Engineering Economics: Financial Decision

Making for Engineers

Seventh Edition

Chapter 2
Time Value of Money

Copyright © 2022 Pearson Canada Inc. 2-1

Learning Goals (1 of 2)
2.1 Recognize key terminology used in understanding the
application of interest to money
2.2 Differentiate between compound and simple interest, and
be able to calculate compound interest over several periods
2.3 Calculate an effective interest rate given the nominal
rate, and vice versa.
2.4 Calculate an effective interest rate under continuous
compounding.
2.5 Construct cash flow diagrams

Copyright © 2022 Pearson Canada Inc. 2-2

Learning Goals (2 of 2)
2.6 Differentiate among common depreciation methods, and
calculate the book value of an asset at any future time.
2.7 Appraise the validity of financial calculations.

Copyright © 2022 Pearson Canada Inc. 2-3

Introduction (1 of 1)
• Engineering decisions frequently involve tradeoffs among
costs and benefits occurring at different times.
– Typically, we invest in a project today to gain future
benefits.

• The key to making comparisons of benefits and costs that

occur at different times is the use of an interest rate.

Copyright © 2022 Pearson Canada Inc. 2-4

2.1 Interest and Interest Rates (1 of 4)
• Interest (I) is compensation for giving up the use of
money.
– The difference between the amount loaned and the
amount repaid.

• An amount of money today, P, can be related to a future

amount, F, by the interest amount I, or interest rate i:

F = P + I = P + Pi = P (1 + i )

Copyright © 2022 Pearson Canada Inc. 2-5

2.1 Interest and Interest Rates (2 of 4)
• The right to P at the beginning is exchanged for the right to
F at some future time, where F = P(1+i)
• i → interest rate, P → present worth of F
• F → future worth of P, base period → interest period

Copyright © 2022 Pearson Canada Inc. 2-6

2.1 Interest and Interest Rates (3 of 4)
• The dimension of an interest rate is (dollars/dollars)/time.
– i.e., if $1 is lent at a 9% interest rate, then $0.09/year
would be paid in interest per time period.

• Period over which interest calculated is the interest

period.

• The longer the interest period, the higher the interest rate
per time-period that must be provided to offer the same
return. In other words, for an account to earn the
equivalent of 1% per month, the account would need to
pay a little over 12% per year.

Copyright © 2022 Pearson Canada Inc. 2-7

2.1 Interest and Interest Rates (4 of 4)
CLOSE-UP 2.2 Interest Periods
Interest Period Interest Is Calculated:
Semiannually Twice per year, or once every six months
Quarterly Four times a year, or once every three months
Monthly 12 times per year
Weekly 52 times per year
Daily 365 times per year
Continuous For infinitesimally small periods

Copyright © 2022 Pearson Canada Inc. 2-8

2.2 Compound and Simple Interest (1 of 7)
Compound Interest
• If amount P is lent for one period at interest rate, i
– then amount repaid at the end of the period is
F = P(1 + i).

• If it’s more than one period, interest is compounded.

– At end of each period, interest is added to principal that
existed at the beginning of that period

Copyright © 2022 Pearson Canada Inc. 2-9

2.2 Compound and Simple Interest (2 of 7)
Compound Interest
• If an amount P is borrowed for N periods at interest rate i,
the amount that must be repaid at the end of N periods is:
F = P (1 + i ) N
• This method of computing interest is called compounding.
– Compounding assumes there are N sequential one-
period loans.
– At the end of each period, the amount borrowed plus
interest added in that period is borrowed for the next
period.
§ See Table 2.1 for compound interest computations
Copyright © 2022 Pearson Canada Inc. 2 - 10
2.2 Compound and Simple Interest (3 of 7)
Compound Interest
• Total interest on a loan over N periods is:

I C = F - P = P (1 + i ) N - P

• IC is referred to as compound interest.

• Interest period used with the compound interest method is
called the compounding period.

Copyright © 2022 Pearson Canada Inc. 2 - 11

2.2 Compound and Simple Interest (4 of 7)
Compound Interest
Example 2.2
• If you were to lend $1000 for 3 years at 10% per year
compound interest, how much interest would you get at the
end of three years? (Example 2.2, Page 22)
• How much is the compound interest, IC, accrued over the
three years?

Copyright © 2022 Pearson Canada Inc. 2 - 12

 Answer:

F = P(1 + i)N = 1000(1 + 0.10)3 = $1331

IC = F − P = $1331 − $1000 = $ 331
The amount owed is $1331. The interest owed is $331.

What is the amount (Balance) owed at each year end?

