Lecture # 4

Gradient Factors/Shifted gradients

1-1
Dr. A. Alim
Gradients
Gradients are special cases where a series of
cash flows consists of regular, unequal
amounts that increase or decrease following a
specific pattern

Gradient factors are the factors used to
calculate equivalent P, A and F for such series
of cash flows.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-2
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
ARITHMETIC GRADIENT

An arithmetic gradient is a cash flow series that either increases or decreases by
a constant amount. The cash flow, whether income or disbursement, changes by
the same constant amount each period. The amount of the increase or decrease
is the gradient G. For example, if a manufacturing engineer predicts that the
cost of maintaining a machine will increase by $500 per year until the machine is
retired, a gradient series is involved and the amount of the gradient is $500.

GEOMETRIC GRADIENT

It is also common for cash flow series, such as operating costs, construction
costs, and revenues, to increase or decrease from period to period by a constant
percentage, for example, 5% per year. This uniform rate of change defines a
geometric gradient series of cash flows. In addition to the symbols i and n used
thus far, we now need the term g.
g = constant rate of change, in decimal form, by which amounts increase or
decrease from one period to the next
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-3
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Arithmetic Gradient Factors
(P/G) and (A/G)
Cash flow profile
0 1 2 3 n-1 n
A
1
+G
A
1
+2G
A
1
+(n-2)G
A
1
+(n-1)G
Find P, given gradient cash flow G
CF
n
= A
1
(n-1)G
Base amount
= A
1

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-4
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Gradient Structure
As we know, arithmetic gradients are
comprised of two components
1. Gradient component
2. Base amount
When working with a cash flow containing a
gradient, the (P/G) factor is only for the
gradient component
Apply the (P/A) factor to work on the base
amount component
P = PW(gradient) + PW(base amount)
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-5
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-6
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Use of the (A/G) Factor
0 1 2 3 n-1 n
G
2G
(n-2)G
(n-1)G
Find A, given gradient cash flow G
CF
n
= (n-1)G
Equivalent A of
gradient series
A A A . . . A A
A = G(A/G,i,n)
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-7
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Use of the (A/G) Factor
A = G(A/G,i,n)
The general equation for P
T
and A
T
:

P
T
= P
A
P
G

A
T
= A
A
A
G


Important: First A is end of year 1, while first G is end of year 2. Same n
is used for both equations !



Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-8
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
The P/G and A/G factors
Remember, there are only two ways to
determine these factors:

* From tables
* From formulas

No EXCEL functions for these factors !
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-9
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-10
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
The P/G and A/G factors
1-11
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
The P/G and A/G factors
formulas
Geometric Gradient Series Factor
Geometric Gradient
Cash flow series that starts with a base amount A
1

Increases or decreases from period to period by a
constant percentage amount
This uniform rate of change defines
A GEOMETRIC GRADIENT
Notation:
g = the constant rate of change, in decimal form, by which
future amounts increase or decrease from one time
period to the next
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-12
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Typical Geometric Gradient
A
1
A
1
(1+g)
A
1
(1+g)
2

. . . .
0 1 2 3 n-2 n-1 n
A
1
(1+g)
n-1

Required: Find a factor (P/A,g %,i %, n) that will convert future
cash flows to a single present worth value at time t = 0
Given A
1
, i%, and g%
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-13
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Two Forms to Consider
1
(1 )
g
nA
P
i
=
+
1
1
1
1
g i
n
g
g
i
P A
i g
(
+
| |

(
|
+
\ .
(
= =
(

(
(

Case: g = i Case: g = i
A
1
is the starting cash flow
There is NO base amount associated with a geometric gradient
The remaining cash flows are generated from the A
1
starting value
No Excel function or tables available to determine this factortoo many combinations of i% and g%
to support tables
The easiest way to get equivalent A or F is to use A/P and F/P factors with the P shown above.
To use the (P/A,g%,i%,n) factor
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-14
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted payment series/gradients
Shifted uniform series.
Shifted arithmetic gradients.
Shifted geometric gradients.

By definition, a shifted series/gradient means
its present value is NOT at time zero.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-15
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1 - Shifted Uniform Series
0 1 2 3 4 5 6 7 8
A = $-500/year
Consider:
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-16
1 - Shifted Uniform Series
0 1 2 3 4 5 6 7 8
A = $-500/year
Consider:
P of this series is at t = 2 (P
2
)
P
2
= - 500 (P/A,i%,4)
P
0
= P
2
(P/F,i%,2)
P
2

P
0

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-17
Example of Shifted Series P and F
A = $-500/year
F for this series is at t = 6; F
6
= A(F/A,i%,4)
P
0
for this series at t = 0 is also
P
0
= - F
6
(P/F,i%,6)
0 1 2 3 4 5 6 7 8
P
2

P
0

F
6

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-18
2 - Shifted Arithmetic Gradients
The Present Worth of an arithmetic gradient
(linear gradient) is always located:
One period to the left of the first cash flow
in the series ( 0 gradient cash flow) or,
Two periods to the left of the 1G cash
flow
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-19
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Gradient

A Conventional Gradient
has its present worth
point at t = 0

A Shifted Gradient has its
present value point
removed from time t = 0

0 1 2 3 4 5 6 7 8 9 10
P
0 1 2 3 4 5 6 7 8 9 10
P
3
P
0
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-20
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Gradient: Numerical Example
Base Series = $500
G = $+100
0
1 2 3 4 .. .. 9 10
Cash flows start at t = 3
$500/year increasing by $100/year through
year 10; i = 10%; Find P at t = 0
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-21
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Gradient: Numerical Example
PW of the base series
Base Series = $500
0
1 2 3 4 .. .. 9 10
P
2
= 500(P/A,10%,8) = 500(5.3349) = $2667.45
n
series
= 8 time periods
P
0
= 2667.45(P/F,10%,2) = 2667.45(0.8264)
= $2204.38
P
2

P
0

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-22
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Gradient: Numerical Example
PW for the gradient component
0
1 2 3 4 .. .. 9 10
G = +$100
P
2
= $100(P/G,10%,8) = $100(16.0287) = $1,602.87
P
0
= $1,602.87(P/F,10%,2) = $1,602.87(0.8264)
= $1,324.61
P
2

P
0

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-23
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example: Total Present Worth Value
For the base series
P
0
= $2204.38
For the arithmetic gradient
P
0
= $1,324.61
Total present worth
P = $2204.38 + $1,324.61 = $3528.99
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-24
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
To Find A for a Shifted Gradient
1) Find the present worth at actual time 0
2) Then apply the (A/P,i,n) factor to
convert the present worth to an
equivalent annuity (series)
3) A = P(A/P, i, n)
A = $3528.99 (A/P, 10%,10)
= $547.36
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-25
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Using Spreadsheet Functions (NPV)
Excel is a powerful tool to calculate P
0
for shifted series or
gradients in one step. We use the NPV function.

Net Present Value for a shifted series or gradient. Excel
function is:
=NPV(i%,second_cell : last_cell) + first_cell

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-26
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Spreadsheet Applications NPV Function


The NPV function requires that all cells in the defined
time range have an entry
The entry can be $0but not blank! A 0 value must
be entered
Incorrect results can be generated if one or more
cells in the defined range is left blank
Unlike the PV function, CF values do not need to be
equal. In fact, they can be negative or zero values
This makes the NPV function particularly suitable for
shifted series and/or gradients.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-27
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Gradient: Numerical Example
Base Series = $500
G = $+100
0
1 2 3 4 .. .. 9 10
Cash flows start at t = 3
$500/year increasing by $100/year through
year 10; i = 10%; Find P at t = 0 using the
NPV function. Then find the equivalent A.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-28
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Using NPV Function
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-29
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
YEAR CF $
0 0
1 0
2 0
3 500 present Worth = $3,529.20
4 600
5 700 Equivalent A = $574.36
6 800
7 900
8 1000
9 1100
10 1200
3 - Shifted Geometric Gradient
Conventional Geometric Gradient
0 1 2 3 n
A
1

Present worth point is at t = 0 for a conventional
geometric gradient
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-30
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Shifted Geometric Gradient
Shifted Geometric Gradient
0 1 2 3 n
A
1

Present worth point is at t = 2 for this example
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-31
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example 3.7, page 83, Blanks 7
th
edition
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-32
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-33
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Using NPV Function
YEAR CF
0 $35,000
1 $7,000
2 $7,000
3 $7,000 Present Worth = $83,229.83
4 $7,000
5 $7,000 Equivalent A = $14,907.33
6 $7,840
7 $8,781
8 $9,834
9 $11,015
10 $12,336
11 $13,817
12 $15,475
13 $17,331
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-35
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-36
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
CHEE 5369/6369
Homework # 1
Thursday January 23, 2014

The following solved examples from Blank (seventh edition):

Example 1.3 page 11
Example 1.4 page 11
Example 1.5 page 12
Example 1.8 page 14
Example 1.9 page 17
Example 1.11 page 18
Example 1.14 page 21
Example 1.15 page 22
Example 2.3 page 44
Example 2.5 page 47
Example 2.8 page 51
Example 2.12 page 60
Example 3.5 page 80
Example 3.8 page 84
Example 14.2 page 372

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-37
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-38
Nominal and Effective Interest Rate
Statements
So far, we have learned:
Simple interest and compound interest definitions
Compound Interest
Interest computed on interest
For a given interest period
The time standard for interest computations One Year
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-39
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Two Common Forms of Quotation
Two types of interest quotation:
1. Quotation using a Nominal Interest Rate
2. Quoting using an Effective Interest Rate
Nominal and Effective interest rates are common in
business, finance, and engineering economy
Each type must be understood in order to solve
problems where interest is stated in various ways
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-40
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-41
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Examples of Nominal Interest Rates
18% per year
Same as: 18/12 = 1.5% per month
Same as: 18/4 = 4.5% per quarter
Same as: 18/0.5 = 36% per two years
1.5% per 6-month period
Same as: (1.5%)(2 six-month periods) = 3% per year
1% per week
Same as: (1%)(52 weeks) = 52% per year
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-42
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Effective Interest Rate
Definition:
The effective interest rate is the actual rate
that applies for a stated period of time.
The compounding of interest during the time
period of the corresponding nominal rate is
accounted for by the effective interest rate.
The effective rate is commonly expressed on
an annual basis denoted as i
a

