HAND OUT # 1

KASHIF NOOR

Assistant Professor Mechanical Eng. Dept

Cash Flow diagram

Q1 A new college graduate has a job with Boeing Aerospace . He plans to borrow $10,000 now to
help in buying a car . He has arranged to repay the entire principal plus 8% per year interest after 5
years. Construct the cash flow diagram.

Q2 Each year a company ABC , expends large amount of funds for a mechanical safety featrures
throughout its world wide operations Mr Ali a lead engineer for Karachi operations plans , expenditure
of $1 million now and each of the next four year just for the improvement of field-based pressure
release valves. Construct the cash flow diagram to find the equivalent value of these expenditures at
the end of year 4 , using a cost of capital estimate for safety related funds of 12% per year.

Q3 A father wants to deposit an unknown lump-sum amount into an investment opportunity 2 years
from now that is large enough to with draw $4000 per year for university tuition for 5 years starting 3
years from now. If the rate of return is estimated to be 15.5% per year , construct the cash flow
diagram?

Q4Before evaluating the economic merits of a proposed investment , the XYZ Corporation insists that
its engineers develop a cash flow diagram of the proposal. An investment of $10,000 can be made that
will produce uniform annual revenue of $5310 for five years and then have a market value of $2000 at
the end of year five. Annual expenses will be $3000 at the end of each year for operating and
maintaining the project . Draw a cash flow diagram for the five year life of the project?

Single Cash Flow – Finding “F” when given “P”

Q1 suppose that you borrow $ 8000 now promising to repay the loan principal plus accumulate
interest in four years at i=10% per year . How much would you repay at the end of 4 years?

Q2 A firm borrows $1000 for 8 years . How much must it repay in a lump sum at the end of the 8
years? (i=10%)

KASHIF NOOR – ASSISTANT PROFESSOR

Single Cash Flow – Finding “P” when given “F”

Q1 An investor (owner) has an option to purchase a land that will be worth $10,000 in 6 years . If the
value of the land increases at 8% each year . How much should the investor be willing to pay now for
this property?

Annuity – Finding “F” when given “A”

Q1 Suppose you make 15 equal amount deposits of $1000 each into a bank account paying 5% interest
per year . The first deposit will be made one year from today . How much money can be withdrawn
from this bank account immediately after the 15th deposit?

Q2 What amount at the end of the 8th year is equivalent to eight end-of-year payments of $187.45 each
(i=10%)?

Annuity – Finding “P” when given “A”

Q1 If a certain machine undergoes a major overhaul now , its output can be increased by 20% which
translates into additional cash flow of $20,000 at the end of each year for five years . If i=15% per
year , how much can we afford to invest to overhaul this machine?

Q2 How much should be deposited in a fund now to provide for eight end of year with drawls of
$187.45 each (i=10%)?

Annuity – Finding “A” when given “F”

Q1 An enterprising student is planning to have personal savings totaling $10, 00000 , when she retires
at the age 65 . She is now 20 years old . If the annual interest rate will average 7 % over the next 45
years on her saving account, what equal end of year amount must she save to accomplish her goal?

Q2 What uniform payment at the end of 8 successive years is equivalent to $ 2143.60 at the end of
eighth year?

Annuity – Finding “A” when given “P”

Q1 What uniform payment at the end of eight successive years is equivalent to $1000 at the beginning
of the first year? (i=10%)

KASHIF NOOR – ASSISTANT PROFESSOR

Deferred Annuity

If the cash flow does not begin until some later date i.e; if the annuity is deferred by J periods (J<N)
,this situation is known as deferred annuity.
𝑃 𝑃
Po = A ( 𝐴 , i% , N-J) ( 𝐹 , i% , J)

Q1 Suppose that a father on the day his son is born wishes to determine what lump-sump amount
would have to be paid into an account bearing interest of 12% per year to provide with drawls of
$2000 on each of the son’s 18th , 19th , 20th and 21st birthday?

