BASIC

CONCEPTS
PREPARED BY: ENGR. OWEN FRANCIS A. MAONGAT
ES 123 INSTRUCTOR
 OBJECTIVES:

• To know the definition, the key concepts in engineering

economics, principles of engineering economy, role of
engineers in economic decision, and design process in an
Engineering Economy
BASIC CONCEPTS
1. INTEREST
2. INTEREST RATE
3. SIMPLE INTEREST
4. COMPOUND INTEREST
5. TIME VALUE OF MONEY
6. INFLATION
7. TAXES
8. CASHFLOWS
BASIC CONCEPTS
1. INTEREST

IT IS A FEE THAT IS CHARGED FOR THE USE

OF SOMEONE ELSE'S MONEY. THE SIZE OF THE FEE
WILL DEPEND UPON THE TOTAL AMOUNT OF
MONEY BORROWED AND THE LENGTH OF TIME
OVER WHICH IT IS BORROWED.
BASIC CONCEPTS
INTEREST: EXAMPLE
BASIC CONCEPTS
2. INTEREST RATE

IT IS THE GIVEN AMOUNT OF MONEY IS

BORROWED FOR A SPECIFIED PERIOD OF TIME
(TYPICALLY, ONE YEAR), A CERTAIN
PERCENTAGE OF THE MONEY IS CHARGED AS
INTEREST. THIS PERCENTAGE IS CALLED THE
INTEREST RATE.
BASIC CONCEPTS
INTEREST RATE: EXAMPLE
BASIC CONCEPTS
3. SIMPLE INTEREST

IT IS DEFINED AS A FIXED PERCENTAGE OF THE

PRINCIPAL (THE AMOUNT OF MONEY
BORROWED), MULTIPLIED BY THE LIFE OF THE
LOAN. THUS,
I = nip
WHERE:
I = total amount of simple interest
n = life of the loan
I = interest rate (expressed as a decimal)
P = principal

It is understood that n and i refer to the same unit of time (e.g., the year).

Normally, when a simple interest loan is made, nothing is repaid until the end
of the loan period; then, both the principal and the accumulated interest are
repaid. The total amount due can be expressed as

F=P+I=P(l+ni)
BASIC CONCEPTS
SIMPLE INTEREST: EXAMPLE

F = P(1+ni)
F = $3,000[1+2(0.055)]
F = $3,330
BASIC CONCEPTS
4. COMPOUND INTEREST

WHEN INTEREST IS COMPOUNDED, THE TOTAL TIME PERIOD IS

SUBDIVIDED INTO SEVERAL INTEREST PERIODS (E.G., ONE YEAR, THREE
MONTHS, ONE MONTH). INTEREST IS CREDITED AT THE END OF EACH
INTEREST PERIOD, AND IS ALLOWED TO ACCUMULATE FROM ONE
INTEREST PERIOD TO THE NEXT.

F=P
NOTICE THAT F, THE TOTAL AMOUNT OF MONEY ACCUMULATED, INCREASES EXPONENTIALLY
WITH N, THE TIME MEASURED IN INTEREST PERIODS.
 BASIC CONCEPTS
COMPOUND INTEREST: EXAMPLE

Compound Interest Simple Interest

F=P F = P(1+ni)
F = $1000 F = $1000[1+12(0.06)]
F = $2,012.20 F = $1,720.00
Thus, the student's original investment will have
more than doubled over the 12-year period
BASIC CONCEPTS
5. TIME VALUE OF MONEY
SINCE MONEY HAS THE ABILITY TO EARN INTEREST, ITS VALUE INCREASES
WITH TIME. FOR INSTANCE, $100 TODAY IS EQUIVALENT TO
F = $100 = $140.26
FIVE YEARS FROM NOW IF THE INTEREST RATE IS 7% PER YEAR, COMPOUNDED
ANNUALLY. WE SAY THAT THE FUTURE WORTH OF $100 IS $140.26 IF I = 7% (PER
YEAR) AND N = 5 (YEARS).

SINCE MONEY INCREASES IN VALUE AS WE MOVE FROM THE PRESENT TO THE

FUTURE, IT MUST DECREASE IN VALUE AS WE MOVE FROM THE FUTURE TO THE
PRESENT. THUS, THE PRESENT WORTH OF $140.26 IS $100 IF I = 7% (PER YEAR)
AND N = 5 (YEARS)
 BASIC CONCEPTS
TIME VALUE OF MONEY: EXAMPLE

Compound Interest
F=P
$5,000 = P
P = $4,258.07
The present worth of $5,000 is $4,258.07 if I =
5.5%, compounded annually, and n=3
BASIC CONCEPTS
6. INFLATION
NATIONAL ECONOMIES FREQUENTLY EXPERIENCE INFLATION, IN
WHICH THE COST OF GOODS AND SERVICES INCREASES FROM ONE YEAR
TO THE NEXT. NORMALLY, INFLATIONARY INCREASES ARE EXPRESSED
IN TERMS OF PERCENTAGES WHICH ARE COMPOUNDED ANNUALLY.
THUS, IF THE PRESENT COST OF A COMMODITY IS PC, ITS FUTURE COST,
FC, WILL BE
FC = PC
WHERE:
= annual inflation rate (expressed as a decimal)
n=number of years
BASIC CONCEPTS
INFLATION: EXAMPLE

FC = PC
FC = $1,000
FC = $133.82
 BASIC CONCEPTS
INFLATION: EXAMPLE
In a inflationary economy, the value (buying power) of money decreases as costs increase.
Thus,

𝐹 𝑃𝐶 1 OR F=
= =
𝑃 𝐹𝐶 (1+ α )𝑛

Where F is the future worth, measured in today’s dollars, of a present amount P

BASIC CONCEPTS
INFLATION: EXAMPLE

F=
Thus, $100 in five years will be worth only
$74.73 in terms of today's dollars. Stated

F= differently, in five years $100 will be required to

purchase the same commodity that can now be
purchased for $74.73.

F = $74.76
 IF INTEREST IS BEING COMPOUNDED AT THE SAME TIME THAT
INFLATION IS OCCURRING, THEN THE FUTURE WORTH CAN BE
DETERMINED BY COMBINING (1.3) AND (1.5):

(1.3)
F= P (1.5) F=

F=
Or, defining the composite interest rate,
 ϴ=

We have

F= P

Observe that may be negative

BASIC CONCEPTS
INFLATION: EXAMPLE

A composite interest rate can be determined from this equation;

ϴ=
ϴ = = 0.0189
Substituting this value, we obtain

F= P = F = $74.76
BASIC CONCEPTS
7. TAXES
IN MOST SITUATIONS, THE INTEREST THAT IS RECEIVED FROM
AN INVESTMENT WILL BE SUBJECT TO TAXATION. SUPPOSE
THAT THE INTEREST IS TAXED AT A RATE T, AND THAT THE
PERIOD OF TAXATION IS THE SAME AS THE INTEREST PERIOD
(E.G., ONE YEAR). THEN THE TAX FOR EACH PERIOD WILL BE
T = tiP , SO THAT THE NET RETURN TO THE
INVESTOR (AFTER TAXES) WILL BE

I’ = I – T = (1 – t)iP
IF THE EFFECTS OF TAXATION AND INFLATION ARE BOTH
INCLUDED IN A COMPOUND INTEREST CALCULATION, MAY
STILL BE USED TO RELATE PRESENT AND FUTURE VALUES,
PROVIDED THE COMPOSITE INTEREST RATE IS REDEFINED AS

ϴ=
 BASIC CONCEPTS
TAXES: EXAMPLE

Let us assume that the engineer is able to invest the entire $10,000 in a savings certificate
and that the tax bracket includes all federal, state, and local taxes. By;
ϴ=
ϴ=

Substituting this value, we obtain

F= $10,000 F = $9,236.61
Because of the combined effects of inflation and taxation, I3 is negative, and the engineer
ends up with less real purchasing power after 15 years than he has today. (To make matters
worse, the engineer will most likely have to pay taxes on the original $10 000, substantially
reducing the amount of money available for investment.)
BASIC CONCEPTS
7. CASH FLOWS
A CASH FLOW IS THE DIFFERENCE BETWEEN TOTAL CASH RECEIPTS (INFLOWS) AND
TOTAL CASH DISBURSEMENTS (OUTFLOWS) FOR A GIVEN PERIOD OF TIME (TYPICALLY,
ONE YEAR). CASH FLOWS ARE VERY IMPORTANT IN ENGINEERING ECONOMICS
BECAUSE THEY FORM THE BASIS FOR EVALUATING PROJECTS, EQUIPMENT, AND
INVESTMENT ALTERNATIVES.

THE EASIEST WAY TO VISUALIZE A CASH FLOW IS THROUGH A CASH FLOW DIAGRAM,
IN WHICH THE INDIVIDUAL CASH FLOWS ARE REPRESENTED AS VERTICAL ARROWS
ALONG A HORIZONTAL TIME SCALE. POSITIVE CASH FLOWS (NET INFLOWS) ARE
REPRESENTED BY UPWARD-POINTING ARROWS, AND NEGATIVE CASH FLOWS (NET
OUTFLOWS) BY DOWNWARD-POINTING ARROWS; THE LENGTH OF AN ARROW IS
PROPORTIONAL TO THE MAGNITUDE OF THE CORRESPONDING CASH FLOW. EACH
CASH FLOW IS ASSUMED TO OCCUR AT THE END OF THE RESPECTIVE TIME PERIOD.
BASIC CONCEPTS
CASH FLOWS: EXAMPLE
In a lender-
borrower situation,
an inflow for the
one is an outflow
for the other.
Hence, the cash
flow diagram for
the lender will be
the mirror image in
the time line of the
cash flow diagram
for the borrower.
 ANNUAL
COMPOUNDING
PREPARED BY: ENGR. OWEN FRANCIS A. MAONGAT
ES 123 INSTRUCTOR
1. SINGLE-PAYMENT, COMPOUND-AMOUNT
FACTOR
F=P
IT IS THE RATIO OF F/P

F/P = ---> Notation: (F/P, i%, n)

 ANNUAL COMPOUNDING
SINGLE-PAYMENT, COMPOUND-AMOUNT FACTOR: EXAMPLE

We wish to solve for F, given P, i, and n. Thus,

F/P = ---> Notation: (F/P, i%, n)

F/$1000 =
F = $1000
F = $2,012.20
2. SINGLE-PAYMENT, PRESENT-WORTH
FACTOR
IT IS THE RECIPROCAL OF THE SINGLE-PAYMENT,
COMPOUND AMOUNT FACTOR:

P/F = = ---> (P/F, i%, n)

 ANNUAL COMPOUNDING
SINGLE-PAYMENT, PRESENT-WORTH FACTOR:
EXAMPLE

We wish to solve for P, given F, i, and n. Thus,

P/F = ---> Notation: (F/P, i%, n)

P/$5000 =
P = $5000
P = $2,792.00
3. UNIFORM-SERIES, COMPOUND-AMOUNT
FACTOR
Let equal amounts of money, A, be deposited in a savings
account (or placed in some other interest-bearing
investment) at the end of each year, as indicated in Fig. 2-1.
If the money earns interest at a rate i, compounded annually,
how much money will have accumulated after n years?
3. UNIFORM-SERIES, COMPOUND-AMOUNT
FACTOR
3. UNIFORM-SERIES, COMPOUND-AMOUNT
FACTOR

F/A = ---> (F/A, i%, n)

 ANNUAL COMPOUNDING
UNIFORM-SERIES, COMPOUND-AMOUNT FACTOR: EXAMPLE

We wish to solve for F, given A, i, and n. Thus,

F/A = ---> (F/A, i%, n)

