CME368 Engineering Economics & Decision Making

Problem Set Solutions

Do not look at these until you have carefully worked fully

through the problems!

Problem Set 4 – Geometric Gradients and Comparison

Methods

Question 4-1 Solution

a) The product should be developed if P of the cash flows is positive.
Calculate the present value of the cash flows (at time 0).
Net revenues = revenues - costs
This is a geometric gradient, g = 20% starting in year 2.

Cash flow diagram

g = 20%
30,000

10 years
i = 12%
225,000

b)
There are several cash flows to bring to present value: the single flow cash payment at
Year 0, and the geometric gradient series with A1 being $30,000.

Single cash flow:

P = -225,000

Geometric gradient series for i≠g (bringing it to P at Year 1, then to P at Year 0).

1 − (1.12)−9 (1.2)9
𝑃′ = 30,000
0.12 − 0.2
P’ = 322,750 (at year 1)
P = P’(P/F,12%,1) = 322,750/1.12 = 288,170 (at year 0)

P Total = -225,000 + 288,170 = $63,184 = ~63,170

Since P is greater than 0, product should be developed.

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Question 4-2 Solution
a) Sam will consider it a good investment when the present value of the cash flows
exceeds his $25,000 investment

Year 1 profit: $70,000 - $50,000 = $20,000

Sam’s share of the year 1 profits: $20,000*0.15 = $3,000

If costs and revenue both grow at a rate of 5% per year, then so do profits, and so does
Sam’s share of the profits. So, this is a geometric gradient problem with:
A1 = $3,000
i = g = 5%
P = 25,000 (or really, we need P > 25,000)

Using the formula for when i = g

P = A1 (N/1+i)
25,000 = 3,000 * N/1.05
N = 8.75

But Sam only gets paid once a year, so we need to round up: N = 9 years

b) This is also a geometric gradient problem with:

A1 = $3,000
i = 5%
g =10%
P = 25,000

Using the formula for i ≠ g:

P = A1 [1- (1+i)-N(1+g)N]/(i –g)

25,000 = 3000 [1- (1.05)-N(1.10)N]/(0.05 –0.10)

Rearranging: (1.10/1.05)N = 1.41667
N = ln(1.41667)/ln(1.04762) = 7.5
Again, we round up, so N = 8 years

Question 4-Mortgage 1
a)
Downpayment: 20% * 700,000 = $140,000
Loan amount: 700,000 – 140,000 = $560,000

Monthly interest rate: is = 6%/12 = 0.5%

Amortization period: 30*12 = 360 months

Monthly payment:
A = P*(A/P,i,N) = 560,000*(A/P,0.5%, 360) = 560,000*0.00600 = $3,360
(the exact value is 3,357.48, but we’ll use the rounded value)

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b)
Remaining mortgage after 10 years:
F10 = 560,000*(F/P,0.5%,10*12) – 3,360*(F/A,0.5%,120)
= 560,000*1.819 – 3360*163.880 = 468,003 ≈ 468,000

Home value: 700,000 + 10,000*10 = 800,000

Equity: Value – loan = 800,000-468,000 = $332,000

c)
Loan to value ratio: 468,000 / 800,000 = 0.585

d)
Current payment is 3,360 per month for 20 more years

New payment would be:

A = 468,000*(A/P,3%/12,20*12) = 468,000*(A/P,0.25%,240) = 468,000*0.00555
A = 2,597

e)
The new payment scheme would provide Ming with monthly savings of:
3360 – 2597 = 763

PW of savings:
P = 763*(P/A,9%/12,240) = 763*(P/A,0.75%,240) = 763*111.145 = 84,803

Ming would be willing to pay up to approximately $84,800 to break his loan early and
switch the Scotiabank.

(Note: the exact value is $84,294, but there was lots of rounding here).

