AEE Merge

11/3/2020
Applied Economics MF-303

For Engineers
1
Introduction to the instructor
Instructor: Ahsan Ahmed (Lecturer, MED)
E-mail: ahsanahmed@neduet.edu.pk
Consulting
Place: Mechanical Vibrations Lab
Course's
Title: Applied Economics For Engineers
Course's
Code: MF-303
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Recommended Books
S.
BOOK Author Edition
No
William G. Sullivan, James A
1 Engineering Economy 14/15/16th
Bontadelli
Operation Research An
2 Hamdy A Taha 10th
Introduction
Leland Blank Anthony
3 Engineering Economy 8th
Tarquin
Eugene L. Grant, W. Grant
Principles of Engineering
4 Ireson, Richard S Leaven 9th
Economy
Worth
Engineering Econimics
5 Donald G. Newman 14th
Analysis
3
Course CLOs and PLOs

No
CLO PLO Level of Learning
.
Explain the basic concepts of
1 economic principles, related to PLO-12 C2
various economic models
Apply the concepts and techniques
of linear programming for
2 PLO-06 C3
optimization of economic
resources.
Evaluate and justify selection of
3 different alternative(s) by using PLO-11 C6
economic analysis technique(s)
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Key Discussion for the semester?

 Lectures do not mean notes?
 Discipline?
 How to answer in class? How to discuss topics other than course?
 Technology?
 Bonus Performance?
 Re-mid? Re-test?
 Emergency cases? Procedure?
 Attendence?
 Extra Classes
 Expectations from the course?
 Others
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Economics
As a subdivision / discipline of social sciences, economics
deals with allocation or deallocation of resources which
seems to be limited and has alternatives to produce goods
and services which can satisfy human wants and desires
which seems to be unlimited.
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Factors of Production / Resources

 Resources required for generation of goods or services, generally
classified into four major groups:
1) Natural Resources (Everything in the universe that is not created
by human being e.g. land, air etc.)
2) Human Resources (Everything that people do to convert natural
resources into human satisfaction e.g. goods or labor services-either
from hand or brain or both)
3) Physical Resources (Roads, bridges, CPEC etc.)
 Capital Goods : Tangible goods made by natural stuff
 Entrepreneur: People who works on opportunities to make it
profitable.
4) Organizational Resources (How well an organization trains, uses ,
maintain, extends and encourages its resources or how well an
organization organizes above three resources.)
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Wants and Desires

 Physiological (needed to sustain us as individuals and as a
species breathing , sleeping etc.)
 Sociological (Family, Society , Social Interactions etc.)
 Biological (free from pain, fear, comfortable living condition, etc.)
 Psychological (which make life just a little more enjoyable)
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Do resources fullfil desires/wants?
Product & Resources

(Limited)
Resources To fullful desires
(Limited) (Choices) (Unlimited)
Two Dimensions of Economics

1) Macro Economics:
As a sub-division of social science macroeconomics deals with an
overall performance off economy. Its concerned variables are
investment, inflation, employment and application of economic
policies like fiscal year and monitoring policies.
2) Micro Economics:
As a sub-division of social science microeconomics deals with
economic behavior of firm and consumers as they go on
performing day to day activities like buying an selling.
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Engineering Economics (Def)

 Engineering economy involves the systematic evaluation
of the economic merits of proposed solutions to
engineering problems. To be economically acceptable (i.e.,
affordable), solutions to engineering problems must
demonstrate a positive balance of long-term benefits over
long-term costs, and they must also
promote the well-being and survival of an organization,

embody creative and innovative technology and ideas,
permit identification and scrutiny of their estimated
outcomes, and
translate profitability to the “bottom line” through a
valid and acceptable measure of merit.
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Engineering Economics
 Engineers use knowledge to find new ways of doing things
economically
 Engineering economy is the dollars-and-cents side of the
decisions that engineers make or recommend as they work to
position a firm to be profitable in a highly competitive
marketplace.
 Inherent to these decisions are trade-offs among different
types of costs and the performance (response time, safety,
weight, reliability, etc.) provided by the proposed design or
problem solution.
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Economic Environment / Behavior

1) Buyer / Consumer (They may be same)
2) Producer / Supplier
 Constraints from Buyer Side:

i. Fixed Prices
Purchasing Power
ii. Limited Income
 Constraints from Producer Side:

i. Input prices are fixed
ii. Limited financial capital to spend
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Economic Environment / Behavior

 Goals:
1) Buyer / Consumer  To earn satisfaction
2) Producer / Supplier  To earn profit
 Consumer Goods and Services:

Consumer goods and services are the product or services that
are directly used by user e.g. cloths etc.
 Producer Goods and Services:

Producer goods or service are used to produce consumer good
e.g. machine tool, factory building, raw material etc.
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Classification of Consumer and

Producer Goods
1) Normal or Superior Goods (Goods for which the demand
rises as consumer income rises e.g. sugar, fans etc.)
2) Inferior Goods (Good whose demand decreases when
consumer income rises, or demand increases when
consumer income decreases e.g. Qmobile vs iPhone or
Ching-chi vs Rickshaw/Bike)
3) Substitute Goods (used for the same purpose by the same
consumers. If price of Good “A” increases people will buy
“Good B” e.g. Petrol vs CNG)
4) Complementary Goods (If price of Good “A” increases the
demand of Good “B” also decreases e.g. if car becomes
expensive so demand of tyres also decreases)
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Theory of Supply and Demand