Q2 Series of year end cash flows extending over eight years are

Year 1 2 3 4 5 6 7 8
$ 100 200 500 400 400 400 400 400
These could represent something like the expected maintenance expenditures for a certain piece of
equipment or payment into a fund. Find :

a. Present equivalent expenditure

b. Future equivalent expenditure
c. Annual equivalent expenditure

Interpolation in interest table

Q1 Determine the value of A/P factor for an interest rate of 7.3% and n of 10 years?
Q2 Find the value of (P/F , 4% , 48) factor

Uniform Gradient

Q1 Suppose that certain end-of year cash flows are expected to be $1000 for the second year , $2000
for third year and $3000 for the fourth year and that if interest rate is 15% per year , it is desired to
find :

a. Present equivalent value at the beginning of the first year.

b. Uniform annual value at the end of each of the four years.

Q2 Suppose that one has cash flows as follows and that one wishes to calculate their present
equivalent at i=15% per year?

End of year Cash Flows ($)

1 $ -5000
2 $ -6000
3 $ -7000
4 $ -8000

Q3 Three contiguous countries in Florida have agreed to pool tax country maintained bridge
refurbishment. At a recent meeting the country engineer estimated that a total of $500,000 will be
KASHIF NOOR – ASSISTANT PROFESSOR
deposited at the end of next year into an account for the repair of old and safety-questionable bridges
throughout the three country area . Further they estimate that the deposits will increase by $100,000
per year for only 9 years , thereafter then cease . Determine :

a. Equivalent present worth

b. Annual series amounts
If country funds earn interest at a rate of 5% per year.

Nominal Interest rate

Q1 Mr. Ali obtained a new credit card from national bank, with a stated rate of 18% per year ,
compounded monthly . For a $ 1000 balance at the beginning of the year . Find the effective annual
rate and the total amount owed to bank after 1 year , provided no payments are made during the year.

Q2 Suppose that a $100 lump-sum amount is invested for 1- years at a nominal interest rate of 6%
compounded quarterly . How much is it worth at the end of the tenth year.

Effective interest rates for any time period

Q1 Visteon , a spin off company of ford motor company , supplies major automobile components to
auto manufacturers worldwide and is Ford’s largest supplier.An engineer is on a Visteon committee to
evaluate bids for new generation co-ordinate measuring machinery to be directly linked to the
automated manufacturing of high-precision components . These vendor bids include the interest rates ,
Visteon will make payments on a semiannually basis only

Bid #1 9 % per year , compounded quarterly

Bid #2 3 % per quarter , compounded quarterly
Bid #3 8.8 % per year , compounded monthly
(a) Determine the effective rate for each bid on the basis of semiannual and construct cash flow
diagram
(b) What are the effective annual rates
(c) Which bid has the lowest effective annual rate?

Equivalence Relations:

Q1 An engineer working as a private consultant made deposits in to as account as follows :

Year 0 Year 4 Year 6

$1000 $3000 $1500
Find the amount in the account at an interest rate of 12% compounded semiannually ?

Q2Suppose that a $ 100 lum sum amount is invested for 10 years at a nominated interest rate of 6 %
compounded quarterly . How much is it worth at the end of 10th year?

KASHIF NOOR – ASSISTANT PROFESSOR

Q3 for the past 7 years , a quality manager has paid $500 every 6 months for the software maintenance
contract for a LAN . what is the equivalent amount after the last payment if these funds are taken from
a pool that has been returning 20% per year compounded quarterly?

Q4 Suppose that there exists a series of 10 end o year receipts of $1000 each and it is desired to
compute their equivalent worth at the end of the tenth year if the nominal interest rate is 12%
compounded quarterly

Q45 Rob is the on-site coordinating engineer for Alcoa Aluminum , where an under renovation mine
has new ore refining equipment being installed by a local contractor . Rob developed the cash flow
diagram (Shown in table) . Included are payments to the contractor he has authorized for the current
year and approved advances from Alcoa’s home office . He knows that the interest rate on equipment
“field project” is 12 % per year compounded quarterly and that Alcoa does not bother with inter-
period compounding of interest . Will Rob’s project finances be in the “red” or “black” at the end of
the year ? By how much?

