3

INTEREST FORMULAS AND

THEIR APPLICATIONS

3.1 INTRODUCTION

Interest rate is the rental value of money. It represents the growth of capital per
unit period. The period may be a month, a quarter, semiannual or a year. An
interest rate 15% compounded annually means that for every hundred rupees
invested now, an amount of Rs. 15 will be added to the account at the end of
the first year. So, the total amount at the end of the first year will be Rs. 115.
At the end of the second year, again 15% of Rs. 115, i.e. Rs. 17.25 will be added
to the account. Hence the total amount at the end of the second year will be
Rs. 132.25. The process will continue thus till the specified number of years.

3.2 TIME VALUE OF MONEY

If an investor invests a sum of Rs. 100 in a fixed deposit for five years with an
interest rate of 15% compounded annually, the accumulated amount at the end
of every year will be as shown in Table 3.1.

Table 3.1 Compound Amounts

(amount of deposit = Rs. 100.00)
Year end Interest Compound amount
(Rs.) (Rs.)
0 100.00
1 15.00 115.00
2 17.25 132.25
3 19.84 152.09
4 22.81 174.90
5 26.24 201.14

The formula to find the future worth in the third column is

F = P ´ (1 + i)n
where
P = principal amount invested at time 0,
F = future amount,
26
 Interest Formulas and Their Applications 27

i = interest rate compounded annually,

n = period of deposit.
The maturity value at the end of the fifth year is Rs. 201.14. This means that
the amount Rs. 201.14 at the end of the fifth year is equivalent to Rs. 100.00
at time 0 (i.e. at present). This is diagrammatically shown in Fig. 3.1. This
explanation assumes that the inflation is at zero percentage.

201.14

0 1 2 3 4 5

i = 15%
100
Fig. 3.1 Time value of money.

Alternatively, the above concept may be discussed as follows: If we want

Rs. 100.00 at the end of the nth year, what is the amount that we should deposit
now at a given interest rate, say 15%? A detailed working is shown in Table 3.2.

Table 3.2 Present Worth Amounts

(rate of interest = 15%)

End of year Present worth Compound amount

(n) after n year(s)
0 100
1 86.96 100
2 75.61 100
3 65.75 100
4 57.18 100
5 49.72 100
6 43.29 100
7 37.59 100
8 32.69 100
9 28.43 100
10 24.72 100

The formula to find the present worth in the second column is

F
P=
(1 + i)n
From Table 3.2, it is clear that if we want Rs. 100 at the end of the fifth
year, we should now deposit an amount of Rs. 49.72. Similarly, if we want
Rs. 100.00 at the end of the 10th year, we should now deposit an amount of
Rs. 24.72.
Also, this concept can be stated as follows:
A person has received a prize from a finance company during the recent
festival contest. But the prize will be given in either of the following two modes:
28 Engineering Economics

1. Spot payment of Rs. 24.72 or

2. Rs. 100 after 10 years from now (this is based on 15% interest rate
compounded annually).
If the prize winner has no better choice that can yield more than 15%
interest rate compounded annually, and if 15% compounded annually is the
common interest rate paid in all the finance companies, then it makes no
difference whether he receives Rs. 24.72 now or Rs. 100 after 10 years.
On the other hand, let us assume that the prize winner has his own business
wherein he can get a yield of 24% interest rate (more than 15%) compounded
annually, it is better for him to receive the prize money of Rs. 24.72 at present
and utilize it in his business. If this option is followed, the equivalent amount
for Rs. 24.72 at the end of the 10th year is Rs. 212.45. This example clearly
demonstrates the time value of money.

3.3 INTEREST FORMULAS

While making investment decisions, computations will be done in many ways.

To simplify all these computations, it is extremely important to know how to use
interest formulas more effectively. Before discussing the effective application of
the interest formulas for investment-decision making, the various interest
formulas are presented first.
Interest rate can be classified into simple interest rate and compound
interest rate.
In simple interest, the interest is calculated, based on the initial deposit for
every interest period. In this case, calculation of interest on interest is not
applicable. In compound interest, the interest for the current period is computed
based on the amount (principal plus interest up to the end of the previous
period) at the beginning of the current period.
The notations which are used in various interest formulae are as follows:
P = principal amount
n = No. of interest periods
i = interest rate (It may be compounded monthly, quarterly, semiannually
or annually)
F = future amount at the end of year n
A = equal amount deposited at the end of every interest period
G = uniform amount which will be added/subtracted period after period to/
from the amount of deposit A1 at the end of period 1

3.3.1 Single-Payment Compound Amount

Here, the objective is to find the single future sum (F) of the initial payment (P)
made at time 0 after n periods at an interest rate i compounded every period.
The cash flow diagram of this situation is shown in Fig. 3.2.
 Interest Formulas and Their Applications 29

. .
0 1 2 3 4 . . n
P i%

Fig. 3.2 Cash flow diagram of single-payment compound amount.

The formula to obtain the single-payment compound amount is

F = P(1 + i)n = P(F/P, i, n)
where
(F/P, i, n) is called as single-payment compound amount factor.

