LECTURE 2

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 Chapter 1
Foundations Of
Engineering Economy

Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

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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
6. Cash flows functions

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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
ENGINEE
RING
ECONOM
Y STUDY

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• DECISION MAKING IS A BROAD TOPIC, FOR IT IS A MAJOR
ASPECT OF EVERYDAY HUMAN EXISTENCE.

• THERE ARE LOTS OF PROBLEMS IN THE WORLD:

1) SIMPLE PROBLEMS
 SHOULD I PAY OR USE CREDIT?
 SHALL WE REPLACE A BURNED-OUT MOTOR?
 IF WE USE THREE CRATES OF AN ITEM A WEEK, HOW MANY CRATES
SHOULD WE BUY AT A TIME?

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2) Intermediate Problems (mainly economic)
 Which equipment should be selected for a new assembly line?
 Which materials should be used as roofing, siding, and structural
support for a new building?
 Which printing press should be purchased? A low cost press
requiring three operators, or a more expensive one needing only two
operators?

3) Complex Problems (mixture of economic, political, and social)

 The decision of Mercedes Benz to build an automobile assembly
plant in Pakistan
 Setting the annual budget for a corporation.

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 EXAMPLES OF ENGINEERING
ECONOMIC ANALYSIS
 Which engineering projects are worthwhile?

 Which engineering projects should have a higher priority?

 How the engineering project should be designed?

 How to achieve long-term financial goals?

 How to compare different ways to finance purchases?

 How to make short and long-term investment decisions?1-8

 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 OR STOCHASTIC IN NATURE

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 THE BIG PICTURE
• ENGINEERING ECONOMY IS AT THE HEART OF MAKING
DECISIONS.
• THESE DECISIONS INVOLVE THE FUNDAMENTAL ELEMENTS
OF CASH FLOWS OF MONEY, TIME AND INTEREST RATES.
• CHAPTER 1 INTRODUCES THE BASIC CONCEPTS AND
TERMINOLOGY NECESSARY FOR AN ENGINEER TO COMBINE
THESE THREE ESSENTIAL ELEMENTS IN ORGANIZED,
MATHEMATICALLY CORRECT WAYS TO SOLVE PROBLEMS
THAT WILL LEAD TO BETTER DECISIONS.

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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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 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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 INTEREST – EXAMPLE [1]
• 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 INTEREST RATE PAID

• INTEREST AMOUNT = $10,700 - $10,000 = $700

• INTEREST RATE = $700/$10,000 = 7% PER YEAR

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 INTEREST – EXAMPLE [2]
• A COMPANY PLANS TO BORROW $20,000 FROM A
BANK FOR ONE YEAR AT 9% INTEREST FOR A NEW
RECORDING EQUIPMENT

• COMPUTE THE INTEREST AND THE TOTAL AMOUNT

DUE AFTER 1 YEAR

• THE TOTAL INTEREST ACCRUED:

INTEREST = $20,000 × 0.09 = $1,800

• THE TOTAL AMOUNT DUE IS THE SUM OF PRINCIPAL

AND INTEREST:
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TOTAL DUE = $20,000 + $1,800 = $21,800 19
 INTEREST – EXAMPLE [3]
• CALCULATE THE AMOUNT DEPOSITED ONE YEAR AGO
TO HAVE $1,000 NOW AT AN INTEREST RATE OF 5% PER
YEAR
THE TOTAL AMOUNT ACCRUED ($1,000) IS THE SUM OF
THE ORIGINAL DEPOSIT AND THE EARNED INTEREST. IF
“Y” IS THE ORIGINAL DEPOSIT THEN,

TOTAL AMOUNT ACCRUED = ORIGINAL + ORIGINAL ×

INTEREST RATE
$1,000 = Y + Y(0.05) WHICH GIVES A VALUE OF Y = $952.38

• CALCULATE THE AMOUNT OF INTEREST EARNED

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DURING THIS TIME PERIOD 20
INTEREST = $1,000 – 952.38 = $47.62
 INTEREST – EXAMPLE [4]
• CALCULATE THE AMOUNT DEPOSITED ONE YEAR AGO
TO HAVE $1,000 AS A NET BENEFIT NOW AT AN
INTEREST RATE OF 5% PER YEAR
THE TOTAL AMOUNT ACCRUED AFTER ONE YEAR OF
DEPOSITION EQUALS THE SUM OF THE ORIGINAL
DEPOSIT AND THE EARNED INTEREST. IF “Y” IS THE
ORIGINAL DEPOSIT THEN,

TOTAL AMOUNT ACCRUED = ORIGINAL + ORIGINAL ×

INTEREST RATE
Y + 1,000 = Y + Y(0.05) WHICH GIVES A VALUE OF Y
$20,000
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CASH FLOWS

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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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 PARAMETERS AND CASH FLOWS
• Parameters
• First cost (investment amounts)
• Estimates of useful or project life
• Estimated future cash flows (revenues and expenses and salvage
values)
• Interest rate
• Cash Flows
• Estimate flows of money coming into the firm – revenues,
salvage values, etc. – positive cash flows--cash inflows
• Estimates of investment costs, operating costs, taxes paid –
negative cash flows -- cash outflows

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THE CASH FLOW DIAGRAM: CFD

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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 1-
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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

P = $-80 1-
Cash flows are shown as directed arrows: + (up) for inflow 28
- (down) for outflow
CASH FLOW DIAGRAM EXAMPLE
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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CASH FLOW DIAGRAM EXAMPLE
Plot observed cash flows over last 8 years and estimated sale next
year for $150.

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