IKT 356 ENGINEERING ECONOMICS

Assoc. Prof. Dr. Serkan KIVRAK

Chapter 3
Chapter 3

The Value of One Future Payment Compared to a

Uniform Series of Payments (F/A, A/F)

A A A A
ETZ

Key Expressions F

A = Uniform series of n end-of-period payments or receipts, with interest

compounded at rate i, on the balance in the account at the end of each period.

ETZ = Equation Time Zero, with reference to a particular payment series, the time
at which n=0.

PTZ = Problem Time Zero, the present time according to the statement of the
problem narrative. 2
 (1+𝑖)𝑛 −1 (1+𝑖)𝑛 −1
 F=A [ 𝑖 ] or F/A = 𝑖

 F = A(F/A,i,n)

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Cash Flow Diagrams

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Example 3.1

Assume your banker is willing to accept equivalent quarterly payments (one

payment every three months) on a home mortgage instead of the usually
stipulated monthly payments of $500 per month. If the interest rate is 1 percent per
month, what would be the equivalent quarterly payments?

The cash flow diagram for this problem:

0 1 2 3 months

A=$500 $500 $500

i = 1%/month
F=?
Note that the arrow for the equivalent future value F points in the same direction
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as the periodic values A.
Example 3.1 (Solution)

Using the equation,

(1+𝑖)𝑛 −1
F=A [ 𝑖 ]

(1+0.01)3 −1
F = 500 [ 0.01 ] = 500*3.0301 = $1,515

The payment of $1,515 per quarter gives the banker the equivalent of three
monthly payments of $500 per month.

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Example 3.6

A young engineer decides to save for a down payment on a new car to be

purchased 30 months from now. He decides to deposit $50 per month into a
savings account which earns 6 percent nominal interest compounded monthly
(use i=6%/12 = 0.5%/month). He plans to make a series of 20 regular monthly
deposits, with the first deposit scheduled for one month from today. After EOM
20, the account will receive monthly interest compounded on the balance at the
end of each month for another 10 months. How much will be in the account at the
end of the 30-month period?

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Example 3.6 (Solution)

A cash flow line diagram illustrates the cash flow of the deposits. The problem is
divided into two parts and solved.

For F1 For F2
i = 0.5%/mo i = 0.5%/mo F2
n = 20 deposits n = 10 interest periods
0 1 20 20 30

A A=$50/mo. A
F1 becomes P1

F1

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Example 3.6 (Solution)

1. Find the lump sum future amount, F1, in the account at the end of the first 20-
month period using equation (or the 0.5 percent table).

(1+𝑖)𝑛 −1 (1+0.005)20 −1
F1 = A [ 𝑖 ] = 50 [ ] = $1,049
0.005

2. Find the future amount, F2, that will accumulate as aresult of just the lump sum
F1 balance at EOM 20,plus 10 additional monthly interest payments (without any
more deposits for the final 10-month period). For this equation, F1 becomes the
initial deposit, P1 at ETZ.

P1 = F1
F2 = P1(1+i)n = $1,049*(1+0.05)10 = $1,103

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Example 3.6 (Solution)

The procedure can be greatly simplified by combining the three lines of equations
that were used into one line of calculations as follows:

F1 = $50(F/A, 0.5%, 20) (F/P, 0.5%,10) = $1.103

20.979 1.0511

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Example 3.7

Assume a proud father bought his son a $100 bond on the day he was born and
continued buying an additional $100 bond on every birthday. How much is the
total value of the investment on his twenty-first birthday after the twenty-second
bond has been received? Assume all the bonds accumulate 6 percent interest
compounded annually.

Example 3.7 (Solution)

First draw a cash flow diagram;

F=?
i = 6%
0 1 2 3 21

A=$100 11
Example 3.7 (Solution)

The initial deposit occurs at PTZ, then ETZ is found one year earlier, at a time
one year before the bay is born. The cash flow diagram showing both problem
time and equation time is shown.

