UNIVERSITY OF NEGROS OCCIDENTAL – RECOLETOS

COLLEGE OF ENGINEERING

ENGINEERING ECONOMY
A COMPILATION OF NOTES

PREPARED BY:
ENGR. HONORATO J. CALVO JR., ChE
2021
 CHAPTER
ENGINEERING ECONOMY
2 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

OBJECTIVE
(1) Describe the return to capital in the form of interest (or profit).
(2) Illustrate how basic equivalence calculations are made with respect to the time value of capital in
engineering economy studies.
(3) Illustrate several basic methods for making engineering economy studies considering the time value of
money.
(4) Describe briefly the underlying assumptions and interrelationship among these methods.

TOPICS FOR DISCUSSION

Correlation between money and time.
• Interest and Discount.
• Annuities and Capitalized Cost.
• Arithmetic and Geometric Gradients.

“An investment in knowledge pays the best interest.” Benjamin Franklin

CAPITAL

The term capital refers to wealth in the form of money or property that can be used to produce more wealth.
Most of engineering economy studies involve commitment of capital for extended periods of time, so the effect
of time must be considered. In this regard, it is recognized that money today is worth more in the future
because of interest (or profit) it can earn. Therefore, money has a time value.

RETURN TO CAPITAL

Return to Capital refers to the recompense received by capital suppliers for supplying the capital and allowing
its use.
Reasons for Return to Capital
1. To pay the supplier for forgoing the use of his money or property.
2. Payment for the risk in permitting another person or organization to use his capital.
3. As an incentive for the supplier to accumulate more available capital.

KINDS OF CAPITAL

Equity Capital that owned by individuals who have invested their money or property in a business project or
venture in the hope of receiving a profit.

Debt Capital often called borrowed capital, is obtained from lenders (e.g., through the sale of bonds) for
investment.

INTEREST AND PROFIT

Interest from the viewpoint of the borrower, is the amount of money paid for the use of borrowed capital. For
the lender, is the income produced by the money which he has lent.

Profit refers to the owner’s (of the business) share in the earnings of the business as return to capital.
2–2 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

ORIGIN OF INTEREST

Records reveal its existence in Babylon in 2000 BC.

Earliest instances, interest was paid in money for the use of grain or other goods. The idea of interest became so
well established that a firm of international bankers existed in 575 BC., with home offices in Babylon.
Typical rates of interest on loans of money were about 6 to 25%, although legally sanctioned rates as high as
40% were permitted in some instances.

The charging of exorbitant interest rates on loans was termed usury, and prohibition of usury is found in the
Bible (see Exodus 22:21 – 27)

SIMPLE INTEREST

The interest on borrowed money is said to be Simple Interest if the interest to be paid is directly proportional to
the length of time the amount or principal is borrowed.

The Principal is the amount of money borrowed and on which interest is charged.

The Rate of Interest is the amount earned by one unit of principal during a unit of time.

The formula of Simple Interest is

𝑰=𝑷𝒊𝑵

Where: I = total interest earned by the principal

p = amount of the principal
i = rate of interest per interest period (expressed in decimal form)
N = number of interest periods

The total amount F to be repaid is equal to the sum of the principal and the total interest and is given by the
formula:

𝑭 = 𝑷 + 𝑰 = 𝑷 + 𝑷 𝒊 𝒏 = 𝑷(𝟏 + 𝒊 𝑵)

ORDINARY AND EXACT INTEREST

There are two types of simple interest – ordinary interest and exact simple interest.

Ordinary Simple Interest is computed on the basis of one banker’s year which is
1 banker’s year = 12 months, each consisting of 30 days = 360 days

Exact Simple Interest is based on the exact number of days, 365 days for an ordinary year and 366 days for a
leap year. The leap years are those which are exactly divisible by 4, but excluding the century years such as the
year 1900, 2000, etc.

Ordinary Simple Interest formula:

𝒅
𝑶𝒓𝒅𝒊𝒏𝒂𝒓𝒚 𝑺𝒊𝒎𝒑𝒍𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 𝑷 𝒊 𝟑𝟔𝟎
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2–3

Exact Simple Interest formula:

𝒅
𝑬𝒙𝒂𝒄𝒕 𝑺𝒊𝒎𝒑𝒍𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 𝑷 𝒊 [ for ordinary year ]
𝟑𝟔𝟓

𝒅
𝑬𝒙𝒂𝒄𝒕 𝑺𝒊𝒎𝒑𝒍𝒆 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 = 𝑷 𝒊 𝟑𝟔𝟔
[ for leap year ]

SIMPLE INTEREST PROBLEMS

PROBLEM 1 – ORDINARY SIMPLE INTEREST

Determine the ordinary simple interest on P10,000 for 9 months and 10 days if the rate of interest is 12%.

