Engineering Economics

Chapter 1 - 1 UOB, Mechanical Engineering Department, Dr Osama Al-Jamal

Introduction
▪ Course Name
MENG 300 – Engineering Economics

▪ Prerequisite
Completion of 60 credits (Junior Level).
Ability to use MS office (Word, Excel, and Power
Point)

▪ Text Book
Engineering Economy, 8th edition
By Blank Leland and Tarquin Anthony. McGraw-Hill
International Edition, 2014

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 Introduction
Course Objectives
Student should be able to
1. Formulate and solve time value of money
problems.
2. Identify sources of data and apply appropriate
techniques to solve economic problems.
3. Understand the importance of data interpretation
and making appropriate economic decisions.
4. Work in multidisciplinary teams, conduct
economical analyses, and communicate the
results

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Course Assessment
▪ Marking Scheme
Quizzes and cases 30%
Mid-term Exam 30%
Final Exam 40%

▪ Class attendance
Attendance is mandatory
• First warning - Fail to attend ~15% of classes
Second warning (WF) - Fail to attend ~25% of classes

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 Chapter 1
Foundations of Engineering Economy
▪ Purpose: Understand and apply fundamental
concepts and use the terminology of engineering
economy
• 1.1 Description and role in decision making
• 1.2 Engineering economy study approach
• 1.4 Interest rate
• 1.5 Terminolgy and symbols
• 1.6 Cash Flows
• 1.7 Economic Equivalence
• 1.8 Simple and Compound Interest
• 1.9 Minimum Attractive Rate of Return (MARR)

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1.1 Description and Role in Decision

Making
▪ Why Engineering Economy is Important to
Engineers (and other professionals)

• Engineers “Design”
• … must be concerned with the economic
aspects of designs and projects they
recommend and perform – economic decisions
• … incorporate economic analysis
• Design (multiple alternatives)
• Synthesis

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 Definition of Engineering Economy

▪ What is Engineering Economics?

• “It is a subset of economics for application to

engineering projects.

• Engineers seek solutions to problems, and the

economic viability of each potential solution is
normally considered along with the technical
aspects”. (WIKIPEDIA)

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Definition of Engineering Economy

▪ Engineering Economy is involved with the

formulation, estimation, and evaluation of
economic outcomes when alternatives to
accomplished a defined purpose are available

▪ Engineering Economy is involved with the

application of defined Mathematical relationships
that aid in the comparison of economic
alternatives

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 Engineering Economics
• The problems that require decisions-making can
be classified into:

• Simple problems - Should I pay cash or use my

credit card?

• Intermediate problems
Engineering
Economy
Analysis

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Intermediate Problems
• Shall I buy or lease my next car?
• Which equipment should be selected for a new
assembly line?
• Which materials should be used as roofing,
windows and structural support for a new
building?

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 Complex problems
• Complex problems are a mixture of economic,
political, and humanistic elements

The decision of Mercedes-Benz to build an automobile assembly

plant in Alabama, USA, illustrates a complex problem.
Beside the economic aspects, Mercedes-Benz had to consider
possible reactions in the American and German auto industries.
Would the German government pass legislation to prevent the
overseas plant?
What about German labor unions?

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1.2 Performing an Engineering

Economy Study

▪ Decision making involves the estimation of

future events/outcomes

▪ Engineering Economy provides a framework

for modeling problems involving:
▪ Time
▪ Money
▪ Interest rates

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 Performing an Engineering
Economy Study

Figure 1 One possible flowchart of the decision process.

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Problem Solving Approach

1. Understand the problem – define objectives
2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
Major Role of
Engineering Economy
7. Implement the alternative
8. Monitor the results
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 Problem Solving Approach
▪ In Identifying the criteria for decision making,
major tools of Engineering Economy are
applied
➢ Present Worth, Future Worth
➢ Annual Worth, Rate of Return
➢ Benefit/Cost, Payback, Capitalized Cost,
Value Added
▪ This lead to the concept of time value of
money

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Time Value of Money

▪ Money can “make” money if Invested
▪ It centers around an interest rate

▪ “It is the change in the amount of money over a

given time period”

➢ By far, the most important concept in

engineering economy”

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 Sec. 1.4: Interest Rate & Rate of Return
▪ Interest is the difference between an ending
amount of money and the beginning amount
❑ There are two types of interest:
▪ Interest paid: when a person borrows money
and repays a larger amount
▪ Interest revenue: when a person saved, or
invested money and obtains a return of a larger
amount
▪ Numerical values are the same for both yet they
are different in interpretation

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Lending Example 1.3

▪ Determine the interest amount and the interest
rate paid for the following:
▪ You borrow $10,000 for one full year
▪ Must pay back $10,700.00 at the end of one year
▪ Interest Earned = $10,700 - $10,000
= $700.00 for one year
▪ Interest rate (i) = $700/$10,000 × 100% = 7% per
year

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 Lending Example 1.4
▪ A company plans to borrow $20,000 from a bank
for one year at 9% interest for a new equipment
▪ Compute the interest and the total amount due
after 1 year
▪ The total interest accrued:
▪ Interest = $20,000 × 0.09 = $1,800.00
▪ The total amount due is the sum of principal and
interest:
▪ Total due = $20,000 + $1,800 = $21,800.00

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Investing Example 1.5

▪ Calculate the amount deposited one year ago to
have $1,000 now at an interest rate of 5% per year
▪ The total amount accrued ($1,000) is the sum of
the original deposit and the earned interest. If “X” is
the original deposit then,
▪ Total amount accrued = original + original × interest
rate
▪ $1,000 = X + X(0.05) which gives a value of
X = $952.38
▪ Calculate the amount of interest earned during this
time period
▪ Interest = $1,000 – 952.38 = $47.62
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 1.5: Terminology & Symbols
▪ P: [dollars]
▪ Value or amount of money at the present time
or time 0
▪ Also, it is referred to as
▪ present worth (PW),
▪ present value (PV),
▪ net present value (NPV), and
▪ capitalized cost (CC)

