ENGINEERING ECONOMICS

Presented by
Maj Zahoor

Lecture 5a
Learning Objectives

 Arithmetic (Linear) Gradient series

 Geometic Gradient series
 Present value calculation for a gradient
series
 Examples

2
 Arithmetic Gradient series
Definition: A collection of end-of-period, increasing cash
payments or receipts arranged in a uniformly increasing series.
The uniform increase in each successive payment is called the
gradient amount, G.

Consider a 4-yr period of uniformly increasing cash flows:

3G Note: for n periods, there are (n-1) terms for G
2G |
G | |
0 | | |
0….....1…..…2….....3…..…4
|
|
|
| F
Arithmetic Gradient
A uniform
increasing amount.
The first cash flow
is always equal to
zero.
G = the difference
between each cash
amount.
G = $10

4
Examples

 Maintenance and repair expenses on

specific equipment that increase at a
relative constant amount
 Leasing a certain equipment

5
Arithmetic Gradient

• The “G” amount is the constant arithmetic

change from one time period to the next.
• The “G” amount may be positive (receipts)
or negative (expense)!
• 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 flow (G)!
6
6
Arithmetic Gradient

 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 is always comprised of
TWO components:
•The base annuity component
•The Gradient component
7
7
Example: Linear Gradient A1+n-1G

A1+n-2G
Assume the
following:
A1+2G

A1+G

0 1 2 3 n-1 N

This represents a positive, increasing arithmetic gradient

8
8
Example: Linear Gradient

• Typical Negative, Increasing Gradient: G=$50

The Base Annuity

= $1500

9
9
 Arithmetic Gradient combined with a
Uniform Series
 Decompose the cash flows into a uniform series
and a pure gradient. Then add or subtract the
Present Value of the gradient to the Present
Value of the Uniform series

10
Example – Present value calculation for
a gradient series
$2,000
$1,750
$1,250 $1,500
$1,000

0
1 2 3 4 5

How much do you have to deposit

now in a savings account that
earns a 12% annual interest, if
P =? you want to withdraw the annual
series as shown in the figure?

11
Method 1:

P1  $1,000( P / A,12%,5)
 $3,604.80

P2  $250( P / G,12%,5)
 $1,599.20

P  $3,604.08  $1,599.20
 $5,204

12
Method 2:
$2,000
$1,750
$1,250 $1,500
$1,000

0
1 2 3 4 5
$1,000(P/F, 12%, 1) = $892.86
$1,250(P/F, 12%, 2) = $996.49
$1,500(P/F, 12%, 3) = $1,067.67
$1,750(P/F, 12%, 4) = $1,112.16
P =? $2,000(P/F, 12%, 5) = $1,134.85
P=F/(1+i) n $5,204.03
13
Arithmetic Gradient Uniform Series Factor

A pure gradient (uniformly increasing amount) can

also be converted into the equivalent present value
of uniform series:

AG = G(A/G, i, n)

14
 Arithmetic Gradient series

 1  i   ni  1
n
F  G 2 
 i 
Can not be measured using Tables

Example: For 6% interest rate over 4 yr. and G of $200,

F = $200[(1.06) 4 – 4(.06) - 1] / (.06) 4 = $200(6.2436)

= $1248.72

15
 Arithmetic Gradient series (contin.)
Recall the single payment present-worth expression:
 1 
P  F n 
 1  i  
Substitute the gradient expression for F:
 1  i n  ni  1 1 
P  G  
 i 2
 1  i n


 1  i n  ni  1
P  G 
 i 1  i 
2 n


\ arithmetic gradient
present-worth factor
 Example:

Our firm has purchased a photocopy machine that will

require increasing service/
maintenance costs over the next six years (at which
time we will sell it and buy a new one). Such costs at
the end of yr. 1 will be $100 and thereafter increase
by $50 each subsequent year (total is $1350). Our
plan is to make these payments by using amounts
based on an initial cash deposit in an investment
account in the local credit union paying 4% annual
interest. What is the required initial deposit?
 Example:
Our firm has purchased a photocopy machine that will require increasing service/
maintenance costs over the next six years (at which time we will sell it and buy a new
one). Such costs at the end of yr. 1 will be $100 and thereafter increase by $50 each
subsequent year (total is $1350). Our plan is to make these payments by using
amounts based on an initial cash deposit in an investment account in the local credit
union paying 4% annual interest. What is the required initial deposit?
250
200 |
150 | |
100 100 100 100 100 100 100 | | |
50 | | | |
| | | | | | 0 | | | | |
0....1….2…..3….4…..5….6 + 0....1….2….3…..4….5…..6
| |
| |
| PA | PG

P = PA+PG = $100[P/A, 4%, 6]+$50[P/G, 4%, 6] = $100(5.242)+$50(12.506)

P = PA+PG = $524.20 + $625.30 = $1149.50
 Example: The Present Worth of $400 in year 1 and amounts increasing by
$30 per year through year 5 at an interest rate of 12% per year is:
(a) $1532 (b) $1,634 (c) $1,744 (d) $1,829

Solution: The cash flow diagram is as follows:

P=? i=12%
P=400(P/A,12%,5) + 30(P/G,12%,5)
1 2 3 4 5 Year

0
=400(3.6048) + 30(6.3970)
400 = $1,633.83
430
460
G = 30 490 Answer is (b)
520

The cash flow could also be converted into an A value as follows:

A = 400 + 30(A/G,12%,5)
= 400 + 30(1.7746) = 400 + 53.238
=$453.24 19
Points to Remember
 Money has a time value because it can
earn more money over time.
 Economic equivalence exists between
individual cash flows and/or patterns of
cash flows that have the same value.
Even though the amounts and timing of
the cash flows may differ, the appropriate
interest rate makes them equal.
 The purpose of developing various
interest formulas was to facilitate the
economic equivalence computation.