EXAMPLE 3.1 A person deposits a sum of Rs. 20,000 at the interest rate of
18% compounded annually for 10 years. Find the maturity value after 10 years.

Solution
P= Rs. 20,000
i= 18% compounded annually
n = 10 years
F= P(1 + i)n = P(F/P, i, n)
= 20,000 (F/P, 18%, 10)
= 20,000 ´ 5.234 = Rs. 1,04,680
The maturity value of Rs. 20,000 invested now at 18% compounded yearly
is equal to Rs. 1,04,680 after 10 years.

3.3.2 Single-Payment Present Worth Amount

Here, the objective is to find the present worth amount (P) of a single future sum
(F) which will be received after n periods at an interest rate of i compounded
at the end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.3.
F

. .
0 1 2 3 4 . . n
P i%
Fig. 3.3 Cash flow diagram of single-payment present worth amount.

The formula to obtain the present worth is

F
P= = F(P/F, i, n)
(1 + i)n
where
(P/F, i, n) is termed as single-payment present worth factor.
30 Engineering Economics

EXAMPLE 3.2 A person wishes to have a future sum of Rs. 1,00,000 for his
son’s education after 10 years from now. What is the single-payment that he
should deposit now so that he gets the desired amount after 10 years? The bank
gives 15% interest rate compounded annually.

Solution
F = Rs. 1,00,000
i = 15%, compounded annually
n = 10 years
P = F/(1 + i)n = F(P/F, i, n)
= 1,00,000 (P/F, 15%, 10)
= 1,00,000 ´ 0.2472
= Rs. 24,720
The person has to invest Rs. 24,720 now so that he will get a sum of
Rs. 1,00,000 after 10 years at 15% interest rate compounded annually.

3.3.3 Equal-Payment Series Compound Amount

In this type of investment mode, the objective is to find the future worth of n
equal payments which are made at the end of every interest period till the end
of the nth interest period at an interest rate of i compounded at the end of each
interest period. The corresponding cash flow diagram is shown in Fig. 3.4.

F
i%
0 1 2 3 4 . .
. . n

A A A A A
Fig. 3.4 Cash flow diagram of equal-payment series compound amount.

In Fig. 3.4,
A = equal amount deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount
The formula to get F is
(1 + i)n − 1
F=A = A(F/A, i, n)
i
where
(F/A, i, n) is termed as equal-payment series compound amount factor.

EXAMPLE 3.3 A person who is now 35 years old is planning for his retired
life. He plans to invest an equal sum of Rs. 10,000 at the end of every year for
 Interest Formulas and Their Applications 31

the next 25 years starting from the end of the next year. The bank gives 20%
interest rate, compounded annually. Find the maturity value of his account when
he is 60 years old.

Solution
A= Rs. 10,000
n= 25 years
i= 20%
F= ?
The corresponding cash flow diagram is shown in Fig. 3.5.
F

i = 20%
0 1 2 3 4 . .
. . 25

10,000 10,000 10,000 10,000 10,000

Fig. 3.5 Cash flow diagram of equal-payment series compound amount.

(1 + i)n − 1
F=A
i
= A(F/A, i, n)
= 10,000(F/A, 20%, 25)
= 10,000 ´ 471.981
= Rs. 47,19,810
The future sum of the annual equal payments after 25 years is equal to
Rs. 47,19,810.

3.3.4 Equal-Payment Series Sinking Fund

In this type of investment mode, the objective is to find the equivalent
amount (A) that should be deposited at the end of every interest period for n
interest periods to realize a future sum (F) at the end of the nth interest period
at an interest rate of i.
The corresponding cash flow diagram is shown in Fig. 3.6.
F
i%
0 1 2 3 4 . .
. . n

A A A A A
i%
Fig. 3.6 Cash flow diagram of equal-payment series sinking fund.
32 Engineering Economics

In Fig. 3.6,
A = equal amount to be deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount at the end of the nth period
The formula to get F is
i
A=F = F(A/F, i, n)
(1 + i)n − 1
where
(A/F, i, n) is called as equal-payment series sinking fund factor.
EXAMPLE 3.4 A company has to replace a present facility after 15 years at
an outlay of Rs. 5,00,000. It plans to deposit an equal amount at the end of every
year for the next 15 years at an interest rate of 18% compounded annually. Find
the equivalent amount that must be deposited at the end of every year for the
next 15 years.

Solution
F= Rs. 5,00,000
n = 15 years
i= 18%
A= ?
The corresponding cash flow diagram is shown in Fig. 3.7.
5,00,000

i = 18%
0 1 2 3 4 . .
. . 15

A A A A A
Fig. 3.7 Cash flow diagram of equal-payment series sinking fund.

i
A=F = F(A/F, i, n)
(1 + i)n − 1
= 5,00,000(A/F, 18%, 15)
= 5,00,000 ´ 0.0164
= Rs. 8,200
The annual equal amount which must be deposited for 15 years is Rs. 8,200.