B1 = 1000(1.10) = 1000 + 100 = 1100

B2 = 1100(1.10) = 1100 + 110 = 1210
B3 = 1210(1.10) = 1210 + 121 = 1331

Copyright © 2017 Pearson Canada Inc. 2 - 13

 2.2 Compound and Simple Interest (5 of 7)
Different Compounding Frequencies
Examples of Different Compounding Frequencies
Q. If you were to lend $1000 for one year at 1% per month,
compounded monthly, how much would you have at the end of
the year?
Answer. $1000(1.01)12 = $1,126.83 (notice this is greater than
12% per year which would result in $1000(1.12) = 1,120)

Q. If you were to lend $1000 at 0.2% per week, compounded

weekly, how much would you have at the end of three years?
Answer. 1000(1.002)52*3 = 1,365.73

Copyright © 2022 Pearson Canada Inc. 2 - 14

2.2 Compound and Simple Interest (6 of 7)
Simple Interest
Simple Interest – interest without compounding (interest is
not added to principal at end of period).
IS = P i N
• Compound and simple interest amounts equal if N = 1.
• As N increases, difference between accumulated interest
amounts for the two methods increases exponentially.
• The conventional approach for computing interest is the
compound interest method.
• Simple interest is rarely used today.

Copyright © 2022 Pearson Canada Inc. 2 - 15

2.2 Compound and Simple Interest (7 of 7)
Example from page 23:
A $1000 state govt. bond is issued in 1865. It carries an
annual interest rate of 24%. How much is the fair market
value of the bond 128 years late in 1993?
Using compound interest: F = P(1+i)N
1000(1.24)128 = 908 trillion
Using simple interest: F = P + PiN
1000+1000*.24*128 = 31,720
Note: Simple interest is rarely used in economic or financial
applications.

Copyright © 2022 Pearson Canada Inc. 2 - 16

2.2 Compound and Simple Interest
Figure 2.1

Copyright © 2022 Pearson Canada Inc. 2 - 17

Example Final Exam Question from W23
You are comparing two investments. The first pays 2 percent interest per
month, compounded monthly, and the second pays 6% per quarter,
compounded quarterly. Suppose you invest $1000 into each investment for two
years. How much less would you have earned in the second investment
compared to the first? The answer is within 0.2 of which of the following?

A) 5.77
B) 14.59
C) 11.23
D) 17.81
E) None of the answers are correct.

Copyright © 2022 Pearson Canada Inc. 2 - 18

Example Final Exam Question from W23
You are comparing two investments. The first pays 2 percent interest per
month, compounded monthly, and the second pays 6% per quarter,
compounded quarterly. Suppose you invest $1000 into each investment for two
years. How much less would you have earned in the second investment
compared to the first? The answer is within 0.2 of which of the following?

A) 5.77
B) 14.59
C) 11.23
D) 17.81
E) None of the answers are correct.

Copyright © 2022 Pearson Canada Inc. 2 - 19

Lecture 1 Practice Problems

End of Lecture 1

See Practice Problems Set 1 on MyLab. They will familiarize you with
how the algorithmic questions that are typical of our coursework will be
like.

Copyright © 2022 Pearson Canada Inc. 2 - 20

Example Final Exam Question from W23
You are comparing two investments. The first pays 2 percent interest per
month, compounded monthly, and the second pays 6% per quarter,
compounded quarterly. Suppose you invest $1000 into each investment for two
years. How much less would you have earned in the second investment
compared to the first? The answer is within 0.2 of which of the following?

(Based on Q#6 from Ch.2 Problem Set )

Solution Method:

Difference between the two investments = F1 – F2

1000(1.02)12*2 – 1000(1.06)4*2 = 14.59

Copyright © 2022 Pearson Canada Inc. 2 - 21

 Nominal vs. Effective (Actual) Interest
• 12% nominal interest rate compounded monthly means the
12%
money is actually earning iM = = 1% per month
12 𝑚𝑜𝑛𝑡ℎ𝑠
• The nominal interest rate is denoted with an r
– r = 12%
• The number of compounding periods in a year is denoted with
an m
– m = 12
• The effective monthly interest rate can be denoted iM
! #$%
– iM = =
" #$ "&'()*
= 1%

Copyright © 2022 Pearson Canada Inc. 2 - 22

 Nominal vs. Effective (Actual) Interest

1% per month for a year is not the same as 12% per year. More
frequent compounding translates into higher returns over an
equivalent period. Compare the effective (actual) annual rate, ie, to
the nominal (announced) rate, r :

§ ie = (1.01)12 – 1 = 0.1268 or 12.68%

§ r = 0.12 or 12%

Copyright © 2022 Pearson Canada Inc. 2 - 23

Nominal vs. Effective (Actual) Interest

• $1000 earning interest at 12% compounded monthly for 4

years will grow to
F = $1000(1+0.12/12)4 yrs*12 mth = $1000(1.01)48 months
= $1612.23
• 8% nominal interest rate compounded quarterly means
the money is actually earning 8%/4 = 2% per quarter
• $1000 earning interest at 8% compounded quarterly for 5
years will grow to
F = $1000(1 + 0.08/4)5 yrs*4 qrts = $1000(1.02)20 quarters
= $1485.95
Copyright © 2022 Pearson Canada Inc. 2 - 24
2.3 Effective and Nominal Interest Rates (1 of 4)
• Interest rates are stated for some period, usually a year.

