Chapter 8

Introduction to Engineering
Economics
ENE 100 Introduction to Electrical Communication and Electronic Engineering
EIE 140 Introduction to Electronic and Infocommunication Engineering
 Objectives
Students are able to
• Understand that the value of money changes with time
• Distinguish between simple and compound interest
• Prepare a cash-flow diagram
• Compute present worth and future worth of multiple sums of money
• Calculate the equivalent uniform annual cost of a series of amounts
• Recognize and solve problems involving sinking funds and
installment loans
• Solve problems with arithmetic and geometric gradients
2
Outline
I. Introduction
II. Cash-Flow Diagram
III. Simple and Compound Interest
IV. Amortization
V. Present Worth and Future Worth
VI. Annual Worth and Gradients
Reference
Appendix I – Derivation of Amortization
Appendix II – Simplification of the Series
Appendix III – Arithmetic Gradient Series
Appendix IV – Geometric Gradient
3
I. Introduction
• Engineers often serve as manager of business and
therefore are required to make financial as well as
technical decisions.
• Estimation and comparison of tangible costs of new equipment,
facilities, software, processes, and so on, as well as intangible
items such as safety or environmental concerns, must be
carefully considered if the business is to be successful and earn a
profit on its products and services.
• In addition, you will also have applications in your personal life
such as purchases of a home or a vehicle, investments of bonds
or company stock, tax deduction, life insurance, and so on.

4
II. Cash-Flow Diagram
Cash-flow diagram is used to graphically illustrate a transaction.
• The horizontal line is a time scale. The interval of time is normally
given in years.
• The arrows signify cash flow. A downward arrow means
money out, and an upward arrow means money in.
• The diagram is constructed on whether it is the lender’s
or the borrower's points of view.
Cash In

0 1 2 3  𝑛–1 𝑛
Periods of Time
Cash Out
5
 III. Simple and Compound Interest
Simple interest is the interest calculated by multiplying the
principal amount by the product of the interest rate and the
number of periods, for example, yearly. Principal Amount
Interest Accrued
𝐼 = 𝑃𝑛𝑖 Interest Rate per Period
Number of Interest Periods
• For example, you open a fixed-deposit account with a bank for a
long-term investment. If 10 000 baht were deposited with 2.25% fixed
interest per annum for five years, the interest would be
𝐼 = 10 000 baht 5 years 0.022 5 per year = 1 125 baht

6
III. Simple and Compound Interest (Cont’d)
• The amount you will get back at the end of the period is the
deposit 10 000 baht added to the interest 1 125 baht.
Future Worth 𝐹 =𝑃+𝐼
= 𝑃 + 𝑃𝑛𝑖 Number of Interest Periods
= 𝑃 1 + 𝑛𝑖
Principal Amount Interest Rate per Period

𝐹 = 10 000 baht 1 + 5 years 0.022 5 per year = 11 125 baht

• When you invest in a fixed deposit, remember that the interest rate
is not the same for all tenures. If you choose the longest tenure
available, does not mean you will get the highest interest rate. You
should check the bank’s interest rate table.
7
 III. Simple and Compound Interest (Cont’d)
• Cash-flow diagram of a saving transaction with a simple interest
𝐹 = ฿11 125
Today
0 1 2 3 4 5 years
𝑃 = ฿10 000
Customer’s Perspective
𝑃 = ฿10 000

0 1 2 3 4 5 years
Today

Bank’s Perspective 𝐹 = ฿11 125

8
III. Simple and Compound Interest (Cont’d)
• For a loan, if 10 000 baht were to be loaned at 7.05% lending
interest per annum for five years, the interest would be
𝐼 = 10 000 baht 5 years 0.070 5 per year = 3 525 baht
and the total amount to be repaid at the end is
𝐹 = 10 000 baht 1 + 5 years 0.070 5 per year = 13 525 baht

• Simple interest was relegated to the single-interest period. The

time value of money surmises that money is worth more now than
at a future date because it can grow when invested. Any delay is a
lost opportunity for growth.
9
 III. Simple and Compound Interest (Cont’d)
• Cash-flow diagram of a loan transaction with a simple interest
𝑃 = ฿10 000

0 1 2 3 4 5 years
Today

Customer’s Perspective
𝐹 = ฿13 525
𝐹 = ฿13 525

Today
0 1 2 3 4 5 years
𝑃 = ฿10 000
Bank’s Perspective 10
III. Simple and Compound Interest (Cont’d)
Compound interest was then developed. It is calculated on both
the principal amount as well as on any interest accumulated on the
amount. Simply put its interest earned on interest already earned.
• The compound interest then grows at an ever-accelerating
rate. For young people, yet the earlier you start saving, the
more compounding interest can work in your favor, even
with relatively small amounts.
• When making loan repayments, if you make more than your
minimum payment, you can leverage the power of compounding
to save on total interest.