 This theory shows how consumer preferences determine
consumer demand for commodities, while business costs are
the foundation of the supply of commodities.
 The increases in the price of “something” occurred either
because the demand for “something” had increased or because
the supply of “something” had decreased. (e.g. In Pakistan, it
is a practice from years that sugar price is at the normal level
when it is at normal supply chain process, but when someone
stores a large quantity of sugar and don’t allow sugar bags to
sell then their prices become high)
 This theory is based on the two laws and their factors:
1. Law of Supply
2. Law of Demand
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Law of Supply
 When economists talk about supply, they mean the
amount of some good or service that is available to
consumers.
𝑆𝑢𝑝𝑝𝑙𝑦 = 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 − 𝑆𝑡𝑜𝑐𝑘
 Price is what the producer receives for selling one unit of
a good or service.
 Law of supply:
“Taking all other things constant,
if a prices of a commodity increases,
its supply also increases and vice versa.”
𝑃𝑟𝑖𝑐𝑒 ∝ 𝑆𝑢𝑝𝑝𝑙𝑦
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Law of Supply
 Supply Schedule (or Supply Curve ):
The supply schedule (or supply curve ) for a commodity shows
the relationship between its market price and the amount of
that commodity that producers are willing to produce and sell,
other things held constant.
 The following table shows a hypothetical supply schedule for
cornflakes,
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Law of Supply
 The figure, at the right, plots the data from the below table in
the form of a supply curve.
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Determinants of Supply
 If Q= Quantity of Commodity, S= Supply, X= Our Commodity
and Y= Substitute Commodities. Then,
Variable
Constant
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 𝒔𝒙 = 𝒙
 𝒔𝒙 = 𝒚
,
Or vice versa
 𝒔𝒙 = )
,
21
 𝒔𝒙 = ) …… (Cont.)
Technological advances, which consist of change that
lower the quantity of inputs needed to produce the same
quantity of output.
For example: It takes far fewer hours of labor to produce
an automobile today than it did just 10 years ago.
 𝒔𝒙 = )
Usually, profit-maximization is the most fundamental
goal of a firm.
But modern business firms aim at maximization of sales
revenue (or capturing market share) rather than profit.
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 𝒔𝒙 = ) …… (Cont.)
Usually, profit-maximization is the most fundamental
objective of a firm.
But modern business firms aim at maximization of sales
revenue (or capturing market share) rather than profit.
Supply of a commodity under these two broad objectives
is likely to be different.
Thus, the supply of a commodity depends on the goals
or objectives of a firm.
Changes in these objectives of the firms will lead to a
change in quantity supplied.
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 𝒔𝒙 = )
Application of taxes will increase cost of the product
which will decrease profit and supply of the same
product. (e.g. Toyota Cars).
Subsidies (reliefs given by government to the company
to keep the price of a commodity low) decreases the cost
of the product which will increase profit and supply of
the same product. (e.g. Toyota Cars).
 𝒔𝒙 = )
If input prices increases, so profit will decrease with
supply of product.
E.g electricity cost, material cost etc.
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 𝒔𝒙 = )
Special influences affect the supply curve.
The weather exerts an important
influence on farming
and on the ski industry.
The computer industry has been marked
by a keen spirit of innovation, which has
led to a continuous flow of new products.
Market structure will affect supply, and
expectation about future prices often have
an important impact upon supply
decisions.
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Shifts in Supply
 When changes in factors other than a good’s own price affect
the quantity supplied, we call these changes shifts in supply.
Supply increases (or decreases) when the amount supplied
increases (or decreases) at each market price.
Constant
Variable
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Shifts in Supply
 When automobile prices change, producers change their
production and quantity supplied, but the supply and the
supply curve do not shift. By contrast, when other influences
affecting supply change, supply changes and the supply curve
shifts.
 We can illustrate a shift in supply for the automobile market.
Supply would increase if the introduction of cost-saving
computerized design and manufacturing reduced the labor
required to produce cars, if autoworkers took a pay cut, if
there were lower production costs in Japan, or if the
government repealed environmental regulations on the
industry. Any of these elements would increase the supply of
automobiles in the United States at each price. The following
figure illustrates an increase in the supply of automobiles.
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Shifts in Supply
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Law of Demand
 Economists use the term demand to refer to the amount
of some good or service consumers are willing and able to
purchase at each price.
 Law of Demand:
“Taking all other things constant,
if a prices of a commodity increases,
its demand decreases and vice versa.”
1
𝑃𝑟𝑖𝑐𝑒 ∝
𝐷𝑒𝑚𝑎𝑛𝑑
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Law of Demand
 Demand Schedule (or Demand Curve ):
There exists a definite relationship between the market price of
a good and the quantity demanded of that good, other things
held constant. This relationship between price and quantity
bought is called the demand schedule, or the demand curve.
 The following table shows a hypothetical demand schedule for
cornflakes,
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Law of Demand
 The figure, at the right, plots the data from the below table in
the form of a demand curve.
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Determinants of Demand
 If Q= Quantity of Commodity, D=Demand, X= Our
Commodity and Y= Substitute Commodities. Then,
Variable
Constant
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 𝑫𝒙 = 𝒙
,
 𝑫𝒙 = 𝒚
, ,
Or vice versa
 𝑫𝒙 = )
Superior Product Inferior Product
Income , Q Income , Q
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 𝑫𝒙 =
,
 𝑫𝒙 =f(population)
,
 𝑫𝒙 = )
Special influences will affect the demand for goods.
The demand for umbrellas is high in rainy Seattle but low in
sunny days.
The demand for air conditioners will rise in hot weather.
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Shifts in Demand
 Why does the demand curve shift? Because influences other
than the good’s price change.
Constant
Variable
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Shifts in Demand
 For Example: In 1990s, the income
of American rises which will rise the
sale of automobiles. So, that rise in
demand was not due to the price, but
it was due to the income rose.
 Now answer the following:
Will a warm winter shift the demand
curve for warm clothes leftward or
rightward?
What will happen to the demand of
social media if young people lose their
interest in it?
What happens to the demand for a
college education if salaries for college-
educated workers are rising rapidly?
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Supply Function / Equation

Here we have the supply equation,
𝑄 = −𝑐 + 𝑑𝑃
Where,
c = quantity intercept of supply. It will
always be negative, since at a price of
zero, no producers are generally
willing or able to provide a good. In
case of subsidies, “c” may be +ve
&
d = Run / Rise = Change in Quantity / Change in Price. “d” is
the responsiveness of the producers. The higher the “d” variable,
the more responsive producers are to price changes, and the
flatter the supply curve.
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Supply Function / Equation