Solution:
Based on a banker’s year, 9 months and 10 days = 9(30) + 10 = 280 days

𝑑 280
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆𝑖𝑚𝑝𝑙𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 𝑖 = P10,000(0.12) ( )
360 360

= 𝑃933.33 𝐴𝑛𝑠𝑤𝑒𝑟

PROBLEM 2 – ORDINARY AND EXACT SIMPLE INTEREST

Determine the ordinary and exact simple interest on P5,000 for the period from Jan 15 to June 20, 1993 if the
rate of simple interest is 14%.

Solution: Determine the number of days in the given period:

Jan 15 – 31 = 16 days (excluding Jan 15)
Feb = 28
Mar = 31
Apr = 30
May = 31
Jun 1 – 20 = 20 days (excluding Jun 20)
Total = 156 days

Solution:
𝑑 156
𝑂𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑆𝑖𝑚𝑝𝑙𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 𝑖 = P5,000(0.14) ( )
360 360

= 𝑃303.33 𝐴𝑛𝑠𝑤𝑒𝑟

𝑑 156
𝐸𝑥𝑎𝑐𝑡 𝑆𝑖𝑚𝑝𝑙𝑒 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃 𝑖 = P5,000(0.14) ( )
365 365

= 𝑃299.18 𝐴𝑛𝑠𝑤𝑒𝑟

PROBLEM 3 – SIMPLE INTEREST AND FUTURE AMOUNT

A loan of P5,000 is made for a period of 15 months, at a simple interest rate of 15%. What future amount is due
at the end of the loan period?

Solution:
𝐹 = 𝑃 + 𝐼 = 𝑃 + 𝑃 𝑖 𝑁 = 𝑃(1 + 𝑖 𝑁)
15
𝐹 = 𝑃5,000(1 + (0.15) (12)
𝐹 = 𝑃5,937.50 𝐴𝑛𝑠𝑤𝑒𝑟
2–4 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

“Compound interest is the eighth wonder of the world. He who understands it, earns it …
he who doesn’t … pays it.” Albert Einstein

COMPOUND INTEREST

Compound Interest is defined as the interest of loan or principal which is based not only on the original amount
of the loan or principal but the amount of loan or principal plus the previous accumulated interest. This means
that aside from the principal, the interest now earns interest as well. Thus, the interest charges grow exponentially
over a period of time.

Compound interest is frequently used in commercial practice that simple interest, more especially it is a longer
period which spans for more than a year.

The future amount of the principal may be derived by the following tabulation:

Period Principal Interest Total Amount

1 P Pi P + Pi = P(1 + i)
2 P(1 + i) P(1 + i) i P(1+i)+P(1+i)i = P(1+i)2
3 P(1 + i)2 P(1 + i)2 i P(1+i)2(1+i) = P(1+i)3
n P(1+i)N

The tabulation shows that the future amount (total amount) is just the value P(1 + i) with an exponent which is
numerically equal to the period.

Using the same nomenclature as that for simple interest, the total amount due after n periods for compound
interest is given by the formula:

𝑭 = 𝑷 (𝟏 + 𝒊)𝑵

The factor (1 + i)N is called the “Single Payment Compound Amount Factor”
and is designated using the functional symbol (F/P, i%, N).
Thus, (1 + i)N = (F/P, i%, N)
And the formula is written as: 𝑭 = 𝑷 (𝟏 + 𝒊)𝑵 = 𝑷(𝑭/𝑷, 𝒊 %, 𝑵)
Where the factor in parentheses is read –
“find F given P at interest per period for n interest periods.”

From the formula: 𝑭 = 𝑷 (𝟏 + 𝒊)𝑵

We also get the formula: 𝑷 = 𝑭 (𝟏 + 𝒊)−𝑵

The factor (1 + i)– N is called the “Single Payment Present Worth Factor”
and is designated using the functional symbol (P/F, i%, N).
Thus, (1 + i)– N = (P/F, i%, N)
And the formula is written as: 𝑷 = 𝑭 (𝟏 + 𝒊)−𝑵 = 𝑭(𝑷/𝑭, 𝒊 %, 𝑵)
Where the factor in parentheses is read –
“find P given F at interest per period for n interest periods.”
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2–5

COMPOUND INTEREST PROBLEMS

PROBLEM 1 – COMPOUND INTEREST AND FUTURE AMOUNT

If the sum of P12,000 is deposited in an account earning interest at the rate of 9% compounded quarterly,
what will it become at the end of 8 years?