Question 4-Mortgage 2
[Term test 2, 2018, Question 2 (10 marks)]
Aditi is planning to buy a condo that she would like to rent out for additional income. The
condo is currently worth $500,000, and she plans to contribute a 30% downpayment. The
rest will be paid for with a mortgage loan. Aditi chooses a 10-year fixed term loan with
3% annual nominal interest (compounded monthly), and a 20-year amortization period.
Aditi has a MARR of 12%. Assume there are no taxes.
[if too many significant figures, remove 0.5]

a) What are Aditi’s monthly payments? [2 pts]

Downpayment = 30%*500,000 = 150,000

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Loan amount = 500,000 – 150,000 = $350,000
A = P*(A/P,i,N) = 350,000*(A/P,0.03/12,20*12) = 350,000*(A/P,0.0025,240) =
350,000*0.00555
A = $1942.5 ≈ $1940 / month
(NB: the exact value is $1941.09)

b) After 7 years, Aditi has $300,000 in equity. How much is the condo worth? [3 pts]

Calculate the remaining loan in year 7 (i.e. month 84):

F = 350,000*(F/P,0.0025,84) – 1940*(F/A,0.0025,84) = 350,000*1.233 – 1940*93.343
F = 431,550 – 181,085 = 250,465

Equity = Value – Loan

Value = Equity + Loan = 300,000 + 250,465 = 550,465 ≈ $550,000
(Note: the exact value is 550,488.96)

c) How much interest has she paid over the course of 7 years? [2 pts]
Total payments = 1940*84 = 162,960
Payments toward equity: 350,000-250,465 (from above) = 99,535
Thus, payments toward interest: 162,960 – 99,535 = 63,425 ≈ 63,400
(Note: the exact value is 63,540.66)

d) If Aditi wants her payback period to be 10 years (without selling the condo), what is
the minimum amount she must charge her tenants? [3 pts]

Let x be the minimum rent amount. Then:

Payback = Capital cost / regular benefits
10*12 months = 150,000 / (x – 1940)
x = 150,000/120 + 1940 = $3190

The minimum rent is $3190.

(The exact value is 3191.09)

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Question 4-4 Solution

Construction of a new plant

Interest rate: 8%

0 1 2 3
Years

85,000 200,00
200,00 0
0 1,000,0
00
1,200,0
00
The present worth is:
PW= - 85,000 - 200,000(P/A,8%,3) - 1,000,000(P/F,8%,2) = - $1,458,000
This can also be called present worth of costs and would be reported as $1,458,000
(positive sign since it is already called a cost)

The future worth is:

FW= - 85,000(F/P,8%,3) - 200,000(F/A,8%,3) - 1,000,000(F/P,8%,1) = - $1,836,000
This can also be called future worth of costs and would be reported as $1,836,000 (positive
sign since it is already called a cost)

Remodeling the available factory

Interest rate: 8%
0 1 2 3
Years

850,000

250,000 250,000 250,000

The present worth is:
PW = -850,000 - 250,000(P/A,8%,3) = - $1,494,000

The future worth is:

FW = -850,000(F/P,8%,3) - 250,000(F/A,8%,3) = - $1,882,000

The new plant is projected to have the smaller costs (using present worth or future worth)
and is thus the preferred alternative.
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Question 4-5 Solution
The cash flow diagram for Equipment A; MARR: 8%:

The present worth of this cash flow is:

PW = -2000 + 400(P/A,8%,8) + 600(P/A,8%,4) – 150(P/A,8%,4)(A/G,8%,4)
= -2000 + 400(5.747) + 600(3.312) – 150(3.312)(1.4)
= $1589

Hence, the present worth of alternative A is 3588.5 – 2000 = +$1589

The cash flow diagram for Equipment B; MARR: 8%:

The present worth of this cash flow is:

PW = -1500 + 300(P/A,8%,8) + (700-300)(P/F,8%,1)
+100(A/G,8%,4)( P/A,8%,4) (P/F,8%,4)
= 300(5.747) + 400(0.926) + 100(1.404)(3.312)(0.735)
= $936

Hence, the present worth of Equipment B +$936

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Equipment A maximizes the PW and is consequently the best choice for the company.

Question 4-6 Solution

a) In order to define the problem we have to specify the available alternatives. The
available options can be specified by:

Option Option Initial investment Notes

number description (must be less than
$1 million)
1 Do nothing $0 Feasible option
2 A 600,000 Feasible
3 B 800,000 Feasible
4 C N/A Not feasible, C is contingent on B
5 A+B N/A Not feasible, A and B mutually
exclusive
6 A+C N/A Not feasible, C contingent on B
7 B+C 1,270,000 Not feasible exceeds budget
8 A +B + C N/A Not feasible, A & B mutually
exclusive
n 3
Check: there should be 2 = 2 = 8 options. Yes, there are.