11
 III. Simple and Compound Interest (Cont’d)
• At the end of the first period (𝑛 = 1 − 0 = 1) the owed amount is
𝐹1 = 𝑃 + 𝐼1 = 𝑃 + 𝑃𝑖.
• Then the interest generated during the second period (𝑛 = 2 − 1 = 1) is
𝐼2 = 𝐹1 𝑖 = 𝑃 + 𝑃𝑖 𝑖 = 𝑃𝑖 + 𝑃𝑖 2 . It can be seen that interest is being
calculated not only the principal but on the previous interest as well.
The sum at the end of two periods becomes
𝐹2 = 𝐹1 + 𝐼2 = 𝑃 + 𝑃𝑖 + 𝑃𝑖 + 𝑃𝑖 2 = 𝑃 + 2𝑃𝑖 + 𝑃𝑖 2 = 𝑃 1 + 𝑖 2 .
• In the same way, the interest during the third period (𝑛 = 3 − 2 = 1) is
𝐼3 = 𝐹2 𝑖 = 𝑃 + 2𝑃𝑖 + 𝑃𝑖 2 𝑖 = 𝑃𝑖 + 2𝑃𝑖 2 + 𝑃𝑖 3 and the sum after three
periods is 𝐹3 = 𝐹2 + 𝐼3 = 𝑃 + 2𝑃𝑖 + 𝑃𝑖 2 + 𝑃𝑖 + 2𝑃𝑖 2 + 𝑃𝑖 3
= 𝑃 + 3𝑃𝑖 + 3𝑃𝑖 2 + 𝑃𝑖 3 = 𝑃 1 + 𝑖 3 .
12
III. Simple and Compound Interest (Cont’d)
Sum after 1 period 𝑃 Principal Amount
𝐹1 = 𝑃 + 𝑃𝑖 +𝑃𝑖 Interest during 1st period
=𝑃 1+𝑖

Sum after 2 periods +𝑃𝑖 + 𝑃𝑖 2 Interest during 2nd period

𝐹2 = 𝑃 + 2𝑃𝑖 + 𝑃𝑖 2
=𝑃 1+𝑖 2 +𝑃𝑖 + 2𝑃𝑖 2 + 𝑃𝑖 3 Interest during 3rd period
The interest accrued for each period
Sum after 3 periods
is calculated on the principle plus
𝐹3 = 𝑃 + 3𝑃𝑖 + 3𝑃𝑖 2 + 𝑃𝑖 3
the total interest accumulated in all
=𝑃 1+𝑖 3
previous periods. 13
III. Simple and Compound Interest (Cont’d)
• This procedure can be generalized to n periods of time and will
result in Future Worth Number of Interest Periods
𝐹 =𝑃 1+𝑖 𝑛

Principal Amount Interest Rate per Period

• For example, consider the sum at the end of five years on loan of
10 000 baht with 7.05% annual interest, compounded annually
𝐹 = 10 000 baht 1 + 0.070 5 per year 5 years = 14 058.32 baht
• Thus the previous sum of 13 525 baht when simple interest was
used is lower than the sum with annual compounding of 14 058.32
baht.
14
 III. Simple and Compound Interest (Cont’d)
• This table demonstrates the difference between 7.05% simple and
compound interest on a year-by-year.
Simple Interest Compound Interest
Year
Principal Interest Principal Interest
0 (Today) 10 000 10 000
1 10 000 705 10 000 705.00 𝑃𝑖
2 10 000 705 10 000 754.70 𝑃𝑖 + 𝑃𝑖 2
3 10 000 705 10 000 807.91 𝑃𝑖 + 2𝑃𝑖 2 + 𝑃𝑖 3
4 10 000 705 10 000 864.87 𝑃𝑖 + 3𝑃𝑖 2 + 3𝑃𝑖 3 + 𝑃𝑖 4
5 10 000 705 10 000 925.84 𝑃𝑖 + 4𝑃𝑖 2 + 6𝑃𝑖 3 + 4𝑃𝑖 4 + 𝑃𝑖 5
฿10 000 + ฿3 525 ฿10 000 + ฿4 058.32

Total Owed ฿13 525 ฿14 058.32 15

 III. Simple and Compound Interest (Cont’d)
• Saving with Simple interest Vs. compound interest of 7.05% per year
for 25 years

฿14 058.32
••
฿13 525.00 Principal
•
฿10 000.00

16
 III. Simple and Compound Interest (Cont’d)
• Consider when the annual rate is 7.05%, but it is to be compounded
every six months (half-yearly or semiannually),
then 𝑖 = 0.070 5 per yearΤ2 periods per year = 0.035 25 per period
and 𝑛 = 5 years × 2 periods per year = 10 periods
𝐹 = 10 000 baht 1 + 0.035 25 per period 10 periods
= 14 140.10 baht
• And when compounded monthly,
then 𝑖 = 0.070 5 per yearΤ12 periods per year = 0.005 875 per period
and 𝑛 = 5 years × 12 periods per year = 60 periods
𝐹 = 10 000 baht 1 + 0.005 875 per period 60 periods

= 14 211.53 baht
17
III. Simple and Compound Interest (Cont’d)
• As you can see that even though the interest rate is the same, the
change in the compounding period changes the sum. Thus to
compare different alternatives, we must know the stated annual
interest rate and the compounding period. We can also define an
annual percentage rate (APR) that would have produced the final
amount under annual (rather than semiannually, monthly, daily, or
other) compounding.

