Engineering Economics

ECOR 3800 - Lecture Notes

Lecture 2: Cashflow Analysis

By: Ahmed Hassan

Based on: Engineering Economics: Financial Decision Making for
Engineers, 7th edition
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 2

Introduction
• Compound interest factors can be used to evaluate
different patterns of cash flows.
• This chapter presents four common discrete cash flow
patterns:
1. Single Disbursement or Receipt
2. Annuity
3. Arithmetic Gradient Series
4. Geometric Gradient Series

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3.1 Timing of Cash Flows and Modelling

• Timing of cash flows are often complicated and irregular
but can work with simplified models and assumptions.
• Assumption: cash flows and compounding occur at the end
of conventionally defined periods.
• Models that make this assumption are called discrete
models.
• Less common are continuous models where cash
flows/compounding occur continuously.

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3.2 Compound Interest Factors for Discrete

Compounding
• Compound interest factors facilitate cash flow analysis.
Spreadsheet functions can be used instead of complicated
formulas.
• Assumptions of Discrete Compounding Models:
1. Compounding periods are of equal length.
2. Each disbursement or receipt occurs at the end of a
period.
 A payment at time 0 considered to be at the end of
time period −1
3. Annuities and Gradients coincide with the ends of
sequential periods (will be covered later).
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3.3 Compound Interest Factors for Single

Disbursements or Receipts (1 of 3)

• Compound amount factor gives future amount, F,

equivalent to a present amount P, interest rate is i and the
number of periods until F is N:
F = P(1 + i) = P(F/P, i, N)

∴ 𝐹/𝑃, i, N = (1 + 𝑖)

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3.3 Compound Interest Factors for Single

Disbursements or Receipts (2 of 3)
• The present worth factor gives the present amount, P,
that is equivalent to the future amount, F, when the interest
rate is i and the number of periods between F and P is N:

P = F/(1 + i) = F(P/F, i, N)

1
∴ 𝑃/𝐹, i, N =
(1 + 𝑖)

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How do we know which equation/formula to

use
• Here is an easy way to remember/figure out which
equation to use What you want in the
numerator
What you have in the
3
4 × ==33
denominator 4
• We can use the same concept when it comes to
compound interest factors…take the case where P is given

𝐹
P× =𝐹 P× =𝐹
𝑃

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3.3 Compound Interest Factors for Single

Disbursements or Receipts (3 of 3)
• Compound interest factors are easy to compute from the
equations.
• Alternatively, appendix A lists values for compound interest
factors over a selection of interest rates and compounding
periods.

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3.3 Compound Interest Factors for Single

Disbursements or Receipts (3 of 3)
• Compound interest factors are easy to compute from the
equations.
• Alternatively, appendix A lists values for compound interest
factors over a selection of interest rates and compounding
periods.
• Using Appendix A, how much will be in the bank account at
the end of 15 years if $100 is invested today and nominal
interest rate is 8 percent compounded semiannually?
• Since a) we need the future value, b) are given the present
value, we know we will need the F/P equation.
• Therefore, we can use: (F/P, i=4%, n=30)
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3.3 Compound Interest Factors for Single

Disbursements or Receipts (3 of 3)
• From table  (F/P, 4%, 30) = 3.243
• Alternatively, you can use the equation:
(F/P, 4%, 30) = (1 + 0.04) = 3.243
• Now all that is left, is to use that to find the future value!
𝐹
𝑃 , 4%, 30 = 𝐹
𝑃
$100 × 3.243 = $324.3

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3.4 Compound Interest Factors for

Annuities (1 of 4)
• Annuity: series of N receipts or disbursements that begin
at end of period 1 and continue to end of period N.
– Loan payments and mortgages are classical examples
of annuities.
• Sinking Fund Factor: series of N receipts/disbursements
that should be set aside each period in order to meet a
major financial need in the future.
𝑖
(𝐴/𝐹, 𝑖, 𝑁) =
(1 + 𝑖) − 1

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3.4 Compound Interest Factors for

Annuities (2 of 4)
• Uniform Series Compound Amount Factor:
– inverse of the sinking fund factor: (A/F, i, N)
– used to compute the total amount saved at the end of a
regular savings plan with constant contribution of an
annuity A.
(1 + 𝑖) − 1
(𝐹/𝐴, 𝑖, 𝑁) =
𝑖

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3.4 Compound Interest Factors for

Annuities (3 of 4)
• The Capital Recovery Factor: (A/P, i, N)
– Is used to compute how much to be set aside each
period to repay a present use of money (example
mortgage or loan repayment installments)

𝑖(1 + 𝑖)
(𝐴/𝑃, 𝑖, 𝑁) =
(1 + 𝑖) − 1

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Example
• You want to save $20 000 for a new car over the time you
are at university (5 years) by saving the same amount A
each month. You can get 7% compounded monthly. What
should you save each month?

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Example
• You save $300/month in your “everyday savings account”
which has 5% interest rate compounded monthly. How
much money will you have at the end of 7 years

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3.4 Compound Interest Factors for

Annuities (4 of 4)
• The Uniform series present worth: (P/A, i, N)
– This is the inverse of capital recovery
– Is used to compute the present worth of a series of
annuity payments to be paid (or received) in the future
(1 + 𝑖) − 1
(𝑃/𝐴, 𝑖, 𝑁) =
𝑖(1 + 𝑖)

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Practice Problem (1 of 3)
• How much principal amount should you have left on your
house mortgage now, so that you only need to pay $2100
per month at 5% fixed interest rate compounded monthly
for the next 15 years?

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Practice Problem (2 of 3)
• A Ford Mustang costs $17,000. It can be financed at 5.9%
for 48 months, with monthly compounding. How much will
the monthly payments be?

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Practice Problem (3 of 3)
• What is the present worth of a series of 16 total annual
payments of $1000 each, when the first payment is now
and the interest rate is 5%, compounded monthly?

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Close-Up 3.1
Capital Recovery Formula
• Capital asset has an initial cost P, and a salvage value, S, after
N periods.
• An equivalent annual cost can be obtained using the capital
recovery factor and the sinking fund factor:
A = P(A/P, i, N) – S(A/F, i, N)
• With some algebra, we have the capital recovery formula:
A = (P – S)(A/P, i, N) + Si

• A is often called the capital recovery cost.

• Capital recovery cost allows us to know what is the annual
return on investment we need to expect for the capital to be
recovered (i.e. not lose money). We will see this in the future
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Practical Example
• In the purchase of equipment, contractors are confronted with how to recover
the cost of purchase and operation over a given life span.

• Assume a contractor buys an earth hauler for $80,000.

• The annual operational costs (operator, fuel, oil, etc.) is $20,000.

• The tire replacement at the end of years 2 and 4 is $11,000.

• Major overhaul at the end of year 3 is $15,000

• Sale at end of year 5 (Salvage value) is $8,000.

• How much annual profit does the contractor needs to make for this purchase
to be justified if the interest rate is 10%?

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3.5 Conversion Factor for Arithmetic

Gradient Series (1 of 2)
• Arithmetic Gradient to Uniform Series Factor: (A/G,i,N)
• A series of N receipts or disbursements that increase by a
constant amount from period to period.

• With base annuity Aꞌ added: Aꞌ, Aꞌ + G, Aꞌ + 2G, ..., Aꞌ + (N−1)G

at the end of periods 1, 2, ..., N.

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3.5 Conversion Factor for Arithmetic

Gradient Series (2 of 2)
• So what we want to do, is convert the “triangular” increase
in distribution to an equivalent annuity
• Annuity equivalent to Gradient Series is A = G(A/G, i, N)
• If there is base annuity Aꞌ, Aꞌ must be included to give the
overall annuity: Atot = Aꞌ + G(A/G, i, N) where:

1 𝑁
𝐴⁄𝐺 , 𝑖, 𝑁 = −
𝑖 1+𝑖 −1

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Example 3.6
• Susan owns an eight-year-old Toyota Prius. She wants to
find the present worth of repair bills over the next four
years. She knows that she needs to take her car for
repairs every six months starting in 6 months. Her repair
bills will start at $500 six-months from now and increase by
$50 every 6 months. What is the present worth of the
repair costs over the next four years if the interest rate is
12% compounded monthly.

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3.6 Conversion Factor for Geometric

Gradient Series (1 of 3)
• A series of cash flows that increase or decrease by a constant
percentage each period.

• Cash flows A, A(1 + g), A(1 + g)2,… A(1 + g)N−1 are at the end of
periods 1, 2, 3, ..., N respectively.

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3.6 Conversion Factor for Geometric

Gradient Series (2 of 3)
• Can model inflation/deflation using geometric series
• Geometric Gradient to PW Conversion:(P/A, g, i, N) with
g is growth rate, positive/negative percentage change
• To account for the growth rate, we need to evaluate the
growth adjusted interest rate defined as 𝑖
1+𝑖
𝑖° = −1
1+𝑔
• Based on this, the present worth of an annuity equation
with a gerometric gradient can be calculated as follows:
(𝑃/𝐴, 𝑖 ° , 𝑁)
(𝑃/𝐴, 𝑔, 𝑖, 𝑁) =
(1 + 𝑔)

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3.6 Conversion Factor for Geometric

Gradient Series (3 of 3)
1. i > g > 0: i° is positive ⇒ use tables or formula

2. g < 0: i° is positive ⇒ use tables or formula

3. g > i > 0: i° is negative ⇒ must use formula

⇒ 𝑃/𝐴 = This
4. g = i > 0: i° = zero is a special case!

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 if comp is notmentioned 29

Example 3.7 assume the same as nominal

• Tru-batt is expecting that its production will increase by

0.25% each month for the next two years. Initially, their
production for the first month is 100 batteries, sold for $800
each. The interest rate is 1.5% per month. What is the
c
present worth of the sales in the first two years.
production first month 100 batteries
g D 25 nominal monthly
Profit
ns years La comp monthly

D base monthly

it 1.5
n 2 12 29 If
Ax f 5 0.25 2 1.590,1 24 P

i 1 2.80no t
12 1 51645.8
29
0.0125
 30

Practice Problem 3.9a (1 of 2)

• A supplier of lab equipment is looking at equipment which
will cost $71,000, have a useful life of 5 years and a
salvage value estimated at $8,000.
a) If the cost of capital (interest rate) is 15% per year,
what are the equivalent annual costs (i.e., the annual
capital recovery costs) of purchasing the equipment?
b) If it produces extra profits of $23,000 per year, is it
justified?

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3.8 When N∞

• Used when the model is reasonable for long-lived projects
• P in this case called the capitalized value
• The capitalized value formula is: P = A/I
(1 + 𝑖) − 1 1
(𝑃/𝐴, 𝑖, ∞) = lim =
→ 𝑖(1 + 𝑖) 𝑖

• The reverse of that is A/P which will be:

𝑖(1 + 𝑖)
(𝐴/𝑃, 𝑖, ∞) = lim =𝑖
→ (1 + 𝑖) − 1

• What about the rest. P/F? F/P? A/F? F/A

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