Feasible options are 1, 2 and 3

Cash Flows for feasible options

End of year Net CF(1) ($) Net CF(2) ($) Net CF(3) ($)
0 0 -600,000 -800,000
1-9 0 270,000 330,000
10 0 340,000 460,000

b) i) Use of present worth method, MARR = 25%

PW1 = $0

PW2 = -600,000 + 270,000(P/A,25%,10) + 70,000(P/F,25%,10) = $371,600

PW3(25%) = -800,000+330,000(P/A,25%,10) + 130,000(P/F,25%,10)

= -800,000 + 330,000(3.5705) + 130,000(0.1074)
= $392,200

Alternative 3 (Proposal B) has highest PW => it will be selected

ii) Use of annual worth method

AW1 = $0/year and
AW2 = 371,553(A/P,25%,10) = $104,100 per year
AW3 = 392,227(A/P,25%,10) = 392,227(.2801) = $109,800 per year

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 Alternative 3 (Proposal B) has highest AW => it will be selected.
Based on equivalency, this should be expected

Question 4-7 Solution

a) Present Worth Criteria
The two mutually exclusive alternatives have different lives, but provide identical
benefits. Therefore, we can make a decision based solely on costs (as long as the analysis
period used is the same for both alternatives if using PW (or FW)).

To make the two projects comparable, we can use the lowest common multiple of lives
(12 years) as the common analysis period. This is the most common method to use if no
data is given in a problem regarding a salvage value after a period of time.
Note that any cash flow difference between the alternatives will be revealed during the
first 12 years. After that, the same cash flow pattern is assumed to repeat itself every 12
years for an indefinite period.
Model A Cash flow diagram
2000 2000 2000 2000

years
0 1 2 3 4 5 6 7 8 9 10 11 12

5000 5000 5000 5000

12,500 12,500 12,500 12,500 MARR=15%

Four replacements occur in the 12 year period

PW of the initial machine.

PW = -$12,500-$5000(P/A,15%,2)-$3000(P/F,15%,3) = -$22,601

With the four replacement cycles, the total PW is

PW = -$22,601 [1+(P/F,15%,3)+(P/F,15%,6)+(P/F,15%,9)] = -$53,660

Model B Cash flow diagram

1500 1500 1500

years
0 4 8 12
MARR=15%
4000 4000 4000

15000 15000 15000

Three replacements occur in the 12 year period.

The PW for the first machine is

PW = -$15,000-$4000(P/A,15%,3)-$2500(P/F,15%,4) = -$25,562
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With the three replacement cycles in 12 years, the total PW is
PW = -$25,562 [1+(P/F,15%,4)+(P/F,15%,8)] = -$48,540

The model with the lowest cost will be preferred, Model B.

b) Annual worth criteria

For Model A:
For a 3 year life:
PW = -$22,601 (from part a)
AW = -$22,601(A/P,15%,3) = -$9,899

Model B
For a 4 year life:
PW = $-25,562
AW = -$25,562(A/P,15%,4) = -$8,954

Therefore, as in a) would prefer Model B (lowest cost)

Note:
For model A if we calculate the AW for the 12 year period

AW = -$53,657(A/P,15%,12) = -$9,899 (which is equal to the AW for the 3 year life).

The AW calculated based on the common service period (12 years) is the same as that
which was obtained over its initial life span. This is why it is not necessary to have equal
lives in order to use the AW measure.

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Question 4-8 Solution
a)
Calculate PW of each system. The system with higher PW or lower present cost should
be preferred.

Use a study period of 10 years.

PW (System 1) = -$100,000-100,000(P/F,10%,5)+10,000(P/F,10%,5)
+10,000(P/F,10%,10) +30,000(P/A,10%,5)+60,000(P/A,10%,5)(P/F,10%,5)
PW (System 1) = -$100,000 - $100,000(0.62092) + $10,000(0.62092)
+ $10,000(0.38554) + $30,000(3.7908)
+ $60,000(3.7908)(0.62092) = $102,920

PW (System 2) = -$500,000+5000(P/F,10%,10)+90,000(P/A,10%,10)
PW (System 2) = -$500,000 + $5,000(0.38554) + $90,000(6.1446) = $54,940

Therefore, the company should purchase System 1.

b)
From part a), the present worth of both systems is positive, so the company should invest
in both.

c)
Using a study period of 8 years.

