EE Theory Notes

Engineering Economics
Department of Aeronautical Engineering, DSCE, Bangalore
DAYANANDA SAGAR COLLEGE OF ENGINEERING

An Autonomous Institute Affiliated to VTU, Belagavi)
Shavige Malleshwara Hills, Kumaraswamy Layout, Bengaluru-560078
DEPARTMENT OF AERONAUTICAL ENGINEERING
ENGINEERING ECONOMICS
19HS6ICEEM
Prepared By:
Dr. Srikanth Salyan,
Asst. Professor, AE, DSCE.
Student Coordinator:
Shri Hari Rao,
1DS19AE051
August 2022
Dr. Srikanth Salyan, Shri Hari Rao,

Assistant Professor, AE, DSCE 1DS19AE051
Unit 1
1. Simple Interest:
Simple interest is a quick and easy method of calculating the interest charge on a loan. Simple
interest is determined by multiplying the daily interest rate by the principal by the number of
days that elapse between payments.
This type of interest usually applies to automobile loans or short-term loans, although some
mortgages use this calculation method.
1.1 KEY TAKEAWAYS
Simple interest is calculated by multiplying the daily interest rate by the principal, by the
number of days that elapse between payments.
Simple interest benefits consumers who pay their loans on time or early each month.
Auto loans and short-term personal loans are usually simple interest loans.
1.2 Understanding Simple Interest
Interest is the cost of borrowing money. Typically expressed as a percentage, it amounts to a

fee or extra charge the borrower pays the lender for the financed sum.
When you make a payment on a simple interest loan, the payment first goes toward that
month’s interest, and the remainder goes toward the principal. Each month’s interest is paid
in full so it never accrues. In contrast, compound interest adds some of the monthly interest
back onto the loan; in each succeeding month, you pay new interest on old interest.
To understand how simple interest works, consider an automobile loan that has a $15,000
principal balance and an annual 5% simple interest rate. If your payment is due on May 1 and
you pay it precisely on the due date, the finance company calculates your interest on the 30
days in April. Your interest for 30 days is $61.64 under this scenario. However, if you make
the payment on April 21, the finance company charges you interest for only 20 days in April,
dropping your interest payment to $41.09, a $20 savings.
1.3 Simple Interest Formula and Example
The formula for simple interest is pretty, well, simple. It looks like this:
Simple Interest=P×I×N
where:
P=Principal I=Daily interest rate N=Number of days between payments
2. Compound Interest
Compound interest (or compounding interest) is the interest on a loan or deposit calculated
based on both the initial principal and the accumulated interest from previous periods.
Thought to have originated in 17th-century Italy, compound interest can be thought of as
"interest on interest," and will make a sum grow at a faster rate than simple interest, which
is calculated only on the principal amount.
The rate at which compound interest accrues depends on the frequency of compounding,
such that the higher the number of compounding periods, the greater the compound interest.
Thus, the amount of compound interest accrued on $100 compounded at 10% annually will
be lower than that on $100 compounded at 5% semi-annually over the same time period.
Because the interest-on-interest effect can generate increasingly positive returns based on
the initial principal amount, compounding has sometimes been referred to as the "miracle of
compound interest.
2.1 KEY TAKEAWAYS:
Compound interest (or compounding interest) is interest calculated on the initial principal,
which also includes all of the accumulated interest from previous periods on a deposit or loan.
Compound interest is calculated by multiplying the initial principal amount by one plus the
annual interest rate raised to the number of compound periods minus one.
Interest can be compounded on any given frequency schedule, from continuous to daily to
annually.
When calculating compound interest, the number of compounding periods makes a

significant difference.
2.2 How Compound Interest Works

Compound interest is calculated by multiplying the initial principal amount by one plus the
annual interest rate raised to the number of compound periods minus one. The total initial
amount of the loan is then subtracted from the resulting value.
Compound interest = total amount of principal and interest in future (or future value) less
principal amount at present (or present value)
= [P (1 + i)n] – P
= P [(1 + i)n – 1]
Where: P = principal, i = nominal annual interest rate in percentage terms , n = number of

compounding periods
3. Time Value of Money
The time value of money (TVM) is the concept that a sum of money is worth more now than
the same sum will be at a future date due to its earnings potential in the interim. This is a core
principle of finance. A sum of money in the hand has greater value than the same sum to be
paid in the future. The time value of money is also referred to as present discounted value.
3.1 KEY TAKEAWAYS
Time value of money means that a sum of money is worth more now than the same sum of
money in the future. This is because money can grow only through investing. An investment
delayed is an opportunity lost.
The formula for computing the time value of money considers the amount of money, its
future value, the amount it can earn, and the time frame. For savings accounts, the number
of compounding periods is an important determinant as well.
3.2 Understanding the Time Value of Money (TVM)
Investors prefer to receive money today rather than the same amount of money in the future
because a sum of money, once invested, grows over time. For example, money deposited into
a savings account earns interest. Over time, the interest is added to the principal, earning
more interest. That's the power of compounding interest.

If it is not invested, the value of the money erodes over time. If you hide $1,000 in a mattress
for three years, you will lose the additional money it could have earned over that time if
invested. It will have even less buying power when you retrieve it because inflation has
reduced its value.
As another example, say you have the option of receiving $10,000 now or $10,000 two years
from now. Despite the equal face value, $10,000 today has more value and utility than it will
two years from now due to the opportunity costs associated with the delay. In other words,
a payment delayed is an opportunity missed.
3.3 Formula for Time Value of Money
Depending on the exact situation, the formula for the time value of money may change
slightly. For example, in the case of annuity or perpetuity payments, the generalized formula
has additional or fewer factors. But in general, the most fundamental TVM formula takes into
account the following variables:
FV = Future value of money
PV = Present value of money
i = interest rate
n = number of compounding periods per year
t = number of years
Based on these variables, the formula for TVM is:
FV = PV x [ 1 + (i / n) ] (n x t
4. Cash Flow Quadrant
The CASHFLOW Quadrant (Figure 1) is divided into four types of people, two in each
category.

Figure 1: Cash Flow Quadrant
4.1 The left side of the CASHFLOW Quadrant
On the left side of the quadrant are Es and Ss. They pay the most in taxes and trade their
time for money. And each has a different mindset.
E is for employee
At the end of the day, the most important thing for employees is security. My poor dad
was an employee his entire life and he craved nothing more than security. That is why he
could not understand why I would want to be a business owner and investor. To him,
there was nothing riskier than that.
Because employees shy away from risk, they don’t see the need to learn about money or
how it works. For them, education is about learning the skills needed to get a steady, high-

paying job with great benefits. Thus, why my poor dad loved working for the State of
Hawaii.
When employees need more money, they look for a higher-paying job.
S is for self-employed
People in the self-employed quadrant are not good employees and often have the
attitude that no one can do it better than them. While they still like the idea of security,
they have a larger tolerance for risk, and thus don’t mind working for themselves. In fact,
they like it that way because they feel in control of their future.
People in the S quadrant are doctors, lawyers, dentists, accountants, and other service-
based businesses and consultants. They have very high-standards for their work and
because of this they have a hard time delegating to others. Again, they don’t like to hire
employees because nobody does it better than them. As a result, they only make money
when they are working. This means they don’t own a business, they own a job.
When self-employed people need more money, they look for more hours they can bill.
4.2 The right side of the CASHFLOW Quadrant
On the right side of the quadrant are Bs and Is. They pay the least in taxes and create or
invest in assets that produce cash flow for them even when they’re sleeping.
B stands for Business Owner
Unlike those in the S Quadrant, business owners don’t own a job. They own a system or a
product that makes money even when they aren’t working. Because they know they can’t
be successful on their own, business owners look to hire people who specialize in skills
needed for the business and hire those who have more talent and skill than them. They
look to delegate as much as possible, not keep all the work for themselves. The best
business owners know they could leave their company for a year and come back to find it
still profitable and running better than they left it.
Business owners are often seen as risk takers, but from the perspective of a business
owner, being an employee is riskiest because employees have no control. A business
owner can make the decision to do layoffs or fire an employee, but no one can take the
business away from the business owner. And when the economy takes a down-turn, the
business owner has the most control to make the business work and survive.
When business owners need more money, they create a new product or create or acquire
a new system that produces money.
I stands for Investor
Investors have the highest financial education of anyone in the CASHFLOW Quadrant.
They are adept at finding assets that provide steady income in the form of cash flow and
they often use other people’s money (OPM) to attain those assets. They then use income
from those assets to acquire even more assets, growing their wealth through this velocity
of money. They enjoy the most in tax breaks, don’t have to work at all if they desire, and
don’t have to deal with managing employees. The richest people in the world are
investors, and as a general principle 70% of their income comes from investments with
the other 30% made up of wages.
When investors need more money, they look for an opportunity to acquire an asset that
produces more passive income.
5. Cash Flow Diagrams
Cash flow diagrams visually represent income and expenses over some time interval. The
diagram consists of a horizontal line with markers at a series of time intervals. At
appropriate times, expenses and costs are shown in Figure 2.
Figure 2: Cash Flow Diagram

Note that it is customary to take cash flows during a year at the end of the year, or EOY
(end-of-year). There are certain cash flows for which this is not appropriate and must be
handled differently. The most common would be rent, which is normally taken at the
beginning of a cash period. There are other pre-paid flows which are handled similarly.
Note that the initial cost, the purchase price, is recorded at the beginning of Year 1,
sometimes referred to as end-of-year 0, or EOY 0. Also, operating and maintenance costs
actually will occur during a year, but they are recorded at EOY, and so forth.
In the context of business, and engineering economics, these are used by management
accountants and engineers, to represent the cash-transactions which will take place over
the course of a given project. Transactions can include initial investments, maintenance
costs, projected earnings or savings resulting from the project, as well as salvage and
resale value of equipment at the end of the project. These diagrams - and the associated
modelling - are then used to determine a break-even point ("cash flow neutrality"), or to
further, and more generally, analyze operations and profitability. See cashflow forecast
and operating cash flow.
6. Economic Analysis
Economic analysis essentially entails the evaluation of costs and benefits. It starts by ranking
projects based on economic viability to aid better allocation of resources. It aims at analyzing
the welfare impact of a project. Economic analysis can address the following questions/issues:
• Should the project be undertaken by the public or private sector?
• What will be the fiscal impact of the project?
• How will we ensure efficiency and equity of cost recovery?
• What will be the environmental impact of a project?
Indeed, economic analysis entails three main elements: These are:
• Identification and estimation of costs related to an investment

• Identification and estimation of benefits to be obtained from an investment
• Comparing the costs with benefits to determine the appropriateness of the
investment
Cost is a major factor for consideration in both financial and economic analysis. From a
financial perspective, cost to the investing party is paramount. Costs which impose
“additional burden” are those considered in economic analysis. Some identifiable cost
elements include
a. Sunk cost
- A cost that has been incurred and which cannot be recovered by any means
- Often excluded in economic analysis of projects since it does not constitute additional
cost.
b. Contingency cost
- Also known as cost of the known-unknowns
- It is cost of some things that will probably occur, based on past experience, but with
uncertainty about the cost
- The part of contingency that represent ‘additional claim’ on resources for the project
is considered in economic analysis.
c. Working capital
- It represents operating liquidity available to a business
- The cost that represent real claim on national economic resources is what is
considered for economic analysis.
d. Transfer payment
- These are payments which transfer command over resources from one party to
another without reducing or increasing the amount of resources available to the
whole (ADB, 2017). Examples include subsidies, welfare, financial aid, social security,
taxes (duties and subsidies) etc.
- Transfer payments are not considered in economic analysis except in cases where
government choses to internalize externalities through tax.
e. Depreciation
- It is used to allocates the cost of a tangible asset over its useful life
- It is used to account for declines in value over time
- It is not considered in economic analysis.
f . Depletion premium

- This is similar to depreciation. However, it is used only in the extractive industries such
as oil and gas
- It is a good cost recovery system for accounting and tax recovery
- It includes depletion rent to reflect economic cost to society of using such resource.
g. External cost
- This is cost that an activity or transaction imposes on third party agents
- Externality can be negative or positive externality
- Economic analysis is not complete without considering external cost.
1) Describe the problem solving process in decision making.
A) Problem-solving is an analytical method to identify the possible solutions to a situation.

It’s a complex process and judgment calls—or decisions—will have to be made on the way.
The main goal is to find the best solution. Problem-solving involves identifying an issue,
finding causes, asking questions and brainstorming solutions. Gathering facts help make the
solution more obvious.
Decision-making is the process of choosing a solution based on your judgment, situation,

facts, knowledge or a combination of available data. The goal is to avoid potential difficulties.
Identifying opportunities is an important part of the decision-making process. Making
decisions is often a part of problem-solving.
Here are five steps that you can follow to make the most of your problem-solving and
decision-making skills:
i- Define the issue
The first step is to define the problem or issue. Once you've pinpointed the issue, analyze it
and think about what might have caused it. Try to identify any smaller issues within the main
problem. It’s important to understand the issue before you start thinking about potential
solutions and decisions. Having a clearly defined problem can make it easier to make decisions
later on in the process.
ii- Brainstorm different approaches

After you've defined and analyzed the issue, you can begin brainstorming different
approaches to resolving it. In an effort to see all sides of the problem, try to get feedback from
mentors and people involved with the issue. You can also think about how you've solved past
problems similar to the current issue. Be sure to consider both short- and long-term
approaches to the issue. Additionally, think about how potential approaches align with your
company’s mission and goals.
iii- Evaluate different approaches
After you've brainstormed approaches, it's time to evaluate them. Think through all of the
pros and cons for each option, and consider how each one would affect your organization.
Additionally, think about the different resources that each decision would require. Taking all
these factors into consideration can help you make the best decision for your company.
iv- Make your decision
Once you have evaluated your different approaches, it’s time to make your decision. After
making your decision, ensure it fully addresses the issue and does not create a new one. Make
sure the decision is something that your company can realistically implement and it aligns
with the mission, vision and values of your company.
v- Implement your decision
After you've made your decision, you must decide how to implement it. Start by identifying
main objectives and deliverables and creating deadlines. Then, outline specific steps to meet
the objectives. In the implementation plan, you can include those who are involved with the
issue and assign responsibilities to the appropriate employees. Then, share your plan with
everyone involved with the issue and get feedback.
2) Distinguish clearly between strategy and tactics with suitable examples.
A) The strategy is a long-term plan which one executes step by step to achieve a goal. It is the
path which leads to the final success. Correct execution of a strategy results in the final
outcome.
Tactics are small steps or concrete actions which one takes to achieve smaller goals or to
complete an action. A good tactic has a clear purpose that aids your strategy.

3) With appropriate examples elaborate on the different areas in which an engineer will
acts as decision maker.
A) https://www.slideshare.net/kevinpaulbelarmino/decision-making-50258496

4) Differentiate between intuition and analysis .Support your answer with suitable
examples.A)

5) What is decision making? Briefly explain the importance of decision making in

engineering economics.
A) The techniques and models of engineering economy assists people in making decisions.
The role of engineers in the decision making is to evaluate the condition, feasibility and
appropriateness of an alternatives of a given project, estimates its value and justify it from an
engineering stand point and finally discover the best alternatives for implementation. For this,
both the knowledge of civil engineering and engineering economics is necessary, which clearly
shows the importance of engineering economics to civil engineer.
Since decision affect what will be done, the time frame of engineering economy is primarily
the future. Therefore, numbers used in an engineering economic analysis are best estimates
of what is expected to occur. These estimates often involve the three essential elements: cash
flow, time of occurrence and interest rate. These estimates are about future, and will
somewhat different than what actually occurs, primarily because of changing circumstances
and unplanned for events. In other words, stochastic nature of estimate will likely make the
observed value in the future differ from the estimate made now. Thus, sensitive analysis is to

be performed during the engineering economic study to determine how the decision might
change based on varying estimate.
Some of the reasons to have knowledge of engineering economics for engineers in decision
making process are:
• Develop the alternatives

• Use a common unit of measure
• Use a consistent viewpoint
• Consider all relevant criteria
• Make uncertainty criteria
• Revisit the decision
The various steps involved in the problem- solving approach i.e, decision making approach
are (Roles of engineer in decision making):
• Understand the problem and define objectives

• Collect relevant information
• Define the feasible alternative solutions and make realistic estimates.
• Identify the criteria for decision making using one or more attributes.
• Evaluate each alternative, using sensitive analysis to enhance the evaluation.
• Select the best alternative.
• Implement the solution and monitor the results.
7) Discuss the role of engineers in decision making
A) same as question 5
8) Differentiate between tactics and strategy. Support your answer with suitable examples.
9) What is the importance of cash flow diagram in economic analysis? Explain with suitable
Examples.
A) The cash flow diagram is the most important and essential element of financial analysis. A
proper and accurate cash flow diagram should be constructed and tested before an attempt

is made to perform the financial analysis. Indeed, with today's special handheld calculators
and personal computer spreadsheets, the financial analysis is completed very quickly without
much financial knowledge required on the part of the operator. But, the construction of a
cash flow diagram requires a deep understanding of the financial situation of the project or
problem at hand. No computer can provide the right answer if the cash flow diagram is not
constructed properly and accurately.
All the cost and benefit components occurring during the course of the proj ect and their time
of occurrence should be accurately presented in the cash flow diagram. Any costs related to
this proj ect incurred before the zero time of the analysis are considered "sunk cost" and do
not enter in the analysis. This is a very important point to remember. It does not mean that
in our future activity we should not consider taking a course of action to recover the sunk
cost. It means that the fact that we have spent money up to this point should not cause us to
continue a non-profitable project; in other words, "don't send good money after bad money".
The interest rate i is assumed to be constant for the duration of the project or operation of
the system under analysis.
There are always two sides to a financial transaction: a borrower and a lender; a buyer and a
seller; an investor and an investment. You should keep in mind the dual nature of financial
transactions when drawing a cash flow diagram. From who's perspective will it be drawn? The
example of a mortgage can illustrate this issue. From the borrower's perspective the
transaction consists of a large cash inflow followed by a series of smaller cash outflows. The
situation is exactly reveresed for the lender:
Note that the calculated amounts (present or future value , payment amount, interest rate,
number of periods) will be the same regardless of the perspective from which the cash flow

diagram is drawn. It simply helps in understanding and describing the problem to be conscious
of the perspective from which it is viewed.
Also note that the angled line at the right end of the time line above is used to represent a
continuation of time (and in this case also of payments) that cannot be shown because of
space limitations.
10) What is CFD? Discuss interest from borrower’s and lender’s point of view with suitable
examples.
11) Briefly explain (i) Nominal interest rate (ii) Effective interest rate (iii) Continous
compounding.
A) The term “interest rate” is one of the most commonly used phrases in the fixed-income
investment lexicon. The different types of interest rates, including real, nominal, effective,
and annual, are distinguished by key economic factors that can help individuals become
smarter consumers and shrewder investors.

The nominal interest rate is the stated interest rate of a bond or loan, which signifies the
actual monetary price borrowers pay lenders to use their money. If the nominal rate on a loan
is 5%, borrowers can expect to pay $5 of interest for every $100 loaned to them. This is often
referred to as the coupon rate because it was traditionally stamped on the coupons redeemed
by bondholders.
The real interest rate is so named, because unlike the nominal rate, it factors inflation into
the equation, to give investors a more accurate measure of their buying power, after they
redeem their positions. If an annually compounding bond lists a 6% nominal yield and the
inflation rate is 4%, then the real rate of interest is actually only 2%.
Investors and borrowers should also be aware of the effective interest rate, which takes the
concept of compounding into account. For example, if a bond pays 6% annually and
compounds semi-annually, an investor who places $1,000 in this bond will receive $30 of
interest payments after the first 6 months ($1,000 x .03), and $30.90 of interest after the next
six months ($1,030 x .03). In total, this investor receives $60.90 for the year. In this scenario,
while the nominal rate is 6%, the effective rate is 6.09%.
Continuous compounding is the mathematical limit that compound interest can reach if it's
calculated and reinvested into an account's balance over a theoretically infinite number of
periods. While this is not possible in practice, the concept of continuously compounded
interest is important in finance. It is an extreme case of compounding, as most interest is
compounded on a monthly, quarterly, or semi-annual basis.
Instead of calculating interest on a finite number of periods, such as yearly or monthly,

continuous compounding calculates interest assuming constant compounding over an infinite
number of periods. The formula for compound interest over finite periods of time takes into
account four variables:
• PV = the present value of the investment

• i = the stated interest rate
• n = the number of compounding periods
• t = the time in years

The formula for continuous compounding is derived from the formula for the future value of
an interest-bearing investment:
Future Value (FV) = PV x [1 + (i / n)](n x t)
Calculating the limit of this formula as n approaches infinity (per the definition of continuous
compounding) results in the formula for continuously compounded interest:
FV = PV x e (i x t), where e is the mathematical constant approximated as 2.7183.
Module 2
1) List and explain conditions present worth comparison.
A) Let us assume that an organization has a huge sum of money for potential investment and
there are three different projects whose initial outlay and annual revenues during their lives
are known. The executive has to select the best alternative among these three competing
projects.
There are several bases for comparing the worthiness of the projects. These bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
PRESENT WORTH METHOD
In this method of comparison, the cash flows of each alternative will be reduced to time zero
by assuming an interest rate i. Then, depending on the type of decision, the best alternative
will be selected by comparing the present worth amounts of the alternatives. In a cost
dominated cash flow diagram, the costs (outflows) will be assigned with positive sign and the
profit, revenue, salvage value (all inflows), etc. will be assigned with negative sign. In a
revenue/profit-dominated cash flow diagram, the profit, revenue, salvage value (all inflows
to an organization) will be assigned with positive sign. The costs (outflows) will be assigned
with negative sign.

Revenue-Dominated Cash Flow Diagram
Cost-Dominated Cash Flow Diagram
2) What is rule 72 as applied to present worth comparisons? Support your answer with
appropriate examples.
A) The Rule of 72 is a quick, useful formula that is popularly used to estimate the number of
years required to double the invested money at a given annual rate of return. Alternatively,
it can compute the annual rate of compounded return from an investment given how many
years it will take to double the investment.
While calculators and spreadsheet programs like Microsoft Excel have functions to accurately
calculate the precise time required to double the invested money, the Rule of 72 comes in
handy for mental calculations to quickly gauge an approximate value. For this reason, the Rule
of 72 is often taught to beginning investors as it is easy to comprehend and calculate. The
Security and Exchange Commission also cites the Rule of 72 in grade-level financial literacy
resources.
• The Rule of 72 is a simplified formula that calculates how long it'll take for an
investment to double in value, based on its rate of return.

