Foundations of engineering economy

Engineering economics

I Engineering economy involves estimating, formulating, and

evaluating the financial outcomes of alternatives.
I It consists of a set of mathematical techniques that simplify
economic comparison.
I This provides a basis for decision making.
Steps of a decision making process

1. Understand the problem and define the objective

2. Collect relevant information
3. Define alternatives and estimate relevant costs
4. Identify the criteria
5. Evaluate each alternative
6. Select the best alternative
7. Implement the solution
8. Monitor the results
9. Refine the solution (go back to 3)
Operations research (OR)

I OR is also concerned with scientific decision making.

I It utilizes many mathematical tools, stats, algorithms, etc.
I It is suited for complex systems and critical decisions.
I Engineering economy concepts are at the heart of the OR
analysis.
Why is eng’g econ important to engineers

I Natural sciences study the world, its laws, and limits.

I Engineers use math and science to ‘design’ and create their
own world (technology) within these limits.
I Designing involves economic decisions.
I Engineers must be able to incorporate economic analysis
into their creative efforts.
I Often engineers must select and execute from multiple
alternatives (Project A vs. Project B).
I A proper economic analysis for selection and execution is a
fundamental aspect of engineering.
Examples of questions eng’g econ can answer

I Replace an old equipment?

I Introduce a new product?
I Build a new plant?
I Invest in project A or in project B?
Engineering economics

I The engineering economy estimates and decisions involve

four essential elements:
1. Cash flows
2. Time occurrence of cash flows
3. Interest rates for time value of money
4. Measure of economic worth for selecting an alternative
Engineering economics

I The criterion used to select an alternative for a specific set

of estimates is called a measure of worth.
I Examples include:
I Present worth (PW)
I Future worth (FW)
I Annual worth (AW)
I Rate of return (ROR)
I Benefit/cost (B/C)
I Capitalized cost (CC)
I etc.
I All these measures of worth account for the fact that
money makes money over time.
I This is the concept of the time value of money.
Time value of money

I If we borrow money today, we expect to return the original

amount plus some additional amount of money.
I $1 today is not ‘equivalent’ to $1 a year later. You can
deposit (invest) the $1 in a bank and gain ‘interest’.
I Money makes money.
I All firms make use of investment of funds.
I Investments are expected to earn a return.
I Investment involves money.
I Money possesses a ‘time value’.
Interest

I Interest is the manifestation of the time value of money.

I Rental fee that one pays to use someone else’s money.
I Difference between an ending amount of money and a
beginning amount of money.
I Interest rate = (interest accrued per time unit) / (original
amount)
I From the lender perspective, the ‘earned’ interest rate is a
‘rate of return’ (ROR)
I Interest rate (%) =
Final loan amount − Original amount borrowed
× 100
Original amount
I ROR (%) =
Final investment value − Original amount invested
× 100
Original amount
Interest

I The time unit of the rate is called the interest period.

I The most common interest period used to state an interest
rate is 1 year.
I Shorter time periods can be used, such as 1% per month.
I Thus, 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.
Interest examples

I The Oracle investment group invested $200,000 on May 1

and withdrew a total of $220,000 exactly one year later.
I Interest earned = $220,000 – $200,000 = $20,000
I ROR = ($20,000 / $200,000) × 100 = 10%

I Another Oracle group borrowed $100,000 on May 1 and

paid a total of $105,000 exactly one year later.
I Interest paid = $105,000 – $100,000 = $5,000
I Interest rate = ($5,000 / $100,000) × 100 = 5%
Interest examples

I Stereophonics, Inc., plans to borrow $20,000 from a bank

for 1 year at 9% interest for new recording equipment.
I Compute the interest and the total amount due after 1
year.
Interest examples
I Interest = $20,000 (0.09) = $1800
I The total amount due is the sum of principal and interest:
I Total due = $20,000 + 1800 = $21,800
I Note: the total amount due may also be computed as:
principal (1 + interest rate) = $20,000 (1.09) = $21,800
Interest examples

I (a) Calculate the amount deposited 1 year ago to have

$1000 now at an interest rate of 5% per year.
I (b) Calculate the amount of interest earned during this
time period.
Interest examples

I (a) Let x be the original deposit, then:

1000
I x(1.05) = $1000 =⇒ x = = $952.38
1.05
I (b) Interest earned: $1000 − $952.38 = $47.62
I Or: $952.38 (0.05) = $47.62
Economic equivalence

I Different sums of money at different times may be

‘equivalent’ in economic value.
I For the Oracle group doing the investment, $200 K now are
equivalent to $220 K a year later.
Equivalence example

I You want to replace your study desk. The new desk is now
$125 and estimated to be worth $135 next year.
I At a market interest rate of 12%, would you replace your
desk now or the next year?
Equivalence example

I $135 next year are equivalent to 135/1.12 = $120.54 < $125

I Then, it’s better to buy the desk next year because this
saves you around $5.
I This is a ‘Present Worth’ analysis.
I Alternatively, $125 (1.12) = $140 > $135
I This is the ‘Future worth’ analysis.
I Or simply: interest earned = $125 × 0.12 = $15 > $10
|{z}
$135−$125
Equivalence example

I If the interest rate is 6% per year, $100 today (present

time) is equivalent to $100 (1.06) = $106 one year from
today.
I If someone offered you a gift of $100 today or $106 one year
from today, it would make no difference which offer you
accepted from an economic perspective.
I In either case you have $106 one year from today.
I The two sums of money are equivalent to each other only
when the interest rate is 6% per year.
I A total of $100 now is equivalent to $100 / 1.06 = $94.34
one year ago at an interest rate of 6% per year.
I We can state the following: $94.34 last year, $100 now, and
$106 one year from now are equivalent at an interest rate of
6% per year.
Terminology and symbols

I P = value or amount of money at a time designated as the

present or time 0. P is referred to as present worth (PW)
I F = value or amount of money at some future time. F is
called future worth (FW)
I A = series of consecutive, equal, end-of-period amounts of
money. A is called the annual worth (AW)
I n = number of interest periods; years, months, days
I i = interest rate per time period; percent per year, percent
per month
I t = time, stated in periods; years, months, days
Terminology and symbols

I P and F represent one-time occurrences; A occurs with the

same value in each interest period for a specified number of
periods.
I A always represents a uniform amount (i.e., the same
amount each period)
Example

I Today, Julie borrowed $5000 to purchase furniture for her

new house. She can repay the loan in either of the two
ways described below. Determine the engineering economy
symbols and their value for each option.
I (a) Five equal annual installments with interest based on
5% per year.
I (b) One payment 3 years from now with interest based on
7% per year.
Example

I (a) P = $5000, i = 5% per year, n = 5 years, A = ?

I (b) P = $5000, i = 7% per year, n = 3 years, F = ?
Example

I You plan to make a lump-sum deposit of $5000 now into an

investment account that pays 6% per year, and you plan to
withdraw an equal end-of-year amount of $1000 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.
Example

I P = $5000
I i = 6% per year
I A = $1000 per year for 5 years
I F = ? at end of year 6
I n = 5 years for the A series and 6 for the F value.
Example

I Last year Jane’s grandmother offered to put enough money

into a savings account to generate $5000 in interest this
year to help pay Jane’s expenses at college.
I (a) Identify the symbols, and (b) calculate the amount that
had to be deposited exactly 1 year ago to earn $5000 in
interest now, if the rate of return is 6% per year.
Example

I (a) Symbols P (last year is −1) and F (this year) are

needed.
I P =?
I i = 6% per year
I n = 1 year
I F = P + interest = ? + 5000

I (b) F = P (1 + i)
I Interest = F − P = P (1 + i) − P = P i = $5000
$5000
I Thus, P = = $83,333.33
i = 0.06
Cash flows

I Cash inflows: amount of funds flowing into the firm.

I Cash outflows: amount of funds flowing out of the firm.
I Cash inflows are the receipts, revenues, incomes, and
savings generated by project and business activity. A plus
sign indicates a cash inflow.
I Cash outflows are costs, disbursements, expenses, and
taxes caused by projects and business activity. A negative
or minus sign indicates a cash outflow. When a project
involves only costs, the minus sign may be omitted for
some techniques, such as benefit/cost analysis.
I For each time period:
I Net cash flow (NCF) = cash inflows − cash outflows
Cash flows
I Because cash flows may take place at any time during an
interest period, as a matter of convention, all cash flows are
assumed to occur at the end of an interest period.
I The end-of-period convention means that when several
inflows and outflows occur within the same period, the net
cash flow is assumed to occur at the end of the period.
I Cash flow diagram time t = 0 is the present, and t = 1 is
the end of time period 1.
Cash flows

I Figure shows a cash inflow at the end of year 1, equal cash

outflows at the end of years 2 and 3, an interest rate of 4%
per year, and the unknown future value F after 5 years.
I Computations will determine the actual sign on the F
value.
Cash flows

I General cash flow diagram

Example
I Assume you borrow $8500 from a bank today to purchase
an $8000 used car for cash next week, and you plan to
spend the remaining $500 on a new paint job for the car
two weeks from now.
I There are several perspectives possible when developing the
cash flow diagram–those of the borrower (that’s you), the
banker, the car dealer, or the paint shop owner.
I Cash flow signs and amounts for these perspectives:
Example
I One and only one of the perspectives is selected to develop
the diagram.
I From your perspective, all three cash flows are involved and
the diagram appears with a time scale of weeks as follows:

I Applying the end-of-period convention, you have a receipt

of $8500 now (time 0) and cash outflows of $8000 at the
end of week 1, followed by $500 at the end of week 2.
Example

I An electrical engineer wants to deposit an amount P now

such that she can withdraw an equal annual amount of
A1 = $2000 per year for the first 5 years, starting 1 year
after the deposit, and a different annual withdrawal of
A2 = $3000 per year for the following 3 years.
I How would the cash flow diagram appear if i = 8.5% per
year?
Example
Example

I A rental company spent $2500 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.
I Construct the cash flow diagram from the company’s
perspective and indicate where the present worth now is
located.
Example
Simple and compound interest

I Interest can be either simple or compound.

I With simple interest, in each period one pays interest on
the principal (the amount borrowed) itself only.
I With compound interest, in each period, one pays interest
on the principal and on the interest accumulated from
previous periods.
I That is, one pays ‘interest on interest’.
Simple and compound interest

I Suppose you borrow an amount P and pay interest for n

years at a rate of i per year.
I Then, the amount, F , you pay back n years later is:
I With simple interest,
I F = P + iP + ... + iP = P + niP
I Then F = P (1 + ni)
I With compound interest,
z }| {
I F = P (1 + i)(1 + i)...(1 + i)
I Then F = P (1 + i)n
I Note: P (1 + i)n > P (1 + ni) for n > 1 since by binomial
expansion (1 + i)n includes the term (1 + ni).
Example

I GreenTree Financing lent an engineering company $100,000

to retrofit an environmentally unfriendly building. The
loan is for 3 years at 10% per year simple interest.
I How much money will the firm repay at the end of 3 years?
Example

I P = $100,000
I n = 3 years
I i = 10% per year (simple interest)
I F = P (1 + ni) = P + P i + ... + P i
| {z }
n times
I F = $100,000(1 + 3 × 0.1) = $100,000(1.3) = $130,000
Example

I Assume an engineering company borrows $100,000 at 10%

per year compound interest and will pay the principal and
all the interest after 3 years.
I Compute the annual interest and total amount due after 3
years.
Example

I Annual interest, year 1: $100,000 (0.1) = $10,000

I Total due, year 1: $110,000
I Annual interest, year 2: $110,000 (0.1) = $11,000
I Total due, year 2: $121,000
I Annual interest, year 3: $121,000 (0.1) = $12,100
I Total due, year 3: $133,100

I F = P (1 + i)n = $100,000(1 + 0.1)3 = $133,100

Minimum Attractive Rate of Return (MARR)

I Investors expect to earn a return on their investment

(commitment of funds) over time.
I Economic projects should earn a reasonable return, which
is termed ‘minimum attractive rate of return’ (MARR).
I The company management establishes the MARR. The
MARR is not a rate that is calculated as an ROR. The
MARR is established by (financial) managers and is used as
a criterion against which an alternative’s ROR is measured,
when making the accept/reject investment decision.
I MARR is estimated based on the weighted average of the
‘cost of capital’ of sources of funding available to the firm
(simply termed cost of capital for the firm).
Minimum Attractive Rate of Return (MARR)

I As an example, if you want to purchase a new widescreen

HDTV, but do not have sufficient money (capital), you
could obtain a bank loan for, say, a cost of capital of 9%
per year and pay for the TV in cash now.
I Alternatively, you might choose to use your credit card and
pay off the balance on a monthly basis. This approach will
probably cost you at least 15% per year.
I Or, you could use funds from your savings account that
earns 5% per year and pay cash. This approach means that
you also forgo future returns from these funds.
I The 9%, 15%, and 5% rates are your cost of capital
estimates to raise the capital for the system by different
methods of capital financing.
Minimum Attractive Rate of Return (MARR)
I Sources of funding can be:
I Equity financing – the firm uses its own assets to
finance often through issuing stocks. In the previous
example, using money from the 5% savings account is
equity financing.
I Debt financing – the firm borrows money to finance
often through issuing bonds. Individuals, too, can
utilize debt sources, such as the credit card (15% rate)
and bank options (9% rate) in the previous example.
I Combinations of debt-equity financing mean that a
weighted average cost of capital (WACC) results.
I If the HDTV is purchased with 40% credit card money at
15% per year and 60% savings account funds earning 5%
per year, the weighted average cost of capital is:
I WACC = 0.4 (15%) + 0.6 (5%) = 9% per year.
Minimum Attractive Rate of Return (MARR)

I For a corporation, the established MARR used as a

criterion to accept or reject an investment alternative will
usually be higher than the WACC.
I MARR is set in such a way that MARR > WACC
I To be considered financially viable, a project’s expected
ROR must meet or exceed the MARR.
I That is, a project should be undertaken if and only if its
ROR ≥ MARR > WACC
Rule of 72

I This rule (approximately) estimates the number of time

periods, n, it takes for an amount of money to double
under an ROR of i(%) (assuming compound interest rate):
72
I n=
i
I An early reference to the rule is in the Summa de
Arithmetica of Luca Pacioli (1445–1514). The rule is
assumed to predate Pacioli by some time.
I So, why 72?
Rule of 72
I F = P (1 + i)n
I 2P = P (1 + i)n
I ln(2) = n × ln(1 + i)
ln(2) ln(2)
I n= = 2 3 (Maclaurin expansion)
ln(1 + i) i − 2 + i3 − ...
i

ln(2) 0.693 69.3

I n≈ = =
i i i(%)
I It is also known as: the rule of 70 or the rule of 69.3
I The value 72 is a convenient choice of numerator
(especially important during Pacioli’s time), since it has
many small divisors: 1, 2, 3, 4, 6, 8, 9, and 12
1
I Note: = 1 − t + t2 − t3 + ..., if |t| < 1 (long-division)
1+t R
x 1 2 3
I ln(1 + x) = dt = x − x2 + x3 − ... ≈ x, for small x.
0 1+t