ENGINEERING ECONOMY LEARNING MODULE

Program: BACHELOR OF SCIENCE IN COMPUTER Topic: INTERESTS FORMULA AND RATES

ENGINEERING
Course: ENGINEERING ECONOMY Instructor: ENGR. RUJEVI S. BADAGUAS
Code BENG01 Module #: 5 Week #: 10-11 # of Pages: 13

I. Preliminaries
Introduction to the In this module includes the discussion of multiple interest formula, nominal and
Module Objective effective rates, bond value, future and annual worth method, and internal and
external rate of return method and some worded problems to be solved.
Assessment/ Evaluation
Section Topics Learning Outcomes Modality
Section 5.1 Interest Formula 1. Solve example problems of Discussion/lecture Presentation
Section 5.2 Multiple Interest future worth, present worth and via Moodle
Formula annuity 05 Seatwork 1
Section 5.3 Nominal Interest
Rates and Effective 2. Differentiate nominal interest
Interest Rates rate from effective interest rate
Section 5.4 Present Worth
Method 3. Differentiate future worth method
Section 5.5 Bond Value from annual worth Method
Section 5.6 Future and
Annual Worth Method 4. Explain internal and external rate
Section 5.7 Internal and of return method
External Rate of Return
Method

II. Instructions
KEYWORDS AND CONCEPTS

Interest rate – relating present and future values of a single cash flows

Annuity – a series of uniform receipts, each of amount occurring at the end of each period for
periods with interest at per period
Ordinary Annuity – a series of equal payments made at the end of consecutive periods over a fixed
length of time

Deferred Annuity – an insurance contract designed for long-term savings which starts annual or
monthly payments

Multiple interest – considered where a series of cash outflows occur over a number of years

Nominal interest rate – interest is quoted as an annual rate

Effective interest rate – the actual or exact rate of interest earned on the principal during one year

Present worth method – a measure of how much money an individual or firm could afford to pay
for the investment in excess of its cost

Bond – an example of commercial value of the present worth of the future net cash flows that are
expected to be received through ownership of an interest-bearing certificate

Future worth method – it is based on the equivalent worth of all cash inflows and outflows at the
end of the study period at an interest rate

Annual worth method – equal annual series of amounts, for a stated study period, that is
equivalent to the cash inflows and outflows at an interest rate

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

Perpetuity – It is when annuity in which payments continue indefinitely

Linear gradients – involves receipts and expenses that are projected to increase or decrease by a
uniform amount each period

Internal rate of return method – most widely used rate of return method for performing engineering
economic analyses

External rate of return method – directly takes into account the interest rate external to a project at
which net cash flows generated by the project over its life can be reinvested

INTERESTS FORMULA AND RATES

SECTION 5.1 INTEREST FORMULA

 Relating present and future values of single cash flows

 Relating a uniform series (annuity) to present and future equivalent values

 for discrete compounding and discrete cash flows

 for deferred annuities (uniform series)

 Equivalence calculations involving multiple interest

 Relating a uniform gradient of cash flows to annual and present equivalents

 Relating a geometric sequence of cash flows to present and annual equivalents

 Relating nominal and effective interest rates

 Relating to compounding more frequently than once a year

 Relating to cash flows occurring less often than compounding periods

 For continuous compounding and discrete cash flows

 For continuous compounding and continuous cash flows

Future Worth

F = P ( 1 + i) N

Where:

F = Future worth of money

N = number of interest period
(1 + i) N = called the single payment compounding amount factor; symbolized
by (F/P, I %, N)

Hence
F = P (F/P, I %, N)

Example 1

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

Suppose you borrow ₱ 8000 now, promising to repay the loan principal plus accumulated interest
in four years at I = 10%/ year. How much would you repay at the end of four years?

Solution:

Present Worth

P = F (1 + i) – N

Where:

P = present worth of money

N = number of interest period
(1 + i) – N = called the single payment present worth factor; symbolized by
(P/F, i %, N)
Hence
P = F (P/F, i %, N)

Example 2

Leo is thinking of purchasing a tract of land that will be worth ₱ 500,000 in six years. If the value of
the land increases at 8% each year, how much should Leo be willing to pay now for this property?

