1 views

Uploaded by Mazin Alahmadi

chapter

- 3rd Term-Finance Management
- Chapter 1 Solution
- Life Insurance and its Mathematical Basis
- Management
- Sbi.co.in-state Bank of India Indias Largest Bank
- Infrastructure Sector Update
- Intro Practice Book Sample FP
- quantitative aptitude questions
- Ratio Word Problems
- Basic Mathematics
- Mm Zg627 Ec-3r Firstsem 2016-2017
- How Does the Stock Market Work
- Memorandum of Understanding
- 301_04
- The Economic and Other Factors Affect
- Basics.pptx
- Bh Ffm13 Webapp Tb Ch05a
- So Luci Ones
- C Onclusion
- inflation.docx

You are on page 1of 11

CHAPTER 1

FOUNDATION OF ENGINEERING ECONOMY

1.1 WHAT IS ENGINEERING ECONOMY?

Engineering economy is a collection of techniques that simplify comparisons of alternatives on an

economic basis.

Engineering economy is not a method or process for determining what the alternatives are.

Engineering economy begins only after the alternatives have been identified. If the best

alternative is actually one that the engineer has not even recognized as an alternative, then all

of the engineering economic analysis tools in this book will not result in its selection.

Economics will be the sole criterion for selecting the best alternatives in this book

The inclusion of other factors (besides economics) in the decision making process is called

multiple attribute analysis. This topic is introduced in Appendix C.

Engineering economy assist people in making the best decision.

Some of the basic terminology and fundamental concepts that form the foundation for

engineering economy studies are described below:

1.2.1 Alternatives

An alternative is a stand-alone solution for a given situation.

In engineering practice, there are always several ways of accomplishing a given task, and it is

necessary to be able to compare them in a rational manner so that the most economical

alternative can be selected.

The alternatives in engineering considerations usually involve such items:

First cost (initial cost); For an asset, it will be the purchase cost which contains:

Equipment cost

Delivery charges

Installation cost

Insurance coverage

Initial training of personnel for equipment use

Anticipated useful life,

Yearly costs of maintaining assets (annual maintenance and operating costs; M&O Cost or the

Annual operating cost AOC):

Direct labor cost for operating personnel

Direct materials

Maintenance (daily, periodic, repairs, etc.)

Rework and rebuild

Some of these elements, such as equipment cost, can be determined with high accuracy;

others, such as maintenance costs, may be harder to estimate.

Anticipated resale value (salvage value),

The interest rate.

After the facts and all the relevant estimates have been collected, an engineering economy

analysis can be conducted to determine which is best from an economic point of view.

Cash Flows are the estimated inflows (revenues, incomes or receipts) and outflows (costs,

expenses or disbursements) of money.

Ch. 1 1

Cash inflows, or receipts:

Samples of Cash Inflow Estimates:

Revenues (from sales and contracts).

Operating cost reductions (resulting from an alternative).

Salvage value.

Construction and facility cost savings.

Receipt of loan principal.

Income tax savings.

Receipts from stock and bond sales.

Samples of Cash Outflow Estimates:

First cost of assets.

Engineering design costs.

Operating costs (annual and incremental).

Periodic maintenance and rebuild costs.

Loan interest and principal payments.

Major expected/unexpected upgrade costs.

Income taxes.

They also represent the weakest part of the analysis, because most of the numbers are

judgments about what is going to happen in the future. (Prediction)Cash flow estimation is likely

the most difficult and inexact.

The end result is only as reliable as the data that it is based on.

These cash flows may be estimates or observed values.

These cash flows, with a plus sign representing cash inflows and a minus sign representing cash

outflows.

Background information for estimates may be available in departments such as accounting,

finance, marketing, sales, engineering, design, manufacturing, production, field services, and

computer services. The accuracy of estimates is largely dependent upon the experiences of the

person making the estimate with similar situations.

We will use point estimates throughout most of this book.

the net cash flow can be determined:

Net cash flow = receipts - disbursements = cash inflows - cash outflows

Every situation has at least two alternatives.

There is always the alternative of inaction, called the do-nothing (DN) alternative. This is the as-

is or status quo condition.

In any situation, when one consciously or subconsciously does not take any action, he or she is

actually selecting the DN alternative.

In economic analysis, financial units (dollars or other currency) are generally used as the

tangible basis for evaluation.

The alternative with the lowest overall cost or highest overall net income is selected.

Ch. 1 2

1.2.5 Intangible Factors

In many cases, alternatives have noneconomic or intangible factors that are difficult to quantify.

When the alternatives under consideration are hard to distinguish economically, intangible

factors may tilt the decision in the direction of one of the alternatives.

Examples of noneconomic factors are goodwill, convenience, friendship, and morale.

It is often said that money makes money. If we elect to invest money today, we inherently expect

to have more money in the future. If a person or company borrows money today, by tomorrow

more than the original loan principal will be owed. This fact is also explained by the time value of

money.

The Time Value of Money is the change in the amount of money over a given time period.

It is the most important concept in engineering economy.

Interest is the difference between an ending amount of money and the beginning amount. If the

difference is zero or negative, there is no interest.

Interest = end amount - original amount

Interest is the manifestation of the time value of money, and it essentially represents “rent”

paid for use of the money.

There are always two perspectives to an amount of interest—interest paid and interest earned:

Interest is paid when a person or organization borrows money (obtains a loan) and repays a

larger amount.

Interest is earned when a person or organization saves, invests, or lends money and obtains a

return of a larger amount.

The computations and numerical values are essentially the same for both perspectives.

The interest rate or rate of return (ROR) is interest over a specific time unit which is expressed as

a percentage of the original amount (principal).

The time unit of the interest rate is called the interest period. The most common interest period

is 1 year.

The interest period of the interest rate should always be included.

If only the rate is stated, for example, 8.5%, a 1-year interest period is assumed.

Return on investment (ROI) is used equivalently with ROR in different industries and settings,

especially where large capital funds are committed to engineering-oriented programs.

The term interest rate paid is more appropriate for the borrower’s perspective, while rate of

return earned is better from the investor’s perspective.

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.

The perspective here is that of the borrower since $10,700 repays a loan.

The interest paid = 10,700 - 10,000 = $700.

Ch. 1 3

Percent interest rate

a. Calculate the amount deposited 1 year ago to have $1,000 now at an interest rate of 5% per

year.

b. Calculate the amount of interest earned during this time period.

$1,000 = X + X(0.05) = X(1 + 0.05) = X(1.05)

The original deposit is X

Engineering alternatives are evaluated upon the prognosis that a reasonable rate of return

(ROR) can be realized. A reasonable rate must be established so that the accept/reject decision

can be made.

The reasonable rate, called the minimum attractive rate of return (MARR), must be higher than

the cost of money used to finance the alternative, as well as higher than the rate that would be

expected from a bank or safe (minimal risk) investment.

The MARR is also referred to as the hurdle rate; that is, a financially viable project’s expected

ROR must meet or exceed the hurdle rate.

The MARR is not a rate calculated like the ROR; MARR is established by financial managers and is

used as a criterion for accept/reject decisions.

The following inequality must be correct for any accepted project.

Ch. 1 4

For a corporation, the MARR is always set above its cost of capital, that is, the interest rate a

company must pay for capital funds needed to finance projects. For example, if a corporation

can borrow capital funds at an average of 5% per year and expects to clear at least 6% per year

on a project, the minimum MARR will be 11% per year.

An additional economic consideration for any engineering economy study is inflation. In simple

terms, bank interest rates reflect two things: a so-called real rate of return plus the expected

inflation rate. Inflation causes interest rates to rise.

1.4 EQUIVALENCE:

In engineering economy, 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.

What is the equivalent amount of $100 today, if the interest rate is 6% per year,:

a. After 1 year? 100(1.06) = $106

b. After 2 years? 100(1.06)2 = $112.36

c. Before 1 year? 100/1.06 = $94.34

d. Before 2 years? 100/(1.06)2 = $89

When more than one interest period is involved, it is necessary to state whether the interest is

accrued on a simple or compound basis from one period to the next. If the type of the interest is

not mentioned that means it is on a compound basis.

Simple interest is calculated using the principal only, ignoring any interest accrued in preceding

interest periods.

Simple Interest = (principal)(number of periods)(interest rate)

The Future worth for simple interest is computed as

Future Worth, F = P(1 + in)

HP borrowed money to do a new project. The loan is $1 million for 3 years at 5% per year simple

interest. How much money will HP repay at the end of 3 years?

Amount

End of Year Interest Amount Owed Amount Paid

Borrowed

0 (now) $1,000,000 0 $1,000,000 0

1 - $50,000 $1,050,000 0

2 - $50,000 $1,100,000 0

3 - $50,000 $1,150,000 $1,150,000

Ch. 1 5

For Compound interest, the interest accrued for each interest period is calculated on the principal

plus the total amount of interest accumulated in all previous periods.

Compound interest means interest on top of interest. It reflects the effect of the time value of

money on the interest also.

Compound Interest = (principal + all accrued unpaid interest)(interest rate)

Total due after a number of years = Principal(1 +interest rate)number of 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. Compare the results of this and the previous example.

