President Ramon Magsaysay State

University
Iba, Zambales, Philippines
Tel/Fax No.: (047) 811-1683

College of Engineering
BES02: Engineering Economics
Semester of A.Y. 2020-2021

Introduction

This course deals with the study of concepts of the time value of money and
equivalence; basic economic study methods; decisions under certainty; decisions
recognizing risk; and decisions admitting uncertainty.

Intended Learning Outcomes

COURSE MODULE

After completing this course, the student must be able to:

A. Solve problems involving interest and the time value of money;
B. Evaluate project alternatives by applying engineering economic principles and
methods and select the most economically efficient one; and
C. Deal with risk and uncertainty in project outcomes by applying the basic economic
decision-making concepts.

Discussion

ECONOMIC STUDY METHODS

THE MINIMUM ATTRACTIVE RATE OF RETURN

For any investment to be profitable, the investor (corporate or individual) expects to

receive more money than the amount of capital invested. In other words, a fair rate of
return, or return on investment, must be realizable. The definition of ROR in Equation [1.4] is
used in this discussion, that is, amount earned divided by the principal.

The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return established for
the evaluation and selection of alternatives. A project is not economically viable unless it is
expected to return at least the MARR. MARR is also referred to as the hurdle rate, cutoff
rate, benchmark rate, and minimum acceptable rate of return.

Figure 1–12 indicates the relations between different rate of return values. In the United

1
Engr. Michelle Angela A. Alejandro
 States, the current U.S. Treasury Bill return is sometimes used as the benchmark safe rate.
The MARR will always be higher than this, or a similar, safe rate. The MARR is not a rate that
is calculated as a 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.

To develop a foundation-level understanding of how a MARR value is established and

used to make investment decisions. Although the MARR is used as a criterion to decide
on investing in a project, the size of MARR is fundamentally connected to how much it
costs to obtain the needed capital funds. It always costs money in the form of interest to
raise capital. The interest, expressed as a percentage rate per year, is called the cost of
capital. As an example, on a personal level, 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. 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. 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. 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. In
COURSE MODULE

analogous ways, corporations estimate the cost of capital from different sources to raise
funds for engineering projects and other types of projects.

Figure 1–12 Size of MAAR relative to other rate of return values.

In general, capital is developed in two ways—equity financing and debt financing. A
2
Engr. Michelle Angela A. Alejandro
 combination of these two is very common for most projects. Chapter 10 covers these in
greater detail, but a snapshot description follows.

Equity financing. The corporation uses its own funds from cash on hand, stock sales, or
retained earnings. Individuals can use their own cash, savings, or investments. In the
example above, using money from the 5% savings account is equity financing.

Debt financing. The corporation borrows from outside sources and repays the principal
and interest according to some schedule, much like the plans in Table 1–1. Sources of debt
capital may be bonds, loans, mortgages, venture capital pools, and many others.
Individuals, too, can utilize debt sources, such as the credit card (15% rate) and bank
options (9% rate) described above.
COURSE MODULE

Combinations of debt-equity financing mean that a weighted average cost of capital

3
Engr. Michelle Angela A. Alejandro
 (WACC) results. 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
0.4(15) 0.6(5) 9% per year.

For a corporation, the established MARR used as a criterion to accept or reject an

investment alternative will usually be equal to or higher than the WACC that the
corporation must bear to obtain the necessary capital funds. So, the inequality must be
correct for an accepted project. Exceptions may be government-regulated requirements
(safety, security, environmental, legal, etc.), economically lucrative ventures expected to
lead to other opportunities, etc.

Often there are many alternatives that are expected to yield a ROR that exceeds the
MARR as indicated in Figure 1–12, but there may not be sufficient capital available for all,
or the project’s risk may be estimated as too high to take the investment chance.
Therefore, new projects that are undertaken usually have an expected return at least as
great as the return on another alternative that is not funded. The expected rate of return
on the unfunded project is called the opportunity cost.

The opportunity cost is the rate of return of a forgone opportunity caused by the inability to
COURSE MODULE

pursue a project. Numerically, it is the largest rate of return of all the projects not accepted
(forgone) due to the lack of capital funds or other resources. When no specific MARR is
established, the de facto MARR is the opportunity cost, i.e., the ROR of the first project not
undertaken due to unavailability of capital funds.

