Intro to Engineering Economy

Objectives
Understand the concept of time value of money
Illustrate the basic equivalence calculations
Understand Project Cash Flows
 Formulate mutually exclusive alternatives
Perform Present Worth Analysis

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 Engineering Economy Decisions
Manufacturing Profit

Planning

Investment

Marketing
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 Role of Engineering Economy

1. Understand the Problem

2. Collect all relevant data/information
3. Define the feasible alternatives
4. Evaluate each alternative
5. Select the “best” alternative
6. Implement and monitor

Tools
Present Worth, Future Worth
Major Role of
Annual Worth, Rate of Return Engineering
Benefit/Cost, Payback, Economy
Capitalized Cost, Value Added
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Interest: The cost of money

 Interest rate: a percentage that is periodically applied and

added to an amount of money over a specified length of time
 Interest rate for saving account
 Interest rate when borrowing money

 Time value of money

 A dollar today is worth more than a dollar one or more years from
now because of the interest (profit) it can earn
 Interest is the cost of money
 A cost to the borrower and an earning to the lender

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 Economic Equivalence
Economic Equivalence exits between cash flows that have the same
economic effect and could be traded for one another in the financial market
place

 Cash flows can be converted to an equivalent cash flow at any point in

time
 Two sums of money at two different points in time can be made
economically equivalent if we consider
• an interest rate and,
• No. of time periods between the two sums

Equality in terms of Economic Value

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 Equivalence Illustrated
$20,000 is
received here
t=0 t = 1 Yr
$21,800 paid
back here

 $20,000 now is not equal in magnitude to $21,800 1 year from now

 But, $20,000 now is economically equivalent to $21,800 one year from
now if the interest rate is 9% per year.
 If you were told that the interest rate is 9%....
 Which is worth more?
 $20,000 now or
 $21,800 one year from now?
 The two sums are economically equivalent but not numerically equal!
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 Simple and Compound Interest
A deposit of P dollars with interest rate of i for N periods.

Simple Interest
 the practice of charging an interest rate only to an initial sum (principal
amount).

Total interest earned is

I = (iP)N
Total future amount is
F = P+I = P(1+iN)

Compound Interest
 the practice of charging an interest rate to an initial sum and to any previously
accumulated interest that has not been withdrawn.

Total future amount is

F = P+I = P(1+i)N
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 Ex: Compound Interest
For compound interest, with 5% annual interest rate for 3 years

P=$1,000

1 2 3

I1=$50.00
I2=$52.50

I3=$55.13

Owe at t = 3 years:
$1,000 + 50.00 + 52.50 + 55.13
= $1,157.63 8
 Terminology and Symbol
 P = value or amount of money at a time designated as the present or
time 0.
Also, P is referred to as present worth (PW), present value (PV), net present
value (NPV), discounted cash flow (DCF), and capitalized cost (CC); dollars
 F = value or amount of money at some future time.
Also, F is called future worth (FW) and future value (FV); dollars
 A = series of consecutive, equal, end-of-period amounts of money.
Also, A is called the annual worth (AW) and equivalent uniform annual worth
(EUAW); dollars per year, dollars per month
 n = number of interest periods; years, months, days
 i = interest rate or rate of return per time period; percent per year,
percent per month
 t = time, stated in periods; years, months, days, etc

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 Cash Flow
CASH INFLOWS
• Money flowing INTO the firm from outside
• Upward arrows ():
• Revenues, Savings, Salvage Values, etc.

CASH OUTFLOWS
• Disbursements
• Downward arrows ():
• First costs of assets, labor, salaries, taxes paid, utilities, rents, interest,
etc.

NET CASH FLOW

 two or more receipts and disbursement at the same time are summed
and shown in a single arrow
 Cash Inflows – Cash Outflows

END-OF-PERIOD CONVENTION
 placing all cash flow transactions at the end of an interest period.
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Types of Cash Flows
1. Single cash flow

2. Equal (uniform) series

3. Linear gradient series

4. Geometric gradient series

5. Irregular series
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Single-Payment Factors (F/P and P/F)
1. Find F, given P , i, N
 “Single-payment compound amount factor” F  P(1  i) N
F
F = P (1+i)N = P (F/P,i,N) F  P( F / P, i, N )
 Ex: If you had $2,000 now an invested it at
10%, how much would it be worth in 8 years 0
N

P
2. Find P, given F , i , N,
“Single-payment present worth factor”

P  F(1  i)  N F
P = F (1+ i )-N = F (P/F,i,N)
P  F( P / F, i, N )
 Ex: Suppose that $1,000 is to be received in 5
years. At an annual interest rate of 12%, what
is the present worth of this amount? 0
N
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Also see Example 2.1 – 2.3 P
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Example
Adapted from Park (2004)

A company has borrowed $250,000 to purchase an

equipment. A loan was offered with 8% interest rate per
year. The company plans to repay installments in equal
amounts over the next 6 years.

