Engineering Economy

Chapter 4: The Time Value of Money

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The objective of Chapter 4 is to
explain time value of money
calculations and to illustrate
economic equivalence

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Money has a time value
• Capital refers to wealth in the form of
money or property that can be used to
produce more wealth
• Engineering economy studies involve the
commitment of capital for extended
periods of time
• A dollar today is worth more than a dollar
one or more years from now (for several
reasons)
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Return to capital in the form of interest and
profit is an essential ingredient of
engineering economy studies
• Time value is assumed to be the cost of capital
• Interest and profit pay the providers of capital for
forgoing its use during the time the capital is being
used
• Interest and profit are payments for the risk the
investor takes in letting another use his or her
capital
• Any project or venture must provide a sufficient
return to be financially attractive to the suppliers
of money or property
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Simple Interest: infrequently used

When the total interest earned or charged is linearly

proportional to the initial amount of the loan
(principal), the interest rate, and the number of
interest periods, the interest and interest rate are said
to be simple.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Computation of simple interest
The total interest, I, earned or paid may be computed
using the formula below.

P = principal amount lent or borrowed

N = number of interest periods (e.g., years)
i = interest rate per interest period
The total amount repaid at the end of N interest
periods is P + I.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
If $5,000 were loaned for five years at a
simple interest rate of 7% per year, the
interest earned would be

So, the total amount repaid at the end

of five years would be the original
amount ($5,000) plus the interest
($1,750), or $6,750.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Compound interest reflects both the remaining principal
and any accumulated interest. For $1,000 at 10%…

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed Interest Amount
at beginning of amount for owed at end
Period period period of period
1 $1,000 $100 $1,100
2 $1,100 $110 $1,210
3 $1,210 $121 $1,331

Compound interest is commonly used in personal and

professional financial transactions.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Economic equivalence allows us to
compare alternatives on a common basis.
• Each alternative can be reduced to an
equivalent basis dependent on
– interest rate,
– amount of money involved, and
– timing of monetary receipts or expenses.
• Using these elements we can “move” cash
flows so that we can compare them at
particular points in time.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
How much interest is payable each year on a loan of $2,000 if the interest rate is
10% per year when half of the loan principal will be repaid as a lump sum at the
end of four years and the other half will be repaid in one lump-sum amount at the
end of eight years? How much interest will be paid over the eight-year period?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Problem: suppose you have a $17,000 balance on your credit card. “This
has got to stop!” you say to yourself. So you decide to repay the $17,000
debt in four months. Interest rate is 1%/month.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We need some tools to find economic
equivalence.
• Notation used in formulas for compound interest
calculations.
➢ i = effective interest rate per interest period
➢ N = number of compounding (interest) periods
➢ P = present sum of money; equivalent value of one or more cash
flows at a reference point in time; the present
➢ F = future sum of money; equivalent value of one or more cash
flows at a reference point in time; the future
➢ A = end-of-period cash flows in a uniform series continuing for
a certain number of periods, starting at the end of the first period
and continuing through the last

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
A cash flow diagram is an indispensable
tool for clarifying and visualizing a
series of cash flows.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Problem: In a company’s renovation of a small office building, two feasible
alternatives for upgrading the heating, ventilation, and air conditioning (HVAC)
system have been identified. Either Alternative A or Alternative B must be
implemented. The costs are as follows:
Alternative A Rebuild (overhaul) the existing HVAC system
• Equipment, labor, and materials to rebuild . . . . . . . . . . . $18,000
• Annual cost of electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32,000
• Annual maintenance expenses . . . . . . . . . . . . . . . . . . . . . . . 2,400
Alternative B Install a new HVAC system that utilizes existing ductwork
• Equipment, labor, and materials to install . . . . . . . . . . . . $60,000
• Annual cost of electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000
• Annual maintenance expenses . . . . . . . . . . . . . . . . . . . . . . . 16,000
• Replacement of a major component four years hence . . 9,400
At the end of eight years, the estimated market value for Alternative A is $2,000 and
for Alternative B it is $8,000. Assume that both alternatives will provide comparable
service (comfort) over an eight-year period, and assume that the major component
replaced in Alternative B will have no market value at EOY eight. (1) Use a cash-flow
table to tabulate the net cash flows for both alternatives. (2) Determine the annual net
cash-flow difference between the alternatives (B − A).
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Cash flow tables are essential to modeling
engineering economy problems in a spreadsheet

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Relating Present and Future Equivalent Values
of Single Cash Flows
Present single sum, P, and a future single sum, F, separated by N periods
with interest at i% per period.