3.3.5 Equal-Payment Series Present Worth Amount

The objective of this mode of investment is to find the present worth of an equal
 Interest Formulas and Their Applications 33

payment made at the end of every interest period for n interest periods at an
interest rate of i compounded at the end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.8. Here,
P= present worth
A= annual equivalent payment
i= interest rate
n = No. of interest periods
The formula to compute P is
(1 + i)n − 1
P=A = A(P/A, i, n)
i(1 + i)n
where
(P/A, i, n) is called equal-payment series present worth factor.

i%
0 1 2 3 4 . . n
. .
A A A A A
Fig. 3.8 Cash flow diagram of equal-payment series present worth amount.

EXAMPLE 3.5 A company wants to set up a reserve which will help the
company to have an annual equivalent amount of Rs. 10,00,000 for the next 20
years towards its employees welfare measures. The reserve is assumed to grow
at the rate of 15% annually. Find the single-payment that must be made now as
the reserve amount.

Solution
A = Rs. 10,00,000
i = 15%
n = 20 years
P=?
The corresponding cash flow diagram is illustrated in Fig. 3.9.

i = 15%
0 1 2 3 4 . . 20
. .
1,00,00,000
10,00,000 10,00,000 10,00,000 10,00,000 10,00,000

Fig. 3.9 Cash flow diagram of equal-payment series present worth amount.
34 Engineering Economics

(1 + i ) n − 1
P =A = A(P/A, i, n)
i (1 + i ) n
= 10,00,000 ´ (P/A, 15%, 20)
= 10,00,000 ´ 6.2593
= Rs. 62,59,300
The amount of reserve which must be set-up now is equal to Rs. 62,59,300.

3.3.6 Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent
amount (A) which is to be recovered at the end of every interest period for n
interest periods for a loan (P) which is sanctioned now at an interest rate of i
compounded at the end of every interest period (see Fig. 3.10).
P

i%
0 1 2 3 4 . . n
. .
A A A A A
Fig. 3.10 Cash flow diagram of equal-payment series capital recovery amount.

In Fig. 3.10,
P= present worth (loan amount)
A= annual equivalent payment (recovery amount)
i= interest rate
n = No. of interest periods
The formula to compute P is as follows:
i(1 + i)n
A=P = P(A/P, i, n)
(1 + i)n − 1
where,
(A/P, i, n) is called equal-payment series capital recovery factor.

EXAMPLE 3.6 A bank gives a loan to a company to purchase an equipment

worth Rs. 10,00,000 at an interest rate of 18% compounded annually. This
amount should be repaid in 15 yearly equal installments. Find the installment
amount that the company has to pay to the bank.
Solution
P= Rs. 10,00,000
i= 18%
n = 15 years
A= ?
 Interest Formulas and Their Applications 35

The corresponding cash flow diagram is shown in Fig. 3.11.

10,00,000

i = 18%
0 1 2 3 4 . . 15
. .
A A A A A
Fig. 3.11 Cash flow diagram of equal-payment series capital recovery amount.

i(1 + i)n
A=P = P(A/P, i, n)
(1 + i)n − 1
= 10,00,000 ´ (A/P, 18%, 15)
= 10,00,000 ´ (0.1964)
= Rs. 1,96,400
The annual equivalent installment to be paid by the company to the bank
is Rs. 1,96,400.

3.3.7 Uniform Gradient Series Annual Equivalent Amount

The objective of this mode of investment is to find the annual equivalent amount
of a series with an amount A1 at the end of the first year and with an equal
increment (G) at the end of each of the following n – 1 years with an interest
rate i compounded annually.
The corresponding cash flow diagram is shown in Fig. 3.12.
0 1 2 3 4 . . 10
. .
A1
A1+G
A1+2G
A1+3G

A1+ (n – 1)G
Fig. 3.12 Cash flow diagram of uniform gradient series annual equivalent amount.

The formula to compute A under this situation is

(1 + i)n − in − 1
A = A1 + G
i(1 + i)n − i
= A1 + G (A/G, i, n)
where
(A/G, i, n) is called uniform gradient series factor.

EXAMPLE 3.7 A person is planning for his retired life. He has 10 more years
36 Engineering Economics

of service. He would like to deposit 20% of his salary, which is Rs. 4,000, at
the end of the first year, and thereafter he wishes to deposit the amount
with an annual increase of Rs. 500 for the next 9 years with an interest rate of
15%. Find the total amount at the end of the 10th year of the above series.

Solution Here,
A1 = Rs. 4,000
G= Rs. 500
i= 15%
n= 10 years
A= ?&F=?
The cash flow diagram is shown in Fig. 3.13.
i = 15%
0 1 2 3 4 . . 10
. .

4,000
4,000 + 500
4,000 + 1,000
4,000 + 1,500

4,000 + 4,500
Fig. 3.13 Cash flow diagram of uniform gradient series annual equivalent amount.

(1 + i)n − in − 1
A = A1 + G
i(1 + i)n − i
= A1 + G(A/G, i, n)
= 4,000 + 500(A/G, 15%, 10)
= 4,000 + 500 ´ 3.3832
= Rs. 5,691.60
This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of
every year for the next 10 years. The future worth sum of this revised series at
the end of the 10th year is obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 5,691.60(20.304)
= Rs. 1,15,562.25
At the end of the 10th year, the compound amount of all his payments will
be Rs. 1,15,562.25.

