CENG – 24: ENGINEERING ECONOMY

 Engineering Economy involves formulating, estimating, and evaluating the expected economic
outcomes of alternatives designed to accomplish a defined purpose. Mathematical techniques
simplify the economic evaluation of alternatives.

Why is Engineering Economy important?

As an Engineer:
 Engineers tend to work on projects. Projects use capital (money) to improve a process, develop
a new product, improve a product, improve the safety of a process, etc…
 Engineers are typically responsible for “writing the project” which determines the cost of the
project and the return on investment.
 When doing a project study, Engineers compare and contrast alternative options for
accomplishing the goals of a project. These alternative are often compared from an economic
standpoint. Lease –vs- Buy. Payback period. Rate of Return. Return on Investment.

Fundamental Concept of Engineering Economy

 The change in the amount of money over a given time period is called the time value of money.
 Money makes money.
 When borrowing money, over time more is owed than amount borrowed.

INTEREST AND INTEREST RATE

Interest is the manifestation of the time value of money.

Interest ($) = amount owed now – original amount

A. $1000 placed in bank account one year ago is now worth $1025. Interest earned is $25.
B. $10,000 borrowed last year from Sharky’s Easy Money, and you now owe $12,000. Interest
owed is $2000.

Interest paid over a specific time period is expressed as a percentage of the principal, the result is called
an Interest Rate.

Interest rate (%) = interest accrued per time x 100%

original amount

The time unit of the rate is called the Interest Period.

RATE OF RETURN

Rate of Return (ROR) – interest earned over a specific time period, expressed as a percentage of the
original amount.
Rate of return (%) = interest accrued per time x 100%
original amount

Borrower’s perspective – interest rate paid

Investor’s perspective – rate of return (ROR) or return on investment (ROI).

Other factors that act as interest:

 Inflation - Expressed as a percentage per time (% per year), it is an increase in the amount of
money required to purchase the same amount of goods or services over time.
 Appreciation -
 Depreciation - Reduction in the value of assets using specific models and rules; there are book
and tax depreciation methods
EQUIVALENCE

Economic Equivalence – different sums of money at different times can be equal in economic value
because of the “time value of money” and interest rates.

- is a combination of interest rate and time value of money to determine the different amounts
of money at different points in time that are equal in economic value.

SIMPLE AND COMPOUND INTEREST

Simple Interest – interest is calculated using the principal only.

Interest = (principal)(number of periods)(interest rate)

Example: you invest $500 in an insurance policy that pays 8% simple interest. How much is the policy
worth in 3 years?
Principal Interest
Year 0) $500
Year 1) $500 $40
Year 2) $500 $40
Year 3) $500 $40
$120

Compound Interest – interest is calculated using both the principal and interest earned.

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

Example: you invest $500 in an insurance policy that pays 8% compound interest. How much is the
policy worth in 3 years?
Principal Interest Total
Year 0) $500.00
Year 1) $500.00 $40.00 $540.00 $500(1.08)1
Year 2) $540.00 $43.20 $583.20 $500(1.08)2
Year 3) $583.20 $46.65 $629.85 $500(1.08)3
$129.85

SYMBOLS AND TERMINOLOGY

P= value or amount of money at time 0, also referred to as present worth (PW), present value (PV),
net present value (NPV), or discounted cash flow (DCF).

F= value or amount of money at some future time, also referred to as future worth (FW) or future
value (FV).

A= a series of consecutive, equal, end-of-period amount of money, also referred to as annual worth
(AW) or equivalent uniform annual worth (EUAW). Does not have to be annual payouts, could be
monthly.

n – number of interest periods; years, months, days

i – interest rate or rate of return per time period; percent per year, percent per month

t – time, stated in periods: years, months, days

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.

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

(b) Let F _ total amount now and P = original amount. We know that F – P = $5000 is accrued interest.
Now we can determine P .
F = P – Pi

The $5000 interest can be expressed as

Interest = F – P
= ( P - Pi ) – P
= Pi
$5000 = P (0.06)

$50000
P=
0.06
= $83,333.33

MINIMUM ATTRACTIVE RATE OF RETURN (MARR)

The Minimum Attractive Rate of Return is a minimum level set by a Corporation when deciding on
whether to pursue or not to pursue projects.