• Computation is based on shorter compounding sub-periods.

• In this section we consider the relation between:

– The nominal interest rate stated for the full period.
– The effective interest rate that results from the
compounding based on multiple sub-periods.

Copyright © 2022 Pearson Canada Inc. 2 - 25

 2.3 Effective and Nominal Interest Rates (2 of 4)
• r is a nominal rate stated for a period (1 year) consisting of m
equal compounding periods (sub-periods).
• The interest rate for each sub-period is calculated as:
• is = r / m (the subscript s refers to a general, non-specific, sub-period)
– When r = 8% and m = 4
– iQ = r / m = 8% / 4 = 2%

• Always assume announced nominal rates are annual.

• Nominal rates can be calculated by multiplying the interest rate per
compounding period by the number of compounding periods per year.
• The nominal rate, r, corresponding to 2% interest per quarter is:
• r = 2% x 4 = 8% per year
• 2% is the effective quarterly rate and 8% is nominal

Copyright © 2022 Pearson Canada Inc. 2 - 26

2.3 Effective and Nominal Interest Rates (3 of 4)
• An effective interest rate, ie, is the actual interest rate
earned over a year, found by:
– converting a given interest rate with an arbitrary
compounding period (normally less than a year) to an
equivalent interest rate with a one-year compounding
period.
𝑖𝑒 = 1 + 𝑖𝑠 𝑚 −1
• is: interest rate over a compounding sub-period,
• ie: effective interest rate over one year
• m: number of sub-periods in the longer period

Derivation of the formula can be found on page 25 in e-Text

Copyright © 2022 Pearson Canada Inc. 2 - 27
2.3 Effective and Nominal Interest Rates (4 of 4)
Example 2.6 on page 25
The Cardex Credit Card Co. charges a nominal 24% interest
on overdue accounts compounded daily. What is the effective
interest rate?
These are how the instructions will appear in MyLab:

(Round the final answer to one decimal place as needed. Round all
intermediate values to five decimal places as needed)

Assuming 365 days per year, we can calculate the

interest rate per year using is = r / m
where is = r / m = 0.24/365 = 0.0006575 (or 0.06575%)
then ie = (1 + is)m − 1 = (1 + 0.0006575)365 − 1 = 0.271
The effective (annual) interest rate is 27.1%
Copyright © 2022 Pearson Canada Inc. 2 - 28
 2.4 Effective and Nominal Rates
• Suppose that the nominal interest rate is 12% and interest is
compounded semi-annually.
• We compute the effective interest rate as follows:
where r = 0.12, m = 2
is = r/m = 0.12/2 = 0.06 (this is the effective semi-annual rate)
ie = (1 + iS)m − 1 = (1 + 0.06)2 − 1 = 0.1236 (or 12.36%)

• What if interest were compounded monthly?

r = 0.12, m = 12
is = r/m = 0.12/12 = 0.01 (this is the effective monthly rate)
ie = (1 + is)m − 1 = (1 + 0.01)12 − 1 = 0.1268 (or 12.68%)

• Daily compounding?
ie = (1+ 0.12/365)365 − 1 = 0.12747 (or 12.75%)
Copyright © 2022 Pearson Canada Inc. 2 - 29
 2.4 Finding Effective Sub-period Rates
• How do you find the effective quarterly rate when the nominal rate is 12%
and the compounding is monthly?
• Step 1) Find the effective monthly rate:
– iM = r/m1 = 0.12/12 = 0.01
• Step 2) Find how many compounding periods are in the period associated
with the effective rate you are looking for (find m2):
– m2 = 12 months/4 quarters = 3 months/quarter
– (Here m2 = 3 because the longer period is a quarter, not a year)
12 months!
year 12 months
You can think of this as = = 3 months/quarter
4 quarters! 4 quarters
year

• Step 3) Find the effective quarterly rate:

iQ = (1 + is)m2 − 1 = (1 + 0.01)3 − 1 = .0303 or 3.03%

Copyright © 2022 Pearson Canada Inc. 2 - 30

2.4 Finding Effective Sub-period Rates
• Find the effective monthly rate when the nominal rate is
10% compounded weekly.
• Solution:
iM = (1 + iW)Weeks/Month – 1
How many weeks are there in a month?
!" #$$%&+
'()*
+" ,-./01+ = 52/12 weeks per month
'()*

iM = (1 + 0.10/52)52/12 – 1
= 0.0084 or 0.84%

Copyright © 2022 Pearson Canada Inc. 2 - 31

2.4 Continuous Compounding (1 of 4)
• Compounding can be done yearly, quarterly, monthly, or
daily.

• Compounding periodically is referred to as discrete

compounding.