EXAMPLE 3.8 A person is planning for his retired life. He has 10 more years
of service. He would like to deposit Rs. 8,500 at the end of the first year and
 Interest Formulas and Their Applications 37

thereafter he wishes to deposit the amount with an annual decrease of Rs. 500
for the next 9 years with an interest rate of 15%. Find the total amount at the
end of the 10th year of the above series.

Solution Here,
A1 = Rs. 8,500
G = –Rs. 500
i = 15%
n = 10 years
A=?&F=?
The cash flow diagram is shown in Fig. 3.14.
i = 15%
0 1 2 3 4 . . 10
. .
4,000
7,000
7,500
8,000
8,500
Fig. 3.14 Cash flow diagram of uniform gradient series annual equivalent amount.

(1 + i)n − in − 1
A = A1 – G
i(1 + i)n − i
= A1 – G (A/G, i, n)
= 8,500 – 500(A/G, 15%, 10)
= 8,500 – 500 ´ 3.3832
= Rs. 6,808.40
This is equivalent to paying an equivalent amount of Rs. 6,808.40 at the end of
every year for the next 10 years.
The future worth sum of this revised series at the end of the 10th year is
obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 6,808.40(20.304)
= Rs. 1,38,237.75
At the end of the 10th year, the compound amount of all his payments is
Rs. 1,38,237.75.

3.3.8 Effective Interest Rate

Let i be the nominal interest rate compounded annually. But, in practice, the
compounding may occur less than a year. For example, compounding may be
monthly, quarterly, or semi-annually. Compounding monthly means that the
interest is computed at the end of every month. There are 12 interest periods in
38 Engineering Economics

a year if the interest is compounded monthly. Under such situations, the formula
to compute the effective interest rate, which is compounded annually, is
E J− 1
Effective interest rate, R = 1 + i /C
C

where,
i = the nominal interest rate
C = the number of interest periods in a year.

EXAMPLE 3.9 A person invests a sum of Rs. 5,000 in a bank at a nominal

interest rate of 12% for 10 years. The compounding is quarterly. Find the
maturity amount of the deposit after 10 years.

Solution
P = Rs. 5,000
n = 10 years
i = 12% (Nominal interest rate)
F=?

METHOD 1
No. of interest periods per year = 4
No. of interest periods in 10 years = 10 ´ 4 = 40
Revised No. of periods (No. of quarters), N = 40
Interest rate per quarter, r = 12%/4
= 3%, compounded quarterly.
F = P(1 + r)N = 5,000(1 + 0.03)40
= Rs. 16,310.19

METHOD 2
No. of interest periods per year, C = 4
Effective interest rate, R = (1 + i/C )C – 1
= (1 + 12%/4)4 – 1
= 12.55%, compounded annually.
F = P(1 + R)n = 5,000(1 + 0.1255)10
= Rs. 16,308.91

3.4 BASES FOR COMPARISON OF ALTERNATIVES

In most of the practical decision environments, executives will be forced to

select the best alternative from a set of competing alternatives. Let us assume
that an organization has a huge sum of money for potential investment and there
are three different projects whose initial outlay and annual revenues during their
lives are known. The executive has to select the best alternative among these
three competing projects.
 Interest Formulas and Their Applications 39

There are several bases for comparing the worthiness of the projects. These
bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
These methods are discussed in detail in Chapters 4–7.

QUESTIONS
1. Explain the time value of money.
2. Give practical applications of various interest formulas.
3. A person deposits a sum of Rs. 1,00,000 in a bank for his son’s education
who will be admitted to a professional course after 6 years. The bank pays
15% interest rate, compounded annually. Find the future amount of the
deposited money at the time of admitting his son in the professional
course.
4. A person needs a sum of Rs. 2,00,000 for his daughter’s marriage which
will take place 15 years from now. Find the amount of money that he should
deposit now in a bank if the bank gives 18% interest, compounded annually.
5. A person who is just 30 years old is planning for his retired life. He plans
to invest an equal sum of Rs. 10,000 at the end of every year for the next
30 years starting from the end of next year. The bank gives 15% interest
rate, compounded annually. Find the maturity value of his account when he
is 60 years old.
6. A company is planning to expand its business after 5 years from now. The
expected money required for the expansion programme is Rs. 5,00,00,000.
The company can invest Rs. 50,00,000 at the end of every year for the next
five years. If the assured rate of return of investment is 18% for the
company, check whether the accumulated sum in the account would be
sufficient to meet the fund for the expansion programme. If not, find the
difference in amounts for which the company should make some other
arrangement after 5 years.
7. A financial institution introduces a plan to pay a sum of Rs. 15,00,000 after
10 years at the rate of 18%, compounded annually. Find the annual
equivalent amount that a person should invest at the end of every year for
the next 10 years to receive Rs. 15,00,000 after 10 years from the institution.
8. A company is planning to expand its business after 5 years from now.
The money required for the expansion programme is Rs. 4,00,00,000.
What annual equivalent amount should the company deposit at the end
of every year at an interest rate of 15% compounded annually to get
Rs. 4,00,00,000 after 5 years from now?
40 Engineering Economics