• The Rule of 72 applies to compounded interest rates and is reasonably accurate for
interest rates that fall in the range of 6% and 10%.
• The Rule of 72 can be applied to anything that increases exponentially, such as GDP or
inflation; it can also indicate the long-term effect of annual fees on an investment's
growth.
• This estimation tool can also be used to estimate the rate of return needed for an
investment to double given an investment period.
• For different situations, it's often better to use the Rule of 69, Rule of 70, or Rule of
73.
The Formula for the Rule of 72
i- Years To Double: 72 / Expected Rate of Return
To calculate the time period an investment will double, divide the integer 72 by the
expected rate of return. The formula relies on a single average rate over the life of the
investment. The findings hold true for fractional results, as all decimals represent an
additional portion of a year.
ii- Expected Rate of Return: 72 / Years To Double
To calculate the expected rate of interest, divide the integer 72 by the number of years
required to double your investment. The number of years does not need to be a whole
number; the formula can handle fractions or portions of a year. In addition, the resulting
expected rate of return assumes compounding interest at that rate over the entire holding
period of an investment.
3) What are the ingredients of a present worth comparison and explain the conditions for
present worth comparisons.
4) Compare present worth analysis of assets with equal lives and unequal lives.
A)
5) Elaborate on present worth comparison of cost dominated and revenue dominated cash
flows. Support your answer with appropriate examples.
6) Elaborate on payback period method of comparison. Support your answer with

appropriate example.
A) The term payback period refers to the amount of time it takes to recover the cost of an
investment. Simply put, it is the length of time an investment reaches a breakeven point.
People and corporations mainly invest their money to get paid back, which is why the payback
period is so important. In essence, the shorter payback an investment has, the more attractive
it becomes. Determining the payback period is useful for anyone and can be done by dividing
the initial investment by the average cash flows.
• The payback period is the length of time it takes to recover the cost of an investment
or the length of time an investor needs to reach a breakeven point.
• Shorter paybacks mean more attractive investments, while longer payback periods are
less desirable.
• The payback period is calculated by dividing the amount of the investment by the
annual cash flow.
• Account and fund managers use the payback period to determine whether to go
through with an investment.
• One of the downsides of the payback period is that it disregards the time value of
money.
PaybackPeriod=CostofInvestment÷AverageAnnualCashFlow
Although calculating the payback period is useful in financial and capital budgeting, this metric
has applications in other industries. It can be used by homeowners and businesses to calculate
the return on energy-efficient technologies such as solar panels and insulation, including
maintenance and upgrades.
There is one problem with the payback period calculation. Unlike other methods of capital
budgeting, the payback period ignores the time value of money (TVM). This is the idea that
money is worth more today than the same amount in the future because of the earning
potential of the present money. The payback period disregards the time value of money and
is determined by counting the number of years it takes to recover the funds invested. For
example, if it takes five years to recover the cost of an investment, the payback period is five
years.
Example of Payback Period
Here's a hypothetical example to show how the payback period works. Assume Company A
invests $1 million in a project that is expected to save the company $250,000 each year. If we
divide $1 million by $250,000, we arrive at the payback period of four years for this
investment.
Consider another project that costs $200,000 with no associated cash savings that will make
the company an incremental $100,000 each year for the next 20 years at $2 million. Clearly,
the second project can make the company twice as much money, but how long will it take to
pay the investment back?
The answer is found by dividing $200,000 by $100,000, which is two years. The second project
will take less time to pay back, and the company's earnings potential is greater. Based solely
on the payback period method, the second project is a better investment.
Module 3
1) Explain the following with respect to asset life
i) Service life ii) Accounting life iii) Economic life iv) Ownership life.
A) One of many types of life concepts associated with forecasting of the service-in-use value
and eventual renewal of assets. The period of time over which an asset (and its components
or assembly) provides adequate performance and function. For example: the boiler is of
medium-grade quality and therefore has an expected service life of 20 years after which the
organization will need to replace it with another boiler. Service life is a technical parameter
that depends on design, construction quality, operations and maintenance practices, use, and
environmental factors.
Types of Service Lives
There are a multitude of terms that are used to capture different nuances in service life, some
of which are listed below.

