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Original Title: Engineering Economics Ch 2

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Dr. Karim

C a s h

F l o w

as

costs

or

revenues

in

projects

financial records.

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

The costs and revenues 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

Salvage value: receipt at project termination for sale or

Revenues: annual receipts due to sale of products or

services

Overhaul: major capital expenditure that occurs during the

The costs and revenues 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

cash flow, a vertical arrow is added pointing

down for costs and up for revenues or benefits.

Cash flows that occur within a time period (both

inflows and outflows), are added together and

represented with a single arrow at the end of the

period.

When space allows, arrow lengths are drawn

proportional to the magnitude of the cash flow.

project or design, we will compare its cash flow

with the cash flow of other alternatives.

Cash-Flow DiagramExample

A grass mower will cost $600. Maintenance costs are

expected to be $180 per year. Income from mowing

grass is expected to be $720 a year. The salvage value

after 3 years is expected to be $175.

OR

+$540 +$540

+$715

+

$175

-$180 -$180 -$180

-$600

-$600

diagram with net cashflow shown at the end

of each time period.

Cash-Flow DiagramPerspective

on your perspective.

interest. From the borrowers perspective, the amount borrowed is

an inflow. From the lenders perspective, it is an outflow.

+$5,000

+$5,300

-$5,300

Borrowers Perspective

-$5,000

Lenders Perspective

The process of calculating

values of cash flows is known

as time value of money.

Time value of money numeral

the sum of interest paid/earned

over a given amount of time.

Time Value of Money?

As a project manager we will need to understandand

recognize the time value of money, which will help us

to understand a variety of financialdecisions such as:

how to put cash flows on an equivalent basis so we can

easily compare the economic utility of multiple options.

$100 received today is worth more than $100

received one year from now.

If you dont believe this, give me $100 and I will gladly

give you back $100 in one year.

That would be a bad deal for you because:

I could invest the money and keep the interest earned on your

money.

If there was inflation in the economy during the time I was

holding onto your money, the purchasing power of the $100 I

give back will be less than the $100 you gave me.

There is a risk I wont return the money.

time you have to take into account the time value of

Interest

Because of the time value of money, whenever

money is loaned, the lender expects to get back

the money loaned plus interest.

Interest is the price paid for the use of borrowed

money.

As with any financial transaction, interest is either

something you pay (a disbursement) or something

you earn (a receipt) depending on whether you

are doing the borrowing or the lending.

Interest Rate

Interest rate Interest paid over a time

period expressed as a percentage of

principal:

Interest rate

Interest paid

Rate of return

Interest earned

Types of Interest

Simple Interest

Interest paid (earned) on only the

original amount, or principal,

borrowed (lent).

Compound Interest

Interest paid (earned) on any previous

interest earned, as well as on the

principal borrowed (lent).

The interest rate that is used in calculations

is known as the effective interest rate.

If compounding is once a year it is known

as the effective annual interest rate.

However, effective quarterly, monthly, or

daily interest rates are also used.

Assume that you will have no need for

money during the next two years, and

any money you receive will immediately

go into your account and earn a 5%

effective annual interest rate.

would be more desirable to

you?

assumptions given. If you choose the first

option, you will immediately place $100 into a

5% account, and in two years the account will

have grown to $110.25.

In fact, the account will contain $110.25 at

the end of two years regardless of which

option

you

choose.

Therefore,

these

( have equal in economic value).

Economic

equivalence

combination of

is

interest rate

and

to determine

different points in time that are

equal in economic value.

The procedure for determining the

equivalent

discounting.

amount

is

known

as

investment earning

simple interest will be

worth in the future ,

Formula

SI:

P0 :

SI = P0(i)(n)

Simple Interest

Deposit today (t=0)

n: Number of Time Periods

Assume that you deposit $1,000 in

an account earning 7% simple

interest for 2 years. What is the

accumulated interest at the end of

the 2nd year?

= P0(i)(n)

SI

$1,000(.07)(2)

=

= $140

What is the Future Value (FV) of the

deposit?

FV = P0 + SI

=

$1,000 + $140

= $1,140

Future Value is the value at some future

time of a present amount of money, or a

series of payments, evaluated at a

given interest rate.

What is the Present Value (PV) of the

previous problem?

The Present Value is simply the

$1,000 you originally deposited.

That is the value today!

Present Value is the current value of a

future amount of money, or a series of

payments, evaluated at a given

interest rate.

Single-Payment Compound-Amount

investment earning

compound interest will be

worth in the future ,

assuming an interest rate

Single

Single Deposit

Deposit Future

Future Value

Value

(Compound

(Compound Interest)

Interest)

FV1 = P0(1+i)1

FV2 = P0(1+i)2

etc ..

FVn = P0 (1+i)n = P0 (FVIFi,n) -- See

Table I

Accordingly,

FV2

= $1,000 (FVIF7%,2)

= $1,000 (1.145)

= $1,145 [Due to Rounding]

Table I: FVIFi,n

Project Example

We are considering a project that will require a $300,000

investment. A viable alternative that must be considered

is to do nothing and bank the money that would have

been invested in the project. What is the value of

$300,000 after 8 years assuming an interest rate of 6%?

In shorthand notation:

Using the formula derived earlier:

FVn = P0 (1+i)n = $300,000 * (1+.06)8 = $478,154

If our 8 year project is expected to return less

than $478,140 (and there arent any intangibles

Single-Payment Present-Worth

How much do we

need to invest today in

order to have a certain

known sum in the future

, assuming an interest

rate of (i)%?