• For periods that are infinitesimally small, we say that

interest is compounded continuously.

Note: You will not be tested on continuous compounding

Copyright © 2022 Pearson Canada Inc. 2 - 32

2.4 Continuous Compounding (2 of 4)
• The effective interest rate under continuous compounding
is: ie = er − 1 (Derivation on page 26)
Figure 2.2

Copyright © 2022 Pearson Canada Inc. 2 - 33

2.4 Continuous Compounding (3 of 4)
Example 2.7, page 26
• Cash flow at the Artic Oil Company is continuously
reinvested (this means it is left invested in an account
rather than withdrawn). An investment in a new data
logging system is expected to return a nominal interest of
40 percent compounded continuously. What is the effective
interest rate earned by this investment?

Copyright © 2022 Pearson Canada Inc. 2 - 34

2.4 Continuous Compounding (4 of 4)
Example 2.7 (cont.)
The nominal interest rate is given as r = 0.40
ie = er − 1
= e0.40 − 1
= 1.492 – 1
= 0.492 or 49.2% is the effective interest rate

Copyright © 2022 Pearson Canada Inc. 2 - 35

2.5 Cash Flow Diagrams (1 of 7)
• Cash flow diagram is a graphical summary of the timing
and magnitude of a set of cash flows.
Figure 2.3

Copyright © 2022 Pearson Canada Inc. 2 - 36

2.5 Cash Flow Diagrams (2 of 7)

Close-Up 2.3 Beginning and Ending of Periods

• As illustrated in a cash flow diagram (see Figure 2.3), the
end of one period is exactly the same point in time as the
beginning of the next period (see Figure 2.4).
• Now is time 0, which is the end of period –1 and, also the
beginning of period 1.
• The end of period 1 is the same as the beginning of period
2, and so on.
• N years from now is the end of period N and the beginning
of period (N + 1).

Copyright © 2022 Pearson Canada Inc. 2 - 37

2.5 Cash Flow Diagrams (3 of 7)
Figure 2.4

Assumptions:
• Cash flows occur at the ends of periods.
• End of time period 1 = beginning of time period 2…
• (Typically) Time 0 = “now”, or some reference starting point
Copyright © 2022 Pearson Canada Inc. 2 - 38
2.5 Cash Flow Diagrams (4 of 7)
Example 2.8, page 28
• For simplicity assume (here only!!!) that there only 4 weeks
in a month: consider Ashok, a recent University graduate
trying to summarize typical cash flows for each month. His
monthly income is $3500, received at the end of each
month. Out of this he pays for rent, food, entertainment,
cell and internet charges, and a credit card bill. Rent is
1700 per month due at the end of each month. Weekly
food and entertainment expenses total roughly 220 each
week. Bundled cell, internet and cable charges are 160
due at the of first week of in the month. Credit card
purchases average 600 due at the end of the second week
of each month.
Copyright © 2022 Pearson Canada Inc. 2 - 39
2.5 Cash Flow Diagrams (6 of 7)
Example 2.8 (cont.)

Figure 2.5 Cash Flow

Diagram for Example
2.8

• Each arrow represents a cash flow, labelled with the

amount of the receipt or disbursement.

Copyright © 2022 Pearson Canada Inc. 2 - 40

2.5 Cash Flow Diagrams (7 of 7)
Example 2.8 (cont.)

Figure 2.6 Cash Flow Diagram

for Example 2.8 in Summary
Form

• When two of more cash flows occur in the same time

period, the amounts may be shown individually or in
summary form.
Copyright © 2022 Pearson Canada Inc. 2 - 41
2.6 Depreciation (1 of 26)
• Projects involve investment in assets, such as buildings
and equipment, that are put to productive use.
• Assets lose value, or depreciate, over time.
• Depreciation is taken into account when:
– a firm states the value of its assets in a Financial
Statement (Chapter 6).
– making decisions as to when to replace an aging asset
(Chapter 7).
– dealing with issues related to taxation (Chapter 8).

Copyright © 2022 Pearson Canada Inc. 2 - 42

2.6 Depreciation(2 of 26)
Reasons for Depreciation
• Assets depreciate for a variety of reasons:
– Use related physical loss:
§ As something is used, parts wear out.
§ Usually measured in units of production, kilometres
driven, hours of use.
– Time related physical loss:
§ Even if something is not actively in use, physical
loss can occur over time.
§ Usually measured in units of time as an unused car
will rust and lose value over time.
Copyright © 2022 Pearson Canada Inc. 2 - 43
2.6 Depreciation (3 of 26)
Reasons for Depreciation
– Functional loss:
§ Losses can occur without any physical changes.
§ Usually expressed in terms of function lost including
fashion, legislative (i.e., pollution control, safety
devices) and technical changes.