PW (System 1) = -$100,000-100,000(P/F,10%,5)+10,000(P/F,10%,5)
+10,000(P/F,10%,8) +30,000(P/A,10%,5)+60,000(P/A,10%,3)(P/F,10%,5)

PW (System 1) = -$100,000 - $100,000(0.62092) + $10,000(0.62092)

+ $10,000(0.46651) + $30,000(3.7908)
+ $60,000(2.4869)(0.62092) = $55,200

PW (System 2) = -$500,000+5000(P/F,10%,8)+90,000(P/A,10%,8)
PW (System 2) = -$500,000 + $5,000(0.46651) + $90,000(5.3349) = -$17,530

If the systems are mutually exclusive, they should go with system 1.

d)
System 1 has a positive PW, and system 2 has a negative PW. So, invest only in system
1.

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Question 4-9 Solution

Set 0 = PW = -$15,000 + $539,250/(1+i*)30

(1+i*)30 = 539,250/15,000 = 35.95
1+i* = 35.95(1/30) = 1.1268
i* = 0.1268 = 12.68%

IRR = 12.68%

IRR > MARR (and this is an investment situation), so yes. Make the investment.

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Question 4-10 Solution
Extra practice (if we had treated the projects as independent)
Note, the projects are mutually exclusive, so what you really need is incremental IRR
(below). For additional practice, however, here are the answers to the IRR for each
project individually:

Project C
PW = (-190,000)+ (19,500) (P/A, i*, 30) = 0
(P/A, i*, 30)=190,000/19,500=9.7436
From the interest factor tables, we find that
(P/A, 9%, 30) = 10.274
(P/A, 10%, 30) = 9.4269
interpolating between (P/A, 9%, 30) and (P/A, 10%, 30) gives
i*=9%+(1%)[(9.7436-10.274)/(9.4269-10.274)]
=9.63%

Project A
PW=(-200,000)+(22,000) (P/A, i*, 30)=0
i* = 10.46%>10%
Therefore, choose A and discard the Do-nothing alternative.

Project B: i* = 12.3%

Project D: i* = 11.55%

Correct solution
1) order alternatives by initial cost from the lowest to the highest.
C A B D
Initial cost ($) -190,000 -200,000 -275,000 -350,000
Annual cash flow ($) 19,500 22,000 35,000 42,000
Life (years) 30 30 30 30

2) All alternatives have a 30-year life.

Compare Location C with the do-nothing alternative by calculating the i* C-do nothing
PW = (-190,000-0)+ (19,500-0) (P/A, i*, 30) = 0
(P/A, i*, 30)=190,000/19,500=9.7436
From the interest factor tables, we find that
(P/A, 9%, 30) = 10.274
(P/A, 10%, 30) = 9.4269
interpolating between (P/A, 9%, 30) and (P/A, 10%, 30) gives
i*=9%+(1%)[(9.7436-10.274)/(9.4269-10.274)]
=9.63%
i* C-do nothing= 9.63%<10%
Therefore, choose Do-nothing and discard C
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 Compare Location A with the do-nothing alternative by calculating the i* A-do nothing
PW=(-200,000-0)+(22,000-0) (P/A, i*, 30)=0
i* A-do nothing= 10.46%>10%
Therefore, choose A and discard the Do-nothing alternative.

Compare Location B with A by calculating the i* B-A

PW= [-275,000-(-200,000)]+(35,000-22,000)(P/A, i*,30)=0
i* B-A=17.51>10%
Therefore, choose B and discard A.

Compare Location D with B by calculating the i*D-B

PW= [-350,000-(-275,000)]+(42,000-35,000)(P/A, i*, 30)=0
i*D-B=8.55%<10%
Therefore, choose B and discard D.

Therefore Location B should be chosen.

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 Question 4-11 Solution
Note, if using this problem as practice for calculating the basic IRR (independent
investments), we’d find: IRRE1 = 23.4% IRRE2 = 33.3%

… however, the correct solution for mutually exclusive investments is below:

E1 and E2 have unequal lives. Adjustment must be made so that the project lives are
equal prior to applying the IRR method. Since no salvage values are given, we will
assume that repetitions of project E2 are possible. Therefore, we assume 3 repetitions of
E2 over the analysis period. Requires incremental analysis in order to use IRR.
Resulting Cash Flows

For E1: 1000 1000 1000

0 1 2 3

2,000
For E2: 4000 4000 4000

0 1 2 3

3000 3000 3000

EOY E1 E2 E2-E1
0 -2000 -3000 -1000
1 1000 4000-3000 = 0
1000
2 1000 4000- 0
3000=1000
3 1000 4000 3000

Project E1 has lowest investment cost, compute IRR

PW = -2000+1000(P/A,i,3) = 0
(P/A,i,3) = 2
i > 20%, therefore, greater than MARR, is acceptable

Compute IRR for increment of cash flows (E2-E1)

PW = -1000+3000(P/F,i,3)=-1000 + 3000/(1+i)3 = 0
Solving for i gives IRRE2-E1=44.23% which is > MARR = 10%

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Therefore, select project E2

If the projects were independent, you would calculate the IRR for each project. Then you
would compare the IRRs with the MARR. As long as there are sufficient funds in the
Company’s budget, they would undertake any projects with IRR> MARR.