All interest formulas, factors, tabulated values, and spreadsheet relations must have
the effective interest rate to properly account for the time value of money.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-43
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Time Based Units
Time Period The period over which the interest is
expressed (always stated).
Ex: 8% per year, or 1% per month

Compounding Period (CP) The shortest time unit over
which interest is charged or earned.
Ex: 8% per year, compounded monthly

Compounding Frequency The number of times m that
compounding occurs within time period t.
Ex: 10% per year, compounded monthly has m = 12
Ex: 1% per month, compounded monthly has m = 1
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-44
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Effective Interest Rates for Any Time
Period
The following equation is the effective interest rate per
time period as related to nominal int. rate and
compounding frequency for the same time period.

r
i = (1+ ) 1
m
m
Effective
where:
r = nominal interest rate per time period
m = number of compounding periods per time period
r/m is the nominal; and also the effective interest rate
per compounding period.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-45
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-46
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Annual Effective Interest Rates
ONLY in this case of ANNUAL rates, there are excel
functions as follow:

To calculate i
a
from r use EFFECT(r,m)
To calculate r from i
a
use NOMINAL(i
a
,m)
where:
r = Annual nominal interest rate
m = number of compounding periods per year
r/m is the nominal; and also the effective interest rate
per compounding period.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-47
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Effective Interest Rates for Any Time
Period
Note: when the CP is equal to the time period:
Then m = 1, and Effective i = r

meaning nominal interest rate is also the effective interest
rate.

When we say interest rate of say 8% per year and do not
refer to a compounding period, it usually means that the
compounding is annual and the 8% is also the effective
rate per year.


Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-48
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example: Calculating the Effective Rate
Interest is 8% per year, compounded quarterly
What is the effective int. rate per quarter?
What is the effective annual interest rate?
Use equation above with r = 0.08, m = 4
Effective quarterly int. rate = nominal quarterly int.
rate = 0.08/4 = 0.02

Effective annual i
a
= (1 + 0.08/4)
4
1
= (1.02)
4
1
= 0.0824 or 8.24%/year
OR: EFFECT(0.08,4) = 8.24%
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-49
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
In the previous example:
What is the future value of $10,000 invested for 5
years?

F = 10,000 (1.0824)
5
= $ 14,859

OR

F = 10,000 (1.02)
20
= $ 14,859
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-50
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Common Compounding Frequencies
Interest may be computed (compounded):
Annually One time a year (at the end)
Every 6 months 2 times a year (semi-annual)
Every quarter 4 times a year (quarterly)
Every Month 12 times a year (monthly)
Every Day 365 times a year (daily)

Continuous infinite number of compounding periods in a
year.

One Year is segmented into: 365 days, 52 weeks, 12 months
One Half Year is segmented into: 182 days, 26 weeks, 6 months
One Quarter is segmented into: 91 days, 13 weeks, 3 months

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-51
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example: APR and APY
APR is Annual Percentage Rate ( Nominal)
APY is Annual Percentage Yield ( Effective)
Example:
A credit card company charges 18 % APR. The Law
requires that the APY must also be stated. What is the
APY if interest is compounded daily?

APY = (1 + 0.18/365)
365
1 = 19.716 %


Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-52
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Effective Interest Rate for
Continuous Compounding
Recall that effective i = (1 + r/m)
m
1
What happens if the compounding frequency, m,
approaches infinity?
This means an infinite number of compounding
periods within a time period, and
The time between compounding approaches 0
A limiting value of i will be approached for a given
value of r
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-53
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Continuous Compounding Effective Rate
The effective i for the same time period when interest
is compounded continuously is then:
Effective i = e
r
1
To find the equivalent nominal rate given i when
interest is compounded continuously, apply:
ln(1 ) r i = +
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-54
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-55
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Examples 4.11, p.150, Blanks 6
th
edition.

Example 4.11
Given r = 18% per year, compounded contin., find:
The effective annual rate
The effective monthly rate
r/month = 0.18/12 = 1.5%/month
Effective monthly rate is e
0.015
1 = 1.511%
The effective annual interest rate is e
0.18
1 = 19.72%
per year.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-56
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example 4.11
Note: The following is critically important.

You obtain the nominal monthly rate by dividing the nominal
annual rate by 12.

You CAN NOT divide the effective annual interest rate by 12
In order to obtain the monthly effective interest rate.

You must follow this sequence:
Nominal annual rate Nominal monthly rate Effective
monthly rate.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-57
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 7th Edition, 2012
1-58
2012 by McGraw-Hill, New York, N.Y All Rights Reserved
Example 4.12, page 150, Blanks 6
th
edition