Chapter 2

Factors:
How Time and Interest Affect Money

Learning Objectives
1. F/P and P/F Factors (Single Payment Factors)
2. P/A and A/P Factors (Uniform Series Present Worth
Factor and Capital Recovery Factor)

3. F/A and A/F Factors (Sinking Fund Factor and UniformSeries Compound Amount Factor)

4. P/G and A/G Factors (Arithmetic Gradient Factors)

5. Geometric Gradient
6. Calculate i (unknown interest rate)
7. Calculate n (number of years)
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Single Payment Factors

(F/P and P/F)
Objective:
Derive factors to determine the present or future
worth of a cash flow
Fn
Cash Flow Diagram basic format
i% / period
0

P0

n-1

Basic Derivation: F/P factor

Fn = P0(1+i)n

(F/P, i%, n) factor:

P0 = Fn1/(1+i)n (P/F, i%, n) factor:

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Derivation: F/P factor

Find F given P

F1 = P + Pi = P(1+i)
F2 = F1 + F1i = F1(1+i)..or
F2 = P(1+i) + P(1+i)i = P(1+i)(1+i) = P(1+i)2
F3 = F2+ F2 i = F2(1+i) =P(1+i)2 (1+i)
= P(1+i)3

In general:

FN = P(1+i)n
FN = P (F/P, i%, n)
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Present Worth Factor from F/P

Since FN = P(1+i)n
We solve for P in terms of FN
P = F{1/ (1+i)n} = F(1+i)-n
P = F(P/F,i%,n) where
(P / F, i%, n) = (1+i)-n

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P/F factor discounting back in time

Discounting back from the future

Fn

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N
P/F factor brings a single future
sum back to a specific point in
time.
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Example- F/P Analysis

Example: P= $1,000;n=3;i=10%
What is the future value, F?
F = ??

P=$1,000

i=10%/year

F3 = $1,000 [F/P,10%,3] = $1,000[1.10]3

= $1,000[1.3310] = $1,331.00
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Example P/F Analysis

Assume F = $100,000, 9 years from now. What is the present
worth of this amount now if i =15%?
F9 = $100,000

i = 15%/yr
0

P= ??
P0 = $100,000(P/F, 15%,9) = $100,000(1/(1.15)9)
= $100,000(0.2843) = $28,426 at time t = 0
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Uniform Series Present Worth and Capital Recovery Factors

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Uniform Series Present Worth

This expression will convert an annuity cash flow

to an equivalent present worth amount one
period to the left of the first annuity cash flow.

(1 i)n 1
P A
for i 0
n
i(1 i)

P / A i%, n factor
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Capital Recovery Factor (CRF) =

A/P factor

CRF calculates the equivalent uniform annual worth A over n years for a given P
in year 0, when the interest rate is i.
The present worth point of an annuity cash flow is always one period to the left of the first
A amount.

Given the P/A factor

(1 i)n 1
P A
for i 0
n
i(1 i)

Solve for A in terms of P

Yielding.

i (1 i)
A P

n
(1 i) 1
n

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A/P, i%, n

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Example
A maker of micro-electromechanical systems [MEMS], believes it can
reduce product recalls if it purchases new software for detecting
faulty parts. The cost of the new software is $225,000.
How much would the company have to save each year for 4 years to
recover its investment if it uses a minimum attractive rate of return of
15% per year?
(A/P, 15%, 4) Using Tables (interest rate i=15%)
column: A/P, row: n=4
A/P factor = 0.35027

Company would have to save $225,000 x 0.35027 = $78,810.75 each

year.

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Example
V-Tek Systems is a manufacturer of vertical compactors, and it is examining its
cash flow requirements for the next 5 years. The company expects to replace office
machines and computer equipment at various times over the 5-year planning
period. Specifically, the company expects to spend $9000 two years from now,
$8000 three years from now, and $5000 five years from now. What is the present
worth of the planned expenditures at an interest rate of 10% per year?

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Sinking Fund and Series Compound Amount Factors

(A/F and F/A)

Take advantage of what we already have

Recall:

Also:

1
PF
n
(1 i)
i (1 i) n
A P

n
(1 i) 1

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Modern context of a Sinking Fund