Solution:
P = P12,000, i = 9%/4 = 0.0225, n = 8(4) = 32
F = P(F/P, i%, n) = P(1 +i)n
F = P12,000(1 + 0.0225)32
F = P24,457.24 Answer

PROBLEM 2 – COMPOUND INTEREST AND PRESENT AMOUNT

A man possesses a promissory note, due 3 years hence, whose maturity value is P 6,700.48. if the rate of interest
is 10% compounded semI-annually, what is the value of this note now?

Solution:
F = P6,700.48, i = 10%/2 = 0.5, n = 3(2) = 6
P = F(P/F, i%, n) = F(1 +i)– n
P = P6,700.48(1 + 0.5)– 6
P = P5,000.00 Answer

EXERCISE 1
At a certain interest rate compounded quarterly, P1,000 will amount to P4,500 in 15 years. What is the amount
at the end of 10 years?
2–6 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

RATES OF INTEREST

Rate of Interest is the cost of borrowing money. It also refers to the amount earned by a unit principal per unit
time.

There are two types of rates of interest

1. Nominal rate of interest
2. Effective rate of interest

A. Nominal Rate of Interest

Nominal rate of interest is defined as the basic annual rate of interest. It specifies the rate of interest and
a number of interest periods in one year.

i = r/m i = rate of interest per interest period

r = nominal interest rate
m = number of corresponding periods per year

If the nominal rate of interest is 10% compounded quarterly, then

i = 10%/4 = 2.5%, the rate of interest per interest period.

B. Effective Rate of Interest

Effective rate of interest is the actual or exact rate of interest on the principal during one year.

if ₱ 1.00 is invested at a nominal rate of 15% compounded quarterly, after one year this will become ₱1

[1 + (0.15/4)]4 = ₱1.1586

the actual interest earned is ₱ 0.1586, therefore the rate of interest after one year is 15.86%.

Hence, effective rate = F1 – 1 = (1 + i)m - 1

where F1 = the amount P1.00 will be after one year.

The following formula is used to determine the effective rate of interest:

𝑁𝑅 𝑚
𝐸𝑅 = [1 + 𝑖]𝑚 − 1 or 𝐸𝑅 = [1 + 𝑚
] −1

Where:
m = number of interest period per year
i = interest per period = NR/m
NR = nominal rate of interest

Note: i = NR if the mode of compounding is annually

The effective rate and nominal rate are equal if the mode of compounding is per annum or annual.
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2–7

RATES OF INTEREST PROBLEM

Find the nominal rate which if converted quarterly could be used instead of 12% compounded monthly. What is
the corresponding effective rate?

Solution: let r = the unknown nominal rate

for two or more nominal rates to be equivalent,
their corresponding effective rates must be equal.
Nominal rate Effective rate
r% compounded quarterly [1 + (r/4)]4 – 1
12% compounded monthly [1 + (0.12/12)]12 – 1

Nominal rate Effective rate

r% compounded quarterly [1 + (r/4)]4 – 1
12% compounded monthly [1 + (0.12/12)]12 – 1

[1 + (r/4)]4 – 1 = [1 + (0.12/12)]12 – 1

r = 0.1212 or 12.12% compounded quarterly

Thus, 12% compounded monthly is equivalent to 12.12% compounded quarterly.

Effective rate = [ 1 + (0.12/12) ]12 – 1 = 12.68%

EXERCISES: RATES OF INTEREST

PROBLEM 1
If you are investing your money which is better: 12% compounded monthly or 12.5% compounded annually?

PROBLEM 2
A loan for P50,000 is to be paid in 3 years at the amount of P65,000. what is the effective rate of money?

PROBLEM 3
What nominal rate, compounded semi-annually, yields the same amount as 16% compounded quarterly?
2–8 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

COMPOUNDING INTEREST

In discrete compounding, the interest is compounded at the end of each infinite-length period, such as a month,
a quarter, or a year.

In continuous compounding, it is assumed that cash payments occur once per year, but the compounding is
continuous throughout the year.

