What is this course about?

• Project and Investment Analysis

• Making good economic decisions
Some interesting questions
 Buy or lease?
 Buy car or land for an investment?
 Buy a bond, stock, keep money in bed?
 Which investment to make?

• Time value of money

• Importance of interest, inflation, etc.
• Cash flow comparisons
 Introduction
The foundation of engineering economics introduces the
basic concepts and terminology necessary for an engineer to
combine the three essential elements of decision making
(cash flows, time value, and interest rates of money) in
organized, mathematically correct ways to solve problems
that will lead to better decisions.
What is Economics?
 The study of: How to allocate resources efficiently to satisfy
unlimited human wants
 How individuals and societies choose to use scarce resources
 What is engineering economics?
 It is a collection of techniques that simplify comparisons of design and
alternatives or projects on an economic basis.
 The application of economic principles to engineering problems, for
example in comparing the comparative costs of two alternative capital
projects or in determining the optimum engineering course from the
cost aspect.
 Engineering economy is not a method or process for determining what
the alternatives are.
 On the contrary, engineering economy begins only after the
alternatives have been identified.
 For example: determining whether to build a nuclear-powered, gas-
fired, or coal-fired power plant; factors such as safety, air pollution,
public acceptance, water demand, waste disposal, global warming,
and many others.
 What is Engineering Economics?

• Engineering economics is Systematic evaluation of the economic merits of

proposed solutions to engineering problems
• Engineering economy, quite simply, is about determining the economic factors and
the economic criteria utilized when one or more alternatives are considered for
selection

Example
 Engineering Economics ……..

• Objective-Evaluation
 How to compare the economic value of alternative design option?

Example

• Basis-Cash Flow Analysis

 Which project or alternative has better net cash flow?
• Key issues-
 Time value of money
 Cash flow occurring at different time
 Designs with different durations
 Cont’d…
The role of engineering economics is to assess the appropriateness of a
given project, estimate its value (outcomes can be deterministic or
stochastic in nature) and justify it.
Engineering Economy involves formulating, estimating, and evaluating
expected economic outcomes of alternatives designed to accomplish a
defined purpose
The technological and social environments continue to change at a rapid
rate.
In recent decades, advances in science and engineering have made space
travel possible, transformed our transportation system, revolutionized the
practice of medicine, and miniaturized electronic circuits.
The utilization of scientific and engineering knowledge is achieved through
the design of things we use However, these achievements don’t occur
without a price, monitory.
Therefore, the purpose of this course is to develop and illustrate the
principle and methodology required to answer the basic economic question
of any design.
 Why Engineering Economics is Important to Engineers Important to
Engineers????


Just being able to build/create things is not enough. Must be able to do it
economically

Engineering processes involve decisions and 

tradeoffs; each has a different cost, i.e., something you give up (usually
money)
Examples 

Construct a building: Where and how to build it?

Design a product: What features? When to launch?

Engineers design and create.

Designing involves economic decisions

Thus, 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 estimations are virtual for engineers.
 Where Does Engineering Economics Fit?

Here is an approach to problem-solving:

• Understand the problem
• Collect all relevant data/information(difficult!)
• Define the feasible alternatives
• Evaluate each alternative This is the major role of
• Select the “best” alternative engineering economics
• Implement and monitor the decision

8
 Where Do I Get the Data?
• Engineering economics is based mainly on estimates of
future costs and benefits:
• So it has to deal with risk and uncertainty
• The costs, benefits, and other parameters are typically
unknown, and can vary over time:
• The values of these parameters will dictate a
particular numerical outcome
• And therefore a particular decision!
• Sensitivity analysis can be used to explore how the
decision changes as our estimates change
9
 Basic Principles of engineering economy

