INTRODUCTION

WHY DO ENGINEERS NEED TO LEARN ABOUT ECONOMICS?

Ages ago, the most significant barriers to engineers were technological. The things that
engineers wanted to do, they simply did not yet know how to do, or hadn't yet
developed the tools to do. There are certainly many more challenges like this which
face present-day engineers. However, we have reached the point in engineering where
it is no longer possible, in most cases, simply to design and build things for the sake
simply of designing and building them. Natural resources (from which we must build
things) are becoming more scarce and more expensive. We are much more aware of
negative side-effects of engineering innovations (such as air pollution from
automobiles) than ever before.

For these reasons, engineers are tasked more and more to place their project ideas
within the larger framework of the environment within a specific planet, country, or
region. Engineers must ask themselves if a particular project will offer some net benefit
to the people who will be affected by the project, after considering its inherent
benefits, plus any negative side-effects (externalities), plus the cost of consuming
natural resources, both in the price that must be paid for them and the realization
that once they are used for that project, they will no longer be available for any other
project(s).

Simply put, engineers must decide if the benefits of a project exceed its costs, and
must make this comparison in a unified framework. The framework within which to
make this comparison is the field of engineering economics, which strives to answer
exactly these questions, and perhaps more. The Accreditation Board for Engineering
and Technology (ABET) states that engineering "is the profession in which a knowledge
of the mathematical and natural sciences gained by study, experience, and practice is
applied with judgment to develop ways to utilize, economically, the materials and
forces of nature for the benefit of mankind".1

It should be clear from this discussion that consideration of economic factors is as

important as regard for the physical laws and science that determine what can be
accomplished with engineering. The following figure shows how engineering is
composed of physical and economic components:

[Eng. Economics]

Figure 1 : Physical and Economic Components of an Engineering System

Figure 1 shows how engineering is composed of physical and economic components.

Physical Environment : Engineers produce products and services depending on physical

laws (e.g. Ohm's law; Newton's law).

Physical efficiency takes the form:

system output(s)

Physical (efficiency ) = -------------------

system input(s)

Economic Environment : Much less of a quantitative nature is known about economic

environments -- this is due to economics being involved with the actions of people,
and the structure of organizations.

Satisfaction of the physical and economic environments is linked through production

and construction processes. Engineers need to manipulate systems to achieve a
balance in attributes in both the physical and economic environments, and within the
bounds of limited resources. Following are some examples where engineering economy
plays a crucial role:

Choosing the best design for a high-efficiency gas furnace

Selecting the most suitable robot for a welding operation on an automotive assembly
line

Making a recommendation about whether jet airplanes for an overnight delivery service
should be purchased or leased

Considering the choice between reusable and disposable bottles for high-demand
beverages

With items 1 and 2 in particular, note that coursework in engineering should provide
sufficient means to determine a good design for a furnace, or a suitable robot for an
assembly line, but it is the economic evaluation that allows the further definition of a
best design or the most suitable robot.

In item 1 of the list above, what is meant by " high-efficiency"? There are two kinds of
efficiency that engineers must be concerned with. The first is physical efficiency, which
takes the form:

System output(s)

Economic (efficiency ) = -----------------

System input(s)

For the furnace, the system outputs might be measured in units of heat energy, and
the inputs in units of electrical energy, and if these units are consistent, then physical
efficiency is measured as a ratio between zero and one. Certain laws of physics (e.g.,
conservation of energy) dictate that the output from a system can never exceed the
input to a system, if these are measured in consistent units. All a particular system can
do is change from one form of energy (e.g. electrical) to another (e.g., heat). There are
losses incurred along the way, due to electrical resistance, friction, etc., which always
yield efficiencies less than one. In an automobile, for example, 10-15% of the energy
supplied by the fuel might be consumed simply overcoming the internal friction of the
engine. A perfectly efficient system would be the theoretically impossible Perpetual
Motion Machine!

The other form of efficiency of interest to engineers is economic efficiency, which

takes the form:

system worth

Economic (efficiency ) = -----------------

system cost

You might have heard economic efficiency referred to as "benefit-cost ratio". Both
terms of this ratio are assumed to be of monetary units, such as dollars. In contrast to
physical efficiency, economic efficiency can exceed unity, and in fact should, if a
project is to be deemed economically feasible. The most difficult part of determining
economic efficiency is accounting for all the factors which might be considered
benefits or costs of a particular project, and converting these benefits or costs into a
monetary equivalent. Consider for example a transportation construction project which
promises to reduce everyone's travel time to work. How do we place a value on that
travel time savings? This is one of the fundamental questions of engineering
economics.

In the final evaluation of most ventures, economic efficiency takes precedence over
physical efficiency because projects cannot be approved, regardless of their physical
efficiency, if there is no conceived demand for them amongst the public, if they are
economically infeasible, or if they do not constitute the "wisest" use of those resources
which they require.
There are numerous examples of engineering systems that have physical design but
little economic worth (i.e it may simply be too expensive !!). Consider a proposal to
purify all of the water used by a large city by boiling it and collecting it again through
condensation. This type of experiment is done in junior physical science labs every
day, but at the scale required by a large city, is simply too costly.

ROLE OF UNCERTAINTY IN ENGINEERING

When conducting engineering economic analyses, it will be assumed at first, for

simplicity, that benefits, costs, and physical quantities will be known with a high degree
of confidence. This degree of confidence is sometimes called assumed certainty. In
virtually all situations, however, there is some doubt as to the ultimate values of
various quantities. Both risk and uncertainty in decision-making activities are caused by
a lack of precise knowledge regarding future conditions, technological developments,
synergies among funded projects, etc. Decisions under risk are decisions in which the
analyst models the decision problem in terms of assumed possible future outcomes,
or scenarios, whose probabilities of occurrence can be estimated. Of course, this type
of analysis requires an understanding of the field of probability. Decisions under
uncertainty, by contrast, are decision problems characterized by several unknown
futures for which probabilities of occurrence cannot be estimated. Other less objective
means exist for the analysis of such problems.

For the purposes of this brief tutorial, we cannot delve further into the analytical
extensions required to accommodate risk or uncertainty in the decision process. We
must recognize that these things exist, however, and be careful about reaching strong
conclusions based on data which might be susceptible to these. Because engineering is
concerned with actions to be taken in the future, an important part of the engineering
process is improving the certainty of decisions with respect to satisfying the objectives
of engineering applications.
THE ENGINEERING PROCESS

Engineering activities dealing with elements of the physical environment take place to
meet human needs that arise in an economic setting. The engineering process
employed from the time a particular need is recognized until it is satisfied may be
divided into a number of phases:

Determination of Objectives

This step involves finding out what people need and want that can be supplied by
engineering. People's wants may arise from logical considerations, emotional drives, or
a combination of the two.

Identification of Strategic Factors

The factors that stand in the way of attaining objectives are known as limiting factors.
Once the limiting factors have been identified, they are examined to locate strategic
factors -- those factors which can be altered to remove limitations restricting the
success of an undertaking. A woman who wants to empty the water from her swimming
pool might be faced with the limiting factor that she only has a bucket to do the job
with, and this would require far greater time and physical exertion than she has at her
disposal. A strategic factor developed in response to this limitation would be the
procurement of some sort of pumping device which could do the job much more
quickly, with almost no physical effort on the part of the woman.

Determination of means (engineering proposals)

This step involves discovering what means exist to alter strategic factors in order to
overcome limiting factors. In the previous example, one means was to buy (or rent) a
pump. Of course, if the woman had a garden hose, she might have been able to
siphon the water out of the pump. In other engineering applications, it may be
necessary to fabricate the means to solve problems from scratch.

Evaluation of Engineering Proposals

It is usually possible to accomplish the same result with a variety of means. Once these
means have been described fully, in the form of project proposals, economic analysis
can be employed to determine which among them, if any, is the best means for
solving the problem at hand.

Assistance in Decision Making

It is commonplace for the final decision-making responsibility to fall on the head(s) of

someone other than the engineer(s). The person(s) so charged, however, may not be
sufficiently knowledgeable about the technical aspects of a proposal to determine its
relevant worth compared to other means. The engineer can help to bridge this gap.

ENGINEERING ECONOMIC STUDIES

The four key steps in planning an economic study are :

Creative Step : People with vision and initiative adopt the premise that better
opportunities exist than are known to them. This leads to research, exploration, and
investigation of potential opportunities.

Definition Step : System alternatives are synthesised with economic requirements and
physical requirements, and enumerated with respect to inputs/outputs.

Conversion Step : The attributes of system alternatives are converted to a common

measure so that systems can be compared.
Future cash flows are assigned to each alternative, consisting of the time-value of
money.

Decision Step : Qualitative and quantitative inputs and outputs to/from each system
form the basis for system comparison and decision making. Decisions among system
alternatives should be made on the basis of their differences. For a small number of
real world systems there will be complete knowledge. All facts/information and their
relationships, judgements and predictive behavior become a certainty. For most
systems, however, even after all of the data that can be bought to bear on it has been
considered, some areas of uncertainty are likely to remain. If a decision must be made,
these areas of uncertainty must be bridged by consideration of non-quantitative
data/information, such as common sense, judgement and so forth.

Decisions among system alternatives should be made on the basis of their differences.

For a small number of real world systems there will be complete knowledge. Dll
facts/information and their relationships, judgements and predictive behavior become
a certainty.

For most systems, however, even after all of the data that can be bought to bear on it
has been considered, some areas of uncertainty are likely to remain. If a decision must
be made, these areas of uncertainty must be bridged by consideration of non-
quantitative data/information, such as common sense, judgement and so forth.

Examples :

Infrastructure expenditure decision

Replace versus repair decisions

Selection of inspection method

Selection of a replacement for an equipment

FUNDAMENTAL ECONOMIC CONCEPTS

Economics deals with the behavior of people, and as such, economic concepts are
usually qualitative in nature, and not universal in application.

UTILITY

Utility is the power of a good or service to satisfy human needs.

VALUE

Designates the worth that a person attaches to an object or service.

Is a measure or appraisal of utility in some medium of exchange.

Is not the same as cost or price.

CONSUMER AND PRODUCER GOODS

Consumer goods : Consumer goods are the goods and services that directly satisfy
human wants. For example, TV, shoes, houses.

Producer goods : Producer goods are the goods and services that satisfy human wants
indirectly as a part of the production or construction process. For example, factory
equipment, industrial chemicals ands materials.

UTILITY OF GOODS
Consumer goods : Basic human needs of food, clothing and shelter. In commercial
advertisements, emphasis is given to senses not reasoning. The utility in this case is
considered objectively and/or subjectively.

Producer goods : The utility stems for their means to get to an end. The utility in this
case is considered objectively.

ECONOMY OF EXCHANGE

Occurs when utilities are exchanged by two or more people.

It is possible because consumer utilities are evaluated subjectively.

Represents mutual benefit in exchange.

Persuasion in exchange. Salesperson.

ECONOMY OF ORGANIZATION

Through organizations, ends can be attained or attained more economically by:

Labor saving

Efficiency in manufacturing or capital use

CLASSIFICATION OF COST

A key objective in engineering applications is the satisfaction of human needs, which

will nearly always imply a cost.

Economic analyses may be based on a number of cost classifications:

First (or Initial) Cost : Cost to get activity started such as property improvement,
transportation, installation, and initial expenditures.

Operation and Maintenance Cost : They are experienced continually over the usefull
life of the activity.

Fixed Cost : Fixed costs arise from making preparations for the future, and includes
costs associated with ongoing activities throughout the operational life-time of that
concern. Fixed costs are relatively constant; they are decoupled from the system
input/output, for example.

Variable Cost : Variable costs are related to the level of operational activity (e.g. the
cost of fuel for construction equipment will be a function of the number of days of
use).

Incremental or Marginal Cost : Incremental (or marginal) cost is the additional expense
that will be incurred from increased output in one or more system units (i.e.
production increase). It is determined from the variable cost.

Sunk Cost : It cannot be recovered or altered by future actions. Usually this cost is not
a part of engineering economic analysis.

Life-Cycle Cost : This is cost for the entire life-cycle of a product, and includes
feasibility, design, construction, operation and disposal costs.

SUPPLY AND DEMAND (not covered)

Demand curve shows the number of units people are willing to buy and cost per unit
(decreasing curve).

Supply curve shows the number of units that vendors will offer for sale and unit price
(increasing curve).

The intersection defines the exchange price.

Elasticity of demand. Price changes and their effect on demand changes. It depends on
whether the consumer product is a necessity or a luxury.
Law of diminishing return. A process can be improved at a rate with a diminishing
return. Example: cost of inspection to reduce cost of repair and lost production.

INTEREST RATE

Interest is a rental amount charged by financial institutions for the use of money.

Called also the rate of capital growth, it is the rate of gain received from an
investment.

It is expressed on an annual basis.

For the lender, it consists, for convenience, of (1) risk of loss, (2) administrative
expenses, and (3) profit or pure gain.

For the borrower, it is the cost of using a capital for immediately meeting his or her
needs.

TIME VALUE OF MONEY

The time-value of money is the relationship between interest and time. i.e.

[Time-Value of Money]

Figure 2 : Time-Value of Money

Money has time-value because the purchasing power of a dollar changes with time.

EARNING POWER OF MONEY

The earning power of money represents funds borrowed for the prospect of gain.
Often these funds will be exchanges for goods, services, or production tools, which in
turn can be employed to generate and economic gain.

PURCHASING POWER OF MONEY

The prices of goods and services can go upward or downward, and therefore, the
purchasing power of money can change with time.

Price Reductions : Caused by increases in productivity and availability of goods.

Price Increases : Caused by government policies, price support schemes, and deficit
financing.

EXAMPLE ECONOMIC STUDIES

Design and Economy

Elimination of overdesign should not be an objective.

Designing for economic production

Economy in the design of producer goods

Design for the economy of maintenance

Design for the economy of shipping

Economy of interchangeable design

Economy of Material Selection

Standardization and Simplification

Selection of Personnel

Range of human capacities

Range of human capacities

Economy of proficiency

Economy of specialization

Economy of dependability

Economy of Resource Input for Organizations

Tangible versus intangible inputs and their evaluations

Knowledge and Information

Tangible versus intangible inputs and their evaluations Qualitative versus quantitative

CASH FLOW DIAGRAMS

Cash flow diagrams are a means of visualizing (and simplifying) the flow of receipts and
disbursements (for the acquisition and operation of items in an enterprise).

The diagram convention is as follows:

Horizontal Axis : The horizontal axis is marked off in equal increments, one per period,
up to the duration of the project.

Revenues : Revenues (or receipts) are represented by upward pointing arrows.

Disbursements : Disbursements (or payments) are represented by downward pointing
arrows.

All disbursements and receipts (i.e. cash flows) are assumed to take place at the end
of the year in which they occur. This is known as the "end-of-year" convention.

Arrow lengths are approximately proportional to the magnitude of the cash flow.

Expenses incurred before time = 0 are sunk costs, and are not relevant to the problem.

Since there are two parties to every transaction, it is important to not that cash flow
directions in cash flow diagrams depend upon the point of view taken.

Example :

[Cash Flows]

Figure 3 : Typical Cash Flow Diagrams

Figure 3 shows cash flow diagrams for a transaction spanning five years. The transaction
begins with a $1000.00 loan. For years two, three and four, the borrower pays the
lender $120.00 interest. At year five, the borrower pays the lender $120.00 interest plus
the $1000.00 principal.

Cash Flow over Time : Upward arrow means positive flow, downward arrow means
negative flow. There are two cash flows to each problem (borrower and lender flows).

Net Cash Flow : The arithmetic sum of receipts (+) and disbursements (-) that occur at
the same point in time.
INTEREST FORMULAE

Interest formulae play a central role in the economic evaluation of engineering

alternatives.

TYPES OF INTEREST

Simple Interest : I = Pni.

P = Principal

i = Interest rate

n = Number of years (or periods)

I = Interestt.

Interest is due at the end of the time period. For fractions of a time period, multiply
the interest by the fraction.

Example : Suppose that $50,000 is borrowed at a simple interest rate of 8% per

annum. At the end of two years the interest owed would be:

I = $ 50,000 * 0.08 * 2

= $ 8,000

Compound Interest : The interest of the interest.

Example : A loan of $1,000 is made at an interest of 12% for 5 years. The interest is
due at the end of each year with the principal is due at the end of the fifth year. The
following table shows the resulting payment schedule:

Principal P = $1000.00

Interest Rate i = 0.12.

Number of years (or periods) n = 5.

================================================================

Amount at Interest at Owed amount at

Year start of year end of year end of year Payment

================================================================

1 $1000.00 $120.00 $1120.00 $120.00

2 $1000.00 $120.00 $1120.00 $120.00

3 $1000.00 $120.00 $1120.00 $120.00

4 $1000.00 $120.00 $1120.00 $120.00

5 $1000.00 $120.00 $1120.00 $120.00

Example : A loan of $1,000 is made at an interest of 12% for 5 years. The principal and
interest are due at the end of the fifth year. The following table shows the resulting
payment schedule:

Principal P = $1000.00

Interest Rate i = 0.12.

Number of years (or periods) n = 5.

================================================================

Amount at Interest at Owed amount at

Year start of year end of year end of year Payment

================================================================

1 $1000.00 $120.00 $1120.00 $0.00

2 $1120.00 $134.40 $1254.40 $0.00

3 $1254.40 $150.53 $1404.93 $0.00

4 $1404.93 $168.59 $1573.52 $0.00

5 $1573.52 $188.82 $1762.34 $1762.34

INTEREST FORMULAE (Discrete Compounding and Discrete Payments)

Notations:

i = The annual interest rate

n = The number of annual interest periods

P = A present principal sum

A = A single payment, in a series of n equal payments, made at the end

of each annual interest period

F = A future sum, n annual interest periods hence

Single-Payment Compound-Amount Factor

F = P.[1 + i]^n
Example 1 : Let the principal P = $1000, the interest rate i = 12%, and the number of
periods n = 4 years. The future sum is:

F = $1000 [1 + 0.12] ^ 4

= $1,573.5

[Single Payment]

Figure 4 : Cash Flow for Single Payment Compound Amount

Figure 4 shows the cash flow for the single present amount (i.e. P = 1000) and the
single future amount (i.e. F = $1,573.5).

Single-Payment Present-Worth Factor

P = =========

[1 + i]^n

The factor 1.0/[ 1 + i ]^n is known as the single-payment present-worth factor, and may
be used to find the present worth P of a future amount F.

Example 1 : Let the future sum F = $1000, interest rate i = 12%, and number of periods
n = 4 years. The single payment present-worth factor is:

F $1000.00

P = ========= = ============== = $635.50.

[1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $635.50.

Example 2 : Let the future sum F = $1,573.5, the interest rate i = 12%, and the number
of periods n = 4 years. The single payment present-worth factor is:

F $1573.50

P = ========= = ============== = $1000.00.

[1 + i]^n [ 1 + 0.12 ]^4

The present worth P = $1000.00.

Equal Payment-Series Compound Amount Factor

Some economic studies require the computation of a single factor value that would
accumulate from a series of payments occurring at the end of succeeding interest
periods.

[Compound Amounts]

Figure 5 : Schematic of Equal Payment-Series Compount Amounts

Figure 5 represents this scenario in graphical terms. At the end of Year 1 a payment of
$ A begins the accumulation of interest at rate i% for (n-1) years. At the end of Year 2
a payment of $ A begins the accumulation of interest at rate i% for (n-2) years. End of
year payments of $ A continue until Year N (or n as written below).

The total accumulatio of funds at Year N is simply the sum of $A payments multiplied
by the appropriate single-payment present-worth factors. In tabular format we have:

End of Compound Amount at Total

 Year the end of n Years Compound Amount

==========================================================

1 $ A . [ 1 + i ] ^ (n - 1)

2 $ A . [ 1 + i ] ^ (n - 2)

3 $ A . [ 1 + i ] ^ (n - 3)

n-1 $A.[1+i]

n $A

==========================================================

$F

==========================================================

The total compound amount is simply the sum of the compound amounts for years 1
though n. This sumation is a geometric series:

F = A + A.[1 + i] + A.[1+i]^2 + ..... + A.[1+i]^(n-1)

With a little bit of mathematical manipulation, it can be shown;

[ 1 + i ]^n - 1

F = A * ---------------

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1
 F = 100 * ------------------ = 477.9

0.12

Equal-Payment Series Sinking-Fund Factor

Given a future amount F, the equal payments compound-amount relationship is:

A = F * ---------------

[ 1 + i ]^n - 1

A = required end-of-year payments to accumulate a future amount F.

Example 1: Let F = 1000, i = 12%, and n = 4 years.

0.12

A = 1000 * ------------------ = 209.2

[ 1 + 0.12 ]^4 - 1

Equal-Payment-Series Capital-Recovery Factor

A deposit of amount P is made now at an interest rate i. The depositor wishes to

withdraw the principal plus earned interest in a series of year-end equal payments
over N years, such that when the last withdrawl is made there should be no funds left
in the account.

[Capital Recovery]
Figure 6 : Schematic of Equal-Payment-Series Capital Recovery

Figure 6 summarizes the flow of disbursements and receipts (from the depositors point
of view) for this scenario.

Equating the principle $P (plus accumulated interest) with the accumulation of equal
payments $A (plus appropriate interest) gives:

[ [ 1 + i ]^n - 1 ]

P [ 1 + i ]^n = A -------------------

which can be rearranging to give:

i * [ 1 + i ]^n

A = P * ---------------

[ 1 + i ]^n - 1

This is the case of loans (mortgages).

Example 1: Let P = 1000, i = 12%, and n = 4 years

0.12 * [ 1 + 0.12 ]^4

A = $1000 * --------------------- = $329.2

[ 1 + 0.12 ]^4 - 1

Equal-Payment-Series Present-Worth Factor

This can be described as

[ 1 + i ]^n - 1

P = A * ---------------

i * [ 1 + i ]^n

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1

P = 100 * --------------------- = 303.7

0.12 * [ 1 + 0.12 ]^4

Uniform Gradient-Series Factor

Often periodic payments do not occur in equal amounts, and may increase or
decrease by constant amounts (e.g. $100, $120, $140, $160 .... $200).

The gradient (G) is a value in the cash flow that starts with 0 at the end of year 1, G at
the end of year 2, 2G at the end of year 3, and so on to (n-1)G at the end of year n.

This can be described as

*- -*

| 1 n |

A = G . | - - --------------- |

| i [ 1 + i ]^n - 1 |
 *- -*

Example 1 : Let G = 100, i = 12%, and n = 4 years.

*- -*

| 1 4 |

A = $100 . | ---- - ------------------ | = $ 135.9

| 0.12 [ 1 + 0.12 ]^4 - 1 |

*- -*

DISCRETE AND CONTINUOUS COMPOUNDING (compounding frequency)

Nominal interest rate : is expressed on an annual basis. Financial institutions refer to

this rate as annual percentage rate (APR).

Effective interest rate : is an interest rate that is compounded using a time period less
than a year. The nominal interest rate in this case is the effective rate times the
number of compounding periods in a year. Then, it is referred to as nominal rate
compounded at the period less than a year.

Example : If the effective rate is 1% per month, it follows that the nominal rate is 12%
compounded monthly.

Relationship between the two rates. Let's define:

r = nominal interest rate per year

 i = effective interest rate in the time interval

l = length of the time interval (in years)

m = reciprocal of the length of the compounding period (in years)

Therefore, the effective interest rate for any time interval is given by:

*- -* ^ l*m

| r |

i = | 1 + --- | - 1.0

| m |

*- -*

Clearly if l*m = 1, then i is simply r/m.

The product l*m is called c = the number of compounding periods in the time interval
l. Note that c should be > 1.

Continuous compounding: The limiting case for the effective rate is when
compounding is performed an infinite times in a year, that is continuously. Using l = 1,
the following limit produces the continuously compounded interest rate

*- -* ^ m

| r |

i_a = Limit | 1 + --- | - 1.0

m->infinity | m |
 *- -*

resulting into and effective interest rate

i_a = e^r - 1

Example :

================================================================

Compounding Number of Effective interest Effective annual

frequency Periods rate per period interest rate

================================================================

Annually 1.0 18% 18.00%

Semiannually 2.0 9% 18.81$

Quarterly 4.0 4.5% 19.25%

Monthly 12.0 1.5% 19.56%

Weekly 52.0 0.3642% 19.68%

Daily 365.0 0.0493% 19.74%

Continuously infinity 0.0000% 19.72%

Interest Formulas (Continuous Compounding and Discrete Payments)

Interest Formulas (Continuous Compounding and Continuous Payments)

Handout. (Table)

ECONOMIC EQUIVALENCE INVOLVING INTEREST

Why? It is common in engineering to compare alternatives.

THE MEANING OF EQUIVALENCE

In engineering economy two things are said to be equivalent when they have the same
effect. Unlike most individual involved with personal finance, industrial decision
makers using engineering economics are not so much concerned with the timing of a
project's cash flows as with the profitability of that project. This means that
mechanisms are needed to compare projects involving receipts and disbursements
occurring at different times, with the goal of identifying an alternative having the
largest eventual profitability [Lindeberg82].

EQUIVALENCE CALCULATIONS INVOLVING A SINGLE FACTOR

The interest equations are affected by three factors: (a) amounts, (b) times of
occurrence of amounts, and (c) rate of interest.

Single-Payment Compound-Amount Factor

F = P.[1 + i]^n

Example 1 : Let P = $1000, i = ??, n = 4 years, and F = $1200. The interest rate is

F = $1200.00 = $1000.00 [1 + i ]^4

Rearranging terms in this equation gives i = 1.2^0.25 - 1 = 0.046635.

Example 2 : Let P = $1000, i = 10%, n = ?? years, and F = $1200.

F = $1200.00 = $1000.00 [1 + 0.10 ]^n

Rearranging terms in this equation gives n = 1.91 years.

Single-Payment Present-Worth Factor

P = ---------

[1 + i]^n

Example 1 : Let F = $1000, i = 12%, n = 4 years, and P = ?

$1000.00

P = ------------ = $635.5

[1 + 0.12]^4

Equal-Payment-Series Compound-Amount Factor

[ 1 + i ]^n - 1

F = A * ---------------

The derivation of this formula can be found on page 46 of the economics text.
Example 1 : Let A = $100.00, i = 10%, and F = $1000.00. How many years n are
needed ?

[ 1 + 0.12 ]^n - 1

$1000.00 = $100.00 * ------------------

0.12

Rearranging the terms in this equation gives n = 7.27 years.

Equal-Payment-Series Sinking-Fund Factor

A = F * ---------------

[ 1 + i ]^n - 1

Example 1 : Paying towards a future amount. Let F = $1000.00, i = 12%, and n = 4

years. What is A ?

0.12

A = $1000.00 * ------------------ = $209.20

[ 1 + 0.12 ]^4 - 1

Equal-Payment-Series Capital-Recovery Factor

i * [ 1 + i ]^n

A = P * ---------------

[ 1 + i ]^n - 1

Example 1 : Paying back a loan. Let P = $1000, i = 12%, n = 4 years, and A = ?

 0.12 * [ 1 + 0.12 ]^4

A = 1000 * --------------------- = 329.2

[ 1 + 0.12 ]^4 - 1

Equal-Payment-Series Present-Worth Factor

[ 1 + i ]^n - 1

P = A * ---------------

i * [ 1 + i ]^n

Example 1 : Let A = 100, i = 10%, and n = 8 years.

[ 1 + 0.10 ]^8 - 1

P = 100 * ---------------------- = 533.49

0.10 * [ 1 + 0.10 ]^8

Uniform Gradient-Series Factor

As explained above, the gradient (G) is a value in the cash flow that starts with 0 at the
end of year 1, G at the end of year 2, 2G at the end of year 3, and so on to (n-1)G at
the end of year n.

This can be described as

*- -*

| 1 n |

A = G . | - - --------------- |
 | i [ 1 + i ]^n - 1 |

*- -*

Example 1 : Let G = 100, i = 12%, n = 4 years, and A = ??

*- -*

| 1 4 |

A = 100.| ---- - ------------------ | = 135.9.

| 0.12 [ 1 + 0.12 ]^4 - 1 |

*- -*

EQUIVALENCE CALCULATIONS INVOLVING CASH FLOW

Two cash flows need to be presented along the same time period using a similar
format to facilitate comparison.

When interest is earned, monetary amounts can be directly added only if they occur
at the same point in time.

EQUIVALENCE BETWEEN CASH FLOWS

Equivalent cash flows are those that have the same value.

Example : Two equivalent cash flows.

 Cash Flow 1 Cash Flow 2

=====================================================

P = $1000.00 P = $0.00

i = 12% i = 12%

n = 4 years n = 4 years

F = $0.00 F = $$1000*[1+0.12]^4 = $1,573.50

The equivalence can be established at any point in time. Arbitrarily setting n = 8 years,
for example, gives:

For cash flow 1 : F = $1000.0 * [1 + 0.12]^8 = $2475.96

For cash flow 2 : F = $1573.5 * [1 + 0.12]^4 = $2475.96

Note : Two or more distinct cash flows are equivalent if they are equivalent to the
same cash flow.

EQUIVALENCE FOR DIFFERENT INTEREST RATES

Example 1 : Given the following cash flow:

===================================================

Interest rate applicable

from previous year (t-1)

Year End Amount to current year end (t)

===================================================
 0 $0.00 NA

1 $200.00 12% compounded quarterly

2 $0.00 12% compounded quarterly

3 $100.00 7% compounded annually

4 $100.00 10% compounded annually

5 $100.00 10% compounded annually

The above cash flow can be converted to its present value as follows:

Assuming the following cash flow:

===================================================

Time (Year End) Receipts Disbursements

===================================================

0 $0.00 -$1000.00

1 $0.00 -$500.00

2 $482.00 $0.00

3 $482.00 $0.00

4 $482.00 $0.00

5 $0.00 -$250.00

6 $482.00 $0.00

7 $482.00 $0.00

In this case, equivalence states that the actual interest rate earned on an investment is
the one that sets the equivalent receipts to the equivalent disbursements.
For the above table, the following equality can be set:

$1000 + $500.00 (P/F,i,1) + $250(P/F,i,5) =

$482(P/A,i,3)(P/F,I,1) + $482.00 (P/A,i,2)(P/F,i,5)

By trial and error i = 10% will make the above equation valid. The equivalence can be
made at any point of reference in time, it does not need to be the origin (time = zero)
to produce the same answer.

If the receipts and disbursement of cash flow are equivalent for some inter= est rate,
the cash flows of any equivalent portion of the investment are eq= ual at that interest
rate to the negative (-) of the equivalent amount of t= he cash flows that constitute
the remaining portion on the investment.

For example, break-up the above cash flow between year 4 and 5. Perform th= e
equivalence at the 4th year produces the following:

-1000(F/P,10,4)-500(F/P10,3)+482(F/A,10,3) = -(-250(P/F,10,1)+482(P/A,10,2)(P/F,10,1))

-1000(1.464)-500(1.331)+482(3.310) = -$(-250(0.9091)+482(1.7355)(0.9091))

-$534 = -$534

EQUIVALENCE CALCULATIONS WITH MORE FREQUENT COMPOUNDS

Compounding and Payment Periods Coincide

Assume for example that

Interest = 10% compounded semiannually => 5% per semiannual period

Payments are done semiannually for three years => 3(2) = 6 periods

The calculations from here on are the same as before.

Compounding More Frequent than Payments

Calculations based on the compounding period:

Example 1 : Payments = 100 at year end for three years; Interest = 6% per year
compounded quarterly.

i = 6/4 = 1.25%

F = $100 (F/P,1.25,8) + $100 (F/P,1.25,4) + $100

= $318.8

Effective interest rate for l = 1 year,

*- -*^l *- -*^4

| r | | 6 |

i = | 1 + --- | - 1 = | 1 + --- | - 1 = 6.14%

| m | | 4 |

*- -* *- -*

The solution of the previous example is

 F = $100 (F/A,6.14,3) = $318.80

Example 2 : Assume that end of month payments = 100 with interest of 15%
continuous compounding. What is the accumulated amount after 5 years ? The
number of periods =12*5 = 60 years. The interest per month is 1/12= 1.25%. Then,

*- -* *- -*

| e^(rn) - 1 | | e^0.0125*60 - 1 |

F = A | ---------- | = $100.00 * | --------------- | = $8,865

| e^r -1 | | e^0.0125 - 1 |

*- -* *- -*

Compounding Less Frequent than Payments

Usually no interest is paid for funds deposited during an interest period. In this case,
funds earn interest after completing the next interest period.

BOND PRICES AND INTEREST

Suppose you can buy a bond for $900 that has a face value of $1000 with 6% annual
interest that is paid semiannually. The bond matures in 7 years. The yield to maturity
is defied as the rate of return on the investment for its duration. Using equivalence,
the following expression can be developed:

$900 = $30 (P/A,i,14) + $1000 (P/F,i,14)

By trial and error, it can be determined that i = 3.94% per semiannual period.

The nominal rate is 2(3.94) = 7.88%.

The effective rate is 8.04%.

The bond market.

EQUIVALENCE CALCULATIONS FOR LOANS

The effective interest rate for a loan is defines as the rate that sets the= receipts equal
to the disbursements on an equivalent basis.

REMAINING BALANCE OF A LOAN

Suppose a five-year loan of $10,000 (with interest of 16% compounded quarterly with
quarterly payments) is to be paid off after the 13th payment. What is the balance?

The quarterly payment is

$10,000 (A/P,4,20) = $10.000 (0.0736) = $736.00

The balance can be based on the remaining payments as

$736 (P/A,4,7) = $736 * (6.0021) = $4418.

PRINCIPAL AND INTEREST PAYMENTS

Consider the case of a loan with fixed rate and constant payment A. Define the
following:
 I_t = Interest payment of A at time t.

B_t = Portion of payment of A to reduce balance at time t.

A = I_t + B_t for t = 1, 2, .... n

The balance at end of (t-1) is given by => A(P/A,i,n-(t-1)).

Therefore,

I_t = A(P/A,i,n-(t-1))(i)

B_t = A - I_t

= A[1-(P/A,i,n-(t-1))(i)]

Since

P/F,i,n = 1 - (P/A,i,n)(i) => B_t = A(P/F,i,n-t+1)

Example : For P = $1000.00 (loan), n = 4, and i = 15%, the following table can be
constructed:

The payment is A = $1000(A/P,15,4) = $1000(0.3503) = $350.30

===============================================================

Year Loan Interest

End Payment Payment on Principal Payment

===============================================================

1 $350.30 $350.30(P/F,15,4) = $200.30 $150.00

 2 $350.30 $230.32 $119.98

3 $350.30 $264.90 $85.40

4 $350.30 $304.62 $45.68

TOTAL $1401.12 $1000.14 $401.06

ECONOMIC EQUIVALENCE INVOLVING INFLATION

MEASURE OF INFLATION AND DEFLATION

The price index is the ratio between the current price of a commodity or service to the
price at some earlier reference time. For example, the base year is 1967 (index =100),
and the commodity price is $1.46/lb.

The price in 1993 is $5.74/lb.

Therefore, the 1993 index is 5.74/1.4 = 393.2

Note : Actual Consumer price index (CPI) and annual inflation rates for 1965 are shown
in Table 5.1 of the Economics Text.

ANNUAL INFLATION RATE

The annual inflation rate at t+1 can be computed as

CPI(t+1) - CPI(t)

-----------------

CPI(t)
Assume the average inflation rate = f. The average rate can be computed as

CPI(t) [ 1 + f ] ^ n = CPI(t+n)

Example : Let the CPI(1966) = 97.2 and the CPI(1980) = 246.80. The average rate of
inflation over the 14 year interval is:

*- -* ^ (1/14)

| 246.80 |

f = | -------- | - 1.0 = 6.88% per year.

| 97.2 |

*- -*

PURCHASING POWER OF MONEY

Purchasing power at time t in reference to time t-n is

CPI(t-n)

--------

CPI(t)

Now let's define k = annual rate of loss in purchasing power. Therefore the average
rate of loss of purchasing power is

CPI(t+n) [ 1 - k] ^ n = CPI(t)

It follows that
 1

[ 1 + f ]^n = -----------

[ 1 - k ]^n

This equation relates the average f inflation rate to k, the annumal rate of loss in
purchasing power.

CONSTANT DOLLARS

By definition

Constant dollars = ------------ (actual dollars)

[ 1 + f] ^ n

When using actual dollars, use the market interest rate (i).

When using constant dollars, use the inflation-free interest rate (i*), defined as

For one year

1+i

i* = ----- - 1

1+f
For several years

1+i

i* = ----------- - 1

[ 1 + f ]^n

CURRENCY EXCHANGE

Add notes later ......

ECONOMIC ANALYSIS OF ALTERNATIVES

NET CASH FLOW OF INVESTMENT OPPORTUNITIES

Payments and disbursements need to be determined. Then a net cash flow can be
developed.

PRESENT-WORTH AMOUNT

It is the difference between the equivalent receipts and disbursements at the present.

Assume F_t is a cash flow at time t, the present worth (PW) is

t=n
 PW(i) = sum F(t) * [ 1 + i ] ^ -t

t=0

for any interest -1 < i < infinity.

ANNUAL EQUIVALENT AMOUNT

The annual equivalent amount is the annual equivalent receipts minus the annual
equivalent disbursements of a cash flow. It is used for repeated cash flows per year.

AE (i) = PW (i) * (A/P,i,n)

*- -* *- -*

|t=n | | i(1+i)^n |

= | sum F(t) * [ 1 + i ] ^ -t | * | ------------- |

|t=0 | | (1+i)^n - 1 |

*- -* *- -*

Example : Given the following cash flow:

=======================================

Year end Receipts Disbursements

=======================================

0 $0.00 -$1000.00

1 $400.00 $0.00
 2 $900.00 -$1000.00

3 $400.00 ....

4 $900.00 -$1000.00

... ....... ....

n-2 $900.00 -$1000.00

n-1 $400.00 $0.00

n $900.00 $0.00

Therefore,

AE(10) = [-1000+400(P/F,10,1)+900(P/F,10,2)](A/P,10,2)

for 10%, or

AE(10) = [-$1000+400(0.9091)+900(0.8265)](0.5762)

= $61.93

FUTURE WORTH AMOUNT

It is the difference between the equivalent receipts and disbursements at s ome

common point in the future.

t=n

FW (i) = Sum F_t * [ 1 + i ]^[ n - t ]

t=o
for any interest rate -1 < i < infinity.

PW, AE, and FW differ in the point of time used to compare the equivalent amounts.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the interest rate that causes the equi= valent
receipts of a cash flow to be equal to the equivalent disbursements = of the cash flow.
Solve for i* such that

t=n

0 = PW(i*) = sum F(t) * [ 1 + i* ] ^ -t

t=0

Example : Given the following cash flow:

=======================================

Year end Receipts Disbursements

=======================================

0 $0.00 -$1000.00

1 $0.00 -$800.00

2 $500.00 $0.00

3 $500.00 $0.00

4 $500.00 $0.00
 5 $1200.00 $0.00

By trial and error i = 12.8 %.

MEANING OF IRR

It represents the rate of return on the unrecovered balance of an investment (or loan).
The following equation can be developed for loans:

U_t = U_(t-1) * [ 1 + i^* ] + F_t

where

U_o = Initial amount of loan or first cost of asset (F_o),

F_t = Amount received at the end of period t.

i^* = IRR.

It should be noted that the basic equation for i^* requires the solution of the roots of
a nonlinear (polynomial) function. Therefore, more than one root might exist. The
following conditions results in one root (single i*):

F_o =< 0 (the first nonzero cash flow is a disbursement).

One change in sign in the cash flow (from disbursements to receipts).

PW(0) >0 (the sum of all receipts is greater than the sum of all disbursements).

In case of multiple IRR, other methods can be used.

PAYBACK PERIOD

Without Interest : The payback period without interest is the length of time required to
recover the first cost of an investment from the cash flow produced by the investment
for an interest rate of zero. It can be computer as the smallest n that produces

t=n

Sum [ F_t > 0 ]

t=o

With Interest : The payback period with interest is the length of time required to
recover the first cost of an investment from the cash flow produced by the investment
for a given interest rate. It can be computer as the smallest n that produces

t=n

Sum F_t * [1 + i]^[-t] >= 0

t=o