Foundation of Engineering Economy

WHAT IS ENGINEERING ECONOMY?

engineering economy is a collection
of techniques that simplify
comparisons of alternatives on an
economic basis.
PERFORMING AN ENGINEERING
ECONOMY STUDY
Terms
Alternatives
Cash Flows
Alternative Selection
Evaluation Criteria
Intangible Factors
Time Value of Money

Principles of Engineering Economy

1. Develop an ALternatives
2. Focus on the Differences
3. Use a Consistent Viewpoint
4. Use a Common unit of Measure
5. Consider all Relevant Criteria
6. Make Uncertainty Explicit
7. Revisit your Decision

Engineering Economic Analysis Procedure

1. Problem Recognition, Definition, and

Evaluation
2. Development of the Feasible
Alternatives

3. Developing of the Cash Flow for

each alternatives

4. Selection of a criterion (or Criteria)

Engineering Design Process

1. Problem need definiton
2. Problem/ need formulation
and Evaluation
3. Synthesis of possible
solutions (alternatives)

4. Analysis, optimization, and

evaluation

5. Specification of preferred
5. Analysis and Comparison of the alternatives
alternative
6. Selection of the preferred alternative
7. Performance monitoring and post
evaluation of results

6. Communication.

Bad news-you just wrecked your car! You need another car immediately
because you have decided that walking, riding a bike, and taking a bus
are not acceptable. An automobile wholesalers offers you 2000 for the
car as is also your insurance companys claims adjuster estimates
that there is 2000 in damages of your car. Because you have collision
insurance with a 1000 deductibility provision, the insurance company
mails you a check for 1000. the odometer reading on your wrecked car
is 58000 miles
what should you do? Use the seven step procedure to analyze your
situation. Also identify which principles accompany each step.
Step 1: Define the problem

Step 2: Develop your alternatives

1. Sell the wrecked car for 2000to the wholesaler and spend this
money, the 1000 insurance check, and all of your 7000 savings
account on a newer car. The total amount paid out of your savings
account is 7000and the car will have 28000 miles of prior use.
2. Spend the 1000 insurance check and 1000 of savings to fix the car.
The total amount paid out of your savings is 1000, and the car will
have 58000miles of prior use.
3. Spend the 1000 insurance check and 1000 of your savings to fix
the car, then sell the car 4500 pplus 5500 off additional savings to
buy the newer car. The total amount paid out of savings is 6500,
and the car will have 28000 miles.
4. Give a car to a part time mechanic, who will repair it to 1100
(1000 insurance and 100of your savings) but will take and
additional month of repair time. You will also have to rent a car for
that time at 400/month (paid out of saving). The total amount paid
out of saving is 500and the car will have 58000 miles on the
odometer.
5. Same aas alternative 4, but you then sell the car for 4500, and
use this money plus 5500 of additional savings to buy the newer car.
The total amount paid out of savings is 6000 and the newer car will
be have 28000 miles of prior use.

TEREST RATE, RATE OF RETURN, AND MARR

Interest is the manifestation of the

time value of money, and it
essentially represents
rent paid for use of the money.
Interest = End amount - Original amount
When interest over a specific time
unit is expressed as a percentage of
the original
amount (principal), the result is called
the interest rate or rate of return
(ROR).
Interest accrued per unit time
Interest rate or Rate of Return = ----------------------------------------- x
100%
Original amount
The time unit of the interest rate is
called the interest period.

EXAMPLE
An employee at LaserKinetics.com
borrows $10,000 on May 1 and must
repay
a total of $10,700 exactly 1 year
later. Determine the interest amount
and the
interest rate paid.

a. Calculate the amount

deposited 1 year ago to have
$1000 now at an interest
rate of 5% per year.
b. Calculate the amount of
interest earned during this time
period.

EQUIVALENCE
In engineering economy, when
considered together, the time value
of money
and the interest rate help develop the
concept of economic equivalence,
which
means that different sums of money
at different times would be equal in
economic
value.

Simple Interest
Simple interest is calculated using the principal only, ignoring
any interest that had been accrued in preceeding period.
I=Pni
F=P + I
F=P(1+ni)
I- ineterst
P-Principal or present worth
N-number of interest periods
i-rate of interest per interest period
F-accumulated amount or future worth

Ordinary Simple Interest is computed on the basis of 12

months of 30 days each or 360 days a year.
1 interest period = 360 days
Exact Simple interest is based on the exact number of
daysin a year, 365 days for ordinary yearand 366 daysfor
a leap year.
1 interest period = 365 or 366 days

Problem
1. Determine the simple ordinary interest
on P700 for 8months and 15 daysif the rate
of interest is 15%
2. What will be the future worth of
money after 14 months if the sum of
P10000is invested todayat a simple
interest rate of 12% per year.

Compound Interest
The interest for an interest period is calculated on the principal
plus total amount of interest accumulated in previous periods.
compound interest means interest on
top of interest.
Interest = (principal + all accrued interest)
(interest rate)

F P(1 i ) n
F
P
(1 i ) n

P-Principal or present worth

n-number of interest periods
i-rate of interest per interest period
F-accumulated amount or future worth

(1 i) n

1
(1 i) n

Single payment compound amount

factor
In Symbol:
F/P,i%,n
Read as F given P at i% in n interest
periods
Single payment present worth factor
In symbol:
P/F,i%,n
Read as P given F at i% in n interest
periods.

If HP borrows $1,000,000 from a

different source at 5% per year
compound
interest, compute the total amount
due after 3 years.

Rate of Interest
Nominal rate of interest, r
the nominal rate of interest specifies the rate of interest and a
number
of interest periods in one year.
i=r/m
where: i- rate interest per interest period
r-nominal interest rate
m-number of compounding periods per year

Effective rate of Interest

effective rate of interest is the actual or exact rate of interest
on the principal during one year.
Effective rate = (1+i)m -1

Find the nominal rate which if converted

quarterlycould be used instead of 12%
compounded monthly. What is the corresponding
effective rate.

Find the amount at the end of two years and seven

months if P1000 is invested at 8%compounded
quarterly using simple interest for anytime less than a
year interest period.

Cash Flow Diagrams

Cash flows are inflows and outflows of money.
A cash flow diagram is simply a graphical representation of
cash flows drawn on a time scale.

A typical cash flow

time scale for 5 years.

A vertical
arrow pointing up indicates a positive
cash flow. Conversely, an arrow
pointing
down indicates a negative cash flow.

Example of positive
and negative cash
flows.

A new college graduate has a job with

Boeing Aerospace. She plans to
borrow
$10,000 now to help in buying a car.
She has arranged to repay the entire
principal
plus 8% per year interest after 5
years. Identify the engineering
economy
symbols involved and their values for
the total owed after 5 years.
Construct the cash flow diagram.

Cash flow diagram on the viewpoint of the borrower

Each year Exxon-Mobil expends large

amounts of funds for mechanical
safety
features throughout its worldwide
operations. Carla Ramos, a lead
engineer for
Mexico and Central American
operations, plans expenditures of $1
million now
and each of the next 4 years just for
the improvement of field-based
pressure release
valves. Construct the cash flow
diagram to find the equivalent value
of
these expenditures at the end of year
4, using a cost of capital estimate for
safety-related funds of 12% per year.

A father wants to deposit an unknown

lump-sum amount into an investment
opportunity 2 years from now that is
large enough to withdraw $4000 per
year
for state university tuition for 5 years
starting 3 years from now. If the rate
of
return is estimated to be 15.5% per
year, construct the cash flow
diagram.