As an illustration of opportunity cost, refer to Figure 1–12 and assume a MARR of 12% per
year. Further, assume that a proposal, call it A, with an expected ROR = 13% is not funded
due to a lack of capital. Meanwhile, proposal B has a ROR = 14.5% and is funded from
available capital. Since proposal A is not undertaken due to the lack of capital, its
estimated ROR of 13% is the opportunity cost; that is, the opportunity to make an
additional 13% return is forgone.

BASIC ECONOMIC STUDY METHODS: PRESENT WORTH, FUTURE WORTH, ANNUAL WORTH, RATE
OF RETURN

The 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
4
Engr. Michelle Angela A. Alejandro
 (outflows) will be assigned with negative sign.

a. Revenue-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in Fig.

To find the present worth of the above cash flow diagram for a given interest rate, the
formula is
COURSE MODULE

b. Cost-Dominated Cash Flow Diagram

A generalized cost-dominated cash flow diagram to demonstrate the present worth

method of comparison is presented in Fig.

To compute the present worth, amount of the above cash flow diagram for a given
interest rate i, we have the formula

The Future Worth Method

5
Engr. Michelle Angela A. Alejandro
  In the future worth method of comparison of alternatives, the future worth of various
alternatives will be computed.

 Then, the alternative with the maximum future worth of net revenue or with the
minimum future worth of net cost will be selected as the best alternative for
implementation.

a. Revenue-Dominated Cash Flow Diagram

A generalized revenue-dominated cash flow diagram to demonstrate the future

worth method of comparison is presented in Fig.
COURSE MODULE

In Fig. P represents an initial investment, Rj the net-revenue at the end of the jth year, and S
the salvage value at the end of the nth year.

The formula for the future worth of the above cash flow diagram for a given interest rate, i
is

In the above formula, the expenditure is assigned with negative sign and the revenues are
assigned with positive sign.

b. Cost-Dominated Cash Flow Diagram

A generalized cost-dominated cash flow diagram to demonstrate the future worth

method of comparison is given in Fig.

In Fig., P represents an initial investment, Cj the net cost of operation and

maintenance at the end of the j th year, and S the salvage value at the end of the
6
Engr. Michelle Angela A. Alejandro
 nth year.

The formula for the future worth of the above cash flow diagram for a given interest
rate, i is

The Annual Equivalent Method

 In the annual equivalent method of comparison, first the annual equivalent cost or
the revenue of each alternative will be computed.

 Then the alternative with the maximum annual equivalent revenue in the case of
revenue-based comparison or with the minimum annual equivalent cost in the case
of cost- based comparison will be selected as the best alternative.

a. Revenue-Dominated Cash Flow Diagram

COURSE MODULE

A generalized revenue-dominated cash flow diagram to demonstrate the annual

equivalent method of comparison is presented in Fig.

In Fig. P represents an initial investment, Rj the net revenue at the end of the j th year, and
S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following
expression for a given interest rate, i:

In the above formula, the expenditure is assigned with a negative sign and the revenues
are assigned with a positive sign.

b. Cost-Dominated Cash Flow Diagram

7
Engr. Michelle Angela A. Alejandro
 A generalized cost-dominated cash flow diagram to demonstrate the annual
equivalent method of comparison is illustrated in Fig.

In Fig, P represents an initial investment, Cj the net cost of operation and maintenance at
the end of the jth year, and S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following
relation for a given interest rate, i.
COURSE MODULE

Rate of Return Method

 The rate of return of a cash flow pattern is the interest rate at which the present
worth of that cash flow pattern reduces to zero.

 In this method of comparison, the rate of return for each alternative is computed.
Then the alternative which has the highest rate of return is selected as the best
alternative.

 A generalized cash flow diagram to demonstrate the rate of return method of

comparison is presented in Fig

In the above cash flow diagram, P represents an initial investment, Rj the net revenue at
the end of the jth year, and S the salvage value at the end of the nth year.

The first step is to find the net present worth of the cash flow diagram using the following
expression at a given interest rate, i.
8
Engr. Michelle Angela A. Alejandro
 Assessment

Link for the online quiz will be announced in the messenger group at the end of the week.
Answering will be done the same day upon posting of announcement.

Resources and Additional Resources

 R. Pammeerselvam (2012), Engineering Economics 2nd Edition

 Sasmita Mishra (2010), Engineering Economics and Costing 2nd Edition
COURSE MODULE

9
Engr. Michelle Angela A. Alejandro