Chapter 1

Foundations Of
Engineering
Economy

Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

© 2017 by McGraw-Hill, New York, N.Y All Rights Reserved

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 LEARNING OUTCOMES

1. Role in decision
7. Economic equivalence
making
8. Simple and compound
2. Study approach
interest
3. Ethics and economics
9. Minimum attractive
4. Interest rate rate of return
5. Terms and symbols 10. Spreadsheet
functions
6. Cash flows

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 Why Engineering Economy is Important to
Engineers

 Engineers design and create

 Designing involves economic decisions
 Engineers must be able to incorporate economic analysis
into their creative efforts
 Often engineers must select and implement from multiple
alternatives
 Understanding and applying time value of money,
economic equivalence, and cost estimation are vital for
engineers
 A proper economic analysis for selection and execution is
a fundamental task of engineering
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 Time Value of Money (TVM)
Description: TVM explains the change in the amount of money
over time for funds owed by or owned by a corporation (or
individual)

 Corporate investments are expected to earn a return

 Investment involves money
 Money has a ‘time value’

The time value of money is the most important

concept in engineering economy

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 Engineering Economy
 Engineering Economy involves
 Formulating
 Estimating, and
 Evaluating
expected economic outcomes of alternatives designed to
accomplish a defined purpose
 Easy-to-use math techniques simplify the evaluation
 Estimates of economic outcomes can be deterministic
nature

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General Steps for Decision Making Processes

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

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Steps in an Engineering Economy Study

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 Ethics – Different Levels
 Universal morals or ethics – Fundamental beliefs:
stealing, lying, harming or murdering another are
wrong
 Personal morals or ethics – Beliefs that an
individual has and maintains over time; how a
universal moral is interpreted and used by each
person
 Professional or engineering ethics – Formal
standard or code that guides a person in work
activities and decision making

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 Code of Ethics for Engineers
All disciplines have a formal code of ethics. National Society of Professional
Engineers (NSPE) maintains a code specifically for engineers; many
engineering professional societies have their own code

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 Interest and Interest Rate
 Interest – the manifestation of the time value of money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and a
beginning amount of money

 Interest = amount owed now – principal

 Interest rate – Interest paid over a time period expressed as

a percentage of principal

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 Example

An employee borrows $10,000 on May 1 and must

repay a total of $10,700 exactly 1 year later.
Determine the interest amount and the interest
rate paid.

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 Solution

The perspective here is that of the borrower since

$10,700 repays a loan.
Apply Equation [1.1] to determine the interest
paid.
Interest paid= $10,700 - 10,000 = $700
Equation [1.2] determines the interest rate paid for 1
year
Percent interest rate= $700/$10,000 *100% = 7%
per year © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 Example

Stereophonics, Inc., plans to borrow $20,000 from

a bank for 1 year at 9% interest for new recording
equipment. Compute the interest and the total
amount due after 1 year.

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 Solution

(a) Compute the total interest accrued by solving

Equation [1.2] for interest accrued. Interest
=$20,000(0.09) =$1800
The total amount due is the sum of principal and
interest.
Total due = $20,000 =1800 = $21,800

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 Rate of Return

 Interest earned over a period of time is expressed as a

percentage of the original amount (principal)
interest accrued per time unit
Rate of return (%) = x 100%
original amount

 Borrower’s perspective – interest rate paid

 Lender’s or investor’s perspective – rate of return earned

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Interest paid Interest earned

Interest rate Rate of return

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 Example

(a) Calculate the amount deposited 1 year ago to

have $1000 now at an interest rate of 5% per
year.
 (b) Calculate the amount of interest earned during
this time period.

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 Solution

(a) The total amount accrued ($1000) is the sum of

the original deposit and the earned interest. If X
is the original deposit,
Total accrued = deposit + deposit (interest rate)
$1000 =X + X (0.05) = X (1 + 0.05) =1.05 X
The original deposit is X = 1000 /1.05 =$952.38 (b)
Apply Equation [1.3] to determine the interest
earned. Interest = $1000 - $952.38= $47.62

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 Interest

In simple terms, interest rates reflect two things: a

so-called real rate of return plus the expected
inflation rate. The real rate of return allows the
investor to purchase more than he or she could
have purchased before the investment, while
inflation raises the real rate to the market rate that
we use on a daily basis.