CONTINOUS COMPOUNDING

If r = the nominal annual interest rate

m = the number of interest period per year,

then the interest rate

r / m = rate of interest of period
mn = number of interest periods in n years

The single payment compound amount factor may be written as

𝒓 𝒎𝒏
𝑭 = 𝑷 (𝟏 + )
𝒎

let m / r = k, then m = rk, as m increases so must k

[1 + (r/m)]mn = [1 +(1/k)]rkn = [1 + (1/k)k]rn

The limit of [1 +(r/m)]k as k approaches infinite is e

[1 + (1/k)k]rn = ern

Thus, 𝑭 = 𝑷𝒆𝒓𝒏

𝑷 = 𝑭𝒆−𝒓𝒏

COMPOUND INTEREST PROBLEM

PROBLEM 1 – COMPOUNDING INTEREST

Compare the accumulated amounts after 5 years of P1,000 invested at the rate of 10% per year compounded
(a) annually, (b) semiannually, (c) quarterly, (d) monthly, (e) daily, and (f) continuously.

using the formula, 𝑭 = 𝑷 (𝟏 + 𝒊)𝑵

a) F = P1,000[1 + (0.10)]5 F = P 1,610.51

b) F = P1,000[1 + (0.10/2)]5(2) F = P 1,628.89
c) F = P1,000[1 + (0.10/4)]5(4) F = P 1,638.62
d) F = P1,000[1 + (0.10/12)]5(12) F = P 1,645.31
e) F = P1,000[1 + (0.10/365)]5(365) F = P 1,648.61
f) F = Pern = P1,000 e(0.10)(5) F = P 1,648.72
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2–9

PROBLEM 2 – COMPOUNDING INTEREST AND PRESENT AMOUNT

A chemical engineer wished to accumulate a total of P10,000 in a savings account at the end of 10 years. If the
bank pays only 4% compounded quarterly. What should be the initial deposit? (ChE Board Problem, May 1989)

F = 10,000 i = 4%/4 = 1% n = (10)(4) = 40

P = F(1 + i) – n = 10,000 (1 + 0.01) – 40

P = P6,716.53 Answer

THE CONCEPT OF ECONOMIC EQUIVALENCE

Established when we are indifferent between a future payment, or a series of future payments, and a present
sum of money.

Considers the comparison of alternative options, or proposals, by reducing them to an equivalent basis,
depending on:
• interest rate;
• amounts of money involved;
• timing of the affected monetary receipts and/or expenditures;
• manner in which the interest, or profit on invested capital is paid and the initial capital is
recovered.

ECONOMIC EQUIVALENCE
FOR FOUR REPAYMENT PLANS OF AN P8,000 LOAN

Plan #1: P2,000 of loan principal plus 10% of BOY principal paid at the end of year; interest paid at the end of
each year is reduced by P200 (i.e., 10% of remaining principal)
Year Amount Owed at Interest Total Money Principal Total end of
Beginning of Year Accrued for Owed at end Payment Year
(BOY) Year of Year Payment
1 P8,000 P800 P8,800 P2,000 P2,800
2 P6,000 P600 P6,600 P2,000 P2,600
3 P4,000 P400 P4,400 P2,000 P2,400
4 P2,000 P200 P2,200 P2,000 P2,200

Total interest paid (P2,000) is 10% of total peso-years (P20,000)

Plan #2: P0 of loan principal paid until end of fourth year; P800 interest paid at the end of each year

Year Amount Owed at Interest Total Money Principal Total end of

Beginning of Year Accrued for Owed at end Payment Year
(BOY) Year of Year Payment
1 P8,000 P800 P8,800 P0 P800
2 P8,000 P800 P8,800 P0 P800
3 P8,000 P800 P8,800 P0 P800
4 P8,000 P800 P8,800 P8,800 P8,800

Total interest paid (P3,200) is 10% of total peso-years (P32,000)

2 – 10 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

Plan #3: P2,524 paid at the end of each year; interest paid at the end of each year is 10% of amount owed at the
beginning of the year.

Year Amount Owed at Interest Total Money Principal Total end of

Beginning of Year Accrued for Owed at end Payment Year
(BOY) Year of Year Payment
1 P8,000 P800 P8,800 P1,724 P2,524
2 P6,276 P628 P6,904 P1,896 P2,524
3 P4,380 P438 P4,818 P2,086 P2,24
4 P2,294 P230 P2,524 P2,294 P2,524

Total interest paid (P2,096) is 10% of total peso-years (P20,950)

Plan #4: No interest and no principal paid for first three years. At the end of the fourth year, the original
principal plus accumulated (compounded) interest is paid.

Year Amount Owed at Interest Total Money Principal Total end of

Beginning of Year Accrued for Owed at end Payment Year
(BOY) Year of Year Payment
1 P8,000 P800 P8,800 P0 P0
2 P8,800 P880 P9,680 P0 P0
3 P9,680 P968 P10,648 P0 P0
4 P10,648 P1,065 P11,713 P8,000 P11,713

Total interest paid (P3,713) is 10% of total peso-years (P37,128)

CASH FLOW DIAGRAMS

A cash flow diagram is simply a graphical representation of cash flows drawn on a time scale. Cash flow diagram
for economic analysis problems is analogous to that of free body diagram for mechanics problems.

receipt (positive cash flow or cash inflow)

disbursement (negative cash flow or cash outflow)

A loan of P100 at simple interest of 10% will become P150 after 5 years.