Solution:

P = F (P/F, 8 %, 6)
P = F (1 + i) – N
P = ₱ 500,000 (1 + 0.08) – 6
P = ₱ 315,085

Annuity

Annuity is 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.

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  Finding future equivalent income (inflow) value given a series of uniform equal payments

Uniform series compound amount factor, functionally expressed as F = A (F/A, i %, N)

 Finding present equivalent income (inflow) value given a series of uniform equal payments

Uniform series present worth factor, functionally expressed as P = A (P/A, i %, N)

Example 3

Suppose you make 15 equal annual deposits of ₱ 1000 each into a bank having 5% interest per
year. The first deposit will be made one year from this day. How much money can be withdrawn
from this bank account immediately after the 15 th deposit?

Solution:

F = A (F/A, 5 %, 15)

( 1+ i ) N −1
= A [ i ]
( 1+0.05 )15−1
= 1000 [ 0.05 ]
F = ₱ 21,578.60

SECTION 5.2 MULTIPLE INTEREST FORMULA

 Considered where a series of cash outflows occur over a number of years

 Considered when the value of the outflows is unique for each of a number (i.e. first three
years)
 Considered when the value of outflows is the same for the last four years
 Used to find the following:
 Present equivalent expenditure
 Future equivalent expenditure
 Annual equivalent expenditure

Example 4

The expected maintenance expenditures for a certain equipment over eight years amounts as
follows: ₱ 100 for the first year, ₱ 200 for the 2nd year, ₱ 500 for the 3rd year, and ₱ 400 for each
year onwards. Make a cash flow diagram representing the expenditures. If I = 20% per year, find

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

the following:

a. Present equivalent expenditure (P0)

b. Future equivalent expenditure (F8)
c. Annual equivalent expenditure (A)

Solution:
a. Find P0

b. Find F8

c. Find A using P0

SECTION 5.3 NOMINAL INTEREST RATES AND EFFECTIVE INTEREST RATES

Nominal Interest Rates

 If the compounding period isn’t a year:

 Interest is quoted as an annual rate (r) called the nominal interest rate
 To solve any problem, you must use a per period rate (r/m) = i

Where:
m is the number of compounding periods in a year

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

 So:
F = P (1 + i) N
Becomes:
F = P (1 + r/m) N
Where:
n is the number of periods not the number of years

Effective Interest Rates

Effective interest rate (ieff) is the actual or exact rate of interest earned on the principal during one
year. This is actually expressed on annual basis. Converting nominal interest to effective interest
rate yields:

Where:
i eff = effective interest rate
r = nominal rate of interest
N = number of compounding period/year

Effective interest rate is only equal to nominal rate of interest when compounding is on annual
basis.

Example 5

A credit company charges at a rate of 1.375% per month on the unpaid balance of all accounts.
The annual interest rate is 16.6%. What is the effective rate of interest per year being charged by
the company?

Solution:

SECTION 5.4 PRESENT WORTH METHOD

Present Worth (PW) is based on the concept of equivalent worth of all cash flows relative to the
present. It is a measure of how much money an individual or firm could afford to pay for the
investment in excess of its cost. To find PW, it is necessary to discount future amounts to the
present by using the interest rate over the appropriate study period.

Where:

i = effective interest rate per compounding period

k = index for each compounding period (0 ≤ k ≤ N)

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 F k = future cash flow at the end of period k

N = number of compounding periods in the planning horizon (i.e., study period)

Example 6

A special purpose machine is to be acquired by paying a ₱ 15,000 initial cash payment plus a debt
assumption of ₱ 135,000. The machine will generate additional net annual cash inflow of useful life
of the asset. At the end of its life, a salvage value of 10% of its initial cost will be realized.
Assuming the effective interest rate is 13.2% per annum, show whether the project is desirable by
using the PW method.

