Introduction to

Engineering Economics,
Time Value of Money & Cash Flow
ISE 182112 – Ekonomi Teknik
References
Newnan, D.G, Eschenbach, T.G & Lavelle, J.P (2012) Engineering
Economic Analysis, 11th edition, Oxford University Press, New York.
Chapter 1, 3, dan 4
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

Problems
❑ People are surrounded by a sea of problems
❑ Just in a single day, problems begin with the sound of an alarm
clock
Should I
?
shut off
the
❑ There are alternatives to be
alarm?
considered
Should I
get up
and go to
campus
? ❑ We solve our daily problems
today?
Should I
through (unconscious)
?
eat a
toast for
decision-making process
breakfast
?
Problem Categories
1. Simple Problems
Can be analyzed in one’s head without extensive analysis, does not
seem of great importance.
2. Intermediate Problems
The economics of the situation will be the primary basis of decision
making.
3. Complex Problems
A mixture of economic, political, and humanistic elements
(unpredictable elements).
The Role of Engineering Economic Analysis
❑ What kinds of problems can be solved by engineering economic
analysis?
❑ Intermediate level of problems and the economic aspects of
complex problems.
❑ There may be other aspects, but the economic aspects dominant in
determining its best solution

Engineering economic analysis focuses on costs, revenues, and

benefits that occur at different times.
The Decision Making Process
❑ To have a decision-making situation, there must be at least two
alternatives available
❑ Consider the following :
At a horse race, a bettor was uncertain which of the five horses to bet on in the
next race. He closed his eyes and pointed his finger at the list of horses printed in
the racing program and he got the chosen horse.

Does it represent the process of decision making?

Does it represent a rational decision making?
Rational Decision Making
Nine steps of rational decision-making process :
1. Recognition of a problem
2. Definition of the goal or objective
3. Assembly of relevant data
4. Identification of feasible alternatives
5. Select the criterion for judging the best alternatives
6. Construct the model that describe relationship between the objective, alternatives,
data, and the criterion
7. Prediction of the outcomes for each alternative
8. Choice of the best alternative to achieve the objective
9. Audit the results
Rational Decision Making (2)
1. Recognition of a problem
“I need a new city car”
2. Definition of the goal or objective
“I need a car that is most economic”
3. Assembly of relevant data
“I need information on price, fuel consumption, and ease of finding spare parts”
4. Identification of feasible alternatives
“I will visit several showrooms and exhibitions, also use information from friends and family to get car
alternatives”
5. Select the criterion for judging the best alternatives
“It’s important to get the most economic price and usage cost”
Rational Decision Making (3)
6. Construct the model that describe relationship between the objective, alternatives, data, and the
criterion
“I’ll define mathematical relationship between initial buying cost, fuel cost, and maintenance cost”

7. Prediction of the outcomes for each alternative

“I’ll calculate the estimated costs for each car alternative”

8. Choice of the best alternative to achieve the objective

“Car A has cheaper price but its fuel consumption isn’t good enough. Car B has higher price but its long
term costs is cheaper so I’ll choose it.”

9. Audit the results

“Compare the actual cost againts its predictions.”
Cost estimating
❑ Engineering economic analysis focuses on the future consequences of current
decision.
❑ The consequences are in the future → need to be estimated and can't be
known with certainty.
❑ Estimated consequences may include: purchase costs, annual revenue, yearly
maintenance, interest rate for investments, annual labor and insurance costs,
equipment salvage value, and tax rates.

❑ The costs and benefits of eng. projects occur over time and are summarized on
a cash flow diagram (CFD).
Cash Flow Diagram
❑ Is a graphical device used to clarify the timing of the cash flows for
an investment.
❑ CFD ilustrate the size, sign, and timing of individual cash flow.
Steps:
(+) receipts
F
1. Draw segmented time -based horizontal
End of Period 4,
Period 1 beginning of
line, divided into time units.
Today 0 Period 5 2. Each time a cash flow will occur → Add
vertical arrow. Cashflow drawn to scale.
1 2 3 4 5

