Engineering Economy Fundamentals

Engr. Elisa G. Eleazar

School of Chemical, Biological, and Materials Engineering and Sciences

CH040: ENGINEERING ECONOMY 1

 Outline
Module 1.1: ENGINEERING ECONOMY FUNDAMENTALS
Engineering Economy
Engineering Economic Analyses
Interest Rate and Rate of Return
Terminology, Symbols and Diagrams
Economic Equivalence
Simple and Compound Interest
Minimum Attractive Rate of Return
Introduction to Spreadsheet Use
CH040: ENGINEERING ECONOMY
Learning Outcomes
1. Define engineering economy and the time value of money
concept
2. Understand and identify the steps in an engineering
economic study
3. Perform calculations involving interest rates and rates of
return
4. Identify and use engineering economic terminology and
symbols
5. Understand cash flows and graphically represent them
6. Describe and calculate economic equivalence
7. Calculate simple and compound interest amounts
8. Explain the Minimum Attractive Rate of Return and
opportunity costs
9. Identify some MS Excel® functions commonly used in
engineering economy
2
 Engineering Economy
the systematic evaluation of the economic merits of proposed solutions to engineering problems

involves the formulation, estimation and evaluation of expected economic outcomes of alternatives designed to accomplish
a defined purpose

Elements of the estimates and decisions in Engineering Economy Measures of Worth Used in Engineering Economy
• Cash flows • Present Worth • Benefit / Cost
• Times of occurrence of cash flows • Future Worth • Payback Period
• Interest rates for time value of money • Annual Worth • Profitability Index
• Measure of worth for selecting an alternative • Capitalized Cost • Economic Value Added
• Rate of Return
Time Value of Money Concept
Money makes money.

CH040: ENGINEERING ECONOMY 3

 Engineering Economic Analyses
Steps in an Engineering Economic Analysis

Problem Description Alternatives Cash Flows

Identify and understand the Collect relevant, available data and

Make realistic cash flow estimates.
problem. define viable solution alternatives.

Best Alternative Selection Engineering Economic Analysis Measure of Worth Criterion

Evaluate each alternative; consider Identify an economic measure of

Select the best alternative. noneconomic factors; use worth criterion for decision
sensitivity analysis as needed. making.

Implementation and Monitoring

Implement the solution and

monitor the results.

CH040: ENGINEERING ECONOMY 4

 Engineering Economic Analyses
Principles of Engineering Economic Analyses

1. Money has a time value.

2. Make investments that are economically justified.
3. Choose the mutually exclusive investment alternative that maximizes economic worth.
4. Two investment alternatives are equivalent if they have the same economic worth.
5. Marginal revenue must exceed marginal cost.
6. Continue to invest as long as each additional increment of investment yields a return that is greater than the
investor’s time value of money.
7. Consider only differences in cash flows among investment alternatives.
8. Compare investment alternatives over a common period of time.
9. Risks and returns tend to be positively correlated.
10. Past costs are irrelevant in engineering economic analyses, unless they impact future costs.

CH040: ENGINEERING ECONOMY 5

 Interest Rate and Rate of Return
Interest manifestation of the time value of money
difference between an initial and final amount of money

Loan Investment

Repayment Repayment
+ Interest + Interest
Bank Borrower Investor Corporation

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑤𝑒𝑑 𝑛𝑜𝑤 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 % = ∗ 100
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑛𝑜𝑤 − 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 % = ∗ 100
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

CH040: ENGINEERING ECONOMY 6

 Interest Rate and Rate of Return
SP1. An employee at LaserKinetics.com borrows $10,000 on May 1 and must repay a total of $10,700 exactly one year later.
Determine the interest amount and the interest rate paid.

$10,000 interest = 10,700 −10,000

interest = $700
$10,700
700
interest rate = ∗ 100
Bank Borrower 10,000
interest rate = 7%

CH040: ENGINEERING ECONOMY 7

 Interest Rate and Rate of Return
SP2. Calculate the amount invested 1 year ago to have $1,000 now at an interest rate of 5% per year. Calculate the amount
of interest earned during this time period.

interest = total amount now − principal

?

let P – principal
$1,000 i – interest rate

P = 1,000 −Pi = 1,000 − P (0.05)

Investor Corporation
1.05P = 1,000
P = $952.4

interest = 1,000 − 952.4

interest = $47.6

CH040: ENGINEERING ECONOMY 8

 Interest Rate and Rate of Return
Inflation represents a decrease in the value of a given currency

Effects of Inflation
• a reduction in purchasing power of the currency
• an increase in the consumer price index
• an increase in the cost of equipment and its maintenance
• an increase in the cost of salaried professionals and hourly employees
• a reduction in the real rate of return on personal savings and certain corporate investments

CH040: ENGINEERING ECONOMY 9

 Terminology, Symbols and Diagrams
Value or amount of money at time designated Cash Inflows
P
as Present
all types of receipts, including sales, revenues, incomes, money
Value or amount of money at time designated from a loan when received from the lender, and savings
F generated by projects and business activities
as Future

Series of consecutive, equal amounts of

A Cash Outflows
money
all types of costs, including disbursements, expenses, deposits
n Number of interest periods into retirement or savings accounts, loan repayments, and taxes
caused by projects and business activities
i Interest rate per time period

t Time 𝑁𝐶𝐹 = 𝑅 − 𝐷

NCF Net Cash Flow

R Receipts
D Disbursements

CH040: ENGINEERING ECONOMY 10

 Terminology, Symbols and Diagrams
Cash Flow Diagram End-of-Period Convention
graphical representation of cash flows drawn on the y- assumes that all cash flows take place at the end of the
axis with a time scale on the x-axis interest period

P F
Year 1 Year 5
i
0 1 2 3 4 5 N=5 0 1 2 3 4 5

CH040: ENGINEERING ECONOMY 11

 Terminology, Symbols and Diagrams
SP3. 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-
SP4. An electrical engineer wants to deposit an amount P
now such that she can withdraw an equal annual
amount of A1 = $2,000 per year for the first 5 years,
starting 1 year after the deposit, and a different
annual withdrawal of A2 = $3,000 per year for the
following 3 years. How would the cash flow diagram
appear if i = 8.5% per year?
A2 = $3,000

related funds of 12% per year.

A1 = $2,000
i = 12%
4
1 2 3 4 5 6 7 8
i = 8.5%
$1M $1M $1M $1M $1M
A P

F
CH040: ENGINEERING ECONOMY 12
 Terminology, Symbols and Diagrams
SP5. A rental company spent $2,500 on a new air compressor 7 years ago. The annual rental income from the compressor
has been $750. The $100 spent on maintenance the first year has increased each year by $25. The company plans to
sell the compressor at the end of next year for $150. Construct the cash flow diagram from the company’s perspective.

$ 650
$ 625 $ 625
$ 600
$ 575
$ 550
$ 525
$ 500

-7 -6 -5 -4 -3 -2 -1 0 1

$ 2,500

CH040: ENGINEERING ECONOMY 13

 Economic Equivalence
Economic Equivalence
combination of interest rate and time value of money to determine the different
amounts of money at different points in time that are equal in economic value

Illustrative Example
$ 105
$ 100 100 + (100)(0.05)
$ 95.2
100 / 1.05

i=5%
-1 0 1

CH040: ENGINEERING ECONOMY 14

 Economic Equivalence
SP6. Manufacturers make backup batteries for computer systems available to Batteries+Bulbs dealers through privately
owned distributorships. In general, batteries are stored throughout the year, and a 5% cost increase is added each
year to cover the inventory carrying charge for the distributorship owner. Assume you own the City Center
Batteries+Bulbs outlet. Make the calculations necessary to show which of the following statements are true and
which are false about battery costs.
a. The amount of $98 now is equivalent to a cost of $105.60 one year from now.
b. A truck battery cost of $200 one year ago is equivalent to $205 now.

a. The amount of $98 now is equivalent to a cost of $105.60 b. A truck battery cost of $200 one year ago is equivalent to
one year from now. $205 now.
F = 98 1 + 0.05 $ 205
P = 205 −P(0.05)
P?
$ 98 F?
F = $102.9 P = $195.24
i = 0.05 False False
-1 0
0 1

CH040: ENGINEERING ECONOMY 15

 Simple and Compound Interest
Simple Interest
the total interest earned or charged is linearly proportional to the initial 𝐼 = 𝑃𝑁𝑖
amount of the loan, the interest rate and the number of interest periods
I Simple interest
SP7. GreenTree Financing lent an engineering company $100,000 to retrofit P Principal amount
an environmentally unfriendly building. The loan is for 3 years at 10%
N Number of interest periods
per year simple interest. How much money will the firm repay at the
end of 3 years? i Interest rate

$ 100,000
Period ABP I AEP
i = 10% 1 100,000 10,000 110,000
0 1 2 3 2 110,000 10,000 120,000
3 120,000 10,000 130,000
F?
I = 100,000 0.10 = 10,000
AEP = 100,000 + 10,000 = 110,000 F = $130,000

CH040: ENGINEERING ECONOMY 16

 Simple and Compound Interest
Compound Interest 𝑗=𝑡−1

the interest accrued for each interest period is calculated on top of interest 𝐼𝑡 = 𝑃 + 𝐼𝑗
accumulated in all previous periods 𝑗=1

SP8. Rework SP7 using compound interest. How much money will the firm repay at the end of 3 years?

$ 100,000
Period ABP I AEP
i = 10% 1 100,000 10,000 110,000
𝐹 =𝑃 1+𝑖 𝑁
0 1 2 3 2 110,000 11,000 121,000
3 121,000 12,100 133,100
F?
I1 = 100,000 0.10 = 10,000 I3 = 121,000 0.10 = 12,100
AEP1 = 100,000 + 10,000 = 110,000 AEP3 = 121,000 + 12,100 = 133,100

I2 = 110,000 0.10 = 11,000 F = $133,100

AEP2 = 110,000 + 11,000 = 121,000

CH040: ENGINEERING ECONOMY 17

 Minimum Attractive Rate of Return
Minimum Attractive Rate of Return (MARR)
a reasonable rate of return established for the evaluation and selection of alternatives
also referred to as the hurdle rate, cutoff rate, benchmark rate and minimum acceptable rate of return

Sources of Capital
Equity Financing: the corporation uses its own funds (cash on hand, stock sales, retained earnings)
Debt Financing: the corporation borrows from outside sources and repays the principal and interest (loans, bonds)

Weighed Average Cost of Capital (WACC)

used for combinations of debt and equity funding
ROR > MARR > WACC

CH040: ENGINEERING ECONOMY 18

 Minimum Attractive Rate of Return
Opportunity Cost
the rate of return of a forgone opportunity caused by the
inability to pursue a project
the largest rate of return of all the projects not accepted due
to the lack of capital funds or other resources

CH040: ENGINEERING ECONOMY 19

 Introduction to Spreadsheet Use
Cash Flows

SP10. A Japan-based architectural firm has asked a United States-based software engineering group to infuse GPS
sensing capability via satellite into monitoring software for high-rise structures in order to detect greater than
expected horizontal movements. This software could be very beneficial as an advance warning of serious tremors in
earthquake-prone areas in Japan and the United States. The inclusion of accurate GPS data is estimated to increase
annual revenue over that of the current software system by $200,000 for each of the next 2 years, and by $300,000,
for each of years 3 and 4. The planning horizon is only 4 years due to the rapid advances made internationally in
building-monitoring software. Develop spreadsheets to answer the following questions:
a. Determine the total interest and total revenue after 4 years, using a compound rate of return of 8% per year.
b. Repeat (a) if inflation is estimated to be 4% per year. This will decrease the real rate of return from 8% to 3.8%
per year.

$ 300,000 $ 300,000

$ 200,000 $ 200,000

i = 8%

0 1 2 3 4

CH040: ENGINEERING ECONOMY 20

 Introduction to Spreadsheet Use
$ 300,000 $ 300,000

$ 200,000 $ 200,000

i = 8%

0 1 2 3 4

CH040: ENGINEERING ECONOMY 21

 Introduction to Spreadsheet Use
$ 300,000 $ 300,000

$ 200,000 $ 200,000

i = 8%

0 1 2 3 4

CH040: ENGINEERING ECONOMY 22

 Introduction to Spreadsheet Use
MS Excel® Functions for Fundamental Engineering Economy Calculations

• To find the Present Value • To find the Number of Periods

P 𝑃𝑉 𝑖%, 𝑛, 𝐴, 𝐹 N 𝑁𝑃𝐸𝑅 𝑖%, 𝐴, 𝑃, 𝐹

• To find the Future Value • To find the Compound Interest Rate

F 𝐹𝑉 𝑖%, 𝑛, 𝐴, 𝑃 i 𝑃𝑉 𝑖%, 𝑛, 𝐴, 𝐹

• To find the Equal, Periodic Value • To find the Compound Interest Rate of any Series
A 𝑃𝑀𝑇 𝑖%, 𝑛, 𝑃, 𝐹 i 𝐼𝑅𝑅 𝑓𝑖𝑟𝑠𝑡_𝑐𝑒𝑙𝑙 ∶ 𝑠𝑒𝑐𝑜𝑛𝑑_𝑐𝑒𝑙𝑙

• To find the Present Value of any Series

P 𝑁𝑃𝑉 𝑖%, 𝑠𝑒𝑐𝑜𝑛𝑑 _𝑐𝑒𝑙𝑙 ∶ 𝑙𝑎𝑠𝑡_𝑐𝑒𝑙𝑙 + 𝑓𝑖𝑟𝑠𝑡_𝑐𝑒𝑙𝑙

CH040: ENGINEERING ECONOMY 23

 Outline
Module 1.1: ENGINEERING ECONOMY FUNDAMENTALS
Engineering Economy
Engineering Economic Analyses
Interest Rate and Rate of Return
Terminology, Symbols and Diagrams
Economic Equivalence
Simple and Compound Interest
Minimum Attractive Rate of Return
Introduction to Spreadsheet Use
CH040: ENGINEERING ECONOMY
Learning Outcomes
1. Define engineering economy and the time value of money
concept
2. Understand and identify the steps in an engineering
economic study
3. Perform calculations involving interest rates and rates of
return
4. Identify and use engineering economic terminology and
symbols
5. Understand cash flows and graphically represent them
6. Describe and calculate economic equivalence
7. Calculate simple and compound interest amounts
8. Explain the Minimum Attractive Rate of Return and
opportunity costs
9. Identify some MS Excel® functions commonly used in
engineering economy
24
 Engineering Economy Fundamentals

Engr. Elisa G. Eleazar

School of Chemical, Biological, and Materials Engineering and Sciences

CH040: ENGINEERING ECONOMY 25