Question 4-12 Solution

Order alternatives by initial cost from lowest to highest. No IRR can be calculated for
the individual options since there are no revenues or profits (IRR requires a sign change).

Alpha is least expensive.

Should the additional $10,000 to fund Beta be invested in order to save
($16,000-$10,000) = $6000 per year?

Calculate the i* Beta-Alpha

PW=P Beta-Alpha +A Beta-Alpha (P/A,i*,7)=0
[-60,000-(-50,000)] + (-10,000-(-16,000))(P/A,i*,7)=0
i* Beta-Alpha = 57%

Therefore, choose Beta (i* > MARR), Discard Alpha from further consideration

Should the additional investment for Gamma be made?

Compare Gamma and Beta
Calculate the i* Gamma-Beta
PW=P Gamma-Beta + A Gamma-Beta (P/A, i*,7)=0
[-70,000-(-60,000)] + (-8,000-(-10,000))(P/A, i*,7)=0
i* Gamma-Beta = 9% < MARR
Therefore, the additional $10,000 to fund Gamma to yield a return of 9% is not justified
since it is less than the desired rate of return of 12% (MARR).
Therefore, we eliminate Gamma and remain with Beta.

Should the additional investment required from Beta to Delta be made?

Calculate i*Delta-Beta
PW=P Delta-Beta + A Delta-Beta (P/A, i*,7)=0
[-75,000-(-60,000)]+(-6,000-(-10,000))(P/A, i*,7)=0
i* Delta-Beta = 19% > MARR

The return on the additional $15,000 is greater than the MARR and therefore the
additional investment should be made.

Therefore the preferred alternative is Delta.

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Question 4-13

a)

Year Cash flow

0 -60,000
1 100,000
2 -10,000
3 -10,000
4 -10,000
5 -10,000

IRR (no guess) 0%

IRR (guess 200%) 31%

b)
PW costs = 60,000 + 10,000*(P/A,15%,4)*(P/F,15%,1)
= 60,000 + 10,000*2.855*0.8696
= 84827.08
So, P = -84827.08

F = FW benefits = 100,000*(F/P,10%,4) = 100,000*1.464 = $146,410

0 = P(1+MIRR)N + F
0 = -84827 (1+MIRR)5 + 146410
MIRR = 11.5%

MIRR < MARR. No. Don’t invest.

c)
MIRR = 11.5%

d)
NPV = 2172
NPV > 0 so yes. Invest.

e)
MIRR assumed an explicit financing rate and reinvestment rate, which added new
information and changed the investment. (This is fine, but it must be a deliberate choice).
If we use MARR as the financing rate and reinvestment rate, then MIRR will always
agree with PW.

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Question 4-14

Consider four investments with the following sequences of cash flows:

year A B C D
0 -$18,000 -$20,000 $34,578 -$56,500
1 $10,000 $32,000 -$18,000 -$2,500
2 $20,000 $32,000 -$18,000 -$6,459
3 $30,000 -$22,000 -$18,000 -$78,345

a) Compute the PW of each investment. Use a MARR of 10%. 10%

b) Compute the rate of return for each investment.

c) Which project has no rate of return?

Solutions
a) PW(A) PW(B) PW( C) PW(D)
$30,159 $19,008 -$10,185 -$122,973

b)
IRR: 74.23% 111.11% 26.09% NO IRR

year A PW of A B PW of B C PW of C D PW of D
0 -$18,000 -$18,000 -$20,000 -$20,000 $34,578 $34,578 -$56,500
1 $10,000 $5,740 $32,000 $15,158 -$18,000 -$14,276 -$2,500
2 $20,000 $6,588 $32,000 $7,180 -$18,000 -$11,322 -$6,459
3 $30,000 $5,672 -$22,000 -$2,338 -$18,000 -$8,980 -$78,345
$0 $0 $0

c) Which project has no rate of return

Answer: D. There is no sign change in the cash flow.