Copyright © 2022 Pearson Canada Inc. 2 - 44

2.6 Depreciation (4 of 26)
Value of an Asset
• Depreciation models are used to:
– model (estimate) value of an asset over time
– determine the remaining value of an asset at any point
in time.

• Remaining value is referred to as:

– Market value
– Book value
– Scrap value
– Salvage value

Copyright © 2022 Pearson Canada Inc. 2 - 45

2.6 Depreciation (5 of 26)
Value of an Asset
• Market Value:
– the actual value an asset can be sold for in an open
market.
§ Market value means an estimate of the market
value.
• Book value:
– the value of an asset calculated from a depreciation
model for accounting purposes.
§ This value may be different from the market value.
§ There may be several book values given for the
same asset (i.e., different for taxation vs
shareholder reports).
Copyright © 2022 Pearson Canada Inc. 2 - 46
2.6 Depreciation (6 of 26)
Value of an Asset
• Scrap Value:
– either actual or estimated value at end of its physical
life (when broken up for material value of its parts).

• Salvage Value:
– either actual or estimated value at end of its useful life
(usually when sold).

Copyright © 2022 Pearson Canada Inc. 2 - 47

2.6 Depreciation (7 of 26)
Value of an Asset
To state the book value of an asset, a good model of
depreciation is desirable for the following reasons:
1. To make managerial decisions it’s important to know the
value of owned assets (i.e., collateral for a loan).
2. One needs an estimate of the value of assets for
planning purposes (i.e., keep an asset or replace).
3. Tax legislation requires company tax to be paid on
profits. Rules are legislated on how to calculate income
and expenses that includes depreciation.

Copyright © 2022 Pearson Canada Inc. 2 - 48

2.6 Depreciation (8 of 26)
CLOSE-UP 2.5 Depreciation Methods
Method Description
Straight-line The book value of an asset diminishes by an equal amount
each year.
Declining-balance The book value of an asset diminishes by an equal
proportion each year.
Sum-of-the-years’-digits An accelerated method, like declining-balance, in which the
depreciation rate is calculated as the ratio of the remaining
years of life to the sum of the digits corresponding to the
years of life.
Double-declining-balance A declining-balance method in which the depreciation rate is
calculated as 2/N for an asset with a service life of N years.
150%-declining-balance A declining-balance method in which the depreciation rate is
calculated as 1.5/N for an asset with a service life of N years.
Units-of-production The depreciation rate is calculated per unit of production as
the ratio of the units produced in a particular year to the total
estimated units produced over the asset’s lifetime.

Copyright © 2022 Pearson Canada Inc. 2 - 49

2.6 Depreciation (9 of 26)
Straight-Line Depreciation

• Straight line depreciation (SLD) assumes annual loss of

asset’s value in dollars is constant over its useful life.
• The book value of an asset is determined by drawing a
straight line between its first cost and its salvage or scrap
value.
– Assumption is that the loss in asset value is constant
(as measured in dollars) over its useful life (illustrated
in Figure 2.7).

Copyright © 2022 Pearson Canada Inc. 2 - 50

2.6 Depreciation (10 of 26)
Straight-Line Depreciation
Figure 2.7

Copyright © 2022 Pearson Canada Inc. 2 - 51

2.6 Depreciation (11 of 26)
Straight-Line Depreciation
• Depreciation in period n P-S
D ( n) =
using SLD: sl N

• Book Value of the asset at æ P-S ö

BVsl (n) = P - n ç ÷
the end of period n: è N ø

Copyright © 2022 Pearson Canada Inc. 2 - 52

2.6 Depreciation (12 of 26)
Straight-Line Depreciation

Dsl(n) = depreciation charge for period n using the

straight-line method
P = purchase price
S = salvage value at the end of N periods.
N = useful life of asset
BVsl(n) = book value at the end of period n using straight-
line depreciation

Copyright © 2022 Pearson Canada Inc. 2 - 53

2.6 Depreciation (13 of 26)
Straight-Line Depreciation
• Advantage: easy to calculate and understand.

• Disadvantage: most assets do not depreciate at a constant

rate.
– Hence, market values often differ from book values
when SLD is used.

Copyright © 2022 Pearson Canada Inc. 2 - 54

2.6 Depreciation (14 of 26)
Straight-Line Depreciation
Example 2.9, page 32
• A laser cutter was purchased four years ago for $380 000.
It will have a salvage value of $30 000 two years from now.
If we believe a dollar-wise constant rate of depreciation is
a reasonable method of determining the book value, what
is the current book value?