9. A company wants to set-up a reserve which will help it to have an annual

equivalent amount of Rs. 15,00,000 for the next 20 years towards its
employees welfare measures. The reserve is assumed to grow at the rate of
15% annually. Find the single-payment that must be made as the reserve
amount now.
10. An automobile company recently advertised its car for a down payment of
Rs. 1,50,000. Alternatively, the car can be taken home by customers without
making any payment, but they have to pay an equal yearly amount of
Rs. 25,000 for 15 years at an interest rate of 18%, compounded annually.
Suggest the best alternative to the customers.
11. A company takes a loan of Rs. 20,00,000 to modernize its boiler section.
The loan is to be repaid in 20 equal installments at 12% interest rate,
compounded annually. Find the equal installment amount that should be
paid for the next 20 years.
12. A bank gives loan to a company to purchase an equipment which is worth
of Rs. 5,00,000, at an interest rate of 18% compounded annually. This
amount should be repaid in 25 yearly equal installments. Find the
installment amount that the company has to pay to the bank.
13. A working woman is planning for her retired life. She has 20 more years
of service. She would like to deposit 10% of her salary which is Rs. 5,000
at the end of the first year and thereafter she wishes to deposit the same
amount (Rs. 5,000) with an annual increase of Rs. 1,000 for the next 14
years with an interest rate of 18%. Find the total amount at the end of the
15th year of the above series.
14. Consider the following cash flow diagram. Find the total amount at the end
of the 10th year at an interest rate of 12%, compounded annually.
i = 15%
0 1 2 3 4 . . 10
. .

8,000
8,000 + 1,000
8,000 + 2,000
8,000 + 3,000

8,000 + 9,000

15. A person is planning for his retired life. He has 10 more years of service.
He would like to deposit 20% of his salary, which is Rs. 10,000, at the end
of the first year and thereafter he wishes to deposit the same amount
(Rs. 10,000) with an annual increase of Rs. 2,000 for the next 9 years with
an interest rate of 20%. Find the total amount at the end of the 10th year
of the above series.
 Interest Formulas and Their Applications 41

16. A person is planning for his retired life. He has 10 more years of service.
He would like to deposit Rs. 30,000 at the end of the first year and
thereafter he wishes to deposit the same amount (Rs. 30,000) with an
annual decrease of Rs. 2,000 for the next 9 years with an interest rate of
18%. Find the total amount at the end of the 10th year of the above series.
17. A person invests a sum of Rs. 50,000 in a bank at a nominal interest rate
of 18% for 15 years. The compounding is monthly. Find the maturity
amount of the deposit after 15 years.
 4
PRESENT WORTH METHOD
OF COMPARISON

4.1 INTRODUCTION

In this method of comparison, the cash flows of each alternative will be reduced
to time zero by assuming an interest rate i. Then, depending on the type of
decision, the best alternative will be selected by comparing the present worth
amounts of the alternatives.
The sign of various amounts at different points in time in a cash flow
diagram is to be decided based on the type of the decision problem.
In a cost dominated cash flow diagram, the costs (outflows) will be assigned
with positive sign and the profit, revenue, salvage value (all inflows), etc. will
be assigned with negative sign.
In a revenue/profit-dominated cash flow diagram, the profit, revenue,
salvage value (all inflows to an organization) will be assigned with positive sign.
The costs (outflows) will be assigned with negative sign.
In case the decision is to select the alternative with the minimum cost, then
the alternative with the least present worth amount will be selected. On the other
hand, if the decision is to select the alternative with the maximum profit, then
the alternative with the maximum present worth will be selected.

4.2 REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in Fig. 4.1.

R1 R2 R3 . Rj Rn

0 1 2 3 . j n

P
Fig. 4.1 Revenue-dominated cash flow diagram.
42
 Present Worth Method of Comparison 43

In Fig. 4.1, P represents an initial investment and Rj the net revenue at the
end of the jth year. The interest rate is i, compounded annually. S is the salvage
value at the end of the nth year.
To find the present worth of the above cash flow diagram for a given
interest rate, the formula is
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...
+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
In this formula, expenditure is assigned a negative sign and revenues are
assigned a positive sign.
If we have some more alternatives which are to be compared with this
alternative, then the corresponding present worth amounts are to be computed
and compared. Finally, the alternative with the maximum present worth amount
should be selected as the best alternative.

4.3 COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in Fig. 4.2.
S

0 1 2 . j . . n
. .

. Cj Cn
C1 C2

P
Fig. 4.2 Cost-dominated cash flow diagram.