• For annual compounding with 7.05% annual interest,

𝐴𝑃𝑅 = 0.070 5 or 7.05% APR
18
III. Simple and Compound Interest (Cont’d)
• For semiannual compounding with 7.05% annual interest,
14 140.10 baht = 10 000 baht 1 + 𝐴𝑃𝑅 per year 5 years
𝐴𝑃𝑅 = 0.071 7 or 7.17% APR

• For monthly compounding with 7.05% annual interest,

5 years
14 211.53 baht = 10 000 baht 1 + 𝐴𝑃𝑅 per year
𝐴𝑃𝑅 = 0.072 8 or 7.28% APR

• The effective APR is always going to be larger than nominal interest.

19
III. Simple and Compound Interest (Cont’d)
• The interest rate charged by commercial banks is
determined by a number of factors, such as the
state of the economy. Bank of Thailand (BOT) sets
the policy interest rate, at which the banks can
borrow money from BOT. Each bank uses this rate
to determine the APR range they offer to customers.
• When inflation occurs, the average prices of goods and services
rise persistently over time. The interest rates will be set at a high
level, the cost of debt rises. It discourages people from borrowing
and slows consumer demand.
• The interest rates will go down, if there is deflation (a negative
inflation rate), to encourage people to spend money.
20
 IV. Amortization
Amortization is to pay down the principal of a loan over
the life of the loan according to an amortization schedule,
typically through regular payments.
• The payments are divided into equal amounts for the duration of
the loan, making it the simplest repayment model. Each periodic
payment is calculated by Principal Amount

Schedule Payment 𝑖 1+𝑖 𝑛 Number of Interest Periods

𝐴=𝑃
1+𝑖 𝑛−1
Fixed Interest Rate per Period
Note: See Appendix I
21
IV. Amortization (Cont’d)
• Amortized loans are beneficial in that there is always a principal
component in each payment, so that the outstanding balance of
the loan is reduced incrementally over time, less interest will be
charged. For example, a five-year loan of 10 000 baht at 7.05%
annual interest. The yearly payment is going to be

5 years
10 000 baht 0.070 5 per year 1 + 0.070 5 per year
𝐴=
1 + 0.070 5 per year 5 years − 1
= 2 442.17 baht per year

22
 IV. Amortization (Cont’d)
• The amortization schedule is as follows
Loan Amount: 10 000 baht Payment Amount: 2 442.17 baht per period
Borrowing Term: 5 years Number of Payment Periods: 5 periods
Annual Interest Rate: 7.05% per year Period Interest Rate: 7.05% per period
No. Payment Interest Principal Balance %Interest %Principal
0 ฿10 000.00
1 2 442.17 705.00 1 737.17 8 262.83 28.87% 71.13%
2 2 442.17 582.53 1 859.64 6 403.19 23.85% 76.15%
3 2 442.17 451.42 1 990.75 4 412.44 18.48% 81.52%
4 2 442.17 311.08 2 131.09 2 281.35 12.74% 87.26%
5 2 442.19 160.84 2 281.35 0.00 6.59% 93.41%
Total ฿12 210.87 + ฿2 210.87 ฿10 000.00
23
IV. Amortization (Cont’d)
• Cash-flow diagram of the amortization
𝑃 = ฿10 000.00

0 1 2 3 4 5 years
Today 𝐴 = ฿2 442.17 ฿2 442.17 ฿2 442.17 ฿2 442.17 ฿2 442.19
Borrower’s Perspective

𝐴 = ฿2 442.17 ฿2 442.17 ฿2 442.17 ฿2 442.17 ฿2 442.19

Today
0 1 2 3 4 5 years

𝑃 = ฿10 000.00 Lender’s Perspective

24
IV. Amortization (Cont’d)
• Prepayment options impact amortization. If you make additional
payments towards the principal, you may be able to pay off more
quickly and reduce the overall interest costs.
• Floating interest rates can impact amortization. The interest
rates, e.g. minimum retail rate (MRR), minimum loan rate
(MLR), and minimum overdraft rate (MOR) that banks charge
from good retail customers, long-term big customers, and
overdraft-type great customers, respectively, are adjusted
according to the economy. If interest rates rise throughout
a loan term, the payments will typically go up as well.

25
V. Present Worth and Future Worth
It is important to keep in mind that the value of any transaction
(loan, investment, and so on) changes with time because of interest.
Thus, to express the value, you must also give the point in time
which that value is computed.
• Present worth (𝑃) is the worth of a monetary transaction
at the current time. It is the amount of money that must
be invested now in order to produce a prescribed sum at
another date.
• Future worth (𝐹) is the worth of monetary transaction at
some point in the future. It is an analysis of what the future amount
of money will be if we take some particular course of action now.
26
V. Present Worth and Future Worth (Cont’d)
• For example, a company can buy a vacant lot and have
a new manufacturing plant constructed on the property.
The timing and costs of various components for the
factory are in the table below. If annual interest is 8%
compounded annually, draw a cash-flow diagram and
determine the future worth of the costs incurred when
the firm begins production at the end of three years.
Year Activity Cost ($)
0 Buy land 75 000
1 Design and initial construction costs 150 000
2 Balance of construction costs 1 150 000
3 Setup production equipment 150 000
Total $1 525 000 27
 V. Present Worth and Future Worth (Cont’d)
• The future worth by compounding the interest,
𝐹 =𝑃 1+𝑖 𝑛
= $75 000 1 + 0.08 per year 3 years
+ $150 000 1 + 0.08 per year 2 years