P (-) disbursements Cash flows are assumed to occur at

or payments time 0 or at the end of each period.
Categories of Cash Flows
The expenses and receipts due to engineering projects usually fall into one
of the following categories:
❑ First cost ≡ expense to build or to buy and install
❑ Operating and maintenance (O&M) ≡ annual expense, such as electricity, labor,
and minor repairs
❑ Salvage value ≡ receipt at project termination for sale or transfer of the
equipment (can be a salvage cost)
❑ Revenues ≡ annual receipts due to sale of products or services
❑ Overhaul ≡ major capital expenditure that occurs during the asset’s life
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

Time Value of Money
Would you prefer to receive:

A year
Now? or from now?
Time Value of Money (2)
❑ Money is quite a valuable asset, so valuable that people are willing
to pay to have money available now for their use

Apartment → Rent --- Money → Interest

❑ Interest rate
→ The compensation paid for the use of funds expressed as a
percentage for a period (normally expressed as an annual rate).
Time Value of Money (3)
❑ A dollar received today is worth more than a dollar received
tomorrow
→ This is because a dollar received today can be invested to earn
interest
→ The amount of interest earned depends on the rate of return that
can be earned on the investment

❑ Time value of money quantifies the value of a dollar through time.

Time Value of Money (4)
Would you prefer to receive:

Now? or A Year from now?

If Bank offers 10% interest per year, and the money invested for one year. How
much will you receive back at the end of the year?
You will receive $1,000,000 plus $100,000 interest, for total $1,100,000.

There is time value of money in the form of the willingness of banks, businesses,
and people to pay interest for the use of various sums.
Interest Rate vs Interest

❑ If you invested money at some time in the past :

Interest = total amount now – original amount

❑ If you borrowed money at some time in the past :

Interest = amount owed now – original amount

There is an increase in the amount of money that was originally invested or

borrowed → interest

Interest that is expressed as a percentage for a period → interest rate

Interest Formula
❑ i = interest rate per interest period
❑ n = number of interest periods
❑ P = a present sum of money
❑ F = a future sum of money
Simple interest
❑ Interest that is computed only on original sum, not on accrued interest.
Total interest earned = P x i x n = Pin

❑ At the end of n years, the amount of money, F, would equal the amount of the
loan P plus the total interest earned (Pin).
F = P + Pin = P (1+in)

❑ The amount earned (for invested money) or due (for borrowed money) in
one period does not effect the principal for interest calculation in later
period.
Example of simple interest
❑ You agreed to loan a friend $100 for 5 years at a simple interest rate =
10% per year. how much will your friend pay you at the end of 5 years?
P = $100
n = 5 years
i = 10%
Total interest earned = Pin = 100. 0,1 . 5 = $50
F = P + Pin = 100 + 50 = $150.
Interest at the end of 1st year: $100 x 0,1 = $10, but this money is not paid to you
until the end of 5th year.
Compounded interest
❑ Interest on top of interest.
❑ For a loan, any interest owed but not paid at the end of the year is
added to the balanced due.
❑ Then the next year’s interest is calculated on the unpaid balance
due, which includes the unpaid interest from the preceding period.
Example of Compounded interest
If you invest $100 now with interest rate = 10% per year, how much will you
have at the end of the year?
You will have $100 plus $10 interest, total = $110

Then instead of removing the investment at the end of 1st year, you let it
remain for another year.
How much will you have at the end of 2nd year?
How much will you have at the end of 3rd year?
How much will you have at the end of 4th year?
How much will you have at the end of 5th year?
Example of Compounded interest (2)
Total Principal
Interest owed at the end of year n Total Amount Due at
Year on which interest is
from Year n’s unpaid total principal the end of year n
calculated in year n

0 (now) - - $100
1 $100 $100 x 10% = $10 $110

2 $110 $110 x 10% = $11 $121

3 $121 $121 x 10% = $12,1 $133,1

4 $133,1 $133,1 x 10% = $13,31 $146,41

5 $146,41 $146,41 x 10% = $14,641 $161,051

It is called compound interest → charging interest on unpaid interest

Equivalence
Which one would you choose :

2 bags of or 2 kgs of
gold? gold?
Equivalence (2)
Which one would you choose :
Year Plan 1 Plan 2
1 $10.000 $3000
2 $3000
3 $3000
4 $3000
$10.000 $12.000

To make a decision, the cash flows must be altered so that they can be compared
→ The technique of equivalence is needed
Equivalence (3)
Which one would you choose :
Year Plan 1 Plan 2
1 $10.000 $3000
2 $3000
3 $3000
4 $3000
$10.000 $12.000

Determine an equivalent value at some point in time for Plan1 and a comparable equivalent
value for Plan2, based on selected interest rate.
Judge relative attractiveness not from their cash flow, but from comparable equivalent values.
Equivalence (4)
❑ Interest rate = 10% per year
Alternative 1 : Given $100 now
Alternative 2 : Given $110 next year
Which one would you choose?

Determine an equivalent value at some point in time for Plan1 and a

comparable equivalent value for Plan2, based on selected interest rate.

In both cases, you would have $110 one year from now.
→ The two sums of money are equivalent
Equivalence (5)
❑ Interest rate = 10% per year
Alternative 1: Given $100 now
Alternative 2: Given $125 two years from now
Which one would you choose?

With interest rate = 10%, $100 now is equivalent to $121 two years
from now.
→ Choose Alternative 2
Equivalence (6)
❑ Interest rate = 20% per year
Alternative 1: Given $100 now
Alternative 2: Given $115 next year
Which one would you choose?

With interest rate = 20%, $100 now is equivalent to $120 a year from
now.
→ Choose Alternative 1
Equivalence (7)
When we are indifferent as to whether we have quantity of money
now or the assurance of some other sum of money in the future, or
series of future sums of money → the present sum of money is
EQUIVALENT to the future sum or series of future sums.

In engineering economic, the technique of equivalence must be used to compare

different alternatives

Equivalence depends on interest rate

Equivalence is dependent on interest rate
Alternative 1 : Given $100 now
Alternative 2 : Given $110 next year

❑ If interest rate = 10% per year, Which one would you choose?
Both alternative are equivalent.
❑ If interest rate = 8% per year, Which one would you choose?
Alternative 2 more attractive.

Changing the interest rate destroys the equivalence between two series of
payments.
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

Single Payment compound AMOUNT
Formulas
Suppose a present sum of money P is invested for one year at interest rate i.
❑ At the end of year 1, we should have: beginning amount + interest
= P + iP = P(1+i)

❑ If we keep the investment,

at the end of year 2 we should have: beginning amount + interest
= P(1+i) + iP(1+i)
= P(1+i) (1+i)
= P(1+i)2
Single Payment compound AMOUNT
Formulas (2)
Beginning Amount at the
n + Interest =
amount end of year n

1 P + iP = P(1+i)
2 P(1+i) + iP(1+i) = P(1+i)2
3 P(1+i)2 + i P(1+i)2 = P(1+i)3
…
n P(1+i)n-1 + iP(1+i)n-1 = P(1+i)n
A present sum P, at interest rate i, increases in n periods to P(1+i)n.
Future sum = Present sum x (1+i)n
F = P (1+i)n
Example 1
A man borrowed $100 from a bank today. He must repay the loan in 5 years. If the
interest rate is 3%, how much must he pay in the end of 5th year?
P = $100
n =5 P = $100

i = 3%
F =?
0 1 2 3 4 5
F= P(1+i)n
= $100(1+0,03)5 F=?
= $115,9 ≈ $116
At 3% interest rate, $100 now is equivalent to $116 five years from now.
Single payment compund amount formula

A present sum P, invested in n periods at interest rate i.

Its equivalent future sum (F) is :
F = P (1+i)n

F = P (F/P,i,n)
F=?

0 1 2 3 … n

P
With the same previous case..
P = $100 P = $100
i = 3%
n =5
0 1 2 3 4 5
F = P (F/P,i,n)
= $100 (F/P,3%,5) F=?

= $100 x 1.159
= $115,9 ≈ $116
Example 2
How much money should we deposit in the bank now if we want to have $116 in
our account 5 years from now? Assume the interest rate is 3%.

F = $116
F = $116
n=5
i = 3%
P=? 0 1 2 3 4 5

P=?
Single payment present worth formula
If F = P (1+i)n, how can we calculate P, given a future sum F?

Future sum = Present sum x (1+i)n

Present sum = Future sum / (1+i)n

P = F / (1+i)n
Example 2
How much money should we deposit in the bank now if we want to have
$116 in our account 5 years from now? Assume the interest rate is 3%.
F = $116
F = $116
i = 3%
n=5
0 1 2 3 4 5
P = F/(1+i)n
= $116/(1+3%)5 P=?
= $100.06 ~ $100

Remember, earlier we’ve found out that at 3% interest rate, $100 now is equivalent to
$116 five years from now.
Single payment present worth formula
A future sum F, obtained in n periods at interest rate i. Its equivalent
present sum (P) is :

P = F / (1+i)n = F (1+i)-n

P = F (P/F,i,n)
F

0 1 2 3 … n

P=?
With the same previous case..
F = $116
F = $116
i = 3%
n=5 0 1 2 3 4 5

P=?