 What is annual installment?

 What if the repayment is deferred for 1 year, what would

be the annual installment in this case?
That is, the 1st loan payment starts at the end of year 2 and
continues to year 7.

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 Shifted Uniform Series
 A shifted series is one whose present worth point in time is
NOT t = 0.
 Shifted either to the left of “0” or to the right of t = “0”.
 Dealing with a uniform series:
 The PW point is always one period to the left of the first series
value
 No matter where the series falls on the time line.

0 1 2 3 4 5 6 7 8

i = 10%

A = -$500/year
P2 16
P0
 Series with other single cash flow
 It is common to find cash flows that are combinations of series and
other single cash flows.
 Solve for the series present worth values then move to t = 0.
 Solve for the PW at t = 0 for the single cash flows.
 Add the equivalent PW’s at t = 0.
F4 = $300
 Consider:
A = $500

0 1 2 3 4 5 6 7 8

i = 10%

F5 = -$400 17
Ex: Final Exam (2004)

An engineering student who will soon receive his B.S. degree is considering
continuing his formal education by working toward an M.S. degree. The
student estimates that his average earnings for the next 6 years with a B.S.
degree will be $40,000 per year. If he can get an M.S. degree in one year,
his earnings should average $44,000 per year for the subsequent 5 years.
His earnings while working on the M.S. degree will be negligible and his
additional expenses to be paid out over this year will be $10,000. The
student estimates that his average per-year earnings in the two decades
following the initial 6-year period will be $42,000 and $45,000, if he does
not stay for an M.S. degree. If he receives an M.S. degree his earnings per
year in the two decades can be stated as $42,000 + x and $45,000 + x.
The interest rate is assumed at 15%.

(a) Draw cash flow diagrams for two options; working and studying. The
diagram must be clearly labeled.
(b) Find the value of x for which the extra investment in formal education will
pay for itself. In other words, find the value of x in which the two options
(working and studying) are break-even and equivalent. Note: Use up to 4
decimal points throughout your calculation.
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Evaluating Alternatives
 Revenue/Cost – the alternatives consist of cash inflow and
cash outflows
 Select the alternative with the maximum economic value

 Service – the alternatives consist mainly of cost elements

 Select the alternative with the minimum economic value
(min. cost alternative)

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Evaluating Alternatives
 Independent: the decision on any one
project has no effect on the decision
made on another project

 Mutually exclusive: Acceptance of one

project will automatically rejects all other
projects

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Alternatives
Do
Nothing

Analysis

Alt.
1

Selection
Problem Alt.
2

Alt. Execution
m
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 Evaluating Alternatives:
Present Worth Analysis (PW)
A process of obtaining the equivalent worth of future cash flows to
some point in time

– called the Present Worth (PW)

At an interest rate usually equal to or greater than the

Organization’s established Minimum Attractive Rate of Return
(MARR).

Step 1: Calculate PW of each alternative at MARR

Step 2: If mutually exclusive Step 2: If independent projects,

alternatives, select the highest PW select all project with PW  0
alternative

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 Present Worth Analysis of
Equal-Life Alternatives
Step 1: Calculate PW of each alternative at MARR

Step 2: If mutually exclusive Step 2: If independent projects,

alternatives, select the highest PW select all project with PW  0
alternative

Ex: Assume 2 investment alternatives with the same useful life of 4 years.
Due to limited investment fund, the 2 alternatives are mutually exclusive.
Based on the following information, which one should we select? Assume
MARR = 10%

A B
Capital Investment $60,000 73,000
Annual Profit $22,000 $26,225

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Also see Ex 5.1
 Ex: PW Analysis (Equal-life)

Consider: Machine A Machine B

First Cost $2,500 $3,500
Annual Operating Cost 900 700
Salvage Value 200 350
Life 5 years 5 years

i = 10% per year

Which alternative should we select?

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 Present Worth Analysis of
Different Life Alternatives
 Comparison must be made over equal time periods
 Compare over the least common multiple, LCM, for their
lives
 Assume repeatability. Alternative will repeat the same
manner over each life cycle
 Cash flow estimates are the same in every life cycle

 Example: {3,4, and 6} years. The lowest common

life is 12 years.
 Evaluate all over 12 years for a PW analysis.

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Also see Ex 5.2
 Ex: PW Analysis (Different-life)

Alternative A Alternative B
Capital Investment $3,500 $5,000
Annual Revenue $1,900 $2,500
Annual Expense $645 $1,020
Useful Life 4 years 6 years
Market Value at the end of $0 $0
useful life
Assume MARR 10% per year.

Which alternative should we select?

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