Finding F when Given P

If an amount of P dollars is invested at a point in time and i% is the interest
(profit or growth) rate per period, the amount will grow to a future amount of
P + Pi = P(1+i) by the end of one period; by the end of two periods, the
amount will grow to P(1 + i)(1 + i) = P(1 + i)2; by the end of three periods, the
amount will grow to P(1 + i)2(1 + i) = P(1 + i)3; and by the end of N periods the
amount will grow to F = P(1 + i)N.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Finding F when Given P and
Vice Versa

F = P(F/P, i%,N)

In a similar way we can find P given F by

P = F(P/F, i%, N)
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Three Rules of Cash Flow

Rule A. Cash flows cannot be added or subtracted unless

they occur at the same point in time

Rule B. To move a cash flow forward in time by one time

unit, multiply the magnitude of the cash flow by (1 + i),
where i is the interest rate that reflects the time value of
money

Rule C. To move a cash flow backward in time by one time

unit, divide the magnitude of the cash flow by (1 + i)

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can apply compound interest
formulas to “move” cash flows along the
cash flow diagram.
Using the standard notation, we find that a
present amount, P, can grow into a future
amount, F, in N time periods at interest rate
i according to the formula below.

In a similar way we can find P given F by

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
It is common to use standard notation for
interest factors.

This is also known as the single payment

compound amount factor. The term on the
right is read “F given P at i% interest per
period for N interest periods.”

is called the single payment present worth

factor.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can use these to find economically
equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six
years if the interest rate is 8% per year?

$3,000 at the end of year seven is equivalent to how

much today (time zero) if the interest rate is 6% per
year?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding i and N

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Relating a Uniform Series (Annuity) to Its Present and Future Equivalent Values
When a cash-flow diagram involving a series of uniform (equal) receipts, each of
amount A, occurring at the end of each period for N periods with interest at i% per
period. Such a uniform series is often called an annuity.
1. P (present equivalent value) occurs one interest period before the first A
(uniform amount),
2. F (future equivalent value) occurs at the same time as the last A, and N periods
after P, and
3. A (annual equivalent value) occurs at the end of periods 1 through N, inclusive.
.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Finding F when Given A
If a cash flow in the amount of A dollars occurs at the end of each
period for N periods and i% is the interest (profit or growth) rate per
period, the future equivalent value, F, at the end of the Nth period is
obtained by summing the future equivalents

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
We know that

The quantity in brackets is called the uniform series present worth factor. We
shall use the functional symbol (P/A, i%, N) for this factor.
Hence, P = A(P/A, i%,N).
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Finding A when Given F

The quantity in brackets is called the sinking fund factor. We

shall use the functional symbol (A/F, i%,N) for this factor.

Finding A when Given P

The quantity in brackets is called the capital recovery

factor.∗ We shall use the functional symbol (A/P, i%, N) for this
factor.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
How much will you have in 40 years if you save $3,000 each
year and your account earns 8% interest each year?

How much would is needed today to provide an annual

amount of $50,000 each year for 20 years, at 9% interest
each year?

How much would you need to set aside each year for 25
years, at 10% interest, to have accumulated $1,000,000 at
the end of the 25 years?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
If you had $500,000 today in an account earning 10% each year, how
much could you withdraw each year for 25 years?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Jonathan borrowed $10,000 at 6% annual compound interest.
He agreed to repay the loan with five equal annual payments
at end-of-years 1–5. How much of the annual payment is
interest, and how much principal is there in each annual
payment?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
In 1885, first-class postage for a one-ounce letter cost $0.02. The same postage in
2015 costs $0.49. What compounded annual increase in the cost of firstclass postage
has been experienced over this period of time?

N = 2015 – 1885 = 130 years

0.49 = 0.02 (1 +i)130
i = 0.0249 or 2.49% per year

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
It can be challenging to solve for N or i.

• We may know P, A, and i and want to find

N.
• We may know P, A, and N and want to find
i.
• These problems present special challenges
that are best handled on a spreadsheet.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding N
Acme borrowed $100,000 from a local bank, which
charges them an interest rate of 7% per year. If Acme
pays the bank $8,000 per year, now many years will it
take to pay off the loan?

So,

This can be solved by using the interest tables and

interpolation, but we generally resort to a computer
solution.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding i
Jill invested $1,000 each year for five years in a local
company and sold her interest after five years for
$8,000. What annual rate of return did Jill earn?

So,

Again, this can be solved using the interest tables

and interpolation, but we generally resort to a
computer solution.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
There are specific spreadsheet functions
to find N and i.
The Excel function used to solve for N is
NPER(rate, pmt, pv), which will compute the
number of payments of magnitude pmt required to
pay off a present amount (pv) at a fixed interest
rate (rate).
One Excel function used to solve for i is
RATE(nper, pmt, pv, fv), which returns a fixed
interest rate for an annuity of pmt that lasts for nper
periods to either its present value (pv) or future value
(fv).
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We need to be able to handle
cash flows that do not occur until
some time in the future.
• Deferred annuities are uniform series that
do not begin until some time in the future.
• If the annuity is deferred J periods then the
first payment (cash flow) begins at the end
of period J+1.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 DEFERRED ANNUITY
Finding the value at time 0 of a deferred annuity is a two-step
process.
1. Use (P/A, i%, N-J) find the value of the deferred annuity at the end
of period J (where there are N-J cash flows in the annuity).
2. Use (P/F, i%, J) to find the value of the deferred annuity at time
zero.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
• How much money should be deposited each year for 12 years if you
wish to withdraw $309 each year for five years, beginning at the end of
the 14th year? Let i = 8% per year.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Sometimes cash flows change by a
constant amount each period.
We can model these situations as a uniform
gradient of cash flows. The table below
shows such a gradient.
End of Period Cash Flows
1 0
2 G
3 2G
: :
N (N-1)G
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 It is easy to find the present value of a uniform
gradient series.
Similar to the other types of cash flows, there is a formula
(albeit quite complicated) we can use to find the present
value, and a set of factors developed for interest tables.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can also find A or F
equivalent to a uniform gradient
series.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Problem: suppose that we have cash flows as follows:

