Exploring Engineering

Chapter 5
Engineering Economics
 Engineering Economics
How much will an engineering project cost?
Simple and compound interest
Cost of borrowing money for an engineering
project
Mathematical and Excel formulae
Breakeven point
Return on Investment

Exploring Engineering
 Engineering Economics
“Money makes the world go around …”
http://www.youtube.com/watch?v=rkRIbUT6u7Q

True in engineering too!

“Cost of Money”: Interest that could be earned if the
amount invested in a business or security was instead
invested in government or in time deposit.
In other words, the business investment vs. a
guaranteed return

Exploring Engineering
 The Cost of Money
Should you buy a car for $20,000 using your own
cash vs. US bonds returning 5%/yr ($600 … forever)
In effect you are paying $1,000 for ever (even after the
car is a certifiable clunker destined for destruction)
Likewise, engineering economics looks beyond the first
cost and adds the interest you have to pay to get the
money to invest

Exploring Engineering
 Simple and Compound
Interest
You have a business project costing $100,000
You get a loan for 7.5% for 5 years at simple interest
payable at the end of the loan
The loan costs $7,500 for each of five years for a total
interest of $37,500
Total cost over 5 years = $137,500
Is the banker really willing to lend you money for 5
years? Isn’t he also lending you $100,000 + 5% of
$7,500 for four years, $15,000 for three years,
$22,500 for two years, $30,000 for four years and
$37,500 for five years?

Exploring Engineering
 Simple and Compound Interest
Guess what? The banker does think you owe him
interest on the interest (known as compound
interest)
He will charge you about $375 after year 1, $750 after
year 2. $1,125 after year 3, $1,500 after year 4 and
$1,875 after year 5
The cost of the 5 year project is thus about
$142,125
Compound interest can be a significant part of an
engineering project

Exploring Engineering
 Terms and Formulae
Principal P is the amount borrowed
# of pay periods, N
Interest rate r per period
Future worth, F, total of how much you have to
payback
Formulae:
Simple interest = P(1 + Nr) ( = $137,500)
Compound interest = P(1 + r)N ( = $143,563)

Exploring Engineering
 Simple and Compound Interest

Exploring Engineering
 Pay Periods
Suppose your load is compounded quarterly,
monthly or daily instead of yearly.
Student loan of $25,000 at 8% for 1) annually
for two years, 2) quarterly and 3) daily
1) r = 0.08 per yr, N = 2 and F = $29,160
2) r = 0.02 per qtr N = 8 and F = $29,291
r = 2.19 x 10-4 per day, N = 730 and F = $29,337
Morale: Watch the effect of increased
compounding!

Exploring Engineering
 Excel Rides to the Rescue …

Exploring Engineering
 Example
A nuclear reactor has
cost $5 Billion when
test trials start that
take an additional 4
years to complete. If
interest rates are 12%
annually (payable
quarterly), what’s the
final reactor cost?

Exploring Engineering
 Example in Excel

Exploring Engineering
 Example Continued
The $5B reactor ends up costing a cool $8 B
Nuclear reactors are only economical if
they are built during times of low cost of
money!

Exploring Engineering
 When is an Investment Worth
it?
‘Break Even Point’ (BEP) has a simple
definition:
BEP occurs when the project has earned back
the cost it took to make it.

Exploring Engineering
 Example
Cost of producing new widget is $1,000,000. If profit
per widget is $1.00 and we’re selling 1,000/day when
is the BEP?.
Need: BEP = _____ years
Know - How: Equate cost to total money stream.
Solve: 1,000 [widgets/day]  1.00 [$/widget]  D [days]
= $1,000,000.
Solving for D gives: D = 1,000 days = 2.74 years.
Most companies require BEP of 12 -18 months to fund
a new widget

Exploring Engineering
 Return on Investment (ROI)
ROI is the ratio of annual return to the cost of the
investment
If an investment of $500,000 produces an income
of $40,000 per year, its ROI is:
ROI = $40,000/$500,000 = 0.08 = 8%.
Many successful large companies operate with
ROI’s of 15% or more

Exploring Engineering
 Return on Investment

Exploring Engineering
 Summary
Manufacturing businesses add to their costs the
cost of borrowing
Compound interest is the only way money is lent
More payment periods is a more expensive loan
Breakeven Point and Return on Investment are the
principal business criteria for a successful
investment
BEP needs to be about 12 -18 months and ROI needs to
be about 15% for a sturdy investment.

Exploring Engineering