ETZ

PTZ
i = 6% F=?
Equation time 0 1 2 3 4 22
Problem time -1 0 1 2 3 21

A=$100

Counting from the new ETZ, n=22 when the twenty-first birthday occurs. The
equation becomes,

F = A(F/A, i, n) = 100(F/A, 6%, 22) = $4,339 12

Example 3.8

An owner of a building expects the present roof to last nine more years and then
need replacement at EOY 9. Anticipating this expenditure, five years ago the
owner began depositing $1,000 per year into an investment account bearing
interest at 6 percent per year. It is now EOY 5, and the fifth annual deposit has
just been made. The bank announces that beginning today, all funds on deposit
will bear interest at 7 percent. The owner, realizing that costs are increasing,
decides to raise the amount of the annual deposits to $2,000 per year, beginning
with the deposit due one year from today. As advisor to the owner, you are
requested to quickly calculate how much the account will total at the end of nine
more years, assuming the deposits remain at $2,000 per year and interest
remains at 7 percent.

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Example 3.8 (Solution)

Cash flow diagram;

i = 6% i = 7%
n=5 n=9 F=?
0 1 9
0 1 2 3 4 5 6 14

A1=$1,000/yr
A2=$2,000/yr

The problem may be divided into three parts:

1. The amount on deposit at the end of five years is F1.

F1 = $1,000 (F/A, 6%, 5) = $5,637

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Example 3.8 (Solution)

2. This amount, $5,637, may now be considered as the present value, P1, of a
lump sum deposit that begins drawing interest at 7 percent from EOY 5 until EOY
14, or n=9. The future amount that accumulates at EOY 14 from this one source is

F2 = $5,637 (F/P, 7%, 9) = $10,364

3. The annual deposits are raised to $2,000 from EOY 6 until EOY 14, with i=7
percent on the accumulated balance. This results in the accumulation of

F3 = $2,000 (F/A, 7%, 9) = $23,956

The total amount on hand at EOY 14 is

F2 + F3 = $10,364 + $23,956 = $34,320

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Example 3.8 (Solution)

To sum any combination of F values (or P values) each value must be transferred
to a common point in time on the cash flow diagram. This series of equations
could be simplifies as follows:

F2 = $1,000 (F/A, 6%, 5) (F/P, 7%, 9) = $10,364 (combining steps)

F3 = $2,000 (F/A, 7%, 9) = $23,956
Ftotal = $34,320

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NEGATIVE INTEREST RATE

Problems sometime ocur where th interest rate (or equivalent growth rate) is
negative. For instance; an investment that turns out poorly may have a negative
net cash flow; thus it yields a negative rate of return.

Population growth patterns can yield a negative rate of increase. For instance;
consider a retirement area with a large number of older people. Due to the large
proportion of older residents, the birth rate may be lower than the death rate,
leading to a negative natural increase. The natural rate of increase is often
simulated by compound interest, so a negative increase may be simulated by a
negative interest rate.

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Example 3.9

A new retirement community will need to add a second unit to the new water
treatment plant when the population reaches 40,000. The community has just
been built and is starting out now with a zero population. On average, 6,000 new
residents are expected to move into the community each year. The estimated
birthrate for the community is 8 per 1,000, and the death rate is 14 per 1,000
resulting in a negative annual increase of -0.6 percent. How long will it be before
the second unit is needed for the new water treatment plant?

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Example 3.9 (Solution)

The population must reach 40,000 before the second unit is needed, so that
F=40,000.
The number of new residents expected each year is 6,000, so A=6,000.
The residents that are there should have a natural rate of increase of -0.6
percent, so i=-0.006.
A diagram similar to the cash flow diagram may be drawn for this problem,

i = -0.6% F=40,000

0 1 2 3 4 5 6 n-1 n

A = 6,000

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Example 3.9 (Solution)

To solve for the number of years, n, that will yield a net population increase of
40,000, use the F/A equation, as follows.

Fi 40,000∗(−0.006)
In( +1) In( 6,000
+1)
A
n= = = 6.78 = 6.8 yr
In(1+i) In(1−0.006)

Note that since the negative i is small, and n is not large either, the number of
years required to reach 40,000 is just a little more than if i were zero
(40,000/6,000=6.67=6.7 yr).

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Example 3.11

A city transit authority is planning on replacing its aging bus fleet siz years from
now at an estimated lump sum cost of $1,000,000. To accumulate this amount,
they decide to raise bus fares by whatever amount is required, with the raised
fare going into effect three months from today. The increased fare increment will
be deposited monthly at the end of aech month of collections (the first deposit will
be made four months from today) into a fund bearing interest at 0.5 percent per
month, compounded monthly. The number of fares per mont for the next siz
years is estimated in the following table:
During months Fares per month

4 through 24 140,000

25 through 72 160,000

How much of a fare increase per passenger is necessary in order to reach the
desired lump sum? The fare increase per passenger will remain constant until
the end of the sixth year (seventy-second month). 21
Example 3.11 (Solution)

The amount collected each month equals the number of fares per month times
the fare per passenger (designated by y). For the first 21 months of collections
the monthly receipts should be
A1 = 140,000y
The monthly receipts for the final 48 months are designated as
A2 = 160,000y
The cash flow diagram for this problem:

i = 0.5%/month
n = 21 n = 48 F=$1,000,000

0 1 2 3 4 5 22 23 24 25 26 27 28 70 71 72

A1=140,000y
A2=160,000y
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Example 3.11 (Solution)

The first series involves 21 payments (24-3=21). A future lump sum F1 equivalent
to this first series is found at EOM 24 as

F1 = 140,000y (F/A, 0.5%, 21) = 3,092,000y

22.084
F1

0 1 2 3 4 21 22 23 24

A1 = 140,000y
i = 0.5%
n = 21

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Example 3.11 (Solution)

Then this lump sum F1 is treated as P1 and transferred another 48 months

(72-24=48) to an equivalent future lump sum F2 at EOM 72, as

F2 = 3,092,000y (F/P, 0.5%, 48) = 3,928,000y

1.12705
F2

24 25 26 27 28 69 70 71 72

i = 0.5%
n = 48

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Example 3.11 (Solution)

The future value F2 of the second series of payments A2 is found at EOM 72, as

F3 = 160,000y (F/A, 0.5%, 48) = 8,656,000y

54.0978

F2 + F3 = 12,584,000y
F3

25 26 27 28 69 70 71 72

A2 = 160,000y
i = 0.5%
n = 48 25
Example 3.11 (Solution)

The total amount needed at the end of the six-year period is $1,000,000, so F2 + F3
is equated to this amount and the equation is solved for y. Thus,

$1,000,000
y = 12,584,000 = $0.079 or,

the fare must increase by $0.08 per passenger

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Example 3.13

The following problem and cash flow diagram represent a requirement that
$1,200 be paid annually. If you were to pay monthly with compounding monthly
at i=1 percent per month, find the future lump sum equivalent at EOM 36.

Example 3.13 (Solution)

The cash flow diagram,
i = 1%/month F=?

0 EOY1 EOY2 EOY3

$1,200 $1,200 $1,200

Find the monthly payment that is equivalent to the annual payment of $1,200.

A = F(A/F, i, n) = $1,200(A/F, 1%, 12) = $94,62/month

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Example 3.13 (Solution)

In order to accumulate $1,200 in an account at EOM 12, you can deposit $94,62
at the end of every moth for 12 months and earn 1 percent interest compounded
monthly. Having found that $94,62/month is equivalent to $1,200 per year, the
equivalent future lump sum at EOM 36 can be determined.

F = A(F/A, i, n) = $94,62(F/A, 1%, 36) = $4,076

Thus if $1,200 is deposited at the end of every 12 months for 36 months, and if
interest is credited every month compounded at 1 percent per month on the
balance in the account, then the balance in the account at EOM 36 is $4,076.
These calculations can be reduced to one line as follows:

F = $1,200(A/F, 1%, 12) (F/A, 1%, 36) = $4,076

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Example 3.14

Assume the same $1,200 annual payment and i=1 percent/month, as in Example
3.13. Find F at EOM 36.

Example 3.14 (Solution)

The effective interest rate for compounding every 12 months that is equivalent to
compounding at 1 percent per month is
ie = (1+i)m -1 = (1+0.01)12 -1 = 0.12683 = 12.68%
Thus the future lump sum equivalent, where i = ie and n=3, is found as

(1+𝑖)𝑛 −1 (1+0.12683)3 −1
F=A [ 𝑖 ] = $1,200 0.12683
= $4,076

This indicates that an interest rate of 12.68 percent compounded annually on

annual deposits of $1,200 yields the same balance at EOY 3 as an interest rate
of 1 percent compounded monthly on the same $1,200 annual deposits. 29
Reference:
Engineering Economics and Cost Analysis,
Courtland A. Collier, Charles R. Glagola,
Addison Wesley Longman.

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