• Design Life
• Economic LIfe
• Useful Life
• Technological Life
• Working Life
• Probable Life
• Shelf Life
Economic life is the expected period of time during which an asset remains useful to the
average owner. When an asset is no longer useful to its owner, then it is said to be past its
economic life. The economic life of an asset could be different than its actual physical life.
Thus, an asset can be in optimal physical condition but may not be economically useful. For
example, technology products often become obsolete when their technology becomes
obsolete. The obsolescence of flip phones occurred due to the advent of smartphones and
not because they ran out of utility. Estimating the economic life of an asset is important for
businesses so that they can determine when it's worthwhile to invest in new equipment,
allocating appropriate funds to purchase replacements once the equipment's useful life is
met. Financial considerations required for calculating the economic life on asset include its
cost at the time of purchase, the amount of time an asset is used in production, and existing
regulations pertaining to it.
In business analysis, an asset's ownership life is the time that ownership has financial
consequences of any kind. Ownership life begins when the decision to acquire the asset starts
causing costs. Some of these costs may appear before the arrival or asset use begins, such as
loan origination fees, planning costs, transportation costs, or set up costs. Ownership life ends
when the asset stops causing costs and has no continuing financial impact of any kind. "No
continuing financial impact" means, for example, that all costs of disposal or decommission
are over, and asset value no longer contributes to an asset account on the company's Balance
sheet.
2) ”Economic comparison involving assets with perpetual life.” Use only interest rate
instead of capital recovery factor. Justify this method

3) Compare equivalent annual worth method and annual average cost method .support
your answer with appropriate examples.
A) Equivalent annual cost (EAC) is the annual cost of owning, operating, and maintaining an
asset over its entire life. Firms often use EAC for capital budgeting decisions, as it allows a
company to compare the cost-effectiveness of various assets with unequal lifespans.
Equivalent annual cost (EAC) is used for a variety of purposes, including capital budgeting. But
it is used most often to analyze two or more possible projects with different lifespans, where
costs are the most relevant variable.
Other uses of EAC include calculating the optimal life of an asset, determining if leasing or
purchasing an asset is the better option, determining the magnitude of which maintenance
costs will impact an asset, determining the necessary cost savings to support purchasing a
new asset, and determining the cost of keeping existing equipment.
The EAC calculation factors in a discount rate or the cost of capital. Cost of capital is the
required return necessary to make a capital budgeting project—such as building a new
factory—worthwhile. Cost of capital includes the cost of debt and the cost of equity and is
used by companies internally to judge whether a capital project is worth the expenditure of
resources.
The average cost method assigns a cost to inventory items based on the total cost of goods
purchased or produced in a period divided by the total number of items purchased or
produced. The average cost method is also known as the weighted-average method. The
average cost method uses a simple average of all similar items in inventory, regardless of
purchase date, followed by a count of final inventory items at the end of an accounting period.
Multiplying the average cost per item by the final inventory count gives the company a figure
for the cost of goods available for sale at that point. The same average cost is also applied to
the number of items sold in the previous accounting period to determine the cost of goods
sold. The average cost method requires minimal labor to apply and is, therefore, the least
expensive of all the methods. In addition to the simplicity of applying the average cost
method, income cannot be as easily manipulated as with the other inventory costing
methods. Companies that sell products that are indistinguishable from each other or that find
it difficult to find the cost associated with individual units will prefer to use the average cost
method. This also helps when there are large volumes of similar items moving through
inventory, making it time-consuming to track each individual item.
4) Compare AAC method with EAC method of comparison.
Module 4
1) List any four methods of computing depreciation. Elaborate on any two methods.
A) The four methods for calculating depreciation allowable under GAAP include straight-line,
declining balance, sum-of-the-years' digits, and units of production. The best method for a
business depends on size and industry, accounting needs, and types of assets purchased.
3) Elaborate on declining balance and sinking fund method of depreciation computation.
4) With neat sketch, explain Profit-Volume (P-V) Chart
A) A profit-volume (PV) chart is a graphic that shows the earnings (or losses) of a company in
relation to its volume of sales. Companies can use profit-volume (PV) charts to establish sales
goals, analyze whether new products are likely to be profitable, or estimate breakeven points.
The profit-volume chart gives a company a visual of how much product must be sold to
achieve profitability. The total costs of a company include variable and fixed costs. Fixed costs
represent the money spent on assets needed to produce the product, which can include the
cost of the building and equipment. Variable costs represent the costs that fluctuate with
sales volumes, such as raw materials and inventory. If a company produces zero sales, they
would still have the expense of their fixed costs but would have no variable costs, assuming
they didn't buy any inventory. A company must generate enough sales to cover both their
variable costs and fixed costs. When pricing the product for sale, management would need to
cover the variable costs to produce each unit, but also some portion of the fixed costs. Over
time and with enough sales volume, the company would reach its breakeven point, which is
when they've generated enough sales volume so that the cumulative total of the profit-per-
unit covers all of the fixed costs.
For example, let's say a company has $1,000 in fixed costs, and they earn $50 per unit in profit,
which covers the variable costs for each unit. The company would need to sell 20 units to
achieve breakeven (20 * $50 = $1,000).
When plotting the profit-volume chart, where the total sales line intersects with the total
cost line is the approximate breakeven point of a product in terms of volume. Profits or
(losses) are plotted on the Y-axis (the vertical axis) while sales volume (quantity or units) is
plotted on the X-axis (the horizontal axis). Initially, the line will begin to the left and below
zero at the amount of the fixed costs. As the volume of sales increases, the line rises from left
to right in an upward sloping manner so that profits rise as sales increase. Sales volumes to
the right of the breakeven point on the chart indicate profits, while volumes to the left result
in losses. The slope of the total sales line is important; the steeper the slope, the less volume
required to earn a profit. The steepness of the slope is a function of the price of the product.
5) Discuss various methods for lowering the break-even point.
A) The break-even point of a business should be kept as low as possible, in order to keep the
firm profitable even when sales decline. There are several ways to reduce the break-even
point, as noted in the following points.
Reduce Fixed Costs
The typical company has many fixed costs, such as periodic rent payments, the salaries of
administrative staff, and underutilized production equipment. By reducing these costs, the
firm needs fewer sales to cover the remaining fixed costs.
Reduce Variable Costs