F/$600 = F = $7,908.48
F/$600 =
4. UNIFORM-SERIES, SINKING-FUND FACTOR

IT IS THE RECIPROCAL OF THE UNIFORM-SERIES,

COMPOUND-AMOUNT FACTOR:

A/F = = --> (A/F, i%, n)

 ANNUAL COMPOUNDING
UNIFORM-SERIES, SINKING-FUND FACTOR: EXAMPLE

We wish to solve for A, given F, i, and n. Thus,

A/F = = --> (A/F, i%, n)

A/$50,000 =
A = $7,908.48
A=$50,0000 [
5. UNIFORM-SERIES, CAPITAL-RECOVERY
FACTOR
Let us now consider a somewhat different situation involving
uniform annual payments. Suppose that a given sum of money,
P, is deposited in a savings account where it earns interest at a
rate i per year, compounded annually. At the end of each year a
fixed amount, A, is withdrawn (Fig. 2-2). How large should A be
so that the bank account will just be depleted at the end of n
years?
5. UNIFORM-SERIES, CAPITAL-RECOVERY
FACTOR
 5. UNIFORM-SERIES, CAPITAL-RECOVERY
FACTOR
IT IS THE PRODUCT OF UNIFORM-SERIES, SINKING-FUND
FACTOR AND SINGLE-PAYMENT, COMPOUND-AMOUNT
FACTOR

A/P = (A/F)x (F/P) = = --> (A/P, i%, n)

= = --> (A/P, i%, n)

 ANNUAL COMPOUNDING
UNIFORM-SERIES, CAPITAL-RECOVERY FACTOR: EXAMPLE

We wish to solve for A, given P, i, and n. Thus,

A/P = (A/F)x (F/P) = = --> (A/P, i%, n)

A/$50,000 = =

A= $50,000[ A = $6,795
6. UNIFORM-SERIES, PRESENT-WORTH FACTOR

IT IS THE RECIPROCAL OF THE UNIFORM-SERIES, CAPITAL-

RECOVERY FACTOR:

P/A = = = --> (P/A, i%, n)

= = --> (P/A, i%, n)

 ANNUAL COMPOUNDING
UNIFORM-SERIES, PRESENT-WORTH FACTOR: EXAMPLE

We wish to solve for P, given A, i, and n. Thus,

P/A = = = --> (P/A, i%, n)

P/$10,000 =

P = $10,000[
P = $83,839
7. GRADIENT SERIES FACTOR
IT IS A SERIES OF ANNUAL PAYMENTS IN WHICH EACH
PAYMENT IS GREATER THAN THE PREVIOUS ONE BY A
CONSTANT AMOUNT, G.
7. GRADIENT SERIES FACTOR
7. GRADIENT SERIES FACTOR
7. GRADIENT SERIES FACTOR
IT IS A SERIES OF ANNUAL PAYMENTS IN WHICH EACH
PAYMENT IS GREATER THAN THE PREVIOUS ONE BY A
CONSTANT AMOUNT, G.

A/G = ( = --> (A/G, i%, n)

A/G = (A/F, i%, n) = --> (A/G, i%, n)

 ANNUAL COMPOUNDING
GRADIENT-SERIES FACTOR

We wish to solve for P, given Ao, G, i, and n. We first obtain a series withdrawals A’
equivalent to the series of gradients
A/G = ( = --> (A/G, i%, n)

A/$1,000 = (

A = $1,000 [ ( ] A = $5,926
 ANNUAL COMPOUNDING
GRADIENT-SERIES FACTOR
A’ = Ao + A
A’ = $5,000 + $5,926
A’ =$ 10,926
We can now calculate P as follows:
P/A’ = = --> (P/A’, i%, n)

P = $10,926 []

P = $106,116.59
 ANNUAL COMPOUNDING
GRADIENT-SERIES FACTOR
A more concise, and the preferable way, to solve this problem is to write

P = Ao x (P/A, i%, n) + G x (A/G, i%, n) x (P/A, i%, n)

P = Ao[]+ G[ ( []

P = $5,000[]+ $1,000[ ( []

P = $106,116.59