Copyright © 2022 Pearson Canada Inc. 2 - 55

2.6 Depreciation (15 of 26)
Straight-Line Depreciation
Example 2.9 (cont.)
From equation (2.6), with P = $380 000, S = $30 000, N = 6,
and n = 4

æ P-S ö
BVsl (n) = P - n ç ÷
è N ø
,-. ... 0,. ...
𝐵𝑉𝑠𝑙 4 = 380 000 −4[ ]
1

𝐵𝑉𝑠𝑙 4 = 146 667

The current book value for the cutter is $146 667.

Copyright © 2022 Pearson Canada Inc. 2 - 56
2.6 Depreciation (16 of 26)
Declining-Balance Method (DB)

• Also known as reducing balance depreciation.

• Models the loss in value of an asset over a period as a
constant fraction of the asset’s current book value.
– Depreciation charge in a particular period is a
constant proportion (called the depreciation rate) of
its closing book value from the previous period.
• See Figure 2.8 for the effect of various depreciation rates
on book values.

Copyright © 2022 Pearson Canada Inc. 2 - 57

2.6 Depreciation (17 of 26)
Declining-Balance Method

Figure 2.8

Copyright © 2022 Pearson Canada Inc. 2 - 58

2.6 Depreciation (18 of 26)
Declining-Balance Depreciation

• Initial Book Value: 𝐵𝑉𝑑𝑏(0) = 𝑃

BVdb (0) = book value at time t = 0

P = purchase price of the asset

• Depreciation in period n : 𝐷𝑑𝑏 𝑛 = 𝐵𝑉𝑑𝑏 𝑛 − 1 𝑥 𝑑

Ddb (n) = depreciation charge in period n
BVdb (n) = book value at the end of period n
BVdb (n –1) = book value at the end of the previous period
d = depreciation rate
Copyright © 2022 Pearson Canada Inc. 2 - 59
Example
P = $10,000
S5 = $2,000
N=5
Suppose d = 1/5 = 20% or 0.2

Dn = d*BVn-1 BVn = (1 – d)n * P

D1 = d*BV0 = (.2)*10k = 2000 BV1 = (.8)1*10k = 8000

D2 = d*BV1 = (.2)*(.8)*10k = 1600 BV2 = (.8)2*10k = 6400
D3 = d*BV2 = (.2)*(.8)2*10k = 1280 BV3 = (.8)3*10k = 5120
D4 = d*BV3 = (.2)*(.8)3*10k = 1024 BV4 = (.8)4*10k = 4096
D5 = d*BV4 = (.2)*(.8)4*10k = 819 BV5 = (.8)5*10k = 3277

If you want to find the depreciation rate so that the book value matches
the estimated salvage value, BV5 = S, then it can be found by solving
10,000(1 – d)5 = 2000 for the unknown depreciation rate, d:

d = 1 – (2k/10k)1/5 = 0.2752
2 - 60
2.6 Depreciation (19 of 26)
Declining-Balance Depreciation

• Book value at the end of a period: 𝐵𝑉𝑑𝑏 𝑛 = 𝑃 1 − 𝑑 𝑛

P = purchase price or current market value

2 𝑆
• Declining balance rate that relates P and S: 𝑑 = 1 −
𝑃
d = depreciation rate
S = estimated salvage value
P = asset’s current value or purchase price
N = (remaining) lifespan of asset
n = time period of interest
Copyright © 2022 Pearson Canada Inc. 2 - 61
2.6 Depreciation (21 of 26)
Declining-Balance Depreciation
• Useful features of Declining-Balance Depreciation:
– Matches observable loss in value that many assets
have over time.
– Rate of loss is expressed on one parameter.
– Often the standard approach used for taxation
purposes.

Copyright © 2022 Pearson Canada Inc. 2 - 62

2.6 Depreciation (22 of 26)
Example 2.11, page 34
Sherbrooke Cloud Services purchased a new server farm for
$250 000. The system is expected to last six years with a
$10 000 salvage value. Using both the straight line and
declining-balance methods, determine the following:
a. The depreciation charge in year 1
b. The depreciation charge in year 6
c. The book value at the end of year 4
d. The accumulated depreciation at the end of year 4

Copyright © 2022 Pearson Canada Inc. 2 - 63

2.6 Depreciation (23 of 26)
Example 2.11 (cont.)
Depreciation charge for each year with the straight-line
method:
($3. ... 0#. ...)
Dsl (n) = 1
= 40 000

Depreciation rate for the declining-balance method:

2 5 3 #. ...
𝑑=1 − =1- = 0.4152
6 $3. ...

