Introduction to Engineering

Economics
Onur Tokdemir, Ph.D., P.E.
Why Engineering Economy is
Important to Engineers
 Engineers play a major role in capital investment
decision base on their analysis, synthesis and design
efforts
 “Engineering economy is a collection of mathematical
techniques that simply economic comparison”
 Engineering economy is important since virtually any
project-local, national, or international – will affect
costs and/or revenues
 For Engineering Activities:
Should a highway bypass be constructed around a city
of
25,000 people or should the current roadway through
the city be expanded?
Application of Engineering Economy
Concepts
 For Public Sector Projects:
 Do the benefits outweigh the costs of a bridge over
the Intra-coastal waterway at this point?
 Is it cost-effective for the state to cost-share with a
contractor to construct a new toll road?
 For Individuals:
 Should I pay off my credit card balance with
borrowed money?
 What are graduate studies worth financially over my
professional career?
 Exactly what rate of return did I make on my stock
investments?
Role of Engineering Economy in
Decision Making
 Decision making involves the estimation of future
events/outcomes
 Engineering economy aids in quantifying past
outcomes
 Engineering Economy provides a framework for
modeling problems involving:
 Time (of transaction)
 Money – cash flow
 Interest rates
The Decision Making Process
1. Understand the problem – define objectives
2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor
results
Time Value of Money
 Money makes money- Investments are expected to
earn a return
 The change in the amount of money (through
investment) over a given period of time is called
“time value of money.”
 The “time value of money” is the most important
concept in engineering economy
Performing An Engineering
Economy Study
 Engineering Economy Studies:
 Define Alternatives
 Do-nothing alternative – maintain the status quo
 Define feasible alternatives – that can solve the problem
 Define/estimate the current and future cash flows
 Perform the analysis
 Apply the tools and methods of engineering economy
 Selection of the best alternative
 Implement and monitor
Interest Rate and Rate of Return
Example
You borrow $10,000 on May 1 and must replay a
total of 10,700 exactly one year later. Determine the
interest amount and the interest rate paid:

 Interest = amount owed now – original amount

interest = $10,700 – $10,000 = $700
 Percent interest rate = interest accrued per time unit x
100% original amount

interest rate = $700/$10,000 x 100% = 7% per year

Rate of Return (ROR)
Lender’s perspective
 Interest = Rental fee that someone else pays to use
your money
 Interest earned = amount received now – amount invested

 Rate of return (%) = interest accrued per time unit x 100%

original amount
Inflation
 A social-economic occurrence in which there is
more currency competing for constrained goods
and services
 Currency becomes worth less over time thus
requiring more of the currency to purchase the
same amount of goods or services in a time period
 Inflation impacts:
 Purchasing Power (reduces)
 Operating Costs (increases)
 Rate of Returns on Investments (reduces)
Equivalence
 Different sums of money at different times may be equal in economic
value
$106 one year from now

0 Interest Rate=6% per year 1

$100 now

 $100 now is said to be equivalent to $106 one year from now, if the
$100 is invested at the interest rate of 6% per year.
 Payments differing in total magnitude at different dates may be
equivalent to each other
 An accepted interest rate is the basis for equivalence
Simple and Compound Interest
 Simple Interest:
 Interest on principal only
 Interest = (principal)(number of periods)(interest
rate)
 Compound Interest:
 Interest earns interest on interest
 Compounds over time
 Interest = (principal + all accrued interest) (interest
rate)
Simple and Compound Interest
 Borrow $1000 for 3 years at 5% per year
 Let P = the principal sum
 i = the interest rate (5%/year)
 Let n = number of years (3)
Simple Interest
 I = P(i)(n)
 I = $1000(0.05)(3) = $150.00

Year by Year Analysis Simple Interest

Year 1 I1 = $1,000(0.05) = $50.00
Year 2 I2 = $1,000(0.05) = $50.00
Year 3 I3 = $1,000(0.05) = $50.00
Simple Interest: Cash Flow
 $150 of interest has accrued

P=$1,000

1 2 3

I1=$50 I2=$50 I1=$50

The (paid or unpaid)

interest Pay back $1,000
did not earn interest over
the
3-year period
Compound Interest: Calculated
 When interest is compounded, the interest that is
accrued during a given time period is added in to form a
NEW principal balance.
 That new balance then earns or is charged interest in the
succeeding time period Compound Interest
 For the example:
 Principal at t = 0: P0 = $1,000
 I1 = $1,000(0.05) = $50.00 (but, we don’t pay yet!)
 Principal at t = 1: P1 = $1,000 + 50 = $1,050
 I2 = $1,050(0.05) = $52.50 (owed but not paid)
 Principal at t = 2: P2 = $1050 + 52.50 = $1102.50
 I3 = $1102.50(0.05) = $55.125 = $55.13
 Amount paid at t = 3: P3 = $1102.50 + 55.13 = $1157.63
Compound Interest Cash Flow
 For compound interest, 3 years, we have:

P=$1,000

1 2 3 I=$157.63

Pay back $1000

Owe at t = 3 years
$1,000 +$50+$52.50+$55.13=$1,1157.63
Terminology and Symbols
 P = a present sum of money at a time designated as t=0 {t
represents time}
 PW (Present Worth), PV (Present Value), NPV (Net Present Value),
DCF (Discounted Cash Flow), CC (Capitalized Cost)
 F = a future amount of money at some point in time later than t =
0
 FW (Future Worth), FV (Future Value)
 A = a series of equal, end-of-period cash flows
 AW (Annual Worth), EUAW (Equivalent Uniform Annual Worth)
 n = the number of interest time periods
 i = the interest rate
Introduction To Solution By
Computer
 Application of Microsoft’s Excel© spreadsheet
program
 Excel financial functions
 Present Value P: =PV(i%,n,A,F)
 Future Value F: =FV(i%,n,A,P)
 Equal, periodic value: =PMT(i%,n,P,F)
 No. of periods: =NPER((i%,A,P,F)
 Compound interest rate: =RATE(n,A,P,F)
 Compound interest rate: =IRR(first_cell:last_cell)
 Present value of a series: =NPV(i%,second_cell:last_cell)
+ first_cell
Single-Payment Compound
Amount Factors (F/P and P/F)
Uniform-Series: Present Worth Factor
(P/A)and Capital Recovery Factor(A/P)
(P/A) Factor Derivation
(P/A) and (A/P) Factor Formulas
ANSI Standard Notation for
Interest Factors
 Standard notation to represent the interest factors
 Consists of two cash flow symbols, the interest rate,
and number of compounding periods
 General form: (X/Y,i%,n)
 X represents what is unknown
 Y represents what is known
 i and n represent input parameters; can be known or
unknown depending upon the problem
Notation - continued
Sinking Fund Factor (A/F) and
Uniform Series Compound Amount Factor (F/A)
(F/A) factor from (A/F)