+ $1 150 000 1 + 0.08 per year 1 year

+$150 000
= $94 478.40 + $174 960.00 + $1 242 000.00 + $150 000
= $1 661 438.40
• In this problem, the source of the money that is being spent must be
examined. If the money is borrowed from a bank, then the company
is paying 8% annual interest.
28
V. Present Worth and Future Worth (Cont’d)
• The company's cash-flow diagram for a loan transaction
Borrowed from a bank for the total amount of $1 525 000.00
$1 150 000.00
$150 000.00 $150 000.00
$75 000.00
In
0 1 2 3 years
Today
Disbursement

Future worth of the costs at the end is $1 661 438.40

29
V. Present Worth and Future Worth (Cont’d)
• The company's cash-flow diagram of the future worth

$94 478.40
$1 150 000.00 $174 960.00
$150 000.00 $1 242 000.00
$75 000.00 $150 000.00
In
0 1 2 3 years
Today

$1 661 438.40

30
V. Present Worth and Future Worth (Cont’d)
• If the company has the money on hand, the cash-flow of the
investment is
Future worth of the investment at the end is $1 661 438.40

Property

Today
Out 0 1 2 3 years
$75 000.00
$150 000.00 $150 000.00
$1 150 000.00
The total investment cost is $1 525 000.00
31
 V. Present Worth and Future Worth (Cont’d)
• The company must also explore what other opportunities for investment
are being forgone in order to build the new factory.
• The property is used for business purpose to produce income during its
useful life that can be determined. However, the property is an asset that
decays, gets used up, wears out, becomes obsolete, or loses value to the
owner or market value from natural causes .
• Depreciation, the gradual reduction in the value of an asset,
must be calculated for recovering the capital that is invested.
As such, when the time comes to replace an asset, funds will
be available to do so. Also, treating depreciation charges as
expenses allows one to incorporate such charges in the cost of production
and ensure that prices are sufficient to recover invested capital.
32
V. Present Worth and Future Worth (Cont’d)
• Another example, determine the capitalized cost of
a public works project that will cost $25 000 000 now
and will require $2 000 000 in maintenance annually
and the effective annual interest rate is 12%.
• The cash-flow diagram of the public works project
Today
0 1 2 3  years
$2 000 000 $2 000 000 $2 000 000
Maintenance cost
$25 000 000
Project cost 𝑃 = 𝐹 1 + 𝑖 −𝑛
𝑃maintenance = 𝐴 σ −𝑛 𝐴
𝑛=1 1 + 𝑛 =
𝑖
Note: See Appendix II 33
V. Present Worth and Future Worth (Cont’d)
• Therefore the capitalized cost is
$2 000 000 per year
𝑃total = 𝑃project + 𝑃maintenance = $25 000 000 +
0.12 per year
= $25 000 000 + $16 666 667
= $41 666 667
• Then the cash-flow diagram for the present worth
Today
0 1 2 3  years

$25 000 000 …

$16 666 667

Capitalized cost
34
VI. Annual Worth and Gradients
• With present and future worth analysis, we resolved cash flows
into single equivalent cash sums. We can also state the value of a
transaction on an equivalent annual basis.
• Annual Worth (𝑨) is the worth of monetary transactions that have
been converted to an equivalent uniform annual cost or benefit
(EUAC or EUAB).
• An annuity involves a series of equal payments at regular intervals.
The value of such a series will be developed from the idea of
compound interest. Consideration of the point in time at which
compounding begins will be of prime importance.

35
 VI. Annual Worth and Gradients (Cont’d)
• Forms of annuities are as annual future worth (sinking fund),
annual present worth (installment loan), and capitalized cost
(infinite life)
• Sinking fund is an annuity that is designed to produce an amount
of money at some future time. The cash-flow diagram for the
sinking fund is as follows.
𝐴 𝐴 𝐴 𝐴 𝐴
Accumulated In
0 1 2 3  𝑛–1 𝑛
Today Available Out
𝐹
36
 VI. Annual Worth and Gradients (Cont’d)
• If an amount 𝐴 is deposited at the end of each period and interest
is compounded each period at a rate of 𝑖, the sum 𝐹 will be
produced after 𝑛 periods.
Deposit at the end of period Interest generated Sum due to this payment
𝑛 None 𝐴
𝑛−1 𝐴𝑖 𝐴 1+𝑖
𝑛−2 𝐴 1+𝑖 𝑖 𝐴 1+𝑖 2