1. Develop the Alternatives

2. Focus on the Differences
3. Use a Consistent Viewpoint
4. Use a Common Unit of Measure
5. Consider All Relevant Criteria
6. Make Uncertainty Explicit
7. Revisit Your Decisions
 Cont…..
1) Problem recognition, definition, and evaluation & Develop the
alternatives
 What is the need? The more concrete the description, the better for
further analysis
 Evaluation of the problem typically includes refinement of needs and
requirements, and information from the evaluation phase may change the
original problem formulation
 What are the possible courses of actions
 Screening alternatives to select a smaller group for further analysis
2) Focus on the differences
 Only the differences in expected future outcomes among the alternatives
are relevant to their comparison and should be considered in the decision.
3) Use a consistent viewpoint
 The prospective outcomes of the alternatives, economic and other,
should be consistently developed from a defined Viewpoint
(perspective).
 Cont…..
4) Use a common unit of measure
 Using a common unit of measurement to enumerate as many of the
prospective outcomes as possible will make easier the analysis and
comparison of alternatives.
5) Consider all relevant criteria
 Selection of a preferred alternative (decision making) requires the use of a
criterion (or several criteria).
 The decision process should consider the outcomes enumerated in the
monetary unit and those expressed in some other unit of measurement or
made explicit in a descriptive manner.
6) Making risk and uncertainty explicit
 Uncertainty is inherent in projecting (or estimating) the future outcomes of
the alternatives and should be recognized in their analysis and comparison.
7) Revisit your decisions
 Improved decision making results from an adaptive process; to the extent
practicable, the initial projected outcomes of the selected alternative should
be subsequently compared with actual results achieved.
 Engineering economics analysis procedure
1. Problem recognition, formulation, and evaluation.
2. Development of the feasible alternatives.
3. Development of cash flows for each alternative.
4. Selection of a criterion ( or criteria).
5. Analysis and comparison of alternatives.
6. Selection of the preferred alternative.
7. Performance monitoring and post-evaluation results.
• Fundamental Principles of Economics
• Principle 1: An instant Cash/birr is worth more than a distant cash/birr
• Principle 2: Only the relative (pair-wise) difference among the
considered alternatives counts
• Principle 3: Marginal revenue must exceed marginal cost, in order to
carry out a profitable increase of operations
• Principle 4: Additional risk is not taken without an expected additional
return of suitable magnitude
 The project concept
•The first phase of a project is the project concept.
•The project concept often takes the form of a formal document created within the
project owner's organization to justify the initiation of the project.
•It outlines the background, context and need for the project, the project's objectives,
expected results and resources required. The role of the individual responsible for
the project concept is often called the 'responsible owner'.
•The procedures used during the concept phase vary widely from organization to
organization.
•research case for project
•key assumptions and constraints
•defined roles and responsibilities
•scope of project (in and out of scope)
•key objectives
•identity of the stakeholders
•success criteria and milestones
•risks to completion of project.
•Its purpose is to help define the project scope as early as possible in the project life
cycle. The Project Charter is a key document to the project's success.
 The project concept
What is project?
• It is an investment plan
• It is undertaken for a particular goal or objective to be achieved
within a limited period of time and with limited resources
(manpower, money, etc.).
• project characterized by:
• A construction period
• An operational period
• (expected) life time
• Specific desired output (benefits)
• Use of scarce and valuable resources and/or undesired
outputs (costs).
• Sometimes a well defined target.
 Classify project period into different phases:
– Project identification
– Project formation and preparation
– Project appraisal
– Project implementation
– Project monitoring and evaluation
Project appraisal or investment analysis is
about the comparison of different investment
alternatives or projects say: A0, A1, A2… Aj,…An
The objective of economic analysis of projects is three fold
• The evaluation as to whether a specific project is economically
desirable.
• The identification of the most desirable project among several
desirable alternatives.
• The placement of the more economically desirable projects in
rank order.
 Projects classifications:
• Private owned
• Public or state owned
This distinction is closely related to the nature of goods and
services in terms of excludability and subtractability.
Excludability: the degree to which users can be excluded
(example: Flood protection…)
Subtractibility: the degree to which consumption by one
user reduces the possibility of consumption by the
others. (example: Fisheries …)
• Public Projects/goods have low subtractibility and low
excludability. Eg. Service of flood protection.
• Private Projects/goods have high subtractibility and high
excludability. Eg. Individual pit (waste water).
Important criterion for public sector decisions;

• Economic efficiency: deals with efficiency of resource

allocation
• Equity: distribution of costs and benefits over
different social classes and different regions. (Eg.
Block tariffing in public water supply.)
• Inter-generation effects or long term aspects:
distribution of costs and benefits over
time.
• Feasibility of implementation: should be
evaluated in technical, financial, social, and
administrative senses
 Classification of cost
Economic analyses may be based on a number of cost
classifications:
• First (or Initial) Cost : Cost to get activity started such as property
improvement, transportation, installation, and initial expenditures.
• Operation and Maintenance Cost : They are experienced
continually over the useful life of the activity .
• Fixed Cost : Costs which could not vary with level of production.
• Variable Cost : Variable costs are related to the level of operational
activity
• Incremental or Marginal Cost : Incremental (or marginal) cost is the
additional expense that will be incurred from increased output in one
or more system units
• Sunk Cost : It cannot be recovered or altered by future actions. Usually
this cost is not a part of engineering economic analysis.
• Life-Cycle Cost :This is cost for the entire life-cycle of a product, and
includes feasibility, design, construction, operation and disposal costs.
• Opportunity Cost: an expired Benefit.
 Cash Flow
• The estimated inflow (revenues/income) and the outflow
(Costs) of money are called cash flow.
• The cash flow diagram is used to evaluate money along with
its equivalent with time: forward time or backward time
• Engineering projects generally have economic consequences
that occur over an extended period of time
– For example, if an expensive piece of machinery is
installed in a plant were brought on credit, the simple
process of paying for it may take several years
– The resulting favorable consequences may last as long as
the equipment performs its useful function
• Each project is described as cash receipts or disbursements
(expenses) at different points in time
20
 Categories of Cash Flows
• The expenses and receipts due to engineering projects
usually fall into one of the following categories:
– First cost: expense to build or to buy and install
– Operations and maintenance (O&M): annual
expense, such as electricity, labor, and minor repairs
– Salvage value: receipt at project termination for sale
or transfer of the equipment (can be a salvage cost)
– Revenues: annual receipts due to sale of products or
services
– Overhaul: major capital expenditure that occurs
during the asset’s life

