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Engineering Economy Lecture

The document provides examples and concepts for calculating present value using formulas for different cash flow patterns, including: - Example 1 shows how to calculate the present value (P) needed today to have $2000 in 4 years at 12% annual interest. - Example 2 calculates the amount (P) that needs to be deposited today to cover 4 years of tuition that starts at $10,000 and increases by 8% annually, with a 5% annual return. - The document discusses breaking complex cash flows into simpler components that can each use standard present value formulas, and provides an example of breaking maintenance costs into annual, gradient, and future cash flows.

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Alpyn
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© © All Rights Reserved
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Download as PPT, PDF, TXT or read online on Scribd
53 views

Engineering Economy Lecture

The document provides examples and concepts for calculating present value using formulas for different cash flow patterns, including: - Example 1 shows how to calculate the present value (P) needed today to have $2000 in 4 years at 12% annual interest. - Example 2 calculates the amount (P) that needs to be deposited today to cover 4 years of tuition that starts at $10,000 and increases by 8% annually, with a 5% annual return. - The document discusses breaking complex cash flows into simpler components that can each use standard present value formulas, and provides an example of breaking maintenance costs into annual, gradient, and future cash flows.

Uploaded by

Alpyn
Copyright
© © All Rights Reserved
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Concepts from the

example problems
( F / P, i, N)
( P / F, i, N)
( F / A, i, N)
( A / F, i, N)
( P / A, i, N)
( A / P, i, N)
( P / G, i, N)
( A / G, i, N)

Problem 1
Problem 2
Problem 3
Problem 4
Problem 5
Problem 6
Problem 7
Problem 8
1

Example 1
How much would you have to
deposit today to have $2000 in 4
years if you can get a 12% interest
rate compounded annually?
GIVEN:
F4 = $2 000
i = 12%

DIAGRAM:
$2 000
0

3
n=4

P?

FIND P:
P = F4(P/F,i,n)
= 2 000(P|F,12%,4)
= 2 000(0.6355) = $1 271

Different Ways
of Looking at P/F
From previous example, if you can earn
12% compounded annually, you need to
deposit $1271 to have $2000 in 4
years.
You are indifferent between $1271
today and $2000 in 4 years, assuming
you can earn a return on your money of
12%.
The present worth of $2000 in 4 years
is $1271 (i = 12% cpd annually).

my abbreviation for compounded

If you could get 13% on your money,


3
would you rather have the $1271 today,

Example 2
Tuition costs are expected to
inflate at the rate of 8% per year.
The first years tuition is due one
year from now and will be $10,000.
To cover tuition cost for 4 years, a
fund is to be set up today in an
account that will earn interest at
the rate of 5% per year,
compounded annually. How much
must be deposited into the fund
today in order to pay the 4 years of
4
tuition expenses?

Present Given Gradient (Geometric)


g is the geometric gradient over the time period

(time period: Time 0 to Time n, 1st flow at Time 1)

P is the present value of the flow at Time 0

(n periods in the past)

i is the effective interest rate for each period

Note: cash flow starts with A1 at Time 1, increases by constant g% per period

P?
0

1
A1

g=%
P = A1(P/A,g,i,n)


( P / A, g , i , n)

(1 g )
1

(1 i )
ig

when i g

n
(1 i )

when i g

Example 2
Tuition costs are expected to inflate at the rate
of 8% per year. The first years tuition is due
one year from now and will be $10,000. To cover
tuition cost for 4 years, a fund is to be set up
today in an account that will earn interest at the
rate of 5% per year, compounded annually. How
much must be deposited into the fund today in
order to pay the 4 years of tuition expenses?

Example 2 - Concept
If your rich Aunt Edna wanted to
put a sum of money in the bank
today to pay for your next four
years of tuition, that sum would be
$39,759 assuming 5% return on
investment and tuition that begins
at $10,000 increasing by 8% per
year. This problem assumes
tuition is due at the end of the
year.
7

Complex Cash Flows


Complex Cash Flows Break
apart (or separate) complex
cash flows into component
cash flows in order to use the
standard formulas.
Remember: You can only
combine cash flows if they
occur at the same point in
time.
(This is like building with

Problem 3
A construction firm is considering the
purchase of an air compressor.
The compressor has the following expected
end of year maintenance costs:
Year 1
$800
Year 2
$800
Year 3
$900
Year 4 $1000
Year 5 $1100
Year 6 $1200
Year 7 $1300
Year 8 $1400
What is the present equivalent maintenance
cost if the interest rate is 12% per year
compounded annually?
9

Problem 3 Alt Soln 1


GIVEN:
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
P = PA + PG + PF = A(P/A,i,n) + G(P/G,i,n) + F(P/F,i,n)
FIND P:
= $700(P/A,12%,8) + $100(P/G,12%,8) + $100(P/F,12%,1)
DIAGRAM:
P?
1

= $700(4.9676) + $100(14.4715) + $100(0.8929) = $5014


PA ?
1
2
3
4
n=8
n=8

$700

PF ?
n=1

0
$700

$100 $100 $200

$300

PG ?
1

$700
0

NOTE: CAN BREAK INTO 3 CASH FLOWS:


ANNUAL, LINEAR GRADIENT, AND FUTURE

$100 $200

n=8

$300

$100

$700
10

Problem 3 Alt Soln 2


GIVEN:
MAINT COST1-8 PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
P = PA + PG(PPG) = A(P/A,i,n) + G(P/G,i,n-1)(P/F,i,1)
FIND P:
= $800(P/A,12%,8) + $100(P/G,12%,7)(P/F,12%,1)
DIAGRAM:
P?
1
2

= $800(4.9676) + $100(11.6443)(0.8929) = $5014


PA ?
1
2
3
4
n=8
n=8

0
$800
$100

$800
PPG ?

$200

PG ?
0

$600
0
NOTE: PG MUST BE OFFSET ONE YEAR SO
BRING THE OFFSET YEAR BACK TO TIME ZERO

1
PG ? $100

n=7
$200
$600
11

Problem 4
A young couple has decided to make advance
plans for financing their 3 year old daughters
college education. Money can be deposited at 8%
per year, compounded annually.

DIAGRAM:
4
0

What annual deposit on each birthday, from the 4 th


to the 17th (inclusive), must be made to provide
$7,000 on each birthday from the 18th to the 21st
(inclusive)?
$7 000

17
18 21 yrs
A?

GIVEN:
WITHDRAWALS18-21 = $7 000
i = 8%/YR, CPD YEARLY
FIND A4-17:
P17 = A(F/A,i,n) = A(P/A,i,n)

STRATEGY: CAN BREAK INTO 2 CASH FLOWS,


SO PICK A CONVENIENT POINT IN TIME AND SET
DEPOSITS EQUAL TO WITHDRAWALS

= A(F/A,8%,14) = 7 000(P/A,8%,4)
= A(24.2149) = 7 000(3.3121)
A = $957
12

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