Year 0 Year 2 Year 4 Year 5 Year 8 Year 9 Year 10 Year 11

$ -150K $ - 200K $ - 75K $ -100K $ 90K $ 120K $ -50K $ 45K

Chapter 4 & 5

Present Worth Analysis (One alternative)

Q1 A piece of new equipment has been proposed by engineers to increase the productivity of a certain
manual welding operation . The investment cost is $ 25000 and the equipment will have a market
value of $5000 at the end of a study period of five years . Increased productivity attributable to the
equipment will amount to $ 8000 per year after extra operating costs have been subtracted from the
revenue generated by the additional production . If the firm’s MARR (before income tax) is 20% per
year , is this proposal accepted or rejected ? (Use P.W. method ).

Comparing alternatives : Present Worth Analysis (Useful life Equal)

Q2 Perform a present worth analysis of equal service machines with the cost shown below , if the
MARR is 10% per year . revenues for all three alternatives are expected to be the same.

Electric powered Gas powered Solar Po0wered

First cost -2500 -3500 -6000
Annual operating cost -900 -700 -50
(AOC),$
Salvage Value ,$ 200 350 100
Life ,years 5 5 5

Present Worth Analysis (Useful life Different)

KASHIF NOOR – ASSISTANT PROFESSOR

Q3 The following data have been estimated for two mutually exclusive investment alternatives A and
B , associated with a small engineering project for which revenues as well as expenses are involved .
They have useful lives for four and six years respectively . If the MARR is 10% per year show whgich
alternative is more desire able by using present equivalent worth method

A B
Capital Investment - $3500 - $5000
Annual revenuue 1900 2500
Annual expenses - 645 -1020
Useful life (year) 4 6
Market value at the end of use 0 0
ful life

Future Worth Analysis :

Future Worth Analysis (One alternative)

Q4 Refer to problem # 01 (manual welding machine) , solve it by F.W. method?

Future Worth Analysis: Comparing alternatives (Two or more alternative)

Q5 Suppose that problem#2 , is modified such that an analysis period of 6 years is used instead of 12
years , which was based on repeatability and the L.C.M of useful lives . Perhaps the responsible
manager did not agree with the repeatability assumption and wanted a xix year analysis period because
it is the planning horizon used in the company for small investment project?

Annual Worth Analysis :

A.W. (One alternative)

Q6 Refer to problem # 01 (manual welding machine) , solve it by A.W. method?

A.W. : Comparing alternatives(two or more alternatives

Q7 Repeat problem#2 , by A.W. method

KASHIF NOOR – ASSISTANT PROFESSOR

 REPLACEMENT DECISION

Types of Lives for Asset:

1. Economic life:
Period of life that results in minimum EUAC (Equivalent uniform annual cost) of owing and
operating an asset
EUAC (i%) = Capital Recovery (i%) + Annual expenses

Where CR (i%) = I (A/P ,i% ,N) – S (A/F ,i% ,N)

2. Ownership Life :

Period between date of acquisition and date of disposal by an owner

3. Physical life
Period between date of acquisition and final disposal of asset over its succession of owners
4. Useful life

Period that an asset is kept in productive service

(Primary or backup) and generates income

KASHIF NOOR – ASSISTANT PROFESSOR

Replacement Analysis using PW (before taxes)

Example 9.2 page395 :A firm owns a pressure vessel that is contemplating replacing.The old pressre
vessel has annual operting and maintenance expense of $ 60,000 per year and it can be kept for five
years , at which time it will have zero MV . It is believed that $30,000 could be obtained for the old
pressure if it were sold now.

