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Engineering Economics

CASH FLOWS

2

Engineering Economy

• It deals with the concepts and techniques

of analysis useful in evaluating the worth

of systems, products, and services in

relation to their costs

3

Engineering Economy

• It is used to answer many different

questions

– Which engineering projects are worthwhile?

• Has the mining or petroleum engineer shown that

the mineral or oil deposits is worth developing?

– Which engineering projects should have a

higher priority?

• Has the industrial engineer shown which factory

improvement projects should be funded with the

available dollars?

– How should the engineering project be

designed?

• Has civil or mechanical engineer chosen the best

thickness for insulation?

4

Basic Concepts

• Cash flow

• Interest Rate and Time value of money

• Equivalence technique

5

Cash Flow

• Engineering projects generally have economic

consequences that occur over an extended

period of time

– For example, if an expensive piece of machinery is

installed in a plant were brought on credit, the simple

process of paying for it may take several years

– The resulting favorable consequences may last as

long as the equipment performs its useful function

• Each project is described as cash receipts or

disbursements (expenses) at different points in

time

6

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

– Operations 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

7

Cash Flow diagrams

• The costs and benefits of engineering

projects over time are summarized on a cash

flow diagram (CFD). Specifically, CFD

illustrates the size, sign, and timing of

individual cash flows, and forms the basis for

engineering economic analysis

• A CFD is created by first drawing a

segmented time-based horizontal line,

divided into appropriate time unit. Each time

when there is a cash flow, a vertical arrow is

added pointing down for costs and up for

revenues or benefits. The cost flows are

drawn to relative scale

8

Drawing a Cash Flow Diagram

• In a cash flow diagram (CFD) the end of period t is

the same as the beginning of period (t+1)

• Beginning of period cash flows are: rent, lease, and

insurance payments

• End-of-period cash flows are: O&M, salvages,

revenues, overhauls

• The choice of time 0 is arbitrary. It can be when a

project is analyzed, when funding is approved, or

when construction begins

• One person’s cash outflow (represented as a

negative value) is another person’s inflow

(represented as a positive value)

• It is better to show two or more cash flows occurring

in the same year individually so that there is a clear

connection from the problem statement to each cash

flow in the diagram

9

An Example of Cash Flow Diagram

• A man borrowed $1,000 from a bank at 8%

interest. Two end-of-year payments: at the

end of the first year, he will repay half of the

$1000 principal plus the interest that is due.

At the end of the second year, he will repay

the remaining half plus the interest for the

second year.

• Cash flow for this problem is:

End of year Cash flow

0 +$1000

1 -$580 (-$500 - $80)

2 -$540 (-$500 - $40)

10

Cash Flow Diagram

$1,000

0

1 2

$580

$540

11

Time Value of Money

• Money has value

– Money can be leased or rented

– The payment is called interest

– If you put $100 in a bank at 9% interest for one time

period you will receive back your original $100 plus

$9

Original amount to be returned = $100

Interest to be returned = $100 x .09 = $9

12

Compound Interest

• Interest that is computed on the original

unpaid debt and the unpaid interest

• Compound interest is most commonly

used in practice

• Total interest earned = I

n

= P (1+i)

n

- P

– Where,

• P – present sum of money

• i – interest rate

• n – number of periods (years)

I

2

= $100 x (1+.09)

2

- $100 = $18.81

13

Future Value of a Loan With

Compound Interest

• Amount of money due at the end of a loan

– F = P(1+i)

1

(1+i)

2

…..(1+i)

n

or F = P (1 + i)

n

– Where,

• F = future value and P = present value

• Referring to slide #10, i = 9%, P = $100 and say

n= 2. Determine the value of F.

F = $100 (1 + .09)

2

= $118.81

14

Notation for

Calculating a Future Value

• Formula:

F=P(1+i)

n

is the

single payment compound amount factor.

• Functional notation:

F=P(F/P,i,n) F=5000(F/P,6%,10)

• F =P(F/P) which is dimensionally

correct.

15

Notation for

Calculating a Present Value

• P=F(1/(1+i))

n

=F(1+i)

-n

is the

single payment present worth factor.

• Functional notation:

P=F(P/F,i,n) P=5000(P/F,6%,10)

Interpretation of (P/F, i, n): a present sum P,

given a future sum, F, n interest periods

hence at an interest rate i per interest

period

16

Spreadsheet Function

P = PV(i,N,A,F,Type)

F = FV(i,N,A,P,Type)

i = RATE(N,A,P,F,Type,guess)

Where, i = interest rate, N = number of interest

periods, A = uniform amount, P = present sum

of money, F = future sum of money, Type = 0

means end-of-period cash payments, Type =

1 means beginning-of-period payments,

guess is a guess value of the interest rate

17

Equivalence

• Relative attractiveness of different

alternatives can be judged by using the

technique of equivalence

• We use comparable equivalent values of

alternatives to judge the relative

attractiveness of the given alternatives

• Equivalence is dependent on interest rate

• Compound Interest formulas can be

used to facilitate equivalence

computations

18

Technique of Equivalence

• Determine a single equivalent value at a

point in time for plan 1.

• Determine a single equivalent value at a

point in time for plan 2.

Both at the same interest rate and at the same time point.

•Judge the relative attractiveness of the

two alternatives from the comparable

equivalent values.

