Engineering Economics

Lectures 3 Topics:
1) Time value of money
2) Interest concepts
3) Cash Flow Diagram (CFD)

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Time Value of Money
• Money is a valuable asset that can be
rented and the charge is called interest.
• Money can “make” money if Invested at a
specific interest rate.

The change in the amount of money over a

given time period is called the time value of
money; by far, the most important concept in
engineering economy.

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• Would you rather receiving $1000 today or
$1000 one year from now?
• If interest rate = 9% per year and you
invest $1000.
At the end of the year you will get:
– original amount of $1000.
– Interest of $90
• Receiving $1000 now better alternative
than receiving $1000 after one year.
– This because time value of money.
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Interest:
• Interest is manifestation of the time value
of money.
– The amount paid to use money.
• Two prospective:
– Interest paid: When a person or organization
borrowed money (loan) and repays larger
amount.
– Interest earned: When a person or
organization saved (invested or lent) money
and obtains a return of larger amount
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• Interest amount to date can be estimated
as:
Interest = amount owed – original amount

interest per unit time

Interest rate (%) = 100%
original amount
Example
You borrow $10,000 for one full year and you must
pay back $10,700 at the end of one year. Estimate
the interest amount and the interest rate.
The interest amount is $700 and the rate is 7%.
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Rate of Return:
• Interest earned over a specific period of
time is expressed as a percentage of the
original amount is called Rate of Return
(ROR).
• Investors (individuals and corporations)
expect to receive more money than the
amount initially invested.
– Some reasonable ROR can be defined for this
purpose. This ROR is defined as the Minimum
Attractive Rate of Return (MARR).
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 Example:
If your MARR on your investments is 5%. I asked
you to lend me $5000 and I will pay you back
$5150 after 1 year. Would you accept?
ROR = (5150 – 5000) / 5000 = 3% < 5%
So you reject the request.

• Two types of interest exist:

– Simple interest
– Compound interest

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1) Simple Interest:
• Interest that is computed only on the
original sum or principal.
• Total interest earned = P x i x n
– Where:
• P – present sum of money.
• i – interest rate.
• n – number of periods (years).
• Future worth (F) after n periods is the
present worth (P) plus the interest and
equals: F = P + P x i x n
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Example:
You lend a friend $5000 for 5 years at a simple
interest rate of 8% per year.
1)How much interest will you receive?
2)How much will your friend pay you at the end of
The 5 years?
Solution: (See the following table)
1) Total interest earned = P x i x n
= ($5000)(0.08)(5 yrs) = $2000
2) Amount due at the end of the loan =P+P x i x n
= 5000 + 2000 = $7000

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 Total Principal Interest owed Total amount
on which at the end of due at the end
Year interest is year n of year n
calculated in
year n
1 $5000 $5000 x 0.08 = 5000 + 400
400 = 5400
2 5000 $5000 x 0.08 = 5400 + 400
400 = 5800
3 5000 $5000 x 0.08 = 5800 + 400
400 = 6200
4 5000 $5000 x 0.08 6200 + 400
= 400 = 6600
5 5000 $5000 x 0.08 6600 + 400
= 400 = 7000
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 2) Compound Interest
• Interest that is computed on the original
principal plus the incurred interest from the
previous years.
• In practice, interest is computed by the
compound interest method.

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Example:
You lend a friend $5000 for 5 years at a compound
interest rate of 8% per year.
1) How much will your friend pay you at the end of
year 5?
2) How much interest will you receive?
Solution: (See the following table)
1) Amount due at the end of the loan = $7347
2) Total interest earned = 7347 – 5000 = $2347

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 Total Principal Interest owed Total amount
on which at the end of due at the end
Year interest is year n of year n
calculated in
year n
1 $5000 $5000 x 0.08 = 5000 + 400
400 = 5400
2 5400 5400 x 0.08 = 5400 + 432
432 = 5832
3 5832 5832 x 0.08 = 5832 + 467
467 = 6299
4 6299 6299 x 0.08 = 6299 + 504
504 = 6803
5 6803 6803 x 0.08 = 6803 + 544
544 = 7347
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• Classification of the different cost
concepts:
– Fixed costs are constant regardless of the level of output
or productivity. In contrast variable costs depend on the
level of output or activity.
– Marginal cost is the cost for one more unit, while average
cost is the total cost divided by the number of units.
– Sunk cost is money already spent as a result of past
decision.
• Sunk cost should be disregarded in our engineering
economic analysis because current decisions cannot
change the past.

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• Classification of the different cost
concepts:
– Opportunity cost is associated with using a
resource in one activity instead of another.
• Every time we use a business resource (equipment,
dollar, manpower, etc.) in one activity we give up the
opportunity to use the same resource in that time in
some other activity.
– Incremental costs refer to the principle that when
one makes a choice among a set of competing
alternatives, the emphasis should be on the
differences between those alternatives.

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 Cash Flow Diagram (CFD):
• Evaluating a set of feasible alternatives
requires understanding of the costs and
benefits concepts.
• Cash Flow Diagrams are used to model
benefits and costs (inflow and outflow)
through out the life cycle of engineering
projects or potential alternatives.
• CFD is the basis for engineering economic
analysis.
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Cash Flow Diagram (CFD):
• CFD illustrates:
– Size of each individual cash flow
– Sign (+ Receipts=Inflow; - Expense=outflow)
– Timing.
• CFD is based on end-of-period convention
that means all cash flows are assumed to
occur at the end of an interest period.

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 FIGURE: An example cash flow diagram (CFD).

Timing of Cash Flow Size of Cash Flow

At time zero (today)
1 time period from today
2 time periods from today
3 time periods from today
4 time periods from today
5 time periods from today
A positive cash flow of $100
A negative cash flow of $100
A positive cash flow of $100
A negative cash flow of $150
A negative cash flow of $150
A positive cash flow of $50

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Categories of Cash Flows:
• Expense and receipts for engineering
project fall into one of the following
categories:
• First cost: expense to build or buy.
• Operation and maintenance (O&M): annual
expense such as electricity, labour, and repair.
• Revenues: annual receipts due to sale of products
or services.
• Overhaul: major expenditure during the life of the
asset.

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Example:
The manager has decided to purchase a new $30,000 machine. The
machine may be paid for in one of two ways:
1) Pay the full price now minus 3% discount.
2) Pay $5000 now; at the end of one year, pay 8000; at the end of
the next four years, pay $6000.
List the alternatives in form of table cash flow and cash flow diagram.
Solution:
-Table cash flow:
End of Year Pay in Full Now Pay over 5 Years
0 (Now) -$29,100 -$5000
1 0 -8000
2 0 -6000
3 0 -6000
4 0 -6000
5 0 -6000

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Cash Flow Diagram:
-Pay in full now:
0 1 2 3 4 5

29,100

- Pay over 5 years:

0 1 2 3 4 5

5000 6000 6000 6000 6000

8000

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