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 Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month

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 Example

Last year Jane’s grandmother offered to put

enough money into a savings account to generate
$5000 in interest this year to help pay Jane’s
expenses at college. ( a ) Identify the symbols,
and ( b ) calculate the amount that had to be
deposited exactly 1 year ago to earn $5000 in
interest now, if the rate of return is 6% per year.

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 Solution

(a) Symbols P (last year is -1) and F (this year)

are needed.
P =?
i= 6% per year
n=1 year
F = P+ interest =? + $5000

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(b) Let F = total amount now and P = original
amount. We know that F – P = $5000 is accrued
interest. Now we can determine P . Refer to
Equations [1.1] through [1.4].
F =P+ Pi
The $5000 interest can be expressed as
Interest = F – P = ( P+ Pi ) – P =Pi
$5000 =P (0.06)
P =$5000 /0.06 = $83,333.33

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 Cash Flows: Terms
 Cash Inflows – Revenues (R), receipts, incomes,
savings generated by projects and activities that
flow in. Plus sign used
 Cash Outflows – Disbursements (D), costs,
expenses, taxes caused by projects and activities
that flow out. Minus sign used
 Net Cash Flow (NCF) for each time period:
NCF = cash inflows – cash outflows = R – D
 End-of-period assumption:
Funds flow at the end of a given interest period
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 Cash Flows: Estimating
 Point estimate – A single-value estimate of a cash
flow element of an alternative
Cash inflow: Income = $150,000 per month

 Range estimate – Min and max values that

estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M
Point estimates are commonly used; however, range estimates with
probabilities attached provide a better understanding of variability of
economic parameters used to make decisions

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 Cash Flow Diagrams
What a typical cash flow diagram might look like
Draw a time line Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow
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 Example

A rental company spent $2500 on a new air

compressor 7 years ago. The annual rental
income from the compressor has been $750. The
$100 spent on maintenance the first year has
increased each year by $25. The company plans
to sell the compressor at the end of next year for
$150. Construct the cash flow diagram from the
company’s perspective and indicate where the
present worth now is located.
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 Cash Flow Diagram Example
Plot observed cash flows over last 8 years and estimated sale next
year for $150. Show present worth (P) arrow at present time, t = 0

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 Example

An electrical engineer wants to deposit an amount

P now such that she can withdraw an equal
annual amount of A1 $2000 per year for the first 5
years, starting 1 year after the deposit, and a
different annual withdrawal of A2 $3000 per year
for the following 3 years. How would the cash flow
diagram appear if i 8.5% per year?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 Economic Equivalence
Definition: Combination of interest rate (rate of
return) and time value of money to determine
different amounts of money at different points in
time that are economically equivalent

How it works: Use rate i and time t in upcoming

relations to move money (values of P, F and A)
between time points t = 0, 1, …, n to make them
equivalent (not equal) at the rate i

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 Example of Equivalence
Different sums of money at different times may be
equal in economic value at a given rate
$110

Year

0 1
Rate of return = 10% per year

$100 now

$100 now is economically equivalent to $110 one year from now, if

the $100 is invested at a rate of 10% per year.

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 Simple and Compound Interest

 Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = Pni

Example: $100,000 lent for 3 years at simple i = 10%

per year. What is repayment after 3 years?
Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

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 Example

GreenTree Financing lent an engineering

company $100,000 to retrofit an environmentally
unfriendly building. The loan is for 3 years at 10%
per year simple interest. How much money will the
firm repay at the end of 3 years?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Solution
The interest for each of the 3 years is Interest per year
is
$100,000(0.10) =$10,000
Total interest for 3 years from Equation [1.7] is Total
interest $100,000(3)(0.10) = $30,000
The amount due after 3 years is
Total due = $100,000+ 30,000 =$130,000 The interest
accrued in the first year and in the second year does
not earn interest. The interest due each year is $10,000
calculated only on the $100,000 loan principal.