Also, assume that we wish to calculate their present equivalent

at i = 15% per year, using gradient conversion factors.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an
2 3,000
annuity portion of the cash
flows and a gradient 3 4,000
portion. 4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Sometimes cash flows change by
a constant rate, ,each period--this
is a geometric gradient series.

This table presents a End of Year Cash Flows ($)

geometric gradient series. It
1 1,000
begins at the end of year 1
and has a rate of growth, , 2 1,200
of 20%. 3 1,440
4 1,728

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 We can find the present value of a
geometric series by using the appropriate
formula below.

Where is the initial cash flow in the series.

Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 When interest rates vary with
time different procedures are
necessary.
• Interest rates often change with time (e.g., a
variable rate mortgage).
• We often must resort to moving cash flows
one period at a time, reflecting the interest
rate for that single period.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The present equivalent of a cash flow occurring at
the end of period N can be computed with the
equation below, where ik is the interest rate for the
kth period.

If F4 = $2,500 and i1=8%, i2=10%, and i3=11%, then

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Nominal and effective interest rates.
• More often than not, the time between successive
compounding, or the interest period, is less than
one year (e.g., daily, monthly, quarterly).
• The annual rate is known as a nominal rate.
• A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.
• The more frequent the compounding the greater
the effective interest.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 The effect of more frequent
compounding can be easily
determined.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year. We can
find, i, the effective interest by using the formula
below.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Finding effective interest rates.
For an 18% nominal rate, compounded quarterly, the
effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Mary’s credit card situation is out of control because she cannot
afford to make her monthly payments. She has three credit cards
with the following loan balances and APRs: Card 1, $4,500, 21%;
Card 2, $5,700, 24%; and Card 3, $3,200, 18%. Interest
compounds monthly on all loan balances. A credit card loan
consolidation company has captured Mary’s attention by stating
they can save Mary 25% per month on her credit card payments.
This company charges 16.5% APR. Is the company’s claim
correct?
The solution assumes a 10-year repayment period.
ACard 1 = $4,500 (A/P, 21/12 %, 120) = $89.97
ACard 2 = $5,700 (A/P, 2%, 120) = $125.67
ACard 3 = $3,200 (A/P, 1.5%, 120) = $57.66
AConsolidated = $13,400 (A/P, 16.5/12 %, 120) = $228.66
Mary’s current monthly payments total $273.30. The onsolidated payment
represents a ($273.30 − $228.66)/$273.30 × 100% = 16.3%. So while
consolidating the credit cards will benefit Mary, the company has overstated
the amount of this savings.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
You owe your best friend $2,000. Because you are short on cash, you offer to
repay the loan over 12 months under the following condition. The first
payment will be $100 at the end of month one. The second payment will be
$100 + G at the end of month two. At the end of month three, you’ll repay $100
+ 2G. This pattern of
increasing G amounts will continue for all remaining months.
a. What is the value of G if the interest rate is 0.5% per month?
b. What is the equivalent uniform monthly payment?

a. $2,000 = $100 (P/A, 0.5%, 12) + G (P/G, 0.5%, 12)

= $100 (11.6189) + G (63.214)
G = $13.26 per month beginning at the end of month 2
b. A = $2,000 (A/P, 0.5%, 12) = $2,000 (0.0861) = $172.20

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
An amount, P, must be invested now to allow withdrawals of $1,000 per year
for the next 15 years and to permit $300 to be withdrawn starting at the end of
year 6 and continuing over the remainder of the 15-year period as the $300
increases by 6% per year thereafter. That is, the withdrawal at EOY seven will
be $318, $337.08 at EOY eight, and so forth for the remaining years. The
interest rate is 12% per year.

Solution:
P1 = $1,000 (P/A, 12%, 15)
P2 = 300[1-(P/F, 12%, 10)(F/P, 6%, 10)] /(0.12-0.06)
= $8,012
P = P1+P2

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Interest can be compounded
continuously.
• Interest is typically compounded at the end
of discrete periods.
• In most companies cash is always flowing,
and should be immediately put to use.
• We can allow compounding to occur
continuously throughout the period.
• The effect of this compared to discrete
compounding is small in most cases.
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
We can use the effective interest
formula to derive the interest
factors.

As the number of compounding periods gets

larger (M gets larger), we find that

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
Continuous compounding interest
factors.

The other factors can be found from these.

Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.