Cash flow diagram on the viewpoint of the lender

ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 11

Cash flow diagram on the viewpoint of the borrower

CASH FLOW DIAGRAMS / TABLE NOTATION

i = effective interest rate per interest period

N = number of compounding periods (e.g., years)
P = present sum of money; the equivalent value of one or more cash flows
at the present time reference point
F = future sum of money; the equivalent value of one or more cash flows
at a future time reference point
A = end-of-period cash flows (or equivalent end-of-period values ) in a uniform
series continuing for a specified number of periods, starting at the end of the
first period and continuing through the last period
G = uniform gradient amounts -- used if cash flows increase by a constant
amount in each period
2 – 12 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

DISCOUNT

Discount on a negotiable paper is the difference between the present worth (the amount received for the paper
in cash) and the worth of paper at some time in the future (the face value of the paper or principal). Discount is
interest deducted in advance.

Discount = Future Worth – Present Worth

The rate of discount is the discount on one unit of principal for one unit of time.

d = 1 – (1 + i) – 1 d = rate of discount for the period involved

i = d / (1 – d) i = rate of interest for the same period

DISCOUNT PROBLEM
A man borrowed P 5,000 from a bank and agreed to pay the load at the end of 9 months. The bank discounted
the loan and gave him P 4,000 in cash. (a) what was the rate of discount? (b) what was the rate of interest? (c)
what was the rate of interest for one year?

Solution:
a) d = discount / principal = P1,000 / P5,000 = 0.20 or 20%
or d = 1 – 0.80 = 0.20 or 20%

b) i = d / (1 – d) = 0.20 / (1 – 0.20) = 0.25 or 25%

or i = interest / principal actually received = P1,000 / P4,000 = 0.25

c) i = I / Pn = P1,000 / P4,000(9/12) = 0.3333 or 33.33%

ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 13

INTEREST FORMULAS RELATING PRESENT AND FUTURE EQUIVALENT VALUES OF SINGLE CASH FLOW

Finding F when given P:

Finding future value when given present value
F = P ( 1+i ) N
(1+i)N – single payment compound amount factor
functionally expressed as F = ( F / P, i%, N )
predetermined values of this are presented in column 2 of Appendix C of text.

Finding P when given F:

Finding present value when given future value
P = F [1 / (1 + i ) ] N = F ( 1+i ) – N
(1+i)-N single payment present worth factor
functionally expressed as P = F ( P / F, i%, N )
predetermined values of this are presented in column 3 of Appendix C of text;

EQUATION OF VALUE

An Equation of Value is obtained by setting the sum of the values in a certain comparison or focal date of one
set of obligations equal to the sum of the values on the same date of another set of obligations.

Example:
A man bought a lot worth one million if paid in cash. On the installment basis, he paid a down payment of
P200,000; P300,000 at the end of one year; P400,000 at the end of three years and a final payment at the end of
five years. What was the final payment if interest was 20%.

Using today as the focal date, the equation of value is

800,000 = 300,000(P/F, 20%, 1) + 400,000(P/F, 20%, 3) + Q(P/F, 20%, 5)
= 300,000(1.20) – 1 + 400,000(1.20) – 3 + Q(1.20) – 5
Q = P 792,560 Answer
2 – 14 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

ANNUITIES AND CAPITALIZED COST

The Annuity is defined as a series of equal payments occurring at equal interval of time.

Financial activities like

• installment payments,
• monthly rentals,
• life-insurance premium,
• monthly retirement benefits,
are familiar examples of annuity.

Annuity can be certain or uncertain.

• In annuity certain, the specific amount of payments are set to begin and end at a specific length of time.
A good example of annuity certain is the monthly payments of a car loan where the amount and number
of payments are known.

• In annuity uncertain, the annuitant may be paid according to certain event. Example of annuity uncertain
is life and accident insurance. In this example, the start of payment is not known and the amount of
payment is dependent to which event.

Annuity certain can be classified into two, simple annuity and general annuity.
• In simple annuity, the payment period is the same as the interest period, which means that if the payment
is made monthly the conversion of money also occurs monthly.