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 Simple and Compound Interest
 Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time

Interest = (principal + all accrued interest) (interest rate)

Interest for time period t is

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 Compound Interest Example
Example: $100,000 lent for 3 years at i = 10% per
year compounded. What is repayment after 3
years?
Interest, year 1: I1 = 100,000(0.10) = $10,000
Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000
Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100
Compounded: $133,100 Simple: $130,000
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 PRACTICE QUESTIONS

1: If a company sets aside $1,000,000 now into a

contingency fund, how much will the company
have in 2 years, if it does not use any of the
money and the account grows at a rate of 10%
per year?
2: Iselt Welding has extra funds to invest for future
capital expansion. If the selected investment pays
simple interest, what interest rate would be
required for the amount to grow from $60,000 to
$90,000 in 5 years?
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3: To finance a new product line, a company that
makes high-temperature ball bearings borrowed
$1.8 million at 10% per year interest. If the
company repaid the loan in a lump sum amount
after 2 years, what was ( a ) the amount of the
payment and ( b ) the amount of interest?

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4: Because market interest rates were near all-time
lows at 4% per year, a hand tool company decided
to call (i.e., pay off ) the high-interest bonds that it
issued 3 years ago. If the interest rate on the
bonds was 9% per year, how much does the
company have to pay the bond holders? The face
value (principal) of the bonds is $6,000,000

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5: A solid waste disposal company borrowed money
at 10% per year interest to purchase new haulers
and other equipment needed at the company
owned landfill site. If the company got the loan 2
years ago and paid it off with a single payment of
$4,600,000, what was the principal amount P of
the loan?

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6: If interest is compounded at 20% per year, how
long will it take for $50,000 to accumulate to
$86,400?
7: To make CDs look more attractive than they
really are, some banks advertise that their rates
are higher than their competitors’ rates; however,
the fine print says that the rate is a simple interest
rate. If a person deposits $10,000 at 10% per year
simple interest, what compound interest rate
would yield the same amount of money in 3
years?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Minimum Attractive Rate of Return
 MARR is a reasonable rate
of return (percent)
established for evaluating
and selecting alternatives
 An investment is justified
economically if it is expected
to return at least the MARR
 Also termed hurdle rate,
benchmark rate and cutoff
rate

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 MARR Characteristics
 MARR is established by the financial managers of
the firm
 MARR is fundamentally connected to the cost of
capital
 Both types of capital financing are used to
determine the weighted average cost of capital
(WACC) and the MARR
 MARR usually considers the risk inherent to a
project

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 Types of Financing

 Equity Financing –Funds either from retained

earnings, new stock issues, or owner’s infusion of
money.
 Debt Financing –Borrowed funds from outside
sources – loans, bonds, mortgages, venture
capital pools, etc. Interest is paid to the lender on
these funds
For an economically justified project
ROR ≥ MARR > WACC
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 Opportunity Cost
 Definition: Largest rate of return of all projects not accepted
(forgone) due to a lack of capital funds
 If no MARR is set, the ROR of the first project not undertaken
establishes the opportunity cost

Example: Assume MARR = 10%. Project A, not

funded due to lack of funds, is projected to have
RORA = 13%. Project B has RORB = 15% and is
funded because it costs less than A
Opportunity cost is 13%, i.e., the opportunity to make
an additional 13% is forgone by not funding project
A
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 Introduction to Spreadsheet Functions
Excel financial functions
Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell

Example: Estimates are P = $5000 n = 5 years i = 5% per year

Find A in $ per year
Function and display: = PMT(5%, 5, 5000) displays A = $1154.87

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 Chapter Summary
 Engineering Economy fundamentals
 Time value of money
 Economic equivalence
 Introduction to capital funding and MARR
 Spreadsheet functions
 Interest rate and rate of return
 Simple and compound interest

 Cash flow estimation

 Cash flow diagrams
 End-of-period assumption
 Net cash flow
 Perspectives taken for cash flow estimation
 Ethics
 Universal morals and personal morals
 Professional and engineering ethics (Code of Ethics)
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