Solution:

Since PW > 0, then acquiring the equipment is economically justified.

SECTION 5.5 BOND VALUE

Bond is an example of commercial value of the PW of the future net cash flows that are expected
to be received through ownership of an interest-bearing certificate. At any time, the value of the
bond is the PW of the future cash receipts.

Bondholders receive two types of payments:

 Series of periodic interest payments until the bond is retired

 Single payment equal to redemption or disposal price when the bond is retired or sold

The PW of the bond is the sum of present worth of the two types of payments at the bond’s yield
rate:

Where:

Z = face or par value

C = redemption or disposal price (usually equal to Z)

r = bond rate (nominal interest) per interest period

N = number of periods before redemption

i = bond yield rate per period

VN = value (price) of the bond N interest periods prior to redemption

Example 7

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

A bond with a face value of ₱ 50,000 pays at an interest of 8% per year. This bond will be
redeemed at par value at the end of its 20-year-life, and the first interest payment is due one year
from now. How much should be paid now for this bond in order to receive a yield of 10% per year
on the investment?
Solution:

VN = C (P/F, i %, N) + r Z (P/A, i %, N)

VN = ₱ 50,000 (P/F, 10 %, 20) + ₱ 50,000 x 0.08 (P/A, 10 %, 20)

VN = ₱ 7,432.18 + ₱ 34,054.25

VN = ₱ 41, 486.43

SECTION 5.6 FUTURE AND ANNUAL WORTH METHOD

Future Worth Method

Future worth method is based on the equivalent worth of all cash inflows and outflows at the end of
the study period at an interest rate. A positive FW would result to acceptance of the problem
solution.

Where:
i = effective interest rate, or MARR, per compounding period

k = index for each compounding period ( 0 ≤ k ≤ N)

Fk – future cash flow

Annual Worth Method

Annual worth (AW) is an equal annual series of amounts, for a stated study period, that is
equivalent to the cash inflows and outflows at an interest rate.

AW (i %) = R – E – CR (i %)

The AW of a project is equivalent to its PW and FW.

AW = PW (A/P, i %, N)

AW = FW (A/F, i %, N)

If AW is greater than or equal to zero, the project is economically attractive.

Annuity

Annuity is a series of equal payments occurring at equal periods of time.

Finding P given A:

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

 Finding F give A:

Types of Annuity

1. Ordinary Annuity – is a series of equal payments made at the end of consecutive periods
over a fixed length of time. Payments can be made as frequently as every week, in practice
they are generally made monthly, quarterly, semi-annually, or annually.
2. Deferred Annuity – an insurance contract designed for long-term savings which starts
annual or monthly payments almost immediately, investors can delay payments from a
deferred annuity indefinitely. During that time, any earnings in the account are tax-deferred.

Example 8

What is the present worth of a 10-year annuity paying ₱ 10,000 at the end of each year, with
interest of 15 % compounded annually?
Solution:

Finding P given A:

( 1+i )N −1
P= A
[ i ( 1+i )N ]
P = ₱ 50,187.69

Perpetuity

When annuity in which payments continue indefinitely, it is called perpetuity.

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

Gradients

Linear Gradient Series

A linear gradient series involves receipts and expenses that are projected to increase or decrease
by a uniform amount each period.

Example Gradient Diagram

The maintenance expense on a certain machine is ₱ 1,000 at the end of the first year and
increasing at a constant rate of ₱ 500 each for the next four years.

Cash flow diagram of a sequence of end-of-period cash flows increasing by a uniform gradient
amount (G).