• In general annuity, the payment period is not the same as the interest period. There are many situations
where the payment for example is made quarterly but the money compounds in another period, say
monthly. To deal with general annuity, we can convert it to simple annuity by making the payment period
the same as the compounding periods by the concept of effective rates

When an annuity has a fixed time span, it is known as annuity certain.

The following are annuity certain:
1. Ordinary Annuity
2. Annuity Due
3. Deferred Annuity

TYPES OF ANNUITY
Ordinary Annuity is one where the equal payments are made at the end of each payment period starting from
the first period.

Deferred Annuity is one where the payment of the first amount is deferred a certain number of period after the
first.

Annuity Due is one where the payments are made at the start of each period, beginning from the first period.

Perpetuity is an annuity where the payment periods extend forever or in which the periodic payments continue
indefinitely.

Symbol and Their Meaning

P = Value or sum of money at present
F = Value or sum of money at some future time
A = A series I periodic, equal amounts of money
n = Number of interest periods
I = Interest rate per interest period
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 15

ORDINARY ANNUITY

Ordinary Annuity is a type of annuity where the payments are made at the end of each period beginning from
the first period.

We will deal with the following:

1. Sum of Ordinary Annuity
2. Present Worth of Ordinary Annuity

Derivation of formula for the Sum of Ordinary Annuity

Let A = periodic or uniform payment and assuming only four payments.

Annuity is based on the principles of compound interest. Hence, the computation of the sum of annuity may be
done using the formulas for geometric progression.

Solving for common ratio:

𝑎
𝑟 = 𝑎2
1

𝐴(1+𝑖)
𝑟= 𝐴

𝑟 =1+𝑖

Solving for the sum:

𝑎1 (𝑟 𝑛 − 1)
𝑆=
𝑟−1

𝐴 [(1 + 𝑖)4 − 1]
𝑆=
1+𝑖−1

𝐴 [(1 + 𝑖)4 − 1]
𝑆=
𝑖
2 – 16 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

SUM OF ORDINARY ANNUITY

𝑨[(𝟏 + 𝒊)𝑵 − 𝟏]
𝑭=
𝒊
Where: i = interest per period
N = number of periods
A = uniform payment

[(𝟏+𝒊)𝑵 −𝟏]
= uniform series compound amount factor
𝒊

PRESENT WORTH OF ORDINARY ANNUITY

Using
𝑭
Compound Interest Formula: 𝐏 = (𝟏+𝒊)𝑵

𝑨[(𝟏+𝒊)𝑵 −𝟏]
But: 𝑭= 𝒊

𝑨[(𝟏 + 𝒊)𝑵 − 𝟏]
𝑷=
𝒊 (𝟏 + 𝒊)𝑵
Where: i = interest per period
N = number of periods
A = uniform payment

[(𝟏+𝒊)𝒏 −𝟏]
= uniform series present worth factor
𝒊(𝟏+𝒊)𝒏
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 17

ANNUITY DUE

Annuity Due is a type of annuity where the payments are made at the beginning of each period starting from
the first period.

DEFERRED ANNUITY

Deferred Annuity is a type of annuity where the first payment does not begin until some time in the cash flow.

PERPETUITY

When an annuity does not have a fixed time span but continues indefinitely, then it is referred to as Perpetuity.
The sum of a perpetuity is an infinite value.

𝑨
Present Worth of Perpetuity: 𝑷= 𝒊

Where: i = interest per period

A = uniform payment
2 – 18 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

ANNUITY PROBLEM – ORDINARY ANNUITY

Today, a businessman borrowed money to be paid in 10 equal payments for 10 quarters. If the interest rate is
10% compounded quarterly and the quarterly payment is P2,000, how much did he borrow?

Solution: A = P2,000
P = the amount borrowed
0.10 10
𝐴[(1 + 𝑖)𝑁 − 1] 2,000[(1 + 4 ) − 1]
𝑃= =
𝑖 (1 + 𝑖)𝑁 0.10 0.10 10
( ) (1 + )
4 4

𝑷 = P17,504.13 𝐴𝑛𝑠𝑤𝑒𝑟

ANNUITY PROBLEM – DEFFERED ANNUITY

What is the present amount of a P500 annuity starting at the end of the third year and continuing to the end of
fourth year. If the annual interest rate is 10%?