The new pressure vessel can be purchased for $120,000. The new pressure vessel will have an MV
of$50,000 in five years and will have annual operating and maintenance expenses of $30,000 per year.
Using a before tax MARR of 20% per year, determine whether of or not the old pressure vessel should
be replaced

Replacement Analysis using Equivalent uniform annual cost-EUAC

Numerical -1:

Two years ago , a machine was purchased at a cost of $200,000 to be useful for eight years. Its salvage
value at the end of its life is $25,000. The annual maintenance cost is $25000 . The market value of the
present machine is 120,000. Now a new machine to cater to the need of the present machine is
available at $150,000 to be useful for six years. Its annual maintenance cost is $14000 .The salvage
value of the new machine is $20,000 .Using an interest rate of 12% .Find whether it is worthful to
replace the present machine or not?

Example 9.3 page395-6

Existing Pump A (Defender)

Capital Investment when purchased five years ago $17000

Annual Expenses
Replacement of impeller and bearings $1750
Operating & Maintenance $3250
Taxes & insurance expense : $17000X0.02 $340
Total Annual expense $5340
Present MV $750
Estimated market value at the end of nine additional years $200

Replacement Pump B (Challenger)

Capital investment $16000

Annual expenses
Operating & Maintenance $3000
Taxes & insurance : $16000X0.02 $320
Total annual expense $3320
Estimated MV at the end of nine years : $16000X0.2 $3200

ECONOMIC LIFE OF A NEW ASSET (CHALLENGER) OR Minimum Cost Life of the

Challenger

KASHIF NOOR – ASSISTANT PROFESSOR

The minimum cost life of any new (or existing) asset is the number of years at which the Equivalent
uniform annual cost (EUAC) of ownership is minimized. This minimum cost life is often shorter than
either the physical or useful life of the asset due to increasing operating and maintenance costs in the
later years of asset ownership.

1. Challenger’s economic life is determined by the minimum EUAC

2. For any new asset ,perform a cash flow analysis and create a table finding the EUAC for each
year
3. Identify lowest EUAC value - - - Year of lowest EUAC corresponds to economic life of the
asset

Numerical :

A piece of machinery costs $ 7500 and has no salvage value after it is installed. The
manufacturer's warranty will pay the first years maintenance and repair costs. In the
second year, maintenance costs will be $900 and this item will increase on a $900
arithmetic gradient in subsequent years. Also operating expenses for the machinery will
be $ 500 the first year and will increase on a $ 400 arithmetic gradient in the following
years . If interest rate is 8%. Compute the useful life of the machinery that results in a
minimum EUAC. That is find its minimum cost life

Pay back Period

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.

Payback period is the time in which the initial cash outflow of an investment is expected to be
recovered from the cash inflows generated by the investment. It is one of the simplest investment
appraisal techniques.

Payback Period = . Initial Investment .

Cash Inflow per Period

When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and
then use the following formula for payback period:

Payback Period = Y + ( A / B)

In the above formula,

Y is the last period with a negative cumulative cash flow;
A is the absolute value of cumulative cash flow at the end of the period Y;
B is the total cash flow during the period after Y

Problem-1

Company C is planning to undertake a project requiring initial investment of $105 million. The project
is expected to generate $25 million per year for 7 years. Calculate the payback period of the project.

KASHIF NOOR – ASSISTANT PROFESSOR

Problem -2 :

Company C is planning to undertake another project requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million
in Year 4 and $22 million in Year 5. Calculate the payback value of the project.

KASHIF NOOR – ASSISTANT PROFESSOR

Discounted Payback Period

One of the major disadvantages of simple payback period is that it ignores the time value of money.
To counter this limitation, an alternative procedure called discounted payback period may be followed,
which accounts for time value of money by discounting the cash inflows of the project.

In discounted payback period we have to calculate the present value of each cash inflow taking the
start of the first period as zero point. For this purpose the management has to set a suitable discount
rate. The discounted cash inflow for each period is to be calculated using the formula:

Actual Cash Inflow

Discounted Cash Inflow =
(1 + i)n

Where,
i is the discount rate;
n is the period to which the cash inflow relates.
Usually the above formula is split into two components which are
(i) actual cash inflow and
(ii) present value factor ( i.e. 1 / ( 1 + i )n ).

