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Chapter 1
Foundations Of
Engineering Economy
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-1
LEARNING OBJECTIVES
1. Questions 7. Symbols
2. Decision making 8. Spreadsheet
functions
3. Study approach
9. Minimum
4. Interest rate
attractive rate of
5. Equivalence return
6. Simple and 10.Cash flows
compound
11.Doubling time
interest
12.Spreadsheets
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-2
Sct 1: Why Engineering Economy is Important
to Engineers
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-3
Engineering Economy
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-4
Sct 1.2 Role of Engineering Economy in
Decision Making
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-5
The Decision Making Process
1. Understand the problem – define objectives
2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply sensitivity
analysis
6. Select the “best” alternative
7. Implement the alternative and monitor results
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-6
Time Value of Money
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-7
Sct 1.3 Performing An Engineering Economy
Study
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-8
Sct 1.4 Interest Rate and Rate of Return
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-9
Rate of Return
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-10
Sct 1.5 Equivalence
Different sums of money at different times may be
equal in economic value $106 one
year from now
0 1
Interest rate = 6% per year
$100 now
$100 now is said to be equivalent to $106 one year from now, if the
$100 is invested at the interest rate of 6% per year.
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-11
Sct 1.6 Simple and Compound Interest
Simple Interest:
Interest = (principal)(number of periods)(interest rate)
Compound Interest:
Interest earns interest on interest
Compounds over time
Interest = (principal + all accrued interest) (interest rate)
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-12
Sct 1.7 Terminology and Symbols
P = a present sum of money at a time designated
as t = 0 { t represents time}
F = a future amount of money at some point in
time later than t = 0
A = a series of equal, end-of-period cash flows
n = the number of interest periods
i = the interest rate or rate of return per time
period, in percent
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-13
Sct 1.8 Introduction To Solution By Computer
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-14
Sct 1.9 Minimum Attractive Rate of Return
Investors expect to earn a return on their investment
(commitment of funds) over time
We expect to see economic efficiencies greater than
100%
A profitable investment should earn (return) funds in
excess of the investment amounts
Economic projects should earn a reasonable return,
which is termed:
MARR – Minimum attractive rate of return
Also termed the “hurdle” rate for an investment
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-15
The MARR
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-16
Types of Financing
Equity Financing – the firm uses funds either from
retained earnings, new stock issues, or owner’s
infusion of money
Debt Financing – the firm borrows funds from
outside sources
The cost of debt financing = the interest rate charged
on the debt (loan) amounts
The MARR is approximated from the weighted
average cost of all sources of capital to the firm
A firm’s ROR > MARR > cost of capital
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-17
Sct 1.10 Cash Flows: Their Estimation and
Diagramming
Definition of terms
Cash Inflows - amount of funds flowing into the firm
Cash Outflows – amount of funds flowing out of the firm
Net Cash Flow equals
cash inflows – cash outflows
Assumption for analysis – end of period
Funds flow at the end of a given (interest) period
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-18
Cash Flow Diagrams
A typical cash flow diagram might look like:
1. Draw a time line
0 1 2 … … … n-1 n
One time period
0 1 2 … … … n-1 n
Cash flows are shown as directed arrows (+ for up or – for down) ---
(+) inflow; (-) outflow
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-19
Sct 1.11 Rule of 72: Estimating Doubling
Time or Interest Rate
Common question:
Estimate the number of time periods it takes for a cash
flow to double in size
Given an interest rate i% per period
The approximate time n for an investment at time
t = 0 to double in value is given by:
n = 72/i
e.g., $10,000 at 7% per year doubles to $20,000 in
10.3 years
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-20
Sct 1.12 Spreadsheet Application
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-22
End of Slide Set
Slide Sets to accompany Blank & Tarquin, Engineering © 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
Economy, 6th Edition, 2005 1-23