The break-event point can be reduced by increasing the average contribution margin earned
on each sale. One way to do so is to reduce variable costs. One approach is to redesign
products to reduce costs. Another option is to standardize components across product
platforms, in order to obtain volume purchase discounts. Yet another possibility is to increase
the reliability of products, so that they require fewer warranty repairs.
Improve the Sales Mix
Another way to improve the contribution margin is to sell a higher proportion of goods and
services with higher contribution margins. This can be done by altering marketing activities to
favor high-margin products, as well as by increasing commissions on high-margin items.
Increase Prices
Yet another way to improve the contribution margin is to set higher prices. This approach only
works if customers are not especially sensitive to price increases; otherwise, they will buy
elsewhere, resulting in a net reduction in sales. Increasing prices is a better option when the
company is seen as a high-quality provider or the products are heavily branded.


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Engineering Economics

Department of Aeronautical Engineering, DSCE, Bangalore

DAYANANDA SAGAR COLLEGE OF ENGINEERING

DEPARTMENT OF AERONAUTICAL ENGINEERING

Dr. Srikanth Salyan,

Asst. Professor, AE, DSCE.

Shri Hari Rao,

Dr. Srikanth Salyan, Shri Hari Rao,

1.1 KEY TAKEAWAYS

1.2 Understanding Simple Interest

Interest is the cost of borrowing money. Typically expressed as a percentage, it amounts to a

1.3 Simple Interest Formula and Example

P=Principal I=Daily interest rate N=Number of days between payments

2.1 KEY TAKEAWAYS:

When calculating compound interest, the number of compounding periods makes a

2.2 How Compound Interest Works

Dr. Srikanth Salyan, Shri Hari Rao,

Where: P = principal, i = nominal annual interest rate in percentage terms , n = number of

3. Time Value of Money

3.1 KEY TAKEAWAYS

3.2 Understanding the Time Value of Money (TVM)

Dr. Srikanth Salyan, Shri Hari Rao,

3.3 Formula for Time Value of Money

FV = Future value of money

PV = Present value of money

n = number of compounding periods per year

Based on these variables, the formula for TVM is:

4. Cash Flow Quadrant

Dr. Srikanth Salyan, Shri Hari Rao,

Figure 1: Cash Flow Quadrant

4.1 The left side of the CASHFLOW Quadrant

Dr. Srikanth Salyan, Shri Hari Rao,

4.2 The right side of the CASHFLOW Quadrant

B stands for Business Owner

I stands for Investor

5. Cash Flow Diagrams

Figure 2: Cash Flow Diagram

Dr. Srikanth Salyan, Shri Hari Rao,

• Should the project be undertaken by the public or private sector?

• What will be the fiscal impact of the project?

• How will we ensure efficiency and equity of cost recovery?

• What will be the environmental impact of a project?

Indeed, economic analysis entails three main elements: These are:

• Identification and estimation of costs related to an investment

Dr. Srikanth Salyan, Shri Hari Rao,

1) Describe the problem solving process in decision making.

A) Problem-solving is an analytical method to identify the possible solutions to a situation.

Decision-making is the process of choosing a solution based on your judgment, situation,

i- Define the issue

ii- Brainstorm different approaches

Dr. Srikanth Salyan, Shri Hari Rao,

iii- Evaluate different approaches

iv- Make your decision

v- Implement your decision

2) Distinguish clearly between strategy and tactics with suitable examples.

Dr. Srikanth Salyan, Shri Hari Rao,

Dr. Srikanth Salyan, Shri Hari Rao,

Dr. Srikanth Salyan, Shri Hari Rao,

5) What is decision making? Briefly explain the importance of decision making in

Dr. Srikanth Salyan, Shri Hari Rao,

• Develop the alternatives

• Understand the problem and define objectives

7) Discuss the role of engineers in decision making