20
Learning Objectives

 Geometric Gradient series

 Present value/Future Value
calculation for a gradient series
 Examples

21
Arithmetic & Geometric Gradient Series
 An arithmetic (linear) gradient
changes by a fixed amount for each
time period.
 A GEOMETRIC gradient changes by a
fixed percentage for each time period.

22
Geometric Gradient Series

g 0
23
Geometric Gradients: Derivation

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 – A

24
 Geometric Gradient Series
Geometric Gradients Change by the Same Percentage Each Period

Cash Flow Diagram for Present Worth of Geometric Gradients is as follows:

There are no Tables for Geometric Factors

P=? Use Following Equation:
1 2 3 4 n

0
A P=A{1-[(1+g)/(1+i)]n}/(i-g)
A(1+g)1
Where: A=Cash Flow in Period 1
A(1+g)2
g=Rate of increase

A(1+g)n-1
If g=i, P=An/(1+i)

 1  (1  g ) n (1  i)  n  Note: If g is negative, change signs in front of both g’s

P  A 
 ig 
25
 Geometric Gradient Series
•Particularly relevant to construction costs
•Cash flows increase/decrease by a constant %(g); compound growth
•Example: price changes due to inflation

A1(1+g)N-1

A1(1+g)
A1 P=A{1-[(1+g)/(1+i)]n}/(i-g)
0
1 2 3 N-1 N
g>0
P Find P, given A, g, i, N

26
Gradient Example:
Example: Find the present worth of $1,000 in year 1 and
amounts increasing by 7% per year through year 10.
Use an interest rate of 12% per year.

(a) $5,670 (b) $7,335 (c) $12,670 (d)$13,550

27
Gradient Example:
Example: Find the present worth of $1,000 in year 1 and
amounts increasing by 7% per year through year 10.
Use an interest rate of 12% per year.

(a) $5,670 (b) $7,335 (c) $12,670 (d)$13,550

Solution:P=1000[1-{(1+0.07)/(1+0.12)}10]/(0.12-0.07)
= $7,333
P=A{1-[(1+g)/(1+i)]n}/(i-g)
Answer is (b) Where: A=Cash Flow in Period 1
g=Rate of increase

28
Example:
Airplane ticket price will increase 8%
in each of the next four years. The
cost at the end of the first year will be
$180. How much should be put away
now to cover a students travel home
at the end of each year for the next
four years? Assume i = 5%.

29
Solution:

 1  (1  g ) n (1  i)  n 
P  A 
 ig 

 1  (1.08) 4 (1.05) 4    0.11928 

P  180   180   $715.67
 .05  .08    0.03 

30
 Check
As a check we can also solve this problem without
using the geometric gradient
Year Ticket
1 A1 = = 180
2 A2 = 180 + 8%(180) = 194.40
3 A3 = 194.40 + 8% (194.50) = 209.95
4 A4 = 209.95 + 8% (209.95) = 226.75

P = 180(P/F,5%,1) + 194.40(P/F,5%,2) +
209.95(P/F,5%,3) + 226.75(P/F,5%,4)
=$715.66
There are no tables for the geometric gradient.
31
Future worth Factor
Since F =P(1+i)
Multiplying (P/A,g,i,n) by (1+i) will give F

1  (1  g) (1  i)  n n

F  P(1  i)  A
n
(1  i)
n

 ig 
 (1  i) n  (1  g) n 
F A  
 ig   1  (1  g ) n (1  i)  n 
P  A 
 i  g 32 
Example
 A graduating CE is going to make $35,000/yr
with Granite Construction. A total of 10% of
the CE salary will be placed in the mutual fund
of their choice. The CE can count on a 3%
salary increase with the standard of living
increases for the next 30 years of employment.
If the CE is aggressive and places their
retirement in a stock index fund that will
average 12% over the course of their career,
what can the CE expect at retirement?
 (1  i) n  (1  g ) n 
F  A 
 i  g  33
 Solution:
A = 35,000 x 0.1 = 3,500
i = 12%
g = 3%
n = 30

 (1  i ) n  (1  g ) n 
F  A 
 i  g 
 (1.12) 30  (1.03) 30 
 3500   3500  305.92  $1,070,714
 0.09 

34
 1,580
1,440 1,510
1,370
Rs.1,300

0
P =? 1 2 3 4 5

Is it an arithmetic gradient or
geometric gradient example?

Arithmetic gradient

35
PRACTICE - 1
Estimate the amount required to be invested
now in ‘Army Welfare Trust’ at an annual
interest rate of 8%,
for the university education of your younger
brother after 12 years. You would require Rs.
113,200 at the end of 12th year. The required
amount would increase by Rs. 11,500 each
year for the next 3 consecutive years.
[Solve it using only the arithmetic gradient method]
36
PRACTICE – 1 a
Estimate the amount required to be invested
now in ‘Army Welfare Trust’ at an interest rate
of 8% compounded half yearly,
for the university education of your younger
brother after 12 years. You would require Rs.
113,200 at the end of 12th year. The required
amount would increase by Rs. 11,500 each
year for the next 3 consecutive years.
[Solve it using only the arithmetic gradient method]
37