Here we have the supply equation,
𝑄 = −𝑐 + 𝑑𝑃
If 𝑷 = 𝟎, 
If 𝑸𝒔 = 𝟎, 
Note:
𝑄 is always +ve.
i.e. Q > 0  P > c/d
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Demand Function / Equation

Here we have the demand equation,
𝑄 = 𝑎 − 𝑏𝑃
Where,
a = quantity intercept of demand.
&
b = Run / Rise = Change in Quantity
/ Change in Price. “b” is the
responsiveness of the consumers.
From demand equation, 𝑄 = 𝑎 − 𝑏𝑃
If 𝑷 = 𝟎, 
If 𝑸𝑫 = 𝟎, 
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MARKET EQUILIBRIUM
 The equilibrium price comes at the
intersection of the supply and
demand curves. There are no
surplus and shortage over this point.
 At high prices: (𝑙𝑖𝑘𝑒 𝑃 ) Supply >
Demand means suppliers want to sell
more than demanders want to buy. The
result is a surplus, or excess of quantity
supplied over quantity demanded.
 At low prices: (𝑙𝑖𝑘𝑒 𝑃 ) Demand > Supply means the demanders
want to buy more than suppliers want to sell. the market shows a
shortage, or lack of quantity supplied over quantity demanded.
Under this condition the competition among buyers for limited
goods causes the price to rise.
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MARKET EQUILIBRIUM
 The equilibrium price is a price at
which quantity demanded is equal to
the quantity supplied over the same
period.
 At equilibrium point, there are no
shortages or surpluses; there is no
tendency for price to rise or fall,
means the forces of supply and
demand are in balance and the price
has settled at a sustainable level.
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EQUILIBRIUM’s Mathematical
Representation
 At equilibrium point,
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EQUILIBRIUM’s Mathematical
Representation
 For equilibrium quantity,
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Price Elasticity of Demand

 Price elasticity of demand measures how much the quantity
demanded of a good changes when its price changes.
 The precise definition of price elasticity is the percentage
change in quantity demanded divided by the percentage
change in price.
 When the price elasticity of a good is high, we say that the good
has “elastic” demand, which means that its quantity demanded
responds greatly to price changes.
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 When the price elasticity of a good is high, we say that the good
has “elastic” demand, which means that its quantity demanded
responds greatly to price changes.
 When the price elasticity of a good is low, it is “inelastic”, and
its quantity demanded responds little to price changes.
 Goods that have ready substitutes tend to have more elastic
demand than those that have no substitutes. If not so, then
they will loose their market.
 Price elasticities tend to be higher when the goods are luxuries,
when substitutes are available, and when consumers have
more time to adjust their behavior.
 By contrast, elasticities are lower for necessities, for goods with
few substitutes, and for the short run.
45

Mathematically,
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑
𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒
 Note: -ve sign represents inverse relation according to the law

of demand.
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 If 𝐸 > 1 (When a 1 percent change in
price calls forth more than a 1 percent
change in quantity demanded) the good
has price-elastic demand.
 If 𝐸 < 1 (When a 1 percent change in
price produces less than a 1 percent
change in quantity demanded) the good
has price-inelastic demand.
 If 𝐸 = 1 (when the percentage change in
quantity is exactly the same as the
percentage change in price) the good has
unit-elastic demand.
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Elasticity & Revenue

 Price elasticity of demand tells us that what happens to the
total revenue (P X Q) as price is decreased.
When demand is price-inelastic, a price decrease

reduces total revenue.
When demand is price-elastic, a price decrease
increases total revenue.
In the borderline case of unit-elastic demand, a price
decrease leads to no change in total revenue.
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Special Cases of Elasticity

 Completely inelastic demands, or
ones with zero elasticity are ones
where the quantity demanded
responds not at all to price
changes; such demand is seen to
be a vertical demand curve.
 By contrast, when demand is
infinitely elastic, a tiny change in
price will lead to an indefinitely
large change in quantity
demanded, as in the horizontal
demand curve
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Market Structure
 There are four basic types of market structure:
1) Perfect Competