CE482

Construction
Management
Introduction to Engineering
Economics
What is Engineering
Economics?
Why study Engineering Economics?

○ Resources are limited

• Money, Time, Labour

○ A question of choice and allocation

Some common questions for engineers and life…
Which of these structural designs should I Which t-shirt/laptop should I choose?
choose?

Should I replace the equipment now or wait? Laptop / Mobile phone

Which project should I invest my money ? Should I spend time studying civil engineering
courses or programming or finance (CFA…)?

Should I take a conservative course of action of How about starting up a company or taking up a
follow a riskier one that offers higher potential job?
gains in a project?

Two important steps in decision making situations:

1. Identify alternative uses for limited resources and obtain appropriate data
2. Analyze the data to determine the preferred alternative.
Concepts and tools to aid in decision making

○ Time value of money

• Interests and equivalence This class

○ Analysis of alternatives
• Present worth Comparisons
• Rate of Return Calculations

○ Replacement Analysis
○ Sensitivity Analysis
○ Break-Even Analysis
○ Risk Analysis
○ Decision Trees
CE482

Construction
Management
Time Value of Money
Time Value of Money
Fundamentals – 4 principle concepts
You do not get money for free…
Do you?
The world of loans…

○ How many of you took an education loan?

○ How many of have some savings in bank?
○ How many of your parents have home loans, car loans?

Did you hear the word “Interest”?

#1. Interest
What is interest?
What is interest?

○ Interest = Amount accumulated – Original Investment

○ Interest = Present Amount Owed – Original Loan

Why should you or I pay interest?

Interest

○ The rent paid for the use of money.

○ When borrowed, owners expect some compensation for the inconvenience
caused.
Interest Rate

𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑
○ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 100 ×
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡

○ Simple interest vs Compound Interest

○ Example #0:
Find the interest paid on Rs. 1000 @ 10% per annum after 2 years? (using SI and CI)
Amounts to be paid
Some factors affecting interest rate

○ Risk associated with borrower

○ Availability of funds
○ Government laws
○ Etc… etc…
Today or Tomorrow?
A simple example

○ You have Rs. 1000 today, you bury I in your backyard and dig it after an year. Did you actually do
anything good by doing this?

○ A) What would have happened if you deposited the money in a bank which pays you 10% interest per
annum?

○ B) What amount now would be equivalent to Rs. 1000 after an year at 10% interest per annum?

Answer to A) Rs. 1100, B) Rs. 909.09.

So by burying the amount did you lose Rs. 100 or Rs. 90.91?
#2. Equivalence
Which one is better at 12% interest rate?

○ Invest Rs. 2610 for the first 6 years and withdraw the total amount after 40
years.

○ Do not invest for the first 6 years and then invest 2600 per year for the next 34
years and withdraw the total amount after 40 years.

○ Both are equivalent to Rs. 10,00,000!

○ Investments double every 72/(interest rate) years.

Fact for your life: Start investing at a young age

The story of credit
cards…
○ Interest rates are normally quoted on annual basis

○ However there can be interest on monthly, quarterly etc.

○ e.g. Credit cards have monthly interest rates.

○ One bank charges 3.40% per month on outstanding amount not paid within 40 days.

○ So the interest charged per year is?

#3. Nominal and
Effective interest
rates
Nominal interest rates

○ 3.40 * 12 = 40.8% compounded monthly

○ 40.8% is the nominal annual interest rate.

Effective interest rate
○ What rate per annum can replace the nominal interest rates in the case of credit
card example?

𝑟 𝑚
𝐴=𝑃× 1+
𝑚

𝐴 = 𝑃 × (1 + 𝑖)

𝑟 𝑚
=> 𝑖 = 1 + −1
𝑚
Effective interest rates

○ How about continuous compounding rates?

𝑟 𝑚
𝑖 = lim 1 + −1
𝑚→∞ 𝑛

𝑚 𝑟
𝑟 𝑟
𝑖 = lim 1+ −1
𝑚→∞ 𝑚

𝑖 = 𝑒𝑟 − 1
A picture is “equivalent” to a thousand
words
#4. Cash flow diagrams
Cash Flow Diagram

○ A graphical representation of the incoming cash (revenue) or outgoing cash

(expenditure) on a time line.
○ 2 parts
• A horizontal timeline
• Vertical cash flow lines.

P= 1000 I = 8%
N=1
year
0 1

P= 1080
Cash Flow Diagram

○ Length not to scale

• Usually large amounts means long arrows

○ My Convention
• Upward arrow – cash flow into the project
• Downward arrow – cash flow out of the project
30
Construct a cash flow diagram
1. You borrow Rs. 5000 today and want to find out how much you should repay
after 5 years at a rate of 12% per annum?

2. What should you deposit 2 years from now to withdraw Rs. 400 per year for 5
years starting 3 years from now @ 15%
A simple example - Revisited
○ You have Rs. 1000 today, you bury I in your backyard and dig it after an year. Did you actually do
anything good by doing this?
○ A) What would have happened if you deposited the money in a bank which pays you 10% interest per
annum?
○ B) What amount now would be equivalent to Rs. 1000 after an year at 10% interest per annum?
Key terms in Cash flow diagrams

○ P = Value of money at present time

○ F = Value of money at future time

○ A = series of equal end-of-year amounts of money

○ n = number of interest periods

○ i = interest rate per interest period

○ BOY = Beginning of year

○ EOY = End of year

Interest Factor Tables

34
Interest factor tables - Example

35
Single Payment – Compound Amount Factor (CAF)

○ What is the equivalent amount for Rs. 1 after n compounding periods when
compounded at i % per compounding period?

○ (F/P,i,n)

F
P i%,
n
0 n
Present Worth Factor (PWF) - Single Payment

○ (P/F,i,n)

P i%, F
n
0 n
CAF - uniform series

○ (A/F,i,n)

i%, n
0 1
n
PWF – Uniform Series

○ (P/A, i, n)

i%, n
0
n
Sinking Fund Factor – Uniform series

i%, n
0
n
Capital Recovery Factor – uniform series

i%, n
0
n
Gradient Uniform Series

○ (A/G,i,n)
Gradient Present Worth

○ (P/G, i, n)
Using Interest tables

Factor Symbol
Present-Worth Factor (single payment) (P/F, i, n)
Sinking fund factor (uniform series) (A/F, i, n)
Series compound factor (uniform series) (F/A, i, n)
Capital recovery factor (uniform series) (A/P, i, n)
Series present worth factor (uniform series) (P/A, i, n)
Arithmetic gradient conversion factor (to (A/G, i, n)
uniform series)
Gradient present worth factor (P/G, i, n)
Example #0
1. You borrow Rs. 5000 today and want to find out how much you should repay after 5 years at a rate of
12% per annum?

2. What should you deposit 2 years from now to withdraw Rs. 400 per year for 5 years starting 3 years from
now @ 15%
Example #1

○ You deposit Rs. 500 every 6 months for 7 years, how much money will you have in your account at the end
of 7 years @20% per year compounded quarterly

○ Effective semi-annual interest rate = 1.05^2-1 = 10.25% semi-annually

○ Find F = A*(F/A,i,n) = Rs. 14,244.50

Example #2

You purchased a new car for Rs. 8,50,000. You plan to borrow money from bank and repay it monthly over a
period of 4 years. If the nominal interest rate is 12% per year compounded monthly, what would be your
monthly installments be (EMI!) ?

A = 8,50,000 (A/P, 1%, 48)

= Rs. 22381
Example #3
Calculate the amount of money that would be there in a savings account after 12 months if the deposits were
made as shown below. The bank pays 6% per year compounded semi-annually.
Solution for #3

○ Treat the in-between periods as earning simple interest

○ After 6 months
• 100 + 100X0.03X5/6 + 90 + 90X0.03X3/6 + 80
• = 273.85

○ Second deposit at 12 months

• 233.93

○ F = 273.85 (1.03) + 233.93 = Rs. 516

Example #4
Your uncle has agreed to make five Rs. 700 per year deposits into a savings account for you starting
now. You have in turn agreed not to withdraw any money until the end of year 9, at which time you
plan to remove Rs. 3000 from the account. Further, you plan to withdraw the remaining amount in 3
equal year-end installments after the initial withdrawal. Diagram the cash flows. Assume i=8%.
What is the value of each of the 3 withdrawals you can make?
Solution #4

○ F=A (F/A, 8, 4) = 700x 4.5061= 3154

○ F= P (F/P, i, n) =3154(F/P, 8, 5) = 3154 x 1.4693 = 4634.5689

○ After drawing 3000 remaining amount is 1634.56

○ Distributing along 3 years
○ A=1634.56(A/P, 8, 3) = 1634.56x0.38803= 634.26