𝑛−3 𝐴 1 + 𝑖 2𝑖 𝐴 1+𝑖 3

…
…

…
1 𝐴 1+𝑖 𝑛−2 𝑖 𝑛−1
𝐴 1+𝑖
37
 VI. Annual Worth and Gradients (Cont’d)
• For four payment 𝑛 − 3, 𝑛 − 2, 𝑛 − 1 and 𝑛
𝐹4 = 𝐴 1 + 𝑖 3 + 𝐴 1 + 𝑖 2 + 𝐴 1 + 𝑖 + 𝐴
= 𝐴 1 + 3𝑖 + 3𝑖 2 + 𝑖 3 + 𝐴 1 + 2𝑖 + 𝑖 2 + 𝐴 1 + 𝑖 + 𝐴
= 𝐴 4 + 6𝑖 + 4𝑖 2 + 𝑖 3
• Multiply and divide it by 𝑖, then add and subtract 1 from the numerator,
the expression becomes
𝐴 1 + 4𝑖 + 6𝑖 2 + 4𝑖 3 + 𝑖 4 − 1 𝐴 1+𝑖 4−1
𝐹4 = =
𝑖 𝑖
• In general, the accumulated future over all periods is
Annuity Number of Interest Periods
𝐴 1+𝑖 𝑛 −1
𝐹= Interest Rate per Period
Future Worth 𝑖 38
 VI. Annual Worth and Gradients (Cont’d)
• For example, determine the money accumulated by a sinking fund if
1 000 baht is deposited at the end of each month for three years with
an annual interest rate of 10% compounded monthly.

𝑖 = 0.10 per yearΤ12 periods per year = 0.008 333 per period
𝑛 = 3 years × 12 periods per year = 36 periods

36 periods
฿1 000 1 + 0.008 333 per period −1
𝐹=
0.008 333 per period
= ฿41 781.57
39
 VI. Annual Worth and Gradients (Cont’d)
• Installment loan is the amortization that annuities are used to
retire a debt by making periodic payment instead of a single large
payment at the end of a given time period.
• Since 𝐹 = 𝑃 1 + 𝑖 𝑛 and 𝐹 = 𝐴 1 + 𝑖 𝑛 − 1 ∕ 𝑖 then
𝑃 1+𝑖 𝑛 =𝐴 1+𝑖 𝑛 −1 ∕𝑖
𝑛 𝑛
Present Worth 𝑃 =𝐴 1+𝑖 −1 ∕𝑖 1+𝑖
Annuity 𝐴 1− 1+𝑖 −𝑛
= Number of Interest Periods
𝑖
𝑃 Interest Rate per Period
Available
0 1 2 3  𝑛–1 𝑛
Today Source Depleted
𝐴 𝐴 𝐴 𝐴 𝐴
40
VI. Annual Worth and Gradients (Cont’d)
• For example, a five-year loan at 7.05% annual interest when you
can only afford a payment of 2 000 baht a year,

𝐴 1− 1+𝑖 −𝑛
𝑃=
𝑖
฿2 400 per year 1 − 1 + 0.070 5 per year − 5 years
=
0.070 5 per year
= ฿9 827.31

41
 VI. Annual Worth and Gradients (Cont’d)
• Capitalized cost refers to the present worth of a long-term investment
that is assumed to last forever (more than, say, 35-40 years).
• For 𝑃 = 𝐴 1 − 1 + 𝑖 −𝑛 ∕ 𝑖 and 𝑛 approaches infinity, then
Annuity
Present Worth
𝐴
𝑃=
𝑖 Interest Rate per Period
𝑃
Capitalization
0 1 2 3 4 
Today Regular Expense
𝐴 𝐴 𝐴 𝐴 (or Benefit)
42
 VI. Annual Worth and Gradients (Cont’d)
Let’s start asking these questions.
• You needs 600 000 baht in 3 years for purchasing your
first car. How much should you deposit each month
in an account?
• You are purchasing your first home and have arranged
for a mortgage of the amount 5 500 000 baht for 30 years.
What will be your monthly payment?
• What does the amount of money must be available at
retirement so that an amount of 20 000 baht can be
withdrawn each month and never affect the principal?

43
VI. Annual Worth and Gradients (Cont’d)
• In many cases, however, annual payments do not occur in equal-
amount payment series. The present worth of this series can be
determined by arithmetic gradients and geometric gradients.
• Arithmetic gradient is a cash-flow series which either increase or
decrease uniformly. The income or payments change by the same
amount called gradient (𝐺) each interest period.
𝐴𝑛
𝐴𝑛−1

…
𝐴3
𝐴2
𝐴1
0 1 2 3  𝑛–1 𝑛
𝑃 44
VI. Annual Worth and Gradients (Cont’d)
• The cash flow can be resolved into two components of base amount
and gradients with present-worth values of 𝑃 and 𝑃, respectively.
𝐴 𝐴 𝐴 𝐴 𝐴
Base
0 1 2 3  𝑛–1 𝑛

𝑃
+ (𝑛– 2)𝐺 (𝑛– 1)𝐺
2𝐺

…
0 𝐺
0 1 2 3  𝑛–1 𝑛
𝑃 45
 VI. Annual Worth and Gradients (Cont’d)
• From the installment loan, 𝑃 = 𝐴 1 − 1 + 𝑖 −𝑛 ∕ 𝑖
Present Worth 𝑃 = 𝑃 + 𝑃 Arithmetic Gradient
Annuity 𝐴 1− 1+𝑖 −𝑛 𝐺 1+𝑖 𝑛 −𝑛𝑖−1
= +
𝑖 𝑖 2 1+𝑖 𝑛
Number of Interest Periods
Note: See Appendix III Interest Rate per Period
• For example, a manufacturing plant installed Year Costs ($)
a new machining cell. It is expected that 1 2 400
initial tooling, adjustments, and repair costs 2 1 800
will be high but that the costs will decline for
3 1 200
several years. The project costs are shown in
the table. What is the present worth of these 4 600
costs if annual interest is 10%? Total $6 000
46
 VI. Annual Worth and Gradients (Cont’d)
• The gradient is $1 800 – $2 400 = $1 200 – $1 800 = $600 – $1 200 = –$600
$2 400 1 − 1 + 0.10 per year − 4 years
𝑃=
0.10 per year
−$600 1 + 0.10 per year 4 years − 4 years 0.10 per year − 1
+
0.10 per year 2 1 + 0.10 per year 4 years
= $7 607.68 − $2 626.87
= $4 980.81
$2 400
$1 800
$1 200
$600
Present worth 0 1 2 3 4 years
of initial tooling,
adjustments,
𝑃 = $4 980.81
and repair costs 47
VI. Annual Worth and Gradients (Cont’d)
• Geometric gradient is a cash-flow which, oftentimes, changes by
a constant percentage or uniform rate (𝑔) in consecutive payment
periods. Number of Interest Periods
𝑛 −𝑛
Annuity 𝑃 = 𝐴 1 − 1 + 𝑔 1+𝑖
where 𝑖 ≠ 𝑔
𝑖−𝑔
Present Worth Geometric Gradient
𝐴𝑛
𝑃= where 𝑖 = 𝑔 𝐴𝑛
1+𝑖 Interest Rate per Period
𝐴𝑛−1
Note: See Appendix IV 𝐴3
𝐴1 𝐴2

0 1 2 3  𝑛–1 𝑛
𝑃 48
 VI. Annual Worth and Gradients (Cont’d)
• For example, the maintenance for an automobile is estimated to be $150
in the first year and is expected to increase at a uniform rate of 10% per
year. Determine the present worth of the cost of the first five years of
maintenance if an 8% annual interest rate is assumed.
5 years − 5 years
$150 1 − 1 + 0.10 per year 1 + 0.08 per year
𝑃=
0.08 per year − 0.10 per year
= $720.65 $219.62
$199.65
$181.50
$150.00 $165.00
0 1 2 3 4 5 years
𝑃 = $720.65 49
VI. Annual Worth and Gradients (Cont’d)
Year Cash Flow 𝑨 ($) Convert to 𝑷 𝑷 ($)
1 150 = 150.00 150(1+0.08)–1 = 138.89
2 150(1+0.10) = 165.00 165(1+0.08)–2 = 141.46
3 150(1+0.10)2 = 181.50 181.50(1+0.08)–3 = 144.08
4 150(1+0.10)3 = 199.65 199.65(1+0.08)–4 = 146.75
5 150(1+0.10)4 = 219.62 219.62(1+0.08)–5 = 149.47
Total $915.77 Total $720.65

50
Albert Einstein once said “Compound interest is the
eighth wonder of the world. He who understands it,
earns it... he who doesn’t... pays it.”

51
Reference
• A. R. Eide, R. D. Jenison, L. L. Northup, and S. K. Mickelson,
“Introduction to Engineering Economics,” in Engineering
Fundamentals and Problem Solving, 6th ed. New York: McGraw-
Hill, 2011, pp. 181-222.

52
 Appendix I – Derivation of Amortization
• To find a payment amount 𝐴 which pay off the loan principal 𝑃 with
an interest rate 𝑖 per period after a specified number of payments 𝑛
• Assuming that all payments are the same amount that consists of its
interest and its principal,
In the 1st payment, 𝐼1 = 𝑃𝑖 and 𝑃1 = 𝐴 − 𝐼1
In the 2nd payment, 𝐼2 = 𝑃 − 𝑃1 𝑖 and 𝑃2 = 𝐴 − 𝐼2
In the 3rd payment, 𝐼3 = 𝑃 − 𝑃1 − 𝑃2 𝑖 and 𝑃3 = 𝐴 − 𝐼3
…

…
In the 𝑛th payment, 𝐼𝑛 = 𝑃 − 𝑃1 − 𝑃2 − ⋯ − 𝑃𝑛−1 𝑖 and 𝑃𝑛 = 𝐴 − 𝐼𝑛
53
 Appendix I – Derivation of Amortization (Cont’d)
• The first payment includes an interest on the total borrowed, which
defines the minimum payment. If you are to make any progress toward
paying off the loan, you must pay more than the amount Pi.
𝑃1 = 𝐴 − 𝐼1 = 𝐴 − 𝑃𝑖
𝑃2 = 𝐴 − 𝐼2 = 𝐴 − 𝑃 − 𝑃1 𝑖 = 𝐴 − 𝑃 − 𝐴 − 𝑃𝑖 𝑖 = 𝐴 − 𝑃𝑖 + 𝐴𝑖 − 𝑃𝑖 2
= 𝐴 − 𝑃𝑖 1 + 𝑖
𝑃3 = 𝐴 − 𝐼3 = 𝐴 − 𝑃 − 𝑃1 − 𝑃2 𝑖
= 𝐴 − 𝑃 − 𝐴 − 𝑃𝑖 − 𝐴 − 𝑃𝑖 + 𝐴𝑖 − 𝑃𝑖 2 𝑖
= 𝐴 + 2𝐴𝑖 + 𝐴𝑖 2 − 𝑃𝑖 − 2𝑃𝑖 2 − 𝑃𝑖 3 = 𝐴 1 + 𝑖 2 − 𝑃𝑖 1 + 𝑖 2