In Fig. 4.2, P represents an initial investment, Cj the net cost of operation

and maintenance at the end of the jth year, and S the salvage value at the end
of the nth year.
To compute the present worth amount of the above cash flow diagram for
a given interest rate i, we have the formula
PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]
+ Cn[1/(1 + i)n] – S[1/(1 + i)n]
In the above formula, the expenditure is assigned a positive sign and the revenue
a negative sign. If we have some more alternatives which are to be compared
with this alternative, then the corresponding present worth amounts are to be
computed and compared. Finally, the alternative with the minimum present
worth amount should be selected as the best alternative.
44 Engineering Economics

4.4 EXAMPLES

In this section, the concept of present worth method of comparison applied to

the selection of the best alternative is demonstrated with several illustrations.

EXAMPLE 4.1 Alpha Industry is planning to expand its production operation.

It has identified three different technologies for meeting the goal. The initial
outlay and annual revenues with respect to each of the technologies are
summarized in Table 4.1. Suggest the best technology which is to be
implemented based on the present worth method of comparison assuming 20%
interest rate, compounded annually.

Table 4.1

Initial outlay Annual revenue Life

(Rs.) (Rs.) (years)
Technology 1 12,00,000 4,00,000 10
Technology 2 20,00,000 6,00,000 10
Technology 3 18,00,000 5,00,000 10

Solution In all the technologies, the initial outlay is assigned a negative sign
and the annual revenues are assigned a positive sign.
TECHNOLOGY 1

Initial outlay, P = Rs. 12,00,000

Annual revenue, A = Rs. 4,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is as shown in Fig. 4.3.

4,00,000 4,00,000 4,00,000 . . 4,00,000

0 1 . j
2 3 10
i = 20%

12,00,000
Fig. 4.3 Cash flow diagram for technology 1.

The present worth expression for this technology is

PW(20%)1 = –12,00,000 + 4,00,000 ´ (P/A, 20%, 10)
= –12,00,000 + 4,00,000 ´ (4.1925)
= –12,00,000 + 16,77,000
= Rs. 4,77,000
 Present Worth Method of Comparison 45

TECHNOLOGY 2
Initial outlay, P = Rs. 20,00,000
Annual revenue, A = Rs. 6,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is shown in Fig. 4.4.
6,00,000 6,00,000 6,00,000

. .
0 1 2 10
i = 20%

20,00,000
Fig. 4.4 Cash flow diagram for technology 2.

The present worth expression for this technology is

PW(20%)2 = – 20,00,000 + 6,00,000 ´ (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 ´ (4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500

TECHNOLOGY 3
Initial outlay, P = Rs. 18,00,000
Annual revenue, A = Rs. 5,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is shown in Fig. 4.5.
5,00,000 5,00,000 5,00,000

. .
0 1 2 10
i = 20%

18,00,000
Fig. 4.5 Cash flow diagram for technology 3.
The present worth expression for this technology is
PW(20%)3 = –18,00,000 + 5,00,000 ´ (P/A, 20%, 10)
= –18,00,000 + 5,00,000 ´ (4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250
46 Engineering Economics

From the above calculations, it is clear that the present worth of technology 2
is the highest among all the technologies. Therefore, technology 2 is suggested
for implementation to expand the production.

EXAMPLE 4.2 An engineer has two bids for an elevator to be installed in a

new building. The details of the bids for the elevators are as follows:

Bid Engineer’s estimates

Initial cost Service Annual operations
life (years) & maintenance
(Rs.) cost (Rs.)
Alpha Elevator Inc. 4,50,000 15 27,000
Beta Elevator Inc. 5,40,000 15 28,500

Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.

Solution
Bid 1: Alpha Elevator Inc.
Initial cost, P = Rs. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually.
The cash flow diagram of bid 1 is shown in Fig. 4.6.

0 1 2 3 4 15
.. ..

27,000 27,000 27,000 27,000 27,000

4,50,000 i = 15%
Fig. 4.6 Cash flow diagram for bid 1.

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)
= 4,50,000 + 27,000 ´ 5.8474
= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80

Bid 2: Beta Elevator Inc.

Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500
Life = 15 years
Interest rate, i = 15%, compounded annually.
 Present Worth Method of Comparison 47

The cash flow diagram of bid 2 is shown in Fig. 4.7.

0 1 2 3 4 .. 15
..

28,500 28,500 28,500 28,500 28,500

i = 15%

5,40,000
Fig. 4.7 Cash flow diagram for bid 2.

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 ´ 5.8474
= 5,40,000 + 1,66,650.90
= Rs. 7,06,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is
to be selected for implementation. That is, the elevator from Alpha Elevator
Inc. is to be purchased and installed in the new building.

EXAMPLE 4.3 Investment proposals A and B have the net cash flows as
follows:

Proposal End of years

0 1 2 3 4
A (Rs.) –10,000 3,000 3,000 7,000 6,000
B (Rs.) –10,000 6,000 6,000 3,000 3,000

Compare the present worth of A with that of B at i = 18%. Which proposal

should be selected?

Solution
Present worth of A at i = 18%. The cash flow diagram of proposal A is
shown in Fig. 4.8.