Cash Flow Diagrams

 Cash flow diagrams are a way to graphically represent the inflows and outflows of cash over time.
o Cash inflows are the receipts, revenues, incomes, and savings generated by project
and business activity. A plus sign indicates a cash inflow.
o Cash outflows are costs, disbursements, expenses, and taxes caused by projects
and business Cash flow activity. A negative or minus sign indicates a cash outflow.

 Estimates of cash flows typically follow the end-of-period convention (cash flows are assumed to
occur simultaneously at the end of an interest period). When several receipts and disbursements
occur within an interest period, the new cash flow is depicted.

Example:
RULE OF 72: ESTIMATING DOUBLING TIME AND INTEREST RATE

The rule of 72 helps estimate how long it will take for an investment, using compound interest, to double
in value.

To estimate how many years,n (periods) to double your money:

estimated n = 72/𝑖

To estimate the interest rate required to double your money in n periods:

Estimated i = 72/𝑛

Example:
If you invested $1000 today in a CD paying 5% annually, how long will it be until the CD is worth $2000?
n = 72/5 = 14.4 years

If you wanted the $1000 to double in 10 years, what interest rate must you earn?
i = 72/10 = 7.2%

HOW TIME AND INTEREST AFFECT MONEY

Single-Payment Factors (P/F, F/P)

The most fundamental factor in engineering economy is the one that determines the amount of money F
accumulated after n years (or periods) from a single present worth P, with interest compounded one time
per year (or period).

𝐹1 = 𝑃 + 𝑃𝑖
= 𝑃(1 + 𝑖)

𝐹2 = 𝐹1 + 𝐹1𝑖
= 𝐹1 (1 + 𝑖)
= 𝑃(1 + 𝑖)(1 + 𝑖)
= 𝑃(1 + 𝑖)2

𝐹3 = 𝑃(1 + 𝑖)3
In general:
𝐹 = 𝑃(1 + 𝑖)n

What is the present value, P, if a future value, F, is desired, assuming P is invested for n periods at i%
compound interest?
𝑃 = 𝐹/(1 + 𝑖)n

Example:
 If you were to invest $2000 today in a CD paying 8% per year, how much would the CD be
worth at the end of year four?
F = $2000(1.08)4
F = $2000(1.3605)
F = $2721

 How much would you need to invest today in a CD paying 5% if you needed $2000 four years
from today?
P = $2000/(1.05)4
P = $2000/(1.2155)
P = $1645.4
UNIFORM SERIES PRESENT WORTH (P/A, A/P)

 To answer the question: what is P given equal payments (installments) of value A are made
for n periods at i% compounded interest?

 (1  i) n  1
P  A n 
 i(1  i) 
 To answer the related question: what is A given P if equal installments of A are made for n
periods at i% compounded interest?

 i(1  i) n 
A  P 
 (1  i)  1
n

Example:
What is your mortgage payment on a $56K loan if you quoted 6.25% interest for a 30 year loan.
(Remember to first convert to months).

i = .5208  .005208(1  .005208)360 

n = 360 A  56,000 
 (1  .005208)  1 
360
P = $56,000

A = $344.79

UNIFORM SERIES FUTURE WORTH (F/A, A/F)

 To answer the question: What is the future value at the end of year n if equal installments of
$A are paid out beginning at the end of year 1 through the end of year n at i% compounded
interest?
Knowing:

Then:

F  i(1  i) n 
A  
(1  i) n  (1  i) n  1

 i   (1  i) n  1
A  F 
and,
F  A 
 (1  i)  1
n
 i 
Example:
If you invest in a college savings plan by making equal and consecutive payments of $2000 on
your child’s birthdays, how much will the account be worth when your child turns 18, assuming
an interest rate of 6% annually?
A = $2000
i = 6% or  (1  .06)18  1
n = 18, F  $2000    $61,811
F=?  .06 
ARITHMETIC GRADIENT FACTORS (P/G, A/G)

 Cash flows that increase or decrease by a constant amount are considered Arithmetic
Gradient Cash Flows. The amount of increase (or decrease) is called the gradient.

Equivalent Cash Flows

To find P for a gradient cash flow that starts at the end of year 2 and end at year n:

G  (1  i) n  1 n 
P   
i  i(1  i) n (1  i) n 
To find the uniform annual series, A, for an arithmetic gradient cash flow G:

GEOMETRIC GRADIENT FACTORS (PG/A)

 A Geometric gradient is when the periodic payment is increasing (decreasing) by a constant

percentage:

 To find the Present Worth, Pg, for a geometric gradient cash flow G: