150,000
4 125,000
5 100,000
Calculate the Present equivalent using gradient series formula at
i=10% per year.
Solution

Given: G =25,000, N =5, i=10%

200,000
175,000
150,000
125,000
100,000

0 1 2 3 4 5

P=?

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money

200,000 200,000 200,000 200,000 200,000

0 1 2 3 4 5

- 100,000
P1=? 75,000

50,000
25,000

0 1 2 3 4 5

P2=?
Using uniform series present worth factor and Gradient to present
equivalent conversion factor
P= P1 –P2
P = 2, 00,000 (P/A, 10%, 5) – 25,000 (P/G, 10%, 5)
P = 2, 00,000 [(1+0.1) 5 - 1] / [0.1* (1+0.1) 5] –
25, 000 (1 + 0.1)5 − 5*0.1 − 1
[ ])
0.12 (1 + 0.1)5
P = 7, 58,160 – 1, 71,545
P = 5, 86,615 (Ans)

2.8 Interest calculation for geometric gradient series

Many Economic problems involve cash flows that increase or
decrease over time, not by a constant amount (linear gradient) but
rather by a constant percentage (geometric), which is called
compound growth. We use g to designate the percentage change in
payment from one period to the next. The magnitude of nth
payment, An, is related to the first payment A1, is expressed by
An = A1 (1+g) n-1, where n=1, 2, 3…N

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

Fig3.8: Cash Flow diagram for geometric gradient

increasing series

Fig3.9: Cash Flow diagram for geometric gradient

decreasing series

Present worth Factor, Find P, given G, g, i, N

If i ≠ g

P = A1 [ 1- (1+g)N (1+i) –N ]
i–g
If i = g
P = [NA1/ (1+i)-1]

Functionally,

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
P = A1 (P/A1, g, i, N) Geometric gradient series present worth
factor

Future worth Factor, Find F, given G, g, i, N

If i ≠ g

F = A1 [(1+i)-N- (1+g)N ]
i–g
If i = g
F = NA1 (1+i) N-1
Functionally,
F= A1 (F/A1, g, i, N) Geometric gradient series future worth factor

Example: 3.21
Air plane ticket price will increase 8% in each of the next four
years. The cost at the end of the first year will be Rs. 2000. How
much should be put away now to cover a passenger travel home at
the end of each year for the next four years. Assume i=5%.

Solution
Given: A1 =2000, g=8%, i=5%
Here i ≠ g
P = A1 [1- (1+g)N (1+i) –N ]
i–g

= 2000 [1- (1+0.08)4(1+0.05) –4 ]

0.05 – 0.08
= 20000* 3.9759
= Rs. 7951.84 (Ans)

For Check; Without Using Geometric gradient

For year 1: A1 = 2000
For year 2: A2 = 2000 + 0.08 (2000) = 2160
For year 3: A3 = 2160 + 0.08 (2160) = 2332.8
For year 4: A3 = 2333.8 + 0.08 (2332.8) = 2519.24
P = 2000 (P/F,5%, 1) + 2160 (P/F, 5%, 2) + 2332.8 (P/F, 5%, 3) +
2519.24 ( P/F, 5%, 4)
= 2000 (1+0.05) -1 + 2160 (1+0.05)-2 + 2332.8 (P/F, 5%) -3 +
2519.24 (1+0.05) -4
= 1904.76 + 1959.18 + 2015.16 + 2072.58 = 7951.684 (Ans)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

Example: 3.22
An investment of Rs. 100,000 is made in a limited partnership in a
natural gas drilling project. The first year of the investment
produced net revenue of Rs. 25,000. Over a 20 year period, the net
revenue received from the investment decreased by 10% each year.
Based on a interest rate of 12%, what is the present worth for the
investment?

Solution
Given; A1 = 25,000, i =12%, g= -10%, and N=20 years.
PW = -100,000 + 25,000 (P/A1, 12%, -10%, 20)
= -100,000 + 25,000 [1- (0.9)20 (1.12) –20 ]
012 – (-0.1)
= 12,204.15 (Ans)

Example: 3.23
A graduating Civil Engineer is going to make Rs 35000 per year
with granite construction. A total of 10% of the salary will be placed
in the mutual fund of their choice. The engineer can count on a 3%
salary increase for the next 30 years of employment. If the engineer
place the retirement fund in a account averaging 12% over the
course of a career. What can he expect at retirement?

Solution
Given: A1 = 10% of 35000 = Rs 3500, i=12%, g=3%, N =30 years
Here i ≠ g
F = A1 [(1+i) -N- (1+g) N]
i–g
= 3500 [(1+0.12) -30- (1+g) 30]
0.12 –0.03
= Rs 1070714

2.9 Introduction to Financial and Economic Analysis

Financial and economic analysis are required to determine overall
project feasibility and sometimes use the same data, they are
conceptually different type of analysis. The objective of economic
analysis is to determine if a project represents the best use of

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
resources over the analysis period. (that is the project is
economically justified). The objective of financial analysis is to
determine financial feasibility (that is whether someone is willing to
pay for a project and has a capability to raise the necessary funds).

In financial analysis, evaluation is from the perspective of parties

expected to pay their allocated costs. Evaluation period is the bond
repayment period. Interest paid during construction is included.
Project income and capital and annual operation costs are estimated
in inflated rupees.

In economic analysis, evaluation is from the many perspective (like

individuals, communities etc). Evaluation period is the economic
life of the project. Project benefits and capital and annual operation
costs are estimated in un-inflated rupees. Financing costs are not
included.

2.10 Life Cycle Cost

The Life cycle cost, as it name implies is commonly applied to
alternatives with cost estimates over the entire system life span. This
means that costs from the very early stage of the project (initiation)
through the final stage (phase-out and disposals) are estimated.
Typical applications for life cycle cost are buildings (new
construction or purchase), manufacturing plants, commercial
aircraft, new automobiles model and the like. A present worth
analysis with all definable costs estimated may be considered a life
cycle cost analysis. Life cycle cost is most effectively applied when
a substantial percentage of the total costs over the system life span,
relative to the initial investment, will be operating and maintenance
costs. To understand how a life cycle cost analysis works, first we
must understand the phases and stages of system development.
Generally, life cycle cost estimates may be categorized into a
simplified format for the major phases of acquisition and operation
and their respective stages.

Acquisition phase: all activities prior to the delivery of products

and services.

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 Fundamentals of Engineering Economic Analysis

• Requirements definition stage: Includes determination of

user/ customer needs, assessing them relative to the
anticipated system, and preparation of the system
requirements documentation.
• Preliminary design stage: Includes feasibility study,
conceptual, and early-stage plans; final go/no go decision is
probably made here.
• Detailed design stage: Includes detailed plans for resources-
capital, human, facilities, information system, marketing
etc. there is some acquisition of assets, if economically
justifiable.
Operation phase: all activities are functioning, product and
services are available.
• Construction and implementation stage: Includes purchase,
construction, and implementation of system components,
testing, preparations etc.
• Usage stage: Uses the system to generate products or
services.
• Phase-out and disposal stage: Covers time of clear transition
to new system; removal/recycling of old system.

Some solved examples

1. Mr. X receives a loan of Rs 1, 20,000 from a bank at an

interest rate of 12% per year. He wishes to repay the loan in
monthly installment with Rs 3,000 per month. How many
installments are necessary to complete his payment? (TU,
IOE 2066)
Solution
Given: P = Rs 1, 20,000, i=12% per year, A = 3,000 per month,
N =?
Since i is in year and A is in month, it is not compatible.
Find i per month first using
im= (1+iyear) 1/12 -1
= (1+0.12) 1/12 -1 = 0.95%
Now using the concept of Equivalence

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
120,000 = 3,000 (P/A, 0.95%, N)
40 = (1+0.0095) N-1)/ 0.0095*(1+0.0095) N
0.38(1+0.0095) N = (1+0.0095) N-1
0.62 (1+0.0095) N = 1
Taking log on both sides
N log 1.0095 = log (1/0.62)
N = 50.5 months (Ans)

2. Find the value of G if i=10% (TU, IOE, 2066)

4G
5,000

0 1 2 3 4 5

50,000
Solution
P = 5,000, N=5, i=10%, G=? 5,000

0
1 2 3 4 5

+
50,000
4G
3G
2G
G
0
1 2 3 4 5
50,000
Applying the uniform series present worth factor and gradient series
present worth factor
50,000 = 5000 (P/A, 10%, 5) + G (P/G, 10%, 5)
Or, 31,046 = 6.8618G

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 Fundamentals of Engineering Economic Analysis

Or, G = 4,524.5 (Ans)