Thus discounted cash flow is the product of actual cash flow and present value factor.
The rest of the procedure is similar to the calculation of simple payback period except that we have to
use the discounted cash flows as calculated above instead of actual cash flows. The cumulative cash
flow will be replaced by cumulative discounted cash flow.
B
Discounted Payback Period = A +
C
Where,
A = Last period with a negative discounted cumulative cash flow;
B = Absolute value of discounted cumulative cash flow at the end of the period A;
C = Discounted cash flow during the period after A.

Problem
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate
the discounted payback period of the investment if the discount rate is 11%.

KASHIF NOOR – ASSISTANT PROFESSOR

Internal rate of return method (IRR)

If i ˂ r :

N.P.V. ˃ 0

P.W.B. – P.W.C. . ˃ 0

P.W.B. ˃ P.W.C.

Hence project is justified

If i ˃ r :

N.P.V. ˂ 0

P.W.B. – P.W.C. ˂ 0

P.W.B. ˂ P.W.C.

Hence project is rejected

Relationship b/w i and NPV:

Let A% = low interest rate = 5%

B% = high interest rate = 15%

a = +ve NPV

b = -ve NPV

KASHIF NOOR – ASSISTANT PROFESSOR

 𝑙𝑖𝑛𝑒 𝐵𝐴 𝑙𝑖𝑛𝑒 𝑑𝐴
𝐿𝑖𝑛𝑒 𝐵𝐶
= 𝐿𝑖𝑛𝑒 𝑑𝑒

𝐵%−𝐴% 𝑟%−𝐴%
𝑎−𝑏
= 𝑎−$0

𝐵%−𝐴% 𝑟%−𝐴%
𝑎−𝑏
= 𝑎

𝑎 (𝐵%−𝐴%)
𝑟% = A% + 𝑎−𝑏

Problem:

A capital investment of $ 10,000 can be made in a project that will produce a uniform annual revenue
of $5310 for five years and then have a salvage value of $ 2000 . Annual expenses will be $3000 . The
company is willing to accept any project that will earn at least 10% per year before income taxes on all
invested capital . Calculate whether it is acceptable by using the IRR method.

KASHIF NOOR – ASSISTANT PROFESSOR

 INCREMENTAL CAH FLOW

Numerical :

Sanderson Meat processor has asked its lead process engineer to evaluate two different types of
conveyors for the bacon curing line . Type A has an intial cost of $ 70,000 and a life of 8 years .Type
B has an initial cost of $ 95,000 and a life expectancy of 12years. The annual operating cost for type A
is expected to be $ 9000 , while the AOC for type B is $7000. If the salvage value are $ 5000 and $
10,000 for type A and type B respectively . Tabulate the incremental cash flow using their LCM

Mutually Exclusive Project analysis:

The phrase mutually exclusive means that the selection of one solution excludes the selection of any
other . Use of incremental analysis is the correct method to solve mutually exclusive projects

Steps :

1. The alternative with the smaller initial investment is the defender

2. The alternative with the greater initial investment is the cjallenger
3. Subtract the defender cash flow from the challenger cash flow to find the incremental cash
flow
4. Find the IRR of the incremental cash flow
5. If IRR ≥ MARR accept the increment and choose the challenger , otherwise reject the
increment and choose the defender

Numerical :

Two companies Bell Atlantic and GTE merged to form a giant telecommunication corporation named
Verizon Communication . As expected , some equipment incompatibilities had to be rectified
,especially for long distance and international wireless and video services . One item had two suppliers
Supplier A- U.S. firm and Supplier B- Asian firm . Approximately 3000 units of this equipment were
needed .Estimates for vendors A and B are given for each unit .Use MARR=15%

Supplier A Supplier B
Initial cost $ -8,000 -13,000
Annual cost $ -3,500 -1,600
Salvage value $ 0 2,000
Life ,years 10 5

KASHIF NOOR – ASSISTANT PROFESSOR