Copyright © 2022 Pearson Canada Inc. 2 - 64

Table 2.3 Spreadsheet for Example 2.11
blank blank Straight-Line Depreciation blank
Year Depreciation Charge Accumulated Depreciation Book Value
0 blank blank $250 000
1 $40 000 $ 40 000 210 000
2 40 000 80 000 170 000
3 40 000 120 000 130 000
4 40 000 160 000 90 000
5 40 000 200 000 50 000
6 40 000 240 000 10 000
blank blank Declining-Balance Depreciation blank
Year Depreciation Charge Accumulated Depreciation Book Value
0 blank blank $250 000
1 $103 799 $103 799 146 201
2 60 702 164 501 85 499
3 35 499 200 000 50 000
4 20 760 220 760 29 240
5 12 140 232 900 17 100
6 7 100 240 000 10 000

Copyright © 2022 Pearson Canada Inc. 2 - 65

 2.6 Depreciation (25 of 26)
Example 2.11 (cont.)
a. Depreciation charge in year 1:
($3. ... 0#. ...)
Dsl (1) = 1
= 40 000

Ddb (1) = 𝐵𝑉𝑑𝑏 0 𝑑 = 250 000 0.4152 = 103 799.11

b. Depreciation charge in year 6:

($3. ... 0#. ...)
Dsl (6) = 𝐷𝑠𝑙(6) = 1
= 40 000
Ddb (6) = [𝐵𝑉𝑑𝑏 5 ]𝑑 = [250 000 0.5848 5](0.4152) = 7099.61

Copyright © 2022 Pearson Canada Inc. 2 - 66

2.6 Depreciation (26 of 26)

Example 2.11 (cont.)

c. Book value at the end of year 4:
!"# ### %&# ###
BVsl (4) = 250 000 − 4 = 250 000 − 4(40 000) = 90 000
'
BVdb (4) = 250 000 1 − 0.4152 4 = 250 000 0.5848 4 = 29 239.47

d. Accumulated depreciation at the end of year 4:

Using the straight-line method: P – BVsl(4) = 160 000 (or = 4 ∗ 𝐷𝑛)
Using the declining-balance method: P – BVdb(4)
250𝑘 − 250𝑘 0.5848 4 = 220 760.53

Note: you can think of 1 – d = 1 – 0.4152 = 0.5848 as the retention rate

Copyright © 2022 Pearson Canada Inc. 2 - 67

2.7 Equivalence (1 of 6)
• Engineering Economics utilizes “time value of money” to
compare certain values at different points in time.

• Equivalence is a condition that exists when:

– The value of a cost at one time is equivalent to the
value of the related benefit at a different time.
– The value of a cost at one time is equivalent to the
value of the same cost at a different time. In this sense,
the two costs can be seen as interchangeable.

Copyright © 2022 Pearson Canada Inc. 2 - 68

2.7 Equivalence (2 of 6)
• Three concepts of equivalence are useful for comparing
costs and benefits at different times:

1. Mathematical Equivalence
2. Decisional Equivalence
3. Market Equivalence

Copyright © 2022 Pearson Canada Inc. 2 - 69

2.7 Equivalence (3 of 6)
• Mathematical Equivalence:
– A consequence of the mathematical relationship
between time and money.
– Decision-makers exchange P dollars now for F dollars
N periods from now using rate i and the mathematical
relationship: F = P(1 + i)N

Copyright © 2022 Pearson Canada Inc. 2 - 70

2.7 Equivalence (4 of 6)
• Decisional Equivalence:
– Happens when a decision maker judges available
choices to be equally good.
– Two cash flows, Pt at time t and Ft+N at time t + N, are
equivalent if the individual is indifferent between the
two.
– Implied interest rate relating to Pt and Ft+N can be
calculated from the decision that the cash flows are
equivalent.
– In mathematical equivalence, the interest rate
determines whether the cash flows are equivalent.

Copyright © 2022 Pearson Canada Inc. 2 - 71

2.7 Equivalence (5 of 6)
• Market Equivalence:
– Arises due to the availability of a market to exchange
one cash flow for another at zero cost.

Copyright © 2022 Pearson Canada Inc. 2 - 72

2.7 Equivalence (6 of 6)
• For the remainder of this text, we assume:
1. Market equivalence holds.
2. Decisional equivalence can be expressed in monetary
terms.
3. Mathematical equivalence can be used as an
accurate model of costs/benefits relationship.

Copyright © 2022 Pearson Canada Inc. 2 - 73

Example 1: Final Exam Question from F23
You purchased a saw cutter five years ago for $24,000. You project a $7000
salvage value in two years’ time. Depreciation follows the declining balance method
with a depreciation rate of 25%. Find the depreciation value for this year.

The answer is within $1 of which of the following?

a) 1890

b) 1892

c) 1894

d) 1896

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 74

Example 1: Final Exam Question from F23
You purchased a saw cutter five years ago for $24,000. You project a $7000
salvage value in two years’ time. Depreciation follows the declining balance method
with a depreciation rate of 25%. Find the depreciation value for this year.