3. Suppose that the guardian of a boy decides to make annual

deposits into a saving account, with the first deposit begin
on the boy’s fifth birthday and the last deposit ends on
boy’s fifteenth birthday. Then starting on the boy’s
eighteenth birthday, the withdrawal will be Rs 4,000 every
year till the boy’s twenty first’s birthday. If the effective
annual interest rate is 8% during this period of time, what
are the annual deposits in year five through fifteen? (PU
2006)
Solution
i=8%, withdrawal =Rs 4,000 from 18th to 21st year
Discounting the withdrawal series to year 15
{4,000 (P/A, 8%, 4)} (P/F, 8%, 2) = Rs 11,358
Again applying uniform series compound amount factor
11,358 = A (F/A, 8%, 11)
11,358= 16.645 A
A = Rs. 682.36 (Ans)
4. What is equal payment series for 12 years that is equivalent
to a payment series of Rs 20,000 at the end of first year
increasing by 10% per year? Interest rate is 8% per year.
(TU, IOE, 2069)
Solution
Given: the first payment (A1) = 20,000, g= 10%, i=8%,N=12 years,
annual equivalent (A) = ?
This is the case of increasing geometric gradient series.
Here i is not equal to g, and we calculate the equivalent future of at
the end of year 12 for the given series of cash flow.
F = A1 [(1+i)-N- (1+g) N]
i–g
= 20,000 {1+0.08)-12 – (1+0.1)12}
0.08 – 0.10
= Rs 620258.25
Converting this future value into the annual equivalent
A = 620258.25 (A/F, 10%, 12)
= 620258.25 * 0.0468 = Rs. 29028.08 (Ans)

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money

5. Mr. Kumar has inspected his yearly household expenses for

the last 10 years. Cost averages were steady at Rs 1, 00,000
per year for the first 5 years, but have increased consistently
by Rs 15,000 per year for each of the last 5 years. Calculate
total present worth in year zero. Use gradient formula. (TU,
IOE, 2068)
Solution
1 2 3 4 5 6 7 8 9 10
0

1, 00,000
1, 15,000
1, 30,000
1, 45,000
1, 60,000
1, 75,000
6 7 8 9 10
5

1, 15,000
1, 30,000
1, 45,000
1, 60,000
= 1, 75,000
6 7 8 9 10
5

1, 15,000
+

6 7 8 9 10
5

15,000
30,000
45,000
60,000
Now using the gradient relation (assume i=10%)
P5 = 115000 (P/A, 10%, 5) + 15000 (P/G, 10%, 5)
= 115000 * 3.7908 + 15000 * 6.8618
= 435942 + 102927
= 538869

Now discounting all the cash flow into year zero.

P = 538869 (P/F, 10%, 5) + 100000 (P/A, 10%, 5)

Er. Santosh K. Shrestha Er. Ishwar Adhikari
 Fundamentals of Engineering Economic Analysis

= 538869 *0.6209 + 100000 * 3.7908

= Rs. 713663.76 (Ans)

Review Questions
1. Explain Time value of Money.
2. What is the practical application of the different interest
formulas?
3. Differentiate between nominal and effective interest rate.
Exercises
1. For an interest rate of 8%, compounded annually, find (i)
how much can be loaned now if Rs. 5,000 will be repaid at
the end of 5 years? (ii) How much will be required in 4
years to repay a Rs 12,000 loan now? (3402.92, 16325.87)
2. You bought 100 shares on 2065 Chaitra 31. Your intention
is to keep the stock until it doubles in value. If you expect
15% annual growth for shares, how many years do you
expect to hold on the stock of shares? Compare the solution
obtained by rule of 72. (5 years)
3. How much invested now at 6% would be sufficient to
provide three payments with the first payment in the amount
of Rs 2,000 occurring at the end of 1st year, Rs 3,000 at the
end of 5 years, and Rs 4,000 at the end of 3 years?
(7487.04)
4. What equal annual series of payments must be paid into a
sinking fund to accumulate the following amount?
(a) Rs 10,000 in 13 years at 5% compounded annually
(564.56)
(b) Rs 25,000 in 10 years at 9% compounded annually
(1645.50)
(c) Rs 15,000 in 25 years at 7% compounded annually
(237.16)
(d) Rs 8,000 in 8 years at 12% compounded annually
(650.42)
5. Part of the income that a machine generates is put into a
sinking fund to replace the machine when it wears out. If Rs
1,500 is deposited annually at 7% interest, how many years

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
must the machine is kept before a new machine costing Rs
25,000 can be purchased? (11.43)
6. What will be the amount accumulated by each of these
present investments?
(a) Rs 2455 in 10 years at 6% compounded semi annually.
(4434)
(b) Rs 5500 in 15 years at 8% compounded quarterly.
(18037.63)
(c) Rs 21000 in 7 years at 9% compounded monthly
(39335.5)
7. Find the present worth of Rs10, 000 per year for 6 years if
the interest rate is compounded continuously? i=10%
(42900)
8. How much money must be invested in an account that pays
6 percent per year interest to be worth Rs 20,000 at the end
of 8 years if interest is compounded (a) annually (b)
semiannually (c) quarterly (d) monthly (e) weekly?
(12,548.25, 12463.34, 12,419.86, 12,390.48 , 12,379.09)
9. A deposit of Rs1, 000 ten years ago at an interest rate of 8%
per year compounded quarterly would be equivalent to how
much money now? (2208)
10. How much money should you be willing to pay now for
guaranteed Rs 6000 per year for 9 years starting next year,
at a rate of return of 16% per year? (27639.263)
11. Suppose that you make $500 monthly deposits to a tax
deferred retirement plan that pays interest rate of 10%
compounded quarterly. Compute the balance at the end
of 10 years. ($101,907.90)
12. ABC Company has a major fabrication plants in Kathmandu
and Pokhara The president want to know the equivalent
future value of Rs 10, 00,000 capital investments each year
for 8 years, starting 1 year from now. ABC Company earns
at a rate of 14% per year. (13232760.16)
13. An engineer is planning for his early retirement 30 years
from now. He believes he can comfortably set aside Rs 60,
000 each year for 30 years, starting now. If he plans to start
withdrawing money in the same year that he makes his last

