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FUNDAMENTALS OF ENGINEERING PROJECT ECONOMICS - 1
Prepared by Prof T.M.Lewis
Our concern here is with project economics so we are interested in how economics interfaces with engineering projects We will look at using economics as a tool for examining the feasibility of implementing a project.
³Economic analysis as applied to engineering is concerned with assessing the real cost of using resources in order to establish priorities between competing proposals. Its purpose is to provide the engineer with a means of judging the relative economic merits of alternative schemes and of ensuring that available resources shall be used to achieve the desired end with the minimum expenditure of means´ The Institution of Civil
Engineers (London) Use economics to choose between alternative projects on the basis of the returns that are generated and the resources that are consumed.
What is Economics? The study of choice and decision-making in a world with limited resources. It explores: 1. producers. The interrelated roles of consumers. and government in an economic system . Growth and productivity 3. The principles of supply and demand and how prices are determined 2. Global interdependence and trade 4.
and consumption of scarce resources. distribution. to produce goods for distribution and consumption in the market. that have alternative uses. choices. . and allocation of scarce resources. Economics studies how individuals and societies seek to satisfy needs and wants through incentives. Engineers use scarce resources.Wikipedia Definition Economics is the study of human choice behavior and how it effects the production.
. 5. People normally act rationally 3. People will normally act in a way that reflects their selfinterest 2. People will normally choose to do things the easy (efficient) way rather than the harder (less efficient) way. If it will cost more to make something than it can be sold for. we would not normally make it.Economics Economics is based on a number of principles and assumptions: 1. If we have to choose between buying from two suppliers we will normally choose to buy from the one with the lower price (other things being equal) 6. People normally prefer more to less 4.
clothing. transportation and entertainment for example But they also want BETTER food. accommodation etc. shelter. . security. People want food.Economics Not all economic choices are clear cut. clothing. Choices become more complicated the more options there are.
so scarcity of resources leads to the need for choices to be made. Once we have to choose. it means we have to give something up. and so we have to make choices. The problem is that we want more things than we can afford.Scarcity Choice is a problem because of µscarcity¶. .
sometimes the net is empty. When it is full they set something aside for the times when it is empty People do not consume all they have immediately. they save some for later.Scarcity There are times when we have plenty and times when we have little .sometimes. . If what they have is perishable they may want to exchange it for something that is not. when the seine is pulled it has fish.
rare shells or teeth.so a medium of exchange as a store of value was introduced.Money In ancient times when people had a surplus they bartered what they had for what they wanted. At first it was some rare and precious commodity (e. .g. people wanted something more durable . or precious metals silver/gold) Nowadays it is (mainly paper) money. The world soon became too complex for bartering to work. and besides.
Its value depends on it being scarce This is worth about US16¢ US16¢ .Money has no intrinsic value .simply a piece of paper which has an agreed store of value (sometimes has a promise to pay ).
It comes in all sorts of values Why is some money worth more than others? This is worth about US$16 Because some money is more scarce .
IT CAN VARY QUITE A LOT FROM DAY TO DAY ESPECIALLY IN TIMES OF HIGH INFLATION .NOTE !!! MONEY DOES NOT HAVE A FIXED VALUE.
47 In May 2008 ZWD 250.000 (500 billion) Yugoslav dinar banknote is the largest nominal value ever officially printed (circa 1993) .000. . dollar. with ZWD 1 = USD 1.000.000.S.INFLATION In 1980 the Zimbabwean dollar was worth more than the U.000 = US20 ¢ Some countries have it worse than others: A 500.
In 2009 due to the effects of hyper-inflation 3 eggs cost ZW$100 billion Inflation rate is 11 million % per annum ± 20% per hour. Every five hours prices double! Due to be revalued on the basis of new Z$1 for old Z$10 billion .
Hyperinflation The value of the currency keeps falling so dramatically because they keep printing more and more of it. It is not scarce There is no demand for it Too much money is available and chasing the same goods .
Deflation is a measure of the decrease in prices .Interest & Inflation 1 Inflation is a measure of the increase in the price of goods in a market It represents a decline in the purchasing power of money because the price of goods is going up.
If you save money. . Interest increases the value of your money while inflation decreases it.Interest & Inflation 2 Interest represents a rate of growth of money savings. The net effect is obviously important. interest increases its purchasing power.
Caribbean Interest Rates What you have to pay to borrow money .
Caribbean Interest Rates What you get for saving money .