= 𝐴 − 𝑃𝑖 1 + 𝑖 2
…

54
Appendix I – Derivation of Amortization (Cont’d)
• In general, for the 𝑗 th payment of 𝐴 = 𝑃𝑗 + 𝐼𝑗
where 𝑃𝑗 = 𝐴 − 𝑃𝑖 1 + 𝑖 𝑗−1 and 𝐼𝑗 = 𝐴 − 𝐴 − 𝑃𝑖 1 + 𝑖 𝑗−1
• A balloon payment is the final amount due on a loan that is
structured as a series of small monthly payments followed
by a single much larger sum at the end of the loan period.
The early payments may be all, or almost all, payments of
interest owed on the loan, with the balloon payment being
the principal of the loan.
• If there is to be a balloon payment 𝐵, then the final payment will
consist of the final principal payment 𝑃f and interest on that
𝐵
principal, 𝐵 = 𝑃f + 𝐼f = 𝑃f + 𝑃f 𝑖 then 𝑃f =
1+𝑖
55
 Appendix I – Derivation of Amortization (Cont’d)
• Next the sum of all payment is equal to the principal borrowed plus
all of the interest paid with regular payment plus interest paid on the
balloon payment, Principal Amount Interest on Regular Payments
Regular Payments
𝑛𝐴 + 𝐵 = 𝑃 + σ𝑛𝑗=1 𝐼𝑗 + 𝐼f Interest on Balloon Payment
𝐵
Balloon Payments = 𝑃 + σ𝑛
𝑗=1 𝐴 − 𝐴 − 𝑃𝑖 1+𝑖 𝑗−1 + 𝑖
1+𝑖

= 𝑃 + 𝑛𝐴 − 𝐴 − 𝑃𝑖 σ𝑛𝑗=1 1 + 𝑖 𝑗−1 + 𝐵𝑖
1+𝑖
𝐵 1
𝐴= 𝑃− σ𝑛−1 𝑗 + 𝑃𝑖
1+𝑖 𝑗=0 1+𝑖

56
 Appendix I – Derivation of Amortization (Cont’d)
• To simplify the summation, substitute by letting 𝑔 = 1 + 𝑖 so that the
𝑛−1 𝑛−1 1−𝑔
series looks like σ𝑗=0 1 + 𝑖 = σ𝑗=0 𝑔 , then multiply it by
𝑗 𝑗
1−𝑔

𝑛−1
1−𝑔 σ𝑛−1
𝑗=0 𝑔 𝑗 − σ𝑛 𝑔 𝑗
𝑗=1 1 − 𝑔𝑛
෍ 𝑔𝑗 = =
1−𝑔 1−𝑔 1−𝑔
𝑗=0
• Then
𝐵 1 𝐵 −𝑖
𝐴= 𝑃− + 𝑃𝑖 = 𝑃 − + 𝑃𝑖
1+𝑖 1− 1+𝑖 𝑛 1+𝑖 1− 1+𝑖 𝑛
1− 1+𝑖
57
Appendix I – Derivation of Amortization (Cont’d)
• The regularly scheduled payments are
−𝑖 𝐵 −𝑖
𝐴=𝑃 𝑛
− 𝑛
+ 𝑃𝑖
1− 1+𝑖 1+𝑖 1− 1+𝑖
−𝑃𝑖 −𝐵𝑖
= + 𝑃𝑖 −
1− 1+𝑖 𝑛 1+𝑖 1− 1+𝑖 𝑛

𝑖 1+𝑖 𝑛 𝑖
=𝑃 𝑛
+𝐵 𝑛+1
1+𝑖 −1 1+𝑖 − 1+𝑖

• Note that if there will be no balloon payment (𝐵 = 0), then the 𝐵

term drops out.
58
Appendix II – Simplification of the Series
To simplify the series σ
𝑛=1 1 + 𝑖 −𝑛 , substitute by letting 𝑔 = 1 + 𝑖