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Terminology & Symbols

▪ F: [dollars]
▪ Value or amount of money at some future time.
▪ Also, it is called
▪ future worth (FW) and
▪ future value (FV)

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 Terminology & Symbols
▪ The symbols P and F represent one-time
occurrences
$F
i%

0 1 2 … … n-1 n

t=n

$P

▪ It should be clear that a present value P

represents a single sum of money at some time
prior to a future value F
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Terminology & Symbols

▪ A: [dollars per year, dollars per months]
▪ Series of consecutive, equal, end-of-period
amounts of money.
▪ Also, it is called
▪ annual worth (AW)
▪ “A” always represents a uniform amount (i.e.,
the same amount each period) that extends
through consecutive interest periods

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 Terminology & Symbols
▪ Cash Flow diagram for annual amounts might
look like the following:

$A $A $A $A $A

…………
0 1 2 3 .. n-1 n

A = equal, end of period cash flow amounts

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Terminology & Symbols

▪ n: [years, months, days]
▪ Number of interest periods

▪ i: [percent per year, percent per month, percent

per day]
▪ Interest rate or rate of return per time period,
in percent (assumed compound rate)

▪ t = time, stated in periods; years, months, days,

etc

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 Terminology & Symbols
▪ For many engineering economy problems:
▪ Involve the dimension of time
▪ At least 4 of the symbols { P, F, A, i% and n }
▪ At least 3 of 4 are either estimated or
assumed to be know with certainty

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1.6 Cash Flows: Their Estimation

and Diagramming
▪ Cash Inflows - amount of funds flowing into the
firm
▪ Cash Outflows – amount of funds flowing out of
the firm
▪ Net Cash Flow = cash inflows – cash outflows
▪ Assumption for analysis - end of period
➢ Funds flow at the end of a given (interest)
period

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 The Cash Flows Diagram: CFD
▪ Extremely valuable analysis tool
▪ First step in the solution process
▪ Graphical Representation on a time scale
▪ Does not have to be drawn “to exact scale”
➢ But, should be neat and properly labeled
➢ Required on most in class exams and part of
the grade for the problem at hand

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Cash Flows Diagram

▪ A typical cash flow diagram might look like:
1. Draw a time line

0 1 2 … … … n-1 n
One time
period

2. Show the cash flows

Always assume end-of-period
cash flows!

0 1 2 … … … n-1 n

Cash flows are shown as directed arrows (+ve for up or

-ve for down) --- (+) inflow; (-) outflow

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 Displaying Cash Flows
▪ A sign convention is applied
➢ Positive cash flows are normally drawn upward
from the time line
➢ Negative cash flows are normally drawn
downward from the time-line

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Lending – Borrowing Perspective

▪ From the Lender’s Perspective
A = +$1100/yr

0 1 2 3 4 5

-$5,000

▪ From the Borrower’s Perspective

P = +$5,000

0 1 2 3 4 5

A = -$1100/yr
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 1.7: Economic Equivalence

▪ $20,000 now is not equal in magnitude to

$21,800 1 year from now
▪ But, $20,000 now is economically equivalent to
$21,800 one year from now if the interest rate in
9% per year.
▪ Two sums of money at two different points in
time can be made economically equivalent if:
✓ We consider an interest rate and,
✓ No. of Time periods between the two sums

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Sec. 1.8: Simple and Compound Interest

▪ Simple interest is named as such because the

interest calculated is not compounded
▪ Calculated on the principal amount only
▪ Easy (simple) to calculate
▪ The total simple interest over several periods is
computed as:
▪ Interest = (principal) × (number of periods) ×
(interest rate)

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 Example
▪ A company loaned money to an engineering
staff member for a radio-controlled model
airplane. The loan is for $1,000 for 3 years at 5%
per year simple interest
▪ How much money will the engineer repay at the
end of 3 years?
▪ The interest for each of the 3 years is:
▪ Interest per year = $1,000 × 0.05 = $50
▪ Total interest for 3 years is
$1,000 × 0.05 × 3 = $150
▪ The amount due after 3 years is
$1,000 + $150 = $1,150.00
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Example

P=$1,000

1 2 3

I1=$50.00 I2=$50.00 I3=$50.00

Pay back $1000 +

$150 of interest

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 Compound Interest
▪ Compound interest: it is the interest that accrued
for each interest period and is calculated on the
principal plus the total amount of interest
accumulated in all previous periods
▪ Thus compound interest means interest on top
of interest
▪ Compound interest reflects the effect of the time
value of money on the interest
▪ Compound interest for one period = (principal +
all accrued interest) × (interest rate)

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Example
▪ Assume:
P = $1,000 N = 3 years
i = 5% per year compounded annually (C.A.)

• For compound interest, 3 years, we have:

P=$1,000
Owe at t = 3 years:
$1,000 + 50.00 + 52.50
1 2 3
+ 55.13 = $1157.63
I1=$50.00
I2=$52.50

I3=$55.13

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 Sec. 1.9 Minimum Attractive Rate of
Return (MARR)
▪ Investors expect to earn a return on their
investment (commitment of funds) over time
▪ A profitable investment should earn (return)
funds in excess of the investment amounts
▪ Most, if not all, projects should earn at a rate
equal to or greater than the established MARR
▪ A firm’s ROR > MARR > cost of capital

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