P = F(P/F,i,n)
= $116 (P/F,3%,5)
= $116 x 0.8626
= $100.06 ~ $100
Exercise 1
Mr. Smith has a 13-year old daughter, and she has just announced her
desire to attend college. After some research, he determines that he
will need about $100,000 on her 17th birthday to pay for it. If he can
earn 9% per year on his investments, how much does he need to invest
today to achieve his goal?

(Answer: $70,840)
Exercise 2
Suppose Mr. Smith decides to deposit $21,870 each year to the bank
for 4 years, beginning next year, with interest rate = 9%. How much
money will he have at the end of 4th year?

(Answer= $100,011.51)
to be continued…..
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

Interest Formula
• i =
interest rate per interest period
• n =
number of interest periods
• P =
a present sum of money
• F =
a future sum of money
• A =
an end-of-period cash receipt or disbursement in a uniform
series, continuing for n periods
• G = uniform period-by-period increase or decrease in cash receipts
or disbursements
Uniform Series COMPOUND interest
Formulas
❑ Uniform series of cash flow (receipts or disbursements) for all
period length.
Annuity (A) is
❑ An end of period cash of receipt/
payment in a uniform series,
continuing for n periods.
❑ A series of nominally equal receipts/
payments equally spaced in time.
Uniform series COMPOUND AMOUNT formula

An amount A, invested at the end of each year for n years, at interest

rate i.
Its equivalent future sum (F) is:
A A A A A

0 1 2 3 … n
F = A (F/A,i,n)
F=?
 A A A A A

F = A (F/A,i,5)
0 1 2 3 4 5
F=?
A A A A

F = A (F/A,i,4)
0 1 2 3 4
F=?

A A A

F = A (F/A,i,4)
0 1 2 3 4
F=?
Uniform series SINKING FUND formula

❑ A sinking fund is a separate fund into which one makes a uniform

series of money deposits (A) to accumulate a desired future sum (F)
by the end of period n.
A=?

0 1 2 3 … n
A = F (A/F,i,n)
F
Uniform series capital recovery formula

❑ How large does the annual return, A, have to be to “recover” the

capital, P, that is invested at Time 0.

A=?

0 1 2 3 … n
A = P (A/P,i,n)
P
Uniform series present worth formula
An amount A, invested at the end of each year for n years, at interest
rate i.
Its equivalent present sum (P) is:
A A A A A
𝟏+𝒊 𝒏 −𝟏
P=A
𝒊 𝟏+𝒊 𝒏

0 1 2 3 … n

P = A (P/A,i,n)
P=?
 A A A A A

P = A (P/A,i,5)
0 1 2 3 4 5
P=?
A A A A

P = A (P/A,i,4)
0 1 2 3 4
P=?

A A A A A

P = A (P/A,i,4)
0 1 2 3 4
P=?
Recall from Exercise 2
Suppose Mr. Smith decides to deposit $21,870 each year to the bank for 4 years, beginning
next year, with interest rate = 9%. How much money will he have at the end of 4th year?

A = $21,870 F=?
n=4
0 1 2 3 4
i = 9%

F = $21,870 (F/A,9%,4)
= $21,870 x 4.573 A = $21,870

= $100,011

(The present value equivalent of this investment is...)

 Exercise 3
$200 $200 $200 $200 $200

a=? i=10% c=?

$200 $200 $200 $200 $200

b=? d=?
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

Arithmetic Gradient
Cash flow series is not of constant amount A, but uniformly increasing.

Uniform Series Uniformly Increasing Series

4G
3G
2G
G

1 2 3 4 5
 P = P’ + P”

P’ = A (P/A, i, n)

P’’ = G (P/G, i, n)
Arithmetic Gradient present worth FORMULA

𝟏+𝒊 𝒏 −𝒊𝒏−𝟏
P’’ = G
𝒊𝟐 𝟏+𝒊 𝒏

0 1 2 3 4 n

P’’ = G (P/G,i,n)
P”=?
 Newnan, p.98-99: Example 4-8

Example 3
0 1 2 3 4 n

P”=?
Example 4
i=5%
$1250
$1000
A = $500
$750 G = $250
$500
P = A(P/A,5%,4) + G(P/G,5%,4)

1 2 3 4

P=?
Arithmetic Gradient UNIFORM SERIES FORMULA

3G

2G
G

1 n
A = G (A/G,i,n)
A=?
 Newnan, p.100: Example 4-9

Example 5
 3G
2G

1 n
A=?

This is not the proper form for the

arithmetic gradient uniform series
equation
 A=

1 2 3 4
Example 6
Operational cost of a machine is $150 at the end of the first year. It’s predicted that
the cost will increase by $100 per year. The machine estimated life is 4 years.
If i=6%, what is the equivalent uniform annual operational cost for the machine?

450
350
250
$150 A = $150 +$100(A/G,6%,4)

1 2 3 4
A=?
Outline

Introduction

Time Value of Money

Single Payment Compound Interest Formula

Uniform Series Compound Interest Formula

Arithmetic Gradient

Nominal and Effective Annual Interest Rate

If you invest $100 now with interest rate = 10% per year, how much will you
have at the end of the first and second year?
1st year: $100+$10 = $110 = $100 (F/P,10%,1)
2nd year: $110+$11 = $121 = $100 (F/P,10%,2)

If the interest rate was 10% per month, compounded monthly, how much
would you have at the end of the 1st and 2nd month?
1st month: $100+$10 = $110 = $100 (F/P,10%,1)
2nd month: $110+$11 = $121 = $100 (F/P,10%,2)

So how much would you have at the end of the first year?
1st year: $100 (F/P,10%,12) = $313.8
If P=100, i=10% per year, compounded annually:
Fat the end of 1st year = $110

If P=100, i=10% per month, compounded monthly:

Fat the end of 1st year = $313.8

Different compounding periods → different results.

Example 7
A person borrow $100 from a bank with 5% interest, compounded
semi annually. How much will this loan be at the end of 1st year?

5% compounded semi annually → 2.5% per semester

1st semester: $100+$100*2.5% = $102.5

2nd semester: $102.5+$102.5*2.5% = $105.06

If P=100, i=5% per year, compounded semi-annually:
Fat the end of 1st year = $105.06

If P=100, i=5% per year, compounded annually:

Fat the end of 1st year = $105

Different compounding periods → different results.

P = $100, F(1 year) = $105.06
How much is the interest rate?

Effective interest rate per year

Effective and Nominal interest rate
❑ Effective interest rate (ieff) per interest period
is the interest rate considering the effect of any compounding during the
period.

❑ Nominal interest rate (r) per interest period

is the interest rate without considering the effect of any compounding.

Previous example: i=5%, compounded semi annually

→ Nominal interest rate (r) = 5%
Effective interest rate (ieff) = 5.06 %
Effective Interest Rate
Effective interest rate (ieff) per interest period :
𝒓 𝒎 𝒎
ieff = 𝟏 + −𝟏= 𝟏+𝒊 −𝟏
𝒎

r = nominal interest rate per interest period

m= number of compounding during the period

i = interest rate used in each compounding

 m = number of compounding
Example 8 ieff = 𝟏 + 𝒊 𝒎
−𝟏
during the period
i = interest rate used in each
compounding

A person borrow $100 from a bank with 5% interest, compounded

semi annually. How much will this loan be at the end of 1st year?

r = 5%
m =2
i = r/m = 5%/2 = 2.5%

ieff = (1+2.5%)2 - 1 = 5.06%

 m = number of compounding
Exercise 5 ieff = 𝟏 + 𝒊 𝒎
−𝟏
during the period
i = interest rate used in each
compounding

If a savings bank pays 1.5% interest every three months, what are the
nominal and effective interest rate per year?

(Answer: r = 6%, ieff = 6.1%)

Exercise 6
What are the nominal and effective interest rate per year, if:
a. i=10% per year, compounded annually
b. i=10% per month, compounded monthly
c. i=10% per quarter, compounded quarterly
d. i=10% per quarter, compounded daily
Terima Kasih
Yani Herawati
Program Studi Teknik Industri
UNPAR
yani.herawati@unpar.ac.id