so that the series looks like σ𝑛=1 𝑔 , then multiply it by
−𝑛 1−𝑔
1−𝑔
 
1 − 𝑔
෍ 1 + 𝑖 −𝑛 = ෍ 𝑔−𝑛
1−𝑔
𝑛=1 𝑛=1
σ
𝑛=1 𝑔
−𝑛 −𝑔 σ 𝑔−𝑛
𝑛=1
=
1−𝑔
σ𝑛=1 𝑔
−𝑛 − 1+σ 𝑔−𝑛
𝑛=1
=
1−𝑔
−1
=
1−𝑔
1
=
𝑖 59
 Appendix III – Arithmetic Gradient Series
For arithmetic gradients,
𝐺 2𝐺 3𝐺 𝑛−2 𝐺 𝑛−1 𝐺
𝑃 = 2
+ 3
+ 4
+  + 𝑛−1
+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
1 2 3 𝑛−2 𝑛−1
𝑃 1 + 𝑖 = 𝐺 + 2
+ 3
+  + 𝑛−2
+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1 + 𝑖 𝑛−1
1 2 3 𝑛−2 𝑛−1
𝑃𝑖 = 𝐺 + 2
+ 3
+  + 𝑛−2
+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1 + 𝑖 𝑛−1
1 2 3 𝑛−2 𝑛−1
−𝐺 2
+ 3
+ 4
+  + 𝑛−1
+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
1 1 1 1 1 𝑛−1
=𝐺 + 2
+ 3
+  + 𝑛−2
+ 𝑛−1
−
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
60
Appendix III – Arithmetic Gradient Series (Cont’d)
1 1 1 1 1 𝑛
𝑃𝑖 = 𝐺 + 2
+ 3
+  + 𝑛−1
+ 𝑛
−𝐺 𝑛
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖 1+𝑖

1+𝑖 𝑛 −1
From installment loan, 𝑃 = 𝐴
𝑖 1+𝑖 𝑛

1+𝑖 𝑛−1 𝑛
𝑃𝑖 = 𝐺 𝑛
−𝐺 𝑛
𝑖 1+𝑖 1+𝑖
1 + 𝑖 𝑛 − 𝑛𝑖 − 1
𝑃 = 𝐺
𝑖2 1 + 𝑖 𝑛
61
 Appendix IV – Geometric Gradient
The cash flow with geometric gradients,
𝐴1 = 𝐴
𝐴2 = 𝐴1 1 + 𝑔 = 𝐴 1 + 𝑔
𝐴3 = 𝐴2 1 + 𝑔 = 𝐴1 1 + 𝑔 2 = 𝐴 1 + 𝑔 2
𝐴4 = 𝐴3 1 + 𝑔 = 𝐴1 1 + 𝑔 3 = 𝐴 1 + 𝑔 3

𝐴𝑛−1 = 𝐴𝑛−2 1 + 𝑔 = 𝐴1 1 + 𝑔 𝑛−2 = 𝐴 1 + 𝑔 𝑛−2

…

𝐴𝑛 = 𝐴𝑛−1 1 + 𝑔 = 𝐴1 1 + 𝑔 𝑛−1 = 𝐴 1 + 𝑔 𝑛−1

From 𝑃 = 𝐹 1 + 𝑖 −𝑛 then
𝑃 = 𝐴1 1 + 𝑖 −1 + 𝐴2 1 + 𝑖 −2 + ⋯ + 𝐴𝑛−1 1 + 𝑖 − 𝑛−1 + 𝐴𝑛 1 + 𝑖 −𝑛

62
 Appendix IV – Geometric Gradient (Cont’d)
Therefore
𝐴 𝐴 1+𝑔 𝐴 1+𝑔 2 𝐴 1+𝑔 𝑛−1
𝑃= + 2
+ 3
+ ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖 1+𝑖
1+𝑔 1+𝑔 1+𝑔 2 1+𝑔 3 1+𝑔 𝑛
𝑃 =𝐴 2
+ 3
+ 4
+⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1 + 𝑖 𝑛+1
1+𝑔 1+𝑔 1+𝑔 2 1+𝑔 3 1+𝑔 𝑛
𝑃 −𝑃 =𝐴 2
+ 3
+ 4
+ ⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 1 + 𝑖 𝑛+1
1 1+𝑔 1+𝑔 2 1 + 𝑔 𝑛−1
−𝐴 + 2
+ 3
+ ⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
63
Appendix IV – Geometric Gradient (Cont’d)
1+𝑔 1+𝑔 𝑛 1
𝑃 −1 =𝐴 𝑛+1
−
1+𝑖 1+𝑖 1+𝑖
1+𝑔 𝑛
𝑃 𝑔−𝑖 =𝐴 𝑛
−1
1+𝑖
𝐴 1− 1+𝑔 𝑛 1+𝑖 −𝑛
𝑃= where 𝑖 ≠ 𝑔
𝑖−𝑔

64
Appendix IV – Geometric Gradient (Cont’d)
When 𝑖 = 𝑔
𝐴 𝐴 1+𝑔 𝐴 1+𝑔 2 𝐴 1+𝑔 𝑛−1
𝑃= + 2
+ 3
+ ⋯+ 𝑛
1+𝑖 1+𝑖 1+𝑖 1+𝑖
𝐴 𝐴 1+𝑖 𝐴 1+𝑖 2 𝐴 1 + 𝑖 𝑛−1
= + 2
+ 3
+ ⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖 𝑛
𝐴 𝐴 𝐴 𝐴
= + + + ⋯+
1+𝑖 1+𝑖 1+𝑖 1+𝑖
𝐴𝑛
=
1+𝑖
65