An extra $7,630 of interest is paid compared to simple interest over the 3-year period because of

the interest of the interests.

Amount

End of Year Interest Amount Owed Amount Paid

Borrowed

0 $1,000,000 0 $1,000,000 0

1 - $50,000 $1,050,000 0

2 - $52,500 $1,102,500 0

3 - $55,130 $1,157,630 $1,157,630

a. Demonstrate the concept of equivalence using the different loan repayment plans described

below. Each plan repays a $6,000 loan in 3 years at 10% interest per year.

Plan 1: Simple interest, pay all at end.

Plan 2: Simple interest paid annually, principal repaid at end.

Plan 3: Compound interest, pay all at end.

Plan 4: Compound interest and portion of principal repaid annually.

Plan 5: Equal payments of compound interest and principal made annually.

b. Make a statement about the equivalence of each plan at 8% simple or compound interest, as

appropriate.

End of Year Interest Owed Total Owed at End-of-Year Total Owed after

(EOY) for Year End of Year Payment Payment

0 - - - $6,000.00

1 600.00 6,600.00 0 6,600.00

2 600.00 7,200.00 0 7,200.00

3 600.00 7,800.00 $7,800.00 0

Totals $1,800.00 Totals $7,800.00

Ij = $6,000(0.10) = $600

Ch. 1 6

Plan 2: Simple Interest Paid Annually; Principal Repaid at End

End of Year Interest Owed Total Owed at End-of-Year Total Owed after

(EOY) for Year End of Year Payment Payment

0 - - - $6,000.00

1 600.00 6,600.00 600.00 6,000.00

2 600.00 6,600.00 600.00 6,000.00

3 600.00 6,600.00 6,600.00 0

Totals $1,800.00 Totals $7,800.00

End of Year Interest Owed Total Owed at End-of-Year Total Owed after

(EOY) for Year End of Year Payment Payment

0 - - - $6,000.00

1 600.00 6,600.00 0 6,600.00

2 660.00 7,260.00 0 7,260.00

3 726.00 7,986.00 7,986.00 0

Totals $1,986.00 Totals $7,986.00

e.g.

End of Year Interest Owed Total Owed at End-of-Year Total Owed after

(EOY) for Year End of Year Payment Payment

0 - - - $6,000.00

1 600.00 6,600.00 2,600.00 4,000.00

2 400.00 4,400.00 2,400.00 2,000.00

3 200.00 2,200.00 2,200.00 0

Totals $1,200.00 Totals $7,200.00

End of Year Interest Owed Total Owed at End-of-Year Total Owed after

(EOY) for Year End of Year Payment Payment

0 - - - $6,000.00

1 600.00 6,600.00 $2,412.66 4,187.34

2 418.73 4,606.07 2,412.66 2,193.41

3 219.34 2,412.66 2,412.66 0

Totals $1,238.07 Totals $7,237.98

To find A = $2,412.66 = $6,000(A/P,10%,3) = 6,000(0.40211)

Terms and symbols:

P Value or amount of money at a time designated as the present or (t = 0).[Single Payment].

Also, it is called present worth (PW), present value (PV), net present value (NPV),

discounted cash flow (DCF), and capitalized cost (CC); dollars ($) or Saudi Riyals (S.R.) or any

other currency.

F Value or amount of money at some future time (t = n). [Single Payment].

Also, it is called future worth (FW) and future value (FV); $

Ch. 1 7

A Uniform Series: Series of consecutive, equal, end-of-period amounts of money. [Series of

Payments].

Also, it is called the annual worth (AW) and equivalent uniform annual worth (EUAW); $ per

period.

G Arithmetic Gradient: Series of consecutive, end-of-period amounts of money which they

increase (or decrease) over time by a fixed amount each interest period. [Series of

Payments]. Increased (or decreased) by $/period.

g% Geometric Gradient: Series of consecutive, end-of-period amounts of money which

increase (or decrease) over time by a fixed percent each interest period. [Series of

Payments]. Increased (or decreased) by %/period.

n Number of interest periods; years, months, weeks, days or any period.

i Interest rate or rate of return (ROR) per interest period; percent (%) per period.

It is assumed to be a compound rate, unless specifically stated as simple interest.

The decimal equivalent for i is always used.

t time, stated in periods; years, months, weeks, days or any period. It has integer values only.

Notes:

Always the Cash flow P is preceding the Cash flow F. It should be clear that a present value P

represents a single sum of money at some time prior to a future value F or prior to the first

occurrence of an equivalent series amount A.

All engineering economy problems involve the element of time n and interest rate i.

Example 1.7 (Page 5)+Example 1.11 (Page 19) [Identify Symbols& Drawing CFD]:

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.

i = 8% per year

n = 5 years

Cash Flow Diagram

P = $10,000

i = 8%/year

F = ?.

P = 10,000

0 1 2 3 4 5

F=?

Assume you borrow $2,000 now at 7% per year for 10 years and must repay the loan in equal

yearly payments. Determine the symbols involved and their values.

i = 7% per year

n = 10 years

P = $2,000

A = ? per year for 10 years.

Ch. 1 8

Cash Flow Diagram

i = 7%/year

P = 2,000

0 1 2 3 4 5 6 7 8 9 10

A=?

On July 1, 2008, your new employer Ford Motor Company deposits $5,000 into your money

market account, as part of your employment bonus. The account pays interest at 5% per year.

You expect to withdraw an equal annual amount each year for the following 10 years. Identify the

symbols and their values.

i = 5% per year

n = 10 years

P = $5,000

A = ? per year

Cash Flow Diagram

i = 5%/year

A=?

0 1 2 3 4 5 6 7 8 9 10

5,000

You plan to make a lump-sum deposit of $5,000 now into an investment account that pays 6% per

year, and you plan to withdraw an equal end-of-year amount of $1,000 for 5 years, starting next

year. At the end of the sixth year, you plan to close your account by withdrawing the remaining

money. Define the engineering economy symbols involved.

i = 6% per year

n = 5 years for the A series and 6 for the F value

P = $5,000

A = $1,000 per year for 5 years

F = ? at end of year 6

Ch. 1 9

Cash Flow Diagram

i = 6%/year

F=?

A = 1,000

0 1 2 3 4 5 6

5,000

Since cash flows normally take place at varying times within an interest period, a simplifying

end-of-period assumption is made.

The end-of-period convention means that all cash flows are assumed to occur at the end of an

interest period.

When several receipts and disbursements occur within a given interest period, the net cash flow is

assumed to occur at the end of the interest period.

The end of the interest period is not necessarily the end of calendar year (December 31).

The cash flow diagram is a graphical representation of cash flows drawn on a time scale.

It is a very important tool in an economic analysis, especially when the cash flow series is

complex.

It is includes what is known, what is estimated, and what is needed.

Since the end-of-year convention places cash flows at the ends of years, the “1” marks the end

of year 1. The present (t = 0), and is the end of time period 1 (t = 1)

It is not necessary to use an exact scale on the cash flow diagram.

The direction of the arrows on the cash flow diagram is important. A vertical arrow pointing up

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

flow.

The perspective or vantage point must be determined prior to placing a sign on each cash flow

and diagramming it.

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.

Ch. 1 10

Cash Flow Diagram

i = 12%/year

F4 = ?

-1 0 1 2 3 4

A = 1,000,000

A father wants to deposit an unknown lump-sum amount into an investment opportunity 2 years

from now that is large enough to withdraw $4,000 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.

Cash Flow Diagram

i = 15.5%/year

A = 4,000

0 1 2 3 4 5 6 7

P2 = ?

P2 = 4,000(P/A,15.5%,5) = 4,000(3.312851) = $13,251.40

Ch. 1 11

- 3rd Term-Finance ManagementUploaded byShreedhar
- Chapter 1 SolutionUploaded bythacal
- Life Insurance and its Mathematical BasisUploaded byAvinash Veerendra Tak
- ManagementUploaded byMatthew Delgado
- Sbi.co.in-state Bank of India Indias Largest BankUploaded bySaran Jl
- Infrastructure Sector UpdateUploaded byallkashish
- Intro Practice Book Sample FPUploaded bynaresh2011
- quantitative aptitude questionsUploaded byKumar Rajadhyaksh
- Ratio Word ProblemsUploaded byGohar Islam
- Basic MathematicsUploaded byFaizanAshraf
- Mm Zg627 Ec-3r Firstsem 2016-2017Uploaded byamarpal07
- How Does the Stock Market WorkUploaded byMyHoard
- Memorandum of UnderstandingUploaded bykondwani B J Manda
- 301_04Uploaded byjrkling
- The Economic and Other Factors AffectUploaded byAyoola Akisanmi
- Basics.pptxUploaded byDeepak Kumar
- Bh Ffm13 Webapp Tb Ch05aUploaded byolafed
- So Luci OnesUploaded bynimesulida
- C OnclusionUploaded byrawparsola
- inflation.docxUploaded byDishant Mittal
- US Federal Reserve: 810707StaffState2Uploaded byThe Fed
- FDUploaded bydeepthyk
- PRAKASH sip final.pptxUploaded byPrakashMhatre
- Formulas in Business Math.docxUploaded byGeraldo Mejillano
- 01 Business Math Loans Worksheet 1Uploaded byDon McArthney Tugaoen
- Appt ItudesgddfhghjhUploaded bySwethaKandukuri
- CE40 - CO1 (3Q1718).pdfUploaded byKim
- My Personal Opinion on the Overall Level of House Prices in AustraliaUploaded byJake Beazley
- 692266_1_636398515721112994_capitalized-interestUploaded byShubham Tomar
- B6005 Lecture 11 Trade Credit and Shortem Loan HandoutUploaded byTeddy Handaya

- Gmoe - Class 12Uploaded byMazin Alahmadi
- IoT Revolution LandscapeUploaded byMazin Alahmadi
- Replacement 01Uploaded byMazin Alahmadi
- Marketing in KSAUploaded byMazin Alahmadi
- Conference Brochure and FeesUploaded byMazin Alahmadi
- Industrial Application TaguchiUploaded byMazin Alahmadi
- prob1Uploaded byMazin Alahmadi
- 2016 Call for Papers.2Uploaded byMazin Alahmadi
- answers to exercises - mathematical statistics with applications (7th edition).pdfUploaded byNikola Krivokapić
- All TestsUploaded byMazin Alahmadi
- A Model to Determine the Optimal Parameters for Sustainable Energy Machining in a Multi Pass Turning OperationUploaded byMazin Alahmadi
- A2.a.36.BinomialExpansions2Uploaded byMazin Alahmadi
- PracticeUploaded byMazin Alahmadi
- Formulas (2)Uploaded byMazin Alahmadi
- 1972 QP QuestionsUploaded byMazin Alahmadi
- Sample Quiz9Uploaded byMazin Alahmadi
- ASQ.Actualtests.CQE.v2015-03-26.by.Miguel.160qUploaded byMazin Alahmadi
- Control Chart EquationsUploaded byMazin Alahmadi
- West Virginia University Calendar Spring 2014pdfUploaded byMazin Alahmadi
- 1974 QP QuestionsUploaded byMazin Alahmadi
- Discrete Probability DistributionsUploaded bydclegaspi
- Modeling and Analyzing Supply Chain Reliability by Different Effects OfUploaded byMazin Alahmadi
- Ch1 Probs & Solutions ParkUploaded byMazin Alahmadi
- exam_1_solnUploaded byMazin Alahmadi
- Modelling With Linear ProgUploaded byvijaydh

- Pomegranate de SeederUploaded byKamal Bharakhda
- DxDiagUploaded byHambaTuhanYme
- BRKINI-2201Uploaded bytkphamy2k9273
- Multimedia Systems, Standards, And NetworksUploaded byMadhava Reddy
- Emoji Meanings.docxUploaded byHarsha Vardhan
- 161104 08MN053 Annual Monitoring Report OT5EUploaded byNunatsiaqNews
- iG5AUploaded bykazacy
- Spectroscopic and Chemical CharacterizationUploaded bycrybaby
- Salient Issues in EthicsUploaded bySravani Vangara
- 06-CompetitorsAnalysisUploaded byNurZul HealMe
- Euronavy Es301 PDFUploaded byJunite
- Tips+for+passing+PMP+Exam (2)Uploaded bydkrbpl20043036
- Individual EvaluationUploaded byPunit Raithatha
- Seksioni i Kabllos Per Rrymat e Lidhjes Se ShkurteUploaded byDukagjin Ramqaj
- Computer and Internet Basics.pdfUploaded byibbl123
- 1st Lecture of Respiratory Histology by Dr RoomiUploaded byMudassar Roomi
- Electronic Spectacles for Paralysed PatientsUploaded byCA Amit Mehta
- Virtual WorkUploaded byvsanthanam
- Lecture 1 Systems ThinkingUploaded byJanet T. Cometa
- As 1418.5-2002 Cranes Hoists and Winches Mobile CranesUploaded bySAI Global - APAC
- Nemirovskii NP HardnessUploaded bySilvia Truşcă
- Math Coaching1 2ndbooklet(FINAL)Uploaded byAchilles Aldave
- Group a Tata CorusUploaded byChÄndra Sharma
- SRMUploaded byKiran Virani
- A Rivalry Story: Red Sox v. YankeesUploaded bySam Redlich
- Cheap Speaker RuckSack Thats LOUDUploaded byjumpupdnbdj
- 2014 RTCEUR Jay Zallan Line Based LabUploaded byJay B Zallan
- NayanUploaded byKaspa Sridhar
- Williams v. DJO Global - ComplaintUploaded bySarah Burstein
- Using SAP Cloud Platform IntegrationUploaded byRavi