50 7.50 7.00 7.50 10.00 2.25 8.50 11.50 8.06 Deposit Rate 1.Spreads .54 21.2006 (The Difference) .00 1.40 7.68 Spread 9.90 9.20 8.00 1.06 19.50 8.50 8.20 1.50 2.50 9.00 3.90 6.50 9.33 4.00 5.00 1.50 14.15 14.50 8.50 12.00 1.00 2.17 5.48 2.What the Bank takes for handling your money Countries Antigua & Barbuda The Bahamas Barbados Belize Dominica Grenada Guyana Jamaica Montserrat St Kitts & Nevis St Lucia St Vincent & Grenadines Trinidad & Tobago Lending Rate 10.00 2.38 As % of Deposit Rate 900 74 93 73 750 750 486 776 375 650 750 750 313 .50 8.
Caribbean Inflation Rates .
48 5.2 = -$2.3 = -$2.25 7.5 5.62 LOSS Guyana : $2.Effect of Inflation Over the year of 2006 if you had savings of $100 you would have earned interest but prices would have gone up the net effect in: Barbados : $5.72 LOSS .30 LOSS Trin & Tob : $2.05 LOSS Jamaica : $2.68 8.8 = -$3.3 = -$5.
3 in T&T should cost US$1 in the USA or the exchange rate is not properly in balance. It is rarely fully in balance because there are so many different goods to compare .Exchange and Value Why do different currencies have different values? Because goods cost different amounts of (local) money The exchange rate is supposed to make the costs of buying things equal in every market What costs TT$6.
Caribbean Exchange Rates .
rather than real.Money illusion Many people think that the T&T $ is weaker than the Barbados $ because its exchange rate against the US$ is higher in T&T (6:1) than Barbados (2:1) . Real value is determined by Purchasing Power . terms this is called Money illusion The value on the note is NOT as important as what it can buy in that country. people tend to think of currency in nominal.but. In other words. it all depends what you can buy for TT$1 here and what that same item costs in Barbados in B$.
Within the OECS. Guyana is the cheapest place to buy a KFC chicken sandwich in the region. Based on prevailing exchange rates to the US$. St Lucia was the cheapest with Antigua & Barbuda tying with St Kitts & Nevis for most expensive. their currencies are over-valued compared with the US$.e.Purchasing Power Parity CHICKENOMICS The KFC chicken sandwich is a standard good and is available in all the Caribbean islands. the most expensive is Cayman Islands with Barbados not far behind i. Suriname and Trinidad were the only countries cheaper than the United States to buy a KFC chicken sandwich i. Guyana.e. . their currencies are under-valued compared with the US$.
We need to know when the bills will have to be paid . We need to be aware of the currencies that will be required.Project Economics Our concern is with the economics of engineering projects We want to build the projects that deliver the highest benefit at the lowest cost. if all cannot be paid for in local $.
On public sector projects especially there will be significant non-cash benefits . they generate benefits over their working life).Principles of Project Appraisal In general terms the projects with which engineers tend to be involved are investment projects (i. This usually means that there is a current outlay of cash in return for an anticipated future flow of benefits.e. they last a relatively long time) in which a capital expenditure is involved (i.e.
± safety equipment (lights and crash barriers) on a road ± determining the degree of protection against flooding. hurricanes and earthquakes. determining whether to rent or buy facilities. office buildings) ± building a road.Principles of Project Appraisal Projects with non-cash costs or benefits must involve an economic evaluation as well as a financial evaluation: building a school constructing a mass-transit system developing agricultural land. ± ± ± ± . equipment or services (e.g.
However.Effect of Time In the broadest terms the principles of project appraisal relate to the quantification of costs and benefits over the life of the project. Would you rather have $100 now or in five year s time? Why? Well it is at least partly because of INTEREST . it is not sufficient simply to examine the total amounts of these costs and benefits because of the 'time value of money'.
and this money is available for others to use in investments. The people who refrain from consumption are compensated for this in the form of interest.Effect of Time People who receive income and do not buy all the goods to which they are entitled save. Interest is a reward for choosing to abstain from consumption The people who borrow have to pay interest for the use of that money .
Interest Interest is the price of money and is determined by supply and demand Supply is determined by people s willingness to save or their marginal time preference rate Demand is determined by people s expectations regarding profits and inflation .
Savings Savings involve risks ± You may not be around to spend it ± The bank may not be around ± The economy may collapse so value may be destroyed or choice reduced ± There may be local or international war ± Alternative investment opportunities may be lost ± Inflation rates may rise ± Currency may be devalued Hence the interest rate is a compensation for these risks .
how much will you have at the end of 2 years? $105 + 105*. for one year.05 = 100(1+0.Time Value of Money If you save $100 today and put it in account earning 5% interest per annum.05) = $105 If you leave the money there. how much will you have at the end of that year? $100 + 100*.05 = 100(1+.25 .05) =$110.05)(1+.
Time Value of Money i = interest rate n = number of periods (years) P = the sum of money you start with F = the sum of money you have in the future This can be expressed as F = P(1+i)n .
Time Value of Money So if you know that F = P(1+i)n This is the Future Worth of a sum of money You also know that P = F/(1+i) n This is the Present Worth of a sum of money .
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