19

Engineering Economic Analysis

Calculation

• Generally involves compound interest

formulas (factors)

• Compound interest formulas (factors) can

be evaluated by using one of the three

methods

– Interest factor tables

– Calculator

– Spreadsheet

20

Given the choice of these two plans

which would you choose?

Year Plan 1 Plan 2

0 $5,000

1 $1,000

2 $1,000

3 $1,000

4 $1,000

5 $1,000

Total $5,000 $5,000

To make a choice the cash flows must be altered

so a comparison may be made.

21

Resolving Cash Flows to Equivalent Present

Values

• P = $1,000(PA,10%,5)

• P = $1,000(3.791) =

$3,791

• P = $5,000

• Alternative 2 is better

than alternative 1 since

alternative 2 has a

greater present value

22

An Example of Future Value

• Example: If $500 were deposited in a

bank savings account, how much would

be in the account three years hence if

the bank paid 6% interest compounded

annually?

• Given P = 500, i = 6%, n = 3, use F =

FV(6%,3,,500,0) = -595.91

• Note that the spreadsheet gives a

negative number to find equivalent of P.

If we find P using F = -$595.91, we get

P = 500.

23

An Example of Present Value

• Example 3-5: If you wished to have

$800 in a savings account at the end of

four years, and 5% interest we paid

annually, how much should you put into

the savings account?

• n = 4, F = $800, i = 5%, P = ?

• P = PV(5%,4,,800,0) = -$658.16

• You should use P = $658.16

24

Economic Analysis Methods

• Three commonly used economic analysis

methods are

• Present Worth Analysis

• Annual Worth Analysis

• Rate of Return Analysis

25

Present Worth Analysis

• Steps to do present worth analysis for a

single alternative (investment)

– Select a desired value of the return on

investment (i)

– Using the compound interest formulas bring

all benefits and costs to present worth

– Select the alternative if its net present worth

(Present worth of benefits – Present worth of

costs) ≥ 0

26

Present Worth Analysis

• Steps to do present worth analysis for

selecting a single alternative (investment)

from among multiple alternatives

– Step 1: Select a desired value of the return on

investment (i)

– Step 2: Using the compound interest formulas

bring all benefits and costs to present worth

for each alternative

– Step 3: Select the alternative with the largest

net present worth (Present worth of benefits –

Present worth of costs)

27

Present Worth Analysis

• A construction enterprise is investigating the

purchase of a new dump truck. Interest rate is

9%. The cash flow for the dump truck are as

follows:

• First cost = $50,000, annual operating cost =

$2000, annual income = $9,000, salvage value

is $10,000, life = 10 years. Is this investment

worth undertaking?

• P = $50,000, A = annual net income = $9,000 -

$2,000 = $7,000, S = 10,000, n = 10.

• Evaluate net present worth = present worth of

benefits – present worth of costs

28

Present Worth Analysis

• Present worth of benefits = $9,000(PA,9%,10) =

$9,000(6.418) = $57,762

• Present worth of costs = $50,000 +

$2,000(PA,9%,10) - $10,000(PF,9%,10)=

$50,000 + $2,000(6..418) - $10,000(.4224) =

$58,612

• Net present worth = $57,762 - $58,612 < 0 do

not invest

• What should be the minimum annual benefit for

making it a worthy of investment at 9% rate of

return?

29

Present Worth Analysis

• Present worth of benefits = A(PA,9%,10)

= A(6.418)

• Present worth of costs = $50,000 +

$2,000(PA,9%,10) - $10,000(PF,9%,10)=

$50,000 + $2,000(6..418) - $10,000(.4224)

= $58,612

• A(6.418) = $58,612 A = $58,612/6.418

= $9,312.44

30

Cost and Benefit Estimates

• Present and future benefits (income) and

costs need to be estimated to determine

the attractiveness (worthiness) of a new

product investment alternative

31

Annual costs and Income for a Product

• Annual product total cost is the sum of

annual material, labor, and overhead

(salaries, taxes, marketing expenses,

office costs, and related costs), annual

operating costs (power, maintenance,

repairs, space costs, and related

expenses), and annual first cost minus the

annual salvage value.

• Annual income generated through the

sales of a product = number of units sold

annuallyxunit price

32

Rate of Return Analysis

• Single alternative case

• In this method all revenues and costs of

the alternative are reduced to a single

percentage number

• This percentage number can be compared

to other investment returns and interest

rates inside and outside the organization

33

Rate of Return Analysis

• Steps to determine rate of return for a

single stand-alone investment

– Step 1: Take the dollar amounts to the same

point in time using the compound interest

formulas

– Step 2: Equate the sum of the revenues to the

sum of the costs at that point in time and

solve for i

34

Rate of Return Analysis

• An initial investment of $500 is being

considered. The revenues from this

investment are $300 at the end of the first

year, $300 at the end of the second, and

$200 at the end of the third. If the desired

return on investment is 15%, is the project

acceptable?

• In this example we will take benefits and

costs to the present time and their present

values are then equated

35

Rate of Return Analysis

• $500 = $300(PF, i, n=1) + 300(PF, i, n=2) +

$200(PF, i, n=3)

• Now solve for i using trial and error method

• Try 10%: $500 = ? $272 + $247 + $156 = $669

(not equal)

• Try 20%: $500 = ? $250 + $208 + $116 = $574

(not equal)

• Try 30%: $500 = ? $231 + $178 + $91 = $500

(equal) i = 30%

• The desired return on investment is 15%, the

project returns 30%, so it should be

implemented

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