Uniform Series

Equivalence

The previous formulas dealt with the

time value of one-time payments.

The next formulas deal with the time

value of a series of equal payments

(A n n u i t i e s ).

Examples of Annuities

Car Loan Payments

Insurance Premiums

Mortgage Payments

Retirement Savings

Equal-Payment-Series CompoundAmount

(n) periods (year/month/etc) if

we invest a known amount

every period for (n) periods,

assuming an interest rate of

(i)% ?

Va

Vallu

ua

attiio

on

n U

Ussiin

ng

g Ta

Tab

blle

e IIIIII

FVAn = R [

] = R (FVIFAi%,n)

Where:

iis the interest rate per compounding period;

nare the number of compounding periods; and

Ris the fixed periodic payment.

Accordingly, FVA3 = $1,000 (FVIFA7%,3)

= $1,000 (3.215)

= $3,215

Mr A deposited $700 at the end of each month of calendar year 2010

in an investment account of 9% annual interest rate. Calculate the

future value of the annuity on Dec 31, 2011. Compounding is done

on monthly basis.

Solution

We have,

Periodic Payment

Number of Periods

Interest Rate

Future Value

=

R = $700

n = 12

i = 9%/12 = 0.75%

FV = $700 {(1+0.75%)^12-1}/1%

$700 {1.0075^12-1}/0.01

$700 (1.0938069-1)/0.01

$700 0.0938069/0.01

$700 9.38069

$6,566.48

Future Value of an Annuity Due:

FVADn = R [

%,n)(1+i)

](1+i) = R (FVIFAi

Where:

iis the interest rate per compounding

period;

nare the number of compounding

periods; and

Ris the fixed periodic payment.

Calculate the future value of 12 monthly deposits of

$1,000 if each payment is made on the first day of the

month and the interest rate per month is 1.1%.

Solution

Periodic Payment

R = $1,000

Number of Periods n = 12

Interest Rate

Future Value

(1+1.1%)

i = 1.1%

= $1,000 {(1+1.1%)^12-1}/1.1%

= $1,000 {1.011^12-1}/0.011

(1+0.011)

=

$1,000 0.140286/0.011 1.011

$1,000 12.75329059 1.011

$12,893.58

Equal-Payment-Series SinkingFund

How much we need to set

known amount of money at

the end of the equal

payments , assuming an

interest rate of (i)%?

V

Va

a ll u

ua

a tt ii o

on

n U

U ss ii n

ng

g Ta

Ta b

b ll e

e II V

V

Present Value of an Ordinary Annuity =

PVAn

RX

= R (PVIFAi%,n)

PVA3

= $1,000 (PVIFA7%,3)

=

$1,000 (2.624)

= $2,624

Where,

iis the interest rate per compounding period;

nare the number of compounding periods;

and

Ris the fixed periodic payment.

Ta b l e I V: (PVIFAi%,n)

Calculate the present value on Jan 1, 2011 of an annuity of

$500 paid at the end of each month of the calendar year

2011. The annual interest rate is 12%.

Solution

We have,

Periodic Payment

Number of Periods

Interest Rate

Present Value

R = $500

n = 12

i = 12%/12 = 1%

PV = $500 (1-(1+1%)^(-12))/1%

= $500 (1-1.01^-12)/1%

$500 (1-0.88745)/1%

$500 0.11255/1%

$500 11.255

$5,627.54

V

Va

a ll u

ua

a tt ii o

on

n U

U ss ii n

ng

g Ta

Ta b

b ll e

e II V

V

Present Value of an Annuity Due =

RX

PVADn = R (PVIFAi%,n)(1+i)

PVAD3 = $1,000 (PVIFA7%,3)(1.07)

= $1,000 (2.624)(1.07)

= $2,808

Where,

iis the interest rate per compounding period;

nare the number of compounding periods;

and

Ris the fixed periodic payment.

Ta b l e I V: (PVIFAi%,n)

A certain amount was invested on Jan 1, 2010 such that it generated

a periodic payment of $1,000 at the beginning of each month of the

calendar year 2010. The interest rate on the investment was 13.2%.

Calculate the present value of the original investment.

Solution

Periodic Payment

R = $1,000

Number of Periods

n = 12

Interest Rate

i = 13.2%/12 = 1.1%

Original Investment

= PV of annuity due on Jan 1, 2010

= $1,000 (1-(1+1.1%)^(-12))/1.1%

(1+1.1%)

= $1,000 (1-1.011^-12)/0.011 1.011

$1,000 (1-0.876973)/0.011 1.011

$1,000 0.123027/0.011 1.011

$1,000 11.184289 1.011

$11,307.32

on $p borrowed assuming (n)

payments and an interest rate

of i%?

Example: Equal-Payment-Series

Capital Recovery

Engineers, Jane took out a $1000 loan at i = 10% per year for 4

years to buy home office equipment.

Solution

From the lenders perspective, the investment in this young engineer

is expected to produce an equivalent net cash flow of $315.47 for

each of 4 years.

= $1000

= $1000 (A/P,10%,4) =

$315.47

2. Create a time line

3. Put cash flows and arrows on time

line

4. Determine if it is a PV or FV

problem

5. Determine if solution involves a

single

CF or annuity stream(s)

6. Solve the problem

7. Check with financial calculator

(optional)

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