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Fundamentals of Engineering Economic Analysis

deposit (i.e. year 30), what uniform amount could he

withdraw each year for next 30 years, if the account earned
interest at a rate of 8% per year? (603759.41)
14. Professional engineers require that Rs 5,000 per year be
placed into a sinking fund account to cover any unexpected
major rework on field equipment. In one case, Rs 5,000 was
deposited for 15 years and covered a rework costing Rs 10,
00,000 in year 15. What rate of interest did this practice
provide to the company? (32.12%)
15. An equipment manufacturer is considering replacing its old
spare parts with new one. The company expects to achieve
cost savings of Rs 4000 in the first year and amounts
increases by Rs 850 each year for the next 4 years. At an
interest rate of 12% per year what is the total present worth
of the savings? (19856.56)
16. Mr. Hem, an engineer has inspected the average cost on a
cement production for 8 years. Cost averages were steady at
Rs 10,000 per completed unit for the first 4 years, but have
increased consistently by Rs 5,000 per unit for each of the
last 4 years. Hem plans to analyze the gradient increase
using the P/G factor. Where is the present worth located for
the gradient? What is the gradient relation used to calculate
total present worth in year zero? i=10% (79126.12)
17. A new machine is expected to cost Rs. 6,000 and have a life
of 5 years. Maintenance costs will be Rs.1500 the first year,
Rs.1, 700 the second year, Rs.1, 900 the third year, Rs.
2,100 the fourth year, and Rs. 2,300 the fifth year. How
much should be deposited in a fund that earns 9% per year,
compounded monthly, in order to pay for this machine? (
49298)
18. A father wants to set aside money for his 8 year old son’s
college education, by making annual deposits to a bank
account in his son’s name that pays 8% per annum,
compounded quarterly. What equal deposits must the father
make on the son’s 9th through 17th birthdays, in order for the

Er. Santosh K. Shrestha Er. Ishwar Adhikari

 Interest and Time Value of Money
son to be able to withdraw Rs.4, 000 on each of his four
birthdays from 18th to 21st? (1044.5)
19. Rs. 90,000 investment is made. Over a 5-year period, a
return Rs 30,000 occurs at the end of the first year. Each
successive year yields a return that is Rs 3,000 less than the
previous year’s return. If money is worth 5 percent, use a
gradient series factor to determine the equivalent present
worth for the investment. ( 15,173.55)
20. You are preparing the business plan for a new company. A
net revenue analysis covering the first six years is required
for obtaining financing. Net revenue in a year one is
expected to be Rs 50,000 and increase by 15% each year
thereafter. If interest rate is 12% and the net revenue is
assumed to be end of year cash flow, what is the present
value of the cash flow series over the 6 years? (286,447.62)
21. Deposits are made at the end of year 1 through 7 into an
account paying 5 percent per year interest. The deposits
start at Rs 40,000 and increase by 15% each year. How
much will be in the account immediately after the last
deposit? (50,116.78)
22. What is the amount of 10 equal annual deposits that can
provide five annual withdrawals, when a first withdrawals
of $ 1000 is made at the end of year 11, and subsequent
withdrawals increase at the rate of 6% per year over the
previous year’s , if
(a)The interest rate is 8% compounded annually?
(b)The interest rate is 6% compounded annually? ($307.96,
$ 357.87)
23. A saving bank offers long-term savings certificates at 7.5%
per year, compounded continuously. If a 10-year certificate
costs Rs.100, what will be its value at maturity? Compare
with the value that would be obtained if the interest were
compounded annually rather than continuously. (48.52,
206.1)
24. A person borrows Rs.5, 000 for 3 years to be repaid in 36
equal monthly installments. The interest rate is 10%per
year, compounded continuously. How much money must be
repaid at the end of the each month? (161.5)

Er. Santosh K. Shrestha Er. Ishwar Adhikari