The answer is within $1 of which of the following?

a) 1890

b) 1892

c) 1894

d) 1896

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 75

Example 2: Final Exam Question from F23
Find the effective monthly interest rate when the nominal rate is 7% with weekly
compounding. Be correct to 4 decimal places. The answer is within 0.0001% of
which of the following?

a) 0.5840%

b) 0.5842%

c) 0.5844%

d) 0.5846%

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 76

Example 2: Final Exam Question from F23
Find the effective monthly interest rate when the nominal rate is 7% with weekly
compounding. Be correct to 4 decimal places. The answer is within 0.0001% of
which of the following?

a) 0.5840%

b) 0.5842%

c) 0.5844%

d) 0.5846%

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 77

Example 3: Final Exam Question from W23
How much more would you earn over 30 years on a $100,000 investment if your
earning rate is 6% compounded weekly instead of 6% compounded monthly?
The answer is within $5 of which of the following?

A) $1852

B) $2530

C) $2270

D) $2150

E) None of the answers are correct.

Copyright © 2022 Pearson Canada Inc. 2 - 78

Example 3: Final Exam Question from W23
How much more would you earn over 30 years on a $100,000 investment if your
earning rate is 6% compounded weekly instead of 6% compounded monthly?
The answer is within $5 of which of the following?

A) $1852

B) $2530

C) $2270

D) $2150

E) None of the answers are correct.

Copyright © 2022 Pearson Canada Inc. 2 - 79

Example 4: Final Exam Question from F23
1) You deposit $2000 into an account paying 9% compounded monthly. After one
year you withdraw $1000. How much do you have in the account at the end of
the 3-year period. The answer is within $1 of which of the following?

a) 1415

b) 1417

c) 1419

d) 1421

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 80

Example 4: Final Exam Question from F23
1) You deposit $2000 into an account paying 9% compounded monthly. After one
year you withdraw $1000. How much do you have in the account at the end of
the 3-year period. The answer is within $1 of which of the following?

a) 1415

b) 1417

c) 1419

d) 1421

e) None of the above

Copyright © 2022 Pearson Canada Inc. 2 - 81

Summary (1 of 2)
• Provided an introduction to:
– Interest
– Interest terminology
– Interest rate conventions
– Depreciation
• Series of examples illustrated the mechanics of working
with:
– Simple and compound interest
– Nominal and effective interest rates
– Continuous compounding

Copyright © 2022 Pearson Canada Inc. 2 - 82

Summary (2 of 2)
• Representing cash flows by diagrams was introduced
• Principles of depreciation and depreciation accounting
were highlighted:
– Reasons for Depreciation
– Value of an Asset
– Straight Line Depreciation
– Declining Balance Depreciation
• Various forms of cash flow equivalence were discussed:
– Mathematical
– Decisional
– Market

Copyright © 2022 Pearson Canada Inc. 2 - 83

Example 1: Final Exam Question from F23
You purchased a saw cutter five years ago for $24,000. You project a $7000
salvage value in two years’ time. Depreciation follows the declining balance
method with a depreciation rate of 25%. Find the depreciation value for this year.
The answer is within $1 of which of the following?

a) 1890

b) 1892

c) 1894

d) 1896

e) None of the above

Solution Method:

D5 = 24,000(0.75)4(0.25) = 1898.44

Copyright © 2022 Pearson Canada Inc. 2 - 84

 Example 2: Final Exam Question from F23
Find the effective monthly interest rate when the nominal rate is 7% with weekly
compounding. Be correct to 4 decimal places. The answer is within 0.0001% of which
of the following?

a) 0.5840%

b) 0.5842%

c) 0.5844%

d) 0.5846%

e) None of the above

Solution Method: im = (1 + 0.07/52)52/12 – 1 = 0.0058464 or 0.5846%

Copyright © 2022 Pearson Canada Inc. 2 - 85

Example 3: Final Exam Question from W23
How much more would you earn over 30 years on a $100,000 investment if your
earning rate is 6% compounded weekly instead of 6% compounded monthly?
The answer is within $5 of which of the following?

A) $1852

B) $2530

C) $2270

D) $2150

E) None of the answers are correct.

Solution Method:

F = 100,000(1 + 0.06/52)52*30 – 100,000(1 + 0.06/12)12*30 = 2079.80

Copyright © 2022 Pearson Canada Inc. 2 - 86

 Example 4: Final Exam Question from F23
You deposit $2000 into an account paying 9% compounded monthly. After one year
you withdraw $1000. How much do you have in the account at the end of the 3-year
period.

The answer is within $1 of which of the following?

a) 1415

b) 1417

c) 1419

d) 1421

e) None of the above

Solution Method: im = 0.09/12 = 0.0075 or 0.75%

F = 2000(1.0075)12*3 – 1000(1.0075)12*2 = 1420.88

= 2000(1.3087) – 1000(1.1964) = 1421

Copyright © 2022 Pearson Canada Inc. 2 - 87