21
 Cash Flow diagrams
 The costs and benefits of engineering projects over time are
summarized on a cash flow diagram (CFD). Specifically, CFD
illustrates the size, sign, and timing of individual cash flows, and
forms the basis for engineering economic analysis
 A CFD is created by first drawing a segmented time-based
horizontal line, divided into appropriate time unit. Each time
when there is a cash flow, a vertical arrow is added  pointing
down for costs and up for revenues or benefits. The cost flows are
drawn to relative scale
• In a cash flow diagram (CFD) the end of period t is the same as
the beginning of period (t+1)
• Beginning of period cash flows are: rent, lease, and insurance
payments
• End-of-period cash flows are: O&M, salvages, revenues, overhauls
• The choice of time 0 is arbitrary. It can be when a project is
analyzed, when funding is approved, or when construction begins

22
 Cont…
• One person’s cash outflow (represented as a negative
value) is another person’s inflow (represented as a
positive value)
• It is better to show two or more cash flows occurring in
the same year individually so that there is a clear
connection from the problem statement to each cash
flow in the diagram
• An Example of Cash Flow Diagram
• A man borrowed $1,000 from a bank at 8% interest.
Two end-of-year payments: at the end of the first year,
he will repay half of the $1000 principal plus the
interest that is due. At the end of the second year, he
will repay the remaining half plus the interest for the
second year.
23
 Time Value of Money (TVM)
 The time value of money (TVM) is the concept that money you have
now is worth more than the identical sum in the future due to its
potential earning capacity.
 This core principle of finance holds that provided money can earn
interest, any amount of money is worth more the sooner it is received.
TVM is also sometimes referred to as present discounted value.
 The time value of money draws from the idea that rational investors
prefer to receive money today rather than the same amount of
money in the future because of money's potential to grow in value
over a given period of time.
 For example, money deposited into a savings account earns a certain
interest rate and is therefore said to be compounding in value. 
 Time value of money is based on the idea that people would rather
have money today than in the future.
 Time Value of Money….
• The time value of money manifested the idea of an
interest rate (if projecting into the future) Or,
equivalently, a discount rate (if rolling back to the
present), Inflation or deflation and risk.
Time value of money deals with changes in the value of money
over some period of time (due to investment opportunities,
uncertainty, etc.)
This is the single most important concept in engineering
economics!
In this course, we will learn methods to:
Compare different cash flows over time
Using the interest rate or discount rate:
How much more a dollar today is worth,
Compared to a dollar in one year
For example, if the interest rate is 5%:
$1 today is worth as much as $1.05 next year
25
 Cont…
 Given that money can earn compound interest, it is more valuable in the present
rather than the future.
 Basic assumption: Given a fixed amount of money, and a choice of having it now
or in the future, most people would prefer to have it sooner
 Reasons:
Security…….? Currency strength………?
Interests …..? Uncertainty………?
 The formula for computing time value of money considers the payment now, the
future value, the interest rate, and the time frame.
 The number of compounding periods during each time frame is an important
determinant in the time value of money formula as well.
 Example: Buying a car
• Alternatives:
– $18,000 now, or
– $600 per month for 3 years(= $21,600 total)
• Which is better assuming interest rate of 6%?
 Cont…
• Time Value of Money Formula
• Depending on the exact situation in question, the time value of
money formula may change slightly. For example, in the case of
annuity or perpetuity payments, the generalized formula has
additional or less factors. But in general, the most fundamental
TVM formula takes into account the following variables:
• FV = Future value of money
• PV = Present value of money
• i = interest rate
• n = number of compounding periods per year
• t = number of years
• Based on these variables, the formula for TVM is:
• FV = PV x [ 1 + (i / n) ] (n x t)
 Time Value of Money Examples
• Assume a sum of $10,000 is invested for one year at 10% interest. The future
value of that money is:
• FV = $10,000 x [1 + (10% / 1)] ^ (1 x 1) = $11,000
• The formula can also be rearranged to find the value of the future sum in
present day dollars. For example, the value of $5,000 one year from today,
compounded at 7% interest, is:
• PV = $5,000 / [1 + (7% / 1)] ^ (1 x 1) = $4,673
• Effect of Compounding Periods on Future Value
• The number of compounding periods can have a drastic effect on the TVM
calculations. Taking the $10,000 example above, if the number of compounding
periods is increased to quarterly, monthly, or daily, the ending future value
calculations are:
• Quarterly Compounding: FV = $10,000 x [1 + (10% / 4)] ^ (4 x 1) = $11,038
• Monthly Compounding: FV = $10,000 x [1 + (10% / 12)] ^ (12 x 1) = $11,047
• Daily Compounding: FV = $10,000 x [1 + (10% / 365)] ^ (365 x 1) = $11,052
• This shows TVM depends not only on interest rate and time horizon, but also
on how many times the compounding calculations are computed each year.
 Which Repayment Plan?

