Module 1: Introduction

SI-4251 Ekonomi Teknik

Muhamad Abduh, Ph.D.
Outline Module 1
 What is Economics?
 What is Engineering Economy?
 The Role of Engineering in Shaping the Economic
Environment
 Project Life Cycle
 Some Concepts, Definitions and Terminologies
 Time Value of Money
 Interest and Interest Rate
 Cash Flow

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What is Economics?
 The study of how limited resources are used to satisfy
unlimited human wants.
 The study of how individual and societies choose to use
and utilize scarce resources
 Resources:
 LAND  all gifts of nature that can be applied to the process
(production)
 LABOR  efforts, skills, expertise, knowledge of people which
can be applied to the process
 CAPITAL  human, tools/machineries, financial

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What is Engineering Economy?
 Engineering and the Economy
 Any endeavor, including engineering, will always have consequences
 Engineering endeavor
 Add value  betterment of effectiveness, efficiency, changing conditions
 Add economic value  the most common comparable measurement
 Example:
 Economic decisions
 A piece of equipment has been used for 10 years as part of important
process. Current condition indicates that service level is slightly decrease,
often breaks down. On the other hand the demand for product is in
constant increase, at least for the next 5 years.
 Alternatives:
 Replaced with a new one or to be repaired
 Current and future technology (?)
 Future demand (?)

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Engineering Economy
 Deals with the concepts and techniques of analysis useful
for evaluating the worth of goods, services, system in
relation to cost
 For engineers, it is used to answer questions such as:
 Which engineering projects are worthwhile?
 Which engineering projects should have higher priority?
 How should an engineering project be designed?
 The answers based on the concepts of:
 Cash flows (cash in and cash out)
 Interest rate and time value of money
 Equivalent techniques

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The Role of Engineering in Shaping the
Economic Environment
 Engineering Options
 There are many (engineering) alternative solution for any
problem or challenge
 What solution is best to satisfy? For now or anytime in the
future
 How do we compare one to another?
 Engineering Steps
1. Determine objectives
2. Identification of strategic factors
3. Determine means  engineering proposals
4. Evaluation of engineering proposals  cash flow of
alternatives
5. Decision making  economic evaluation

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Project Life Cycle
Concept &
Definition Phase
Next Cycle
Design Phase

Construction Phase

Level of Change Operation & Maintenance Phase

scope cost

Time

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Time Value of Money
 Purchasing or earning power of money
 Funds borrowed for the prospects of gain are commonly
exchanged for goods, services or instruments of production,
that ultimately leads to increase earning
 Time value of money
 What you could buy with Rp. 1 million a year ago will not be
the same with the ones you buy today.
 Rp. 1 million you invested in a bank a year ago will yield more
when you draw today.
 Rp 1 million today is worth more than a year latter.
 Concept of equivalence  different sums of money at different
time can be equal in economic value.
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n
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Interest and Interest Rate
 Interest is defined as a rental amount charged by financial institution
of the use of money
 Interest rate (also known as rate of capital growth) is defined as the
rate gain received from an investment  measured in %
 Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply and
demand  market value.
 From lender’s point of view:
 Involves risk of default
 Compensate for not taking other alternative (including for own use)
 Cost of investigating borrower and other administrative expenses
 To make up for inflation
 From borrower’s point of view:
 Based in one’s utility, for personal use
 Based on expected return, for financing operation or investment

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Basic Calculation of Interest
Rp. 1 Mill P F Rp. 1 Mill
+ interest

0 1 2 3 n-1 n

 Original investment  present value (P)

 Total accumulated amount  future value (F)
 Interest , I = F – P
 Interest rate, i = (interest accrued per unit time) /
(original amount)

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Simple Interest
 Simple interest = (principal)(number of periods)(interest rate), I = P.n.i
 Accumulated amount, F = P + I = P(1+ni)

i=12%
End of Amount Owed at Interest Amount Owed at Amount Paid at
Period Beginning of Period Charged End of Period End of Period
(A) (B) (C) = (B) x i (D) = (B) + (C)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0
2 Rp. 1.120. 000,- Rp. 120.000,- Rp. 1.240.000,- Rp. 0
3 Rp. 1.240.000,- Rp. 120.000,- Rp. 1.360.000,- Rp. 0
4 Rp. 1.360.000,- Rp. 120.000,- Rp. 1.480.000,- Rp. 1.480.000,-

EXCEL

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 Compound Interest
 Compound interest  interest will be charged for all unpaid amount
 Accumulated amount, F = P(1+i)n
End of Amount Owed at Interest Charged Amount Owed at Amount Paid at
Period Beginning of Period (C) = (B) x i End of Period End of Period
(A) (B) = (C)n-1 (D) = (B) + (C) (E)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0,-
2 Rp. 1.120. 000,- Rp. 134.400,- Rp. 1.254.400,- Rp. 0,-
3 Rp. 1.254.400,- Rp. 150.528,- Rp. 1.404,928- Rp. 0,-
4 Rp. 1.404.928,- Rp. 168.592,- Rp. 1.573.519,- Rp. 1.573.519,-

End of Amount Owed at Interest Amount Owed at End of Period

Period Beginning of Period Charged
1 P Pi P + Pi = P (1+i)1
2 P(1+i) P(1+i) i P(1+i) 1 + P(1+i)i = P (1+i) 2
3 P(1+i) 2 P(1+i) 2i P(1+i) 2 + P(1+i) 2.i = P (1+i) 3
n P(1+i) n-1 P(1+i) n-1i P(1+i) n-1 + P(1+I) n-1i = P(1+i) n EXCEL

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Exercise for Concept of Equivalence
 Loan: $ 5,000, i = 8%, n = 5
 Repayment plans:
 Plan 1: Simple interest, pay all at end.
 Plan 2: Compound interest, pay all at end.
 Plan 3: Simple interest paid annually, principal repaid at end.
 Plan 4: Compound interest and portion of principal repaid
annually.
 Plan 5: Equal payments of compound interest and principal
made annually.

EXCEL

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Cash Flows
 Any undertaking and/or business endeavor (including
engineering projects) generally have economic consequences
that occur over an extended period of time.
 Each project is described as cash received (inflow – cash in) or
disbursement or expenses (outflow – cash out) at different
point in time.
 Cash Flow Diagram (CFD) summarizes the costs and benefits
of engineering project over time. CFD illustrates the size, sign
and timing of individual cash flows and form as the basis for
engineering economic analysis

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Cash Flows Diagram
 In a CFD the end of period t is the same as the
beginning of next period t+1
 The choice of time 0 is arbitrary. It can be when the
project is analyzed, when funding is approved or when
the construction begins

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Homework #1
1. What will be the accumulated amount of Rp 1.750.000,-
compounded annually for three years at the rate of 15% p.a?
2. How much do you have to save now if you’d like to have
Rp. 12.500.000,- to start a new company 3 years from now at
the interest rate of 12% per year?
3. What is the rate of return of an initial investment worth Rp.
30 millions that yield Rp. 45.000.000,- after 3 years?
4. An initial investment of Rp. 50 millions is being considered.
The revenues from this investment are Rp 20 millions at the
end of first year, Rp 25 millions and Rp 15 millions at the end
of second and third years. If the alternative will give a
revenue of Rp 57,5 millions at the end of the third year, which
investment would you recommend? The interest rate is set at
10% annually.
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