3,000 3,000 7,000 6,000

0 1 2 3 4
i = 18%

10,000
Fig. 4.8 Cash flow diagram for proposal A.
48 Engineering Economics

The present worth of the above cash flow diagram is computed as

PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)

+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182)
+ 7,000(0.6086) + 6,000(0.5158)
= Rs. 2,052.10

Present worth of B at i = 18%. The cash flow diagram of the proposal

B is shown in Fig. 4.9.

6,000 6,000 3,000 3,000

0 1 2 3 4
i = 18%

10,000
Fig. 4.9 Cash flow diagram for proposal B.

The present worth of the above cash flow diagram is calculated as

PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2)

+ 3,000(P/F, 18%, 3) + 3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182)
+ 3,000(0.6086) + 3,000(0.5158)
= Rs. 2,767.40

At i = 18%, the present worth of proposal B is higher than that of proposal A.

Therefore, select proposal B.

EXAMPLE 4.4 A granite company is planning to buy a fully automated

granite cutting machine. If it is purchased under down payment, the cost of the
machine is Rs. 16,00,000. If it is purchased under installment basis, the
company has to pay 25% of the cost at the time of purchase and the remaining
amount in 10 annual equal installments of Rs. 2,00,000 each. Suggest the best
alternative for the company using the present worth basis at i = 18%,
compounded annually.

Solution There are two alternatives available for the company:

1. Down payment of Rs. 16,00,000
2. Down payment of Rs. 4,00,000 and 10 annual equal installments of
Rs. 2,00,000 each
 Present Worth Method of Comparison 49

Present worth calculation of the second alternative. The cash flow diagram
of the second alternative is shown in Fig. 4.10.

0 1 2 3 10
. . .

2,00,000 2,00,000 2,00,000 2,00,000

4,00,000 i = 18%
Fig. 4.10 Cash flow diagram for the second alternative.

The present worth of the above cash flow diagram is computed as

PW(18%) = 4,00,000 + 2,00,000(P/A, 18%, 10)
= 4,00,000 + 2,00,000 ´ 4.4941
= Rs. 12,98,820
The present worth of this option is Rs. 12,98,820, which is less than the first
option of complete down payment of Rs. 16,00,000. Hence, the company should
select the second alternative to buy the fully automated granite cutting machine.

EXAMPLE 4.5 A finance company advertises two investment plans. In plan 1,

the company pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now.
In plan 2, for every Rs. 1,000 invested, the company pays Rs. 4,000 at the end
of the 10th year and Rs. 4,000 at the end of 15th year. Select the best investment
plan from the investor’s point of view at i = 12%, compounded annually.

Solution Plan 1. The cash flow diagram for plan 1 is illustrated in Fig. 4.11.

12,000

0 1 2 3 . . . . 15

i = 12%
1,000
Fig. 4.11 Cash flow diagram for plan 1.

The present worth of the above cash flow diagram is calculated as

PW(12%) = –1,000 + 12,000(P/F, 12%, 15)
= –1,000 + 12,000(0.1827)
= Rs. 1,192.40
Plan 2. The cash flow diagram for plan 2 is shown in Fig. 4.12.
50 Engineering Economics

4,000 4,000

0 1 2 3 . . 10 . 15

i = 12%
1,000
Fig. 4.12 Cash flow diagram for plan 2.

The present worth of the above cash flow diagram is computed as

PW(12%) = –1,000 + 4,000(P/F, 12%, 10) + 4,000(P/F, 12%, 15)
= –1,000 + 4,000(0.3220) + 4,000(0.1827)
= Rs. 1,018.80
The present worth of plan 1 is more than that of plan 2. Therefore, plan 1 is the
best plan from the investor’s point of view.
.
EXAMPLE 4.6 Novel Investment Ltd. accepts Rs. 10,000 at the end of
every year for 20 years and pays the investor Rs. 8,00,000 at the end of the
20th year. Innovative Investment Ltd. accepts Rs. 10,000 at the end of
every year for 20 years and pays the investor Rs. 15,00,000 at the end of
the 25th year. Which is the best investment alternative? Use present worth
base with i = 12%.

Solution Novel Investment Ltd’s plan. The cash flow diagram of Novel
Investment Ltd’s plan is shown in Fig. 4.13.

8,00,000

i = 12%
0 1 2 3 20
. . .

10,000 10,000 10,000 10,000

Fig. 4.13 Cash flow diagram for Novel Investment Ltd.

The present worth of the above cash flow diagram is computed as

PW(12%) = –10,000(P/A, 12%, 20) + 8,00,000(P/F, 12%, 20)
= –10,000(7.4694) + 8,00,000(0.1037)
= Rs. 8,266
Innovative Investment Ltd’s plan. The cash flow diagram of the Innovative
Investment Ltd’s plan is illustrated in Fig. 4.14.
 Present Worth Method of Comparison 51

15,00,000

i = 12%
0 1 2 3 20 25
.

10,000 10,000 10,000 10,000

Fig. 4.14 Cash flow diagram for Innovative Investment Ltd.

The present worth of the above cash flow diagram is calculated as

PW(12%) = –10,000(P/A, 12%, 20) + 15,00,000(P/F, 12%, 25)
= –10,000(7.4694) + 15,00,000(0.0588)
= Rs. 13,506
The present worth of Innovative Investment Ltd’s plan is more than that of
Novel Investment Ltd’s plan. Therefore, Innovative Investment Ltd’s plan is the
best from investor’s point of view.

EXAMPLE 4.7 A small business with an initial outlay of Rs. 12,000 yields
Rs. 10,000 during the first year of its operation and the yield increases by
Rs. 1,000 from its second year of operation up to its 10th year of operation. At
the end of the life of the business, the salvage value is zero. Find the present
worth of the business by assuming an interest rate of 18%, compounded
annually.

Solution
Initial investment, P = Rs. 12,000
Income during the first year, A = Rs. 10,000
Annual increase in income, G = Rs. 1,000
n = 10 years
i = 18%, compounded annually
The cash flow diagram for the small business is depicted in Fig. 4.15.

19,00,000
19,000
12,000
11,000
10,000

. .
0 1 2 3 . . 10
i = 18%

12,000
Fig. 4.15 Cash flow diagram for the small business.
52 Engineering Economics

The equation for the present worth is

PW(18%) = –12,000 + (10,000 + 1,000 ´ (A/G, 18%, 10)) ´ (P/A, 18%, 10)
= –12,000 + (10,000 + 1,000 ´ 3.1936) ´ 4.4941
= –12,000 + 59,293.36
= Rs. 47,293.36
The present worth of the small business is Rs. 47,293.36.

QUESTIONS

1. A project involves an initial outlay of Rs. 30,00,000 and with the following
transactions for the next five years. The salvage value at the end of the life
of the project after five years is Rs. 2,00,000. Draw a cash flow diagram of
the project and find its present worth by assuming i = 15%, compounded
annually.

End Maintenance and Revenue

of year operating expense
(Rs.) (Rs.)
1 2,00,000 9,00,000
2 2,50,000 10,00,000
3 3,00,000 12,00,000
4 3,00,000 13,00,000
5 4,00,000 12,00,000

2. Find the present worth of the following cash flow series. Assume i = 15%,
compounded annually.

End of year 0 1 2 3 4 5
Cash flow
(Rs.) –10,000 30,000 30,000 30,000 30,000 30,000

3. Consider the following cash flow series over a 20-year period. Assuming
the interest rate as 18% compounded annually, compute the present worth
of the series; give your comments.

End of year Cash flow (Rs.)

0 –50,00,000
1 6,00,000
2 6,00,000
. .
. .
. .
20 6,00,000
 Present Worth Method of Comparison 53

4. The cost of erecting an oil well is Rs. 1,50,00,000. The annual equivalent
yield from the oil well is Rs. 30,00,000. The salvage value after its useful
life of 10 years is Rs. 2,00,000. Assuming an interest rate of 18%,
compounded annually, find out whether the erection of the oil well is
financially feasible, based on the present worth method.
5. The details of the feasibility report of a project are as shown below. Check
the feasibility of the project based on present worth method, using i = 20%.
Initial outlay = Rs. 50,00,000
Life of the project = 20 years.
Annual equivalent revenue = Rs. 15,00,000
Modernizing cost at the end of the 10th year = Rs. 20,00,000
Salvage value at the end of project life = Rs. 5,00,000.
6. Consider the following cash flow diagram. Find the present worth using an
interest rate of 15%, compounded annually.
0 1 2 3 4 .. .. 10

7,000
7,000 + 1,000
7,000 + 2,000
7,000 + 3,000

7,000 + 9,000
7. An automobile company recently advertised its car for a down payment of
Rs. 1,50,000. Alternatively, the car can be taken home by customers without
making any payment, but they have to pay an equal yearly amount of
Rs. 25,000 for 15 years at an interest rate of 18%, compounded annually.
You are asked to advise the best alternative for the customers based on
the present worth method of comparison.
8. The cash flows of two project proposals are as given below. Each of the
project has an expected life of 10 years. Select the best project based on
present worth method of comparison using an interest rate of 18%,
compounded annually.

Initial Annual Salvage

outlay equivalent value after
revenue 10 years
(Rs.) (Rs.) (Rs.)
Project 1 –7,50,000 2,00,000 50,000
Project 2 –9,50,000 2,25,000 1,00,000

9. A company has two alternatives for satisfying its daily travel requirements
of its employees for the next five years:
54 Engineering Economics

Alternative 1: Renting a vehicle at a cost of Rs. 10,00,000 per year.

Alternative 2: Buying a vehicle for Rs. 5,00,000 with an operating and
maintenance cost of Rs. 3,50,000 per year. The salvage value of the vehicle
after five years is Rs. 1,00,000.
Select the best alternative based on the present worth method of comparison
using the interest rate of 20%, compounded annually.
10. A working woman is planning for her retired life. She has 20 more years
of service. She would like to have an annual equivalent amount of
Rs. 3,00,000, starting from the end of the first year of her retirement. Find
the single amount that should be deposited now so that she receives the
above mentioned annual equivalent amount at the end of every year for
20 years after her retirement. Assume i = 15%, compounded annually.