Solution: A = P500 i = 0.10

P = the amount borrowed

𝐴[(1 + 𝑖)𝑛 − 1] 500[(1 + 0.1)2 − 1]

𝑃1 = =
𝑖 (1 + 𝑖)𝑛 (0.1) (1 + 0.1)2

𝑷𝟏 = P867.77

𝐹 𝑃1 867.77
𝑃= = =
(1+𝑖)𝑛 (1+𝑖)𝑛 (1+0.1)2

𝑷 = P717.17 𝐴𝑛𝑠𝑤𝑒𝑟
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 19

Another Solution:

𝑭
𝑷= (𝟏+𝒊)𝒏

500
𝑃1 = = 375. 66
(1 + 𝑖)3

500
𝑃2 = = 341. 51
(1 + 𝑖)4

𝑷 = 𝑃1 + 𝑃2 = 375.66 + 341.51 = 717.17 𝐴𝑛𝑠𝑤𝑒𝑟

2 – 20 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

ANNUITY PROBLEMS – EXERCISES

PROBLEM 1: ECE Board November 1998

What is the accumulated amount of five-year paying P6,000 at the end of each year, with interest at 15%
compounded annually?

PROBLEM 2: ECE Board November 1998

A debt of P10,000 with 10% interest compounded semi-annually is to be amortized by semi-annual payment
over the next 5 years. The first due in 6 months. Determine the semi-annual payment.

PROBLEM 3: CE Board November 1998

A man borrowed P300,000 from a lending institution which will be paid after 10 years at an interest rate of 12%
compounded annually. If money is worth 8% per annum, how much should he deposit to a bank monthly in
order to discharge his debt 10 years hence?

PROBLEM 4:
A parent on the day the child is born wishes to determine what lump sum would have to be paid into an account
bearing interest at 5% compounded annually, in order to withdraw P20,000 each on the child’s 18th, 19th, 20th
and 21st birthdays. How much is the lump sum amount?

PROBLEM 5:
A Civil Engineering student borrowed P2,000 to meet college expenses during his senior year. He promised to
repay the loan with interest at 4.5% in 10 semi-annual installments, the first payment to be made 3 years after
the date of the loan. How much will this payment be?

PROBLEM 6: CE Board May 1998

A man loans P187,400 from a bank with interest at 5% compounded annually. He agrees to pay his obligations
by paying 8 equal annual payments, the first being due at the end of 10 years. Find the annual payments.

PROBLEM 7: ECE Board April 1998

A person buys a piece of lot for P100,000 downpayment and 10 deferred semi-annual payments of P8,000 each,
starting three years from now. What is the present value of the investment if the rate of interest is 12%
compounded semi-annually?

PROBLEM 8: ME Board April 1993

Rainer Wandrew borrowed P50,000 from Social Security System, in the form of calamity loan, with interest 8%
compounded quarterly payable in equal quarterly installments for 10 years. Find the quarterly payments.

PROBLEM 9: ME Board October 1995

How much money must you invest today in order to withdraw P1,000.00 per year for 10 years if the interest rate
is 12%?
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 21

ANNUITY PROBLEM – PERPETUITY

What is the amount of money invested today at 15% interest can provide the following scholarships: P30,000 at
the end of each year for 6 years; P40,000 for the next 6 years and P50,000 thereafter?

Solution:

Using today as the focal date, the equation of value is

𝑃50,000
𝑃 = 𝑃30,000(𝑃/𝐴, 15%, 6) + 𝑃40,000(𝑃/𝐴, 15%, 6)(𝑃/𝐹, 15%, 6) + (𝑃/𝐹, 15%, 12)
0.15

𝑃 = 𝑃241,277 𝐴𝑛𝑠𝑤𝑒𝑟

CAPITALIZED COST
One of the most important applications of perpetuity is in capitalized cost. The Capitalized Cost of any property
is the sum of the first cost and the present worth of all cost of replacement, operation and maintenance for a
long time or forever.

Capitalized cost is an application for perpetuity. It is one method used in comparing alternatives. It is defined as
the sum of the first cost (FC) and the present worth of all perpetual maintenance and replacement cost.

Case 1: No replacement, only maintenance and or operation every period.

Capitalized Cost = First cost + Present worth of perpetual operation and or maintenance

Where: FC = First cost (initial investment)

PO & M = Present worth of all perpetual operation and maintenance cost

Example:
Determine the capitalized cost of a structure that requires an initial investment of P1,500,000 and an annual
maintenance of P150,000. Interest is 15%.

𝑨 𝑃150,000
Solution: 𝑷= 𝒊
= 0.15
= 𝑃1,000,000

Capitalized Cost = First cost + P

Capitalized Cost = P1,500,000 + 1,000,000 = P2,500,000

2 – 22 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

Case 2: Replacement only, no maintenance and or operation

Capitalized Cost = First cost + Present worth of perpetual replacement

Let: S = amount needed to replace a property every k periods

X = amount of principal invested at rate i% the interest on which will amount to S
every k periods
Xi = interest on X every period, the periodic deposit towards the accumulation of S

Cash flow diagram to find X given S

S = Xi (F/A, i%, k)

𝑆 1 𝑆 𝑖 𝑆
𝑋= [ ]= [(1+𝑖)𝑘 ] =
𝑖 , 𝑖%, 𝑘 𝑖 −1 (1+𝑖)𝑘 −1

Difference between P and X in a Perpetuity

P is the amount invested now at i% per period whose interest at the end of ever period forever is A while X is the
amount invested not at 1% per period whose interest at the end of every k periods forever is S. if k =1 then, X = P.
Replacement cost
Let: X = present worth of perpetual replacement
S = amount of replacement
k = replacement period or the life of the property

Salvage Value (SV) is defined as the worth of the property at the end of useful life.
Scrap Value (SV) is defined as the worth of the property if disposed of as a junk.
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 23

Then the amount needed for replacement will be:

S = FC – SV

Example:
A new boiler was installed by a textile plant at a cost of P300,000 and projected to have a useful life of 15 years.
At the end of its useful life, it is estimated to have a salvage value of P30,000. Determine its capitalized cost if
interest is 18% compounded annually.
(ME Board Problem – April 24, 1987)

Solution:
𝑆 𝑃270,000
𝑋= = = 𝑃24,604
(1 + 𝑖)𝑘 − 1 (1 + 0.18)15 − 1
Capitalized Cost = First Cost + X = P300,000 + P24,604 = P324,604 Answer

Case 3: Replacement, maintenance and or operation every period

Capitalized Cost = First cost + Present worth of perpetual operation and/or maintenance
+ Present worth of cost of perpetual replacement

Example:
Determine the capitalized cost of a research laboratory which requires P5,000,000 for original construction;
P100,000 at the end of every year for the first 6 years and then P120,000 each year thereafter for operating
expenses, and P500,000 every 5 years for replacement of equipment with interest at 12% per annum?
2 – 24 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 25

AMORTIZATION
Amortization is any method of repaying a debt, the principal and interest included, usually by a series of equal
payments at equal interval of time.

AMORTIZATION PROBLEM
A debt of P5,000 with interest of 12% compounded semiannually is to be amortized by equal semiannual
payments over the next 3 years, the first due in 6 months. Find the semiannual payment and construct an
amortization schedule.

Solution:
𝑃 𝑃5,000
𝐴= = = 𝑃1,016.62
𝑃/𝐴, 6%, 6 4.9173

Amortization Schedule
Period Outstanding principal Interest due at Payment Principal repaid
at beginning of period end of period at end of period
1 P5,000 P300.00 P1,016.82 P716.82
2 P4,283.18 P256.99 P1,016.82 P759.83
3 P3,523.35 P211.40 P1,016.82 P805.42
4 P2,717.93 P163.08 P1,016.82 P853.74
5 P1,864.19 P111.85 P1,016.82 P904.97
6 P 959.22 P 57.55 P1,016.82 P959.27
Totals P1,100.87 P6,100.92 P5,000.05

AMORTIZATION PROBLEM EXERCISE

A debt of P10,000 with interest at the rate of 20% compounded semiannually is to be amortized by 5 equal
payments at the end of each 6 months, the first payment is due to be made after 3 years. Find the semiannual
payments and construct an amortization schedule.
2 – 26 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

UNIFORM ARITHMETIC GRADIENT

In certain cases, economic analysis problems involved receipts or disbursement that increase or decrease by a
uniform amount each period For example, maintenance and repair expenses on specific equipment or property
may increase by a relatively constant amount each period This is known as a uniform arithmetic gradient.

Suppose that the maintenance expense on a certain machine is P 1000 at the end of the first year and increasing
at constant rate of P 500 each year for the next four years.

This cash flow may be resolved into two components

= +
ENGINEERING ECONOMY: 3 TIME-MONEY RELATIONSHIPS & EQUIVALENCE 2 – 27

Example:
A loan was to be amortized by a group of four end of the year payments forming as ascending arithmetic
progression The initial payment was to be P 5 000 and the difference between successive payments was to be P
400 But the loan was renegotiated to provide for the payment of equal rather than uniformly varying sums If the
interest rate of the loan was 15 what was the annual payment?
2 – 28 ENGINEERING ECONOMY: 3 TIME – MONEY RELATIONSHIPS AND EQUIVALENCE

Exercise Problem 1
Find the equivalent annual payment of the following obligations at 20 interest

End of Year Payment

1 P 8 000
2 P 7 000
3 P 6 000
4 P 5 000

Exercise Problem 2
Compute the values of x and F