Formulas for Linear Gradient Series

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Example 9

Suppose a certain end-of-year cash flows are expected to be ₱ 1,000 for the second year, ₱ 2,000
for the third year, and ₱ 3,000 for the fourth year and that its interest is 15 % per year. Find the:
a. Present equivalent value at the beginning of the first year

b. Uniform annual equivalent value at the end of each of the four years

Solution:

a. Present equivalent value:

P0 = G (P/G, 15%, 4)

b. Uniform annual equivalent value:

A = G (A/G, 15%, 4)

SECTION 5.7 INTERNAL AND EXTERNAL RATE OF RETURN METHOD

Internal Rate of Return Method

Internal rate of return method is the most widely used rate of return method for performing
engineering economic analyses. It is also called as the investor’s method, the discounted cash
flow method, and the profitability index. Helps to solve for the interest rate that equates the
equivalent worth of an alternative’s cash inflows to be equivalent worth of cash outflows.

An IRR that is greater than the MARR would result to acceptance of the problem solution. By using

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

a PW formulation, the IRR is the i % at which:

Where:

Rk = net revenues or savings for the kth year

Ek = net expenditures including any investment cost for the kth year

N = project life (or study period)

There are some difficulties associated with IRR Method, these are:
 IRR method is difficult to compute given that it is associated with the trial and error
method.
 It must be carefully applied and interpreted in the analysis of two or more alternatives
when only one of them is to be selected.

The main advantage of IRR is its widespread acceptance among industries.

Example 10

A capital investment of ₱ 10,000 can be made in a project that will produce a uniform annual
revenue of ₱ 5,310 for five years and then have a salvage (market) value of ₱ 2,000. The annual
expenses will be ₱ 3,000. The company is willing to accept any project that will earn at least 10 %
per year on all invested capital. Determine whether it is acceptable by using the IRR method

Solution:
PW = 0 = − 10,000 + (5,310 – 3,000) (P/A, i%, 5) + 2,000 (P/F, i%, 5)
To solve for i, use linear interpolation:

At i = 5%; PW = + ₱ 1,568

At i = 15%; PW = − ₱ 1,262

Applying linear interpolation, we will get:

Since IRR > MARR (10.5% > 10%), the project is acceptable.

External Rate of Return Method

External rate of return method directly takes into account the interest rate (ε) external to a project
at which net cash flows generated (or required) by the project over its life can be reinvested (or
borrowed).

Three steps used in the calculating procedure:

I. All net cash outflows are discounted to time 0 (the present) at ε % per compounding
period.
II. All net cash inflows are compounded to period N at ε %.
III. The external rate of return, which is the interest rate that establishes equivalence
TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY
 between the two quantities, is determined.

Where:
Rk = excess of receipts over expenses in period k
Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
Ε = external reinvestment rate per period

Example 11

Determine whether the project, whose total cash flow diagram appears bellow, is acceptable when
ε = 15% and MARR = 20% per year.

Solution:

III. Viable and vibrant Activities

Description of the Learning Activities

Discussion – the students need to share ideas and knowledge about Interests Formula and
Rates and how it is related to the present situation

05 Seatwork 1 – the students will perform the seatwork to know how well they understand the
lesson

IV. Opportunity to reflect and articulate students’ acquired knowledge.

Criteria for Evaluation

05 Seatwork 1 – PROBLEM SOLVING: Solve the problem and show the complete solution.
(30 points)

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY

Purpose of Activity:

Discussion – The students are required to give their opinions and share their knowledge about
the topics being discussed. They also need to identify the different formulas to be used in each
situation

05 Seatwork 1 – a seatwork will determine the students understanding of the whole lesson

Summary and Reflection

The students are required to write on their learning journal what they have learned during the
discussion.

V. Textbooks and other References

1. R. A. Chadderton, Purposeful Engineering Economics, 1st edition, Springer International Publishing

Switzerland, 2015
2. D. G. Newnan, J. Whittaker, T. G. Eschenbach and J. P. Lavelle, Engineering Economic Analysis,
3rd edition, Don Mills, Toronto, Ontario, 2014.
3. N. M. Fraser and E. M. Jewkes, Engineering Economics: Financial Decision Making for Engineers,
5th edition, Pearson, Toronto, Ontario, 2013

TANAUAN CITY COLLEGE BENG01 /MODULE NUMBER 5 ENGINEERING ECONOMY