  End of Year Receipts Payments  

     Plan 1 Plan 2  

  Year 0 20,000.00 200.00 200.00 

  Year 1   5,141.85 0 
  Year 2   5,141.85 0 
  Year 3   5,141.85 0 
  Year 4   5,141.85 0 
  Year 5   5,141.85 30,772.48 
 Cash Flow Diagram
Represent time by a horizontal line marked off with the number of interest
periods specified. Cash flow diagrams give a convenient summary of all the
important elements of a problem.
 Cont….

Elements of Transactions involve Interest

(terminology)
1. Initial amount of money in transactions involving debt or
investments is called the principal (P).
2. The interest rate (i) measures the cost or price of money
and is expressed as a percentage per period of time.
3. A period of time, called the interest period (n), determines
how frequently interest is calculated.
4. A specified length of time marks the duration of the
transactions and thereby establishes a certain number of
interest periods (N).
5. A plan for receipts or disbursements (An) that yields a
particular cash flow pattern over a specified length of
time. [monthly equal payment]
6. A future amount of money (F) results from the cumulative
effects of the interest rate over a number of interest
periods.
 Interest Calculations

• Simple interest: the practice of charging an interest rate only to

an initial sum (principal amount)
• It is calculated using the principal only, ignoring any interest
accrued in preceding interest periods
• The total simple interest over several periods is computed as
Interest =(principal)(number of periods)(rate)
• Compound interest: Interest that is computed on the original
unpaid debt and the unpaid interest
• Compound interest is most commonly
used in practice
Interest = (principal + all accrued interest)(interest rate)
 Simple Interest
F= P ( iP )N where
• P = Principal amount
• = simple interest rate
• = number of interest periods
• = total amount accumulated at the end of period N 
• $1,000 (0.08)($1,000)(3) =$1, 240
 Compound Interest

• The practice of charging an interest rate to an

initial sum and to any previously accumulated
interest that has not been withdrawn. 
• P = Principal amount
• i = Interest rate End Beginning Interest Ending
of Balance earned Balance
• N = Number of interest periods
Year      
0 $1,000
• Example:
   
       
1 $1,000 $80 $1,080
– P = $1,000        
2 $1,080 $86.40 $1,166.40
– i = 8%        

3 $1,166.40 $93.31 $1,259.71

– N = 3 years        
 Cash Flow Diagram

$1,259.71

0 1 2

3
F $1,000(1 0.08)
$1,000
$1, 259.71
 Example on Simple and compounded interest

• Compute the compound interest and loan balance for each year for the $1000 a
certain person borrowed at 5% per year. Graphically compare the result for
compound interest and simple
Solution:

Final Value Final Value

Initial Inter at the end at the end
End of Amount e Simple of Comp. of
Year (Principal) st interest each yrs  interest each yrs  
  Rate interest Balance interest Balance
0 $1,000.00 5%   $1,000.00   $1,000
1     $50.00 $1,050.00 $50 $1,050
2     $50.00 $1,100.00 $52.50 $1,102.50
3     $50.00 $1,150.00 55.13 1157.63

1. Interest= (principal + all accrued interest)X(interest rate) ------ for

compound Interest
2. Interest=(principal)x(number of periods)x(interest rate)---- for
Simple interest
 Problem Statement
• If you deposit $100 now (n = 0) and $200 two years from now
(n = 2) in a savings account that pays 10% interest, how much
would you have at the end of year 10?

$100
$200

100(1 0.10)10 =100(2.59) =259

200(1 0.10)8 = 200(2.14) = $429
F =259 +429=688
Cont…..
 Solution

End of Period Beginning Deposit Withdraw Ending

balance made   balance
n=0 0 $1,000 0 $1,000
n=1 $1,000(1 + 0.10) $1,000 0 $2,100
 
   
=$1,100   
 
 
 
 

n=2 $2,100(1 + 0.10) 0 $1,210 $1,100

 
   
=$2,310   
 
 
 
 

n=3 $1,100(1 + 0.10) $1,500 0 $2,710

 
   
=$1,210   
 
 
 
 

n=4 $2,710(1 + 0.10) 0 0 $2,981

 
   
=$2,981