In modern finance, a sinking fund is a method enabling an organization to set aside
money over time to retire its indebtedness. More specifically, it is a fund into which
money can be deposited, so that over time its preferred stock, debentures or stocks
can be retired. For the organization that is retiring debt, it has the benefit that the
principal of the debt or at least part of it, will be available when due. For the
creditors, the fund reduces the risk the organization will default when the principal is
due.
In some US states, Michigan for example, school districts may ask the voters to
approve a taxation for the purpose of establishing a Sinking Fund. The State
Treasury Department has strict guidelines for expenditure of fund dollars with the
penalty for misuse being an eternal ban on ever seeking the tax levy again.
Historical Context: A Sinking Fund was a device used in Great Britain in the 18th
century to reduce national debt.
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Example
Southwestern Moving and Storage wants to have enough
money to purchase a new tractor-trailer in 3 years. If the
unit will cost $250,000, how much should the company
set aside each year if the account earns 9% per year?
(A/F, 9%, 3) or n = 3, F = $250,000, i = 9%
Using Table 14 (pg 740), the A/F = 0.30505
A= $250,000 x 0.30505 = $76262.50

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Arithmetic Gradient Factors

An arithmetic (linear) Gradient is a cash flow series that either
increases or decreases by a constant amount over n time periods.
A linear gradient always has TWO components:
The gradient component
The base annuity component
The objective is to find a closed form expression for the Present Worth
of an arithmetic gradient

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Linear Gradient Example

A1+n-1G
A1+n-2G

Assume the following:

A1+2G
A1+G

n-1

This represents a positive, increasing arithmetic gradient

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Example: Linear Gradient

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Arithmetic Gradient Factors

The G amount is the constant arithmetic change from
one time period to the next.
The G amount may be positive or negative.
The present worth point is always one time period to the
left of the first cash flow in the series or,
Two periods to the left of the first gradient cash (G) flow.

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Present Worth Point

$700

$600
$500
$400
$300
$200
$100

X0

The Present Worth Point of the

Gradient

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Present Worth: Linear Gradient

The present worth of a linear gradient is the present

worth of the two components:
1. The Present Worth of the Gradient Component
and,
2. The Present Worth of the Base Annuity flow
Requires 2 separate calculations.

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Present Worth: Gradient Component

(Example 2.10*)
Three contiguous counties in Florida have agreed to pool tax
resources already designated for county-maintained bridge
refurbishment. At a recent meeting, the county engineers estimated
that a total of $500,000 will be deposited at the beginning of next
year into an account for the repair of old and safety-questionable
bridges throughout the three-county area. Further, they estimate that
the deposits will increase by $100,000 per year for only 9 years
thereafter, then cease.

Determine the equivalent (a) present worth and (b) annual series
amounts if county funds earn interest at a rate of 5% per year.
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Example 2.10 (b)*

Determine the equivalent annual series amounts if
county funds earn interest at a rate of 5% per year.

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Equations for P/G and A/G

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Geometric Gradients
An arithmetic (linear) gradient changes by a fixed dollar
amount each time period.
A GEOMETRIC gradient changes by a fixed percentage
each time period.
We define a UNIFORM RATE OF CHANGE (%) for each
time period
Define g as the constant rate of change in decimal
form by which amounts increase or decrease from one
period to the next

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cash flow diagrams for geometric gradient series

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Geometric Gradients: Increasing

Typical Geometric Gradient Profile

Let A1 = the first cash flow in the series

The series starts in year 1 at an initial amount A1, not considered a base
amount as in the arithmetic gradient.
0

A1

..

n-1

A1(1+g)
A1(1+g)2
A1(1+g)3

A1(1+g)n-1
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Geometric Gradients
For a Geometric Gradient the following parameters are required:

The interest rate per period i

The constant rate of change g
No. of time periods n
The starting cash flow A1

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Pg /A Equation
In summary, the engineering economy relation and factor
formulas to calculate Pg in period t = 0 for a geometric
gradient series starting in period 1 in the amount A1 and
increasing by a constant rate of g each period are

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 Engineers at SeaWorld, a division of Busch Gardens, Inc., have

completed an innovation on an existing water sports ride to
make it more exciting. The modification costs only $8000 and
is expected to last 6 years with a $1300 salvage value for the
solenoid mechanisms. The maintenance cost is expected to be
high at $1700 the first year, increasing by 11% per year
thereafter. Determine the equivalent present worth of the
modification and maintenance cost. The interest rate is 8%
per year.

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continued
Assume maintenance costs will be $1700 one year from now.
Assume an annual increase of 11% per year over a 6-year time period.
If the interest rate is 8% per year, determine the present worth of the future expenses at time t = 0.
First, draw a cash flow diagram to represent the model.
0

1
$1700

$1700(1.11)1
$1700(1.11)2
$1700(1.11)3

PW(8%) = ??

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$1700(1.11)5

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continued

Cash flow diagram

Solution: The cash flow diagram shows the salvage value as a

positive cash flow and all costs as negative.
Use Equation [2.24] for g i to calculate Pg. The total PT is

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continued *

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Payment Periods (PP), Interest Periods (IP) and

Compounding Periods (CP)
PP how often cash flows occur
IP how often the interest is incurred
CP how often interest in compounded
If PP = CP, no problem concerning effective i rate

PP IP or PP CP or IP CP
Then there is a problem

Payment Periods (PP), Interest Periods (IP) and

Compounding Periods (CP)
If MARR of the cash flow below is 6% per month
compounded semiannually then:
PP=1 month,

IP=1 month,

CP=6 months

PP IP or PP CP or IP CP
Then there is a problem

Nominal and Effective interest Rates

In an effective interest rate: IP = CP.

All factors are using effective interest rate.
If IP CP then this is a nominal interest rate.

PP IP or PP CP or IP CP
Then there is a problem

Nominal and Effective interest Rates

Important rules:
If nominal interest rate is divided or multiplied by any
number the value of the interest and the IP period are
multiplied or divided.
Example:
6% per month compounded semiannually x 6 =
36 per semi annual compounded semi annually.

PP IP or PP CP or IP CP
Then there is a problem

Effective Interest Rate Formula

i = effective rate per some stated period, e.g., quarterly,

annually
r = nominal rate for same time period
m = frequency of compounding per same time period

Effective Interest Rate

Example: Find i per year, if m = 4 for quarterly
compounding, and r = 12% per year

r m
Effective i = (1+ ) 1
m
Stated period for i is YEAR
i = (1 + 0.12/4)4 - 1 = 12.55%

Nominal and Effective Rates

Nominal

Effective

r = rate/period periods

r m
Effective i = (1+ ) 1
m

Example: Rate is 1.5% per month.

Determine nominal rate per
quarter, year, and over 2 years
Qtr: r = 1.5 3 mth = 4.5%

Example: Credit card rate is 1.5% per month

compounded monthly. Determine effective
rate per quarter and per year

Year: r = 1.5 12 mth = 18%

= 4.5 4 qtr = 18%

Period is quarter:
r = 1.5 3 mth = 4.5%
m=3
i = (1 + 0.045/3)3 1 = 4.57% per quarter

2 yrs: r =1.5 24 mth = 36%

= 18 2 yrs = 36%

Period is year:

r = 18%

m = 12

i = (1 + 0.18/12)12 - 1) = 19.6% per year

Effective Interest Rate

As m , continuous compounding is approached
r

effective i = ( 1)
Example: r = 14% per year compounded

continuously

i = ( 0.14 - 1) = 15.03% per year

Interpolation (Estimation Process)

At times, a set of interest tables may not have the exact

interest factor needed for an analysis

One may be forced to interpolate between two tabulated

values

Linear Interpolation is not exact because:

The functional relationships of the interest factors are

non-linear functions

From 2-5% error may be present with interpolation.

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Example 2.7

Assume you need the value of the A/P factor for i = 7.3% and
n = 10 years.

7.3% is likely not a tabulated value in most interest tables

So, one must work with i = 7% and i = 8% for n fixed at 10

Proceed as follows:

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Basic Setup for Interpolation

Work with the following basic relationships

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i rate is unknown
A class of problems may deal with all of the parameters know
except the interest rate.
For many application-type problems, this can become a difficult task
Termed, rate of return analysis

In some cases:
i can easily be determined
In others, trial and error must be used

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Example: i unknown
Assume one can invest $3000 now in a venture in anticipation of
gaining $5,000 in five (5) years.
If these amounts are accurate, what interest rate equates these two
cash flows?
$5,000

F = P(1+i)n
$3,000

(1+i)5 = 5,000/3000 = 1.6667

(1+i) = 1.66670.20
i = 1.1076 1 = 0.1076 = 10.76%

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Unknown Number of Years

Some problems require knowing the number of time periods
required given the other parameters
Example:
How long will it take for $1,000 to double in value if the discount rate
is 5% per year?
Fn = $2000

Draw the cash flow diagram as.

i = 5%/year; n is unknown!

...

. . . .

P = $1,000
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Unknown Number of Years

Fn = $2000

Solving we have..
0

...

. . . .

P = $1,000

(1.05)x = 2000/1000
X ln(1.05) =ln(2.000)
X = ln(1.05)/ln(2.000)
X = 0.6931/0.0488 = 14.2057 yrs
With discrete compounding it will take 15 years
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WHAT A DIFFERENCE THE YEARS AND COMPOUND

INTEREST CAN MAKE

Real World Situation - Manhattan Island purchase.

It is reported that Manhattan Island in New York was
purchased for the equivalent of $24 in the year
1626. In the year 2001, the 375th anniversary of the
purchase of Manhattan was recognized.

F = P (1+i)n = 24 (1+ 0.06)382 = 111,443,000,000 (2008)

F = P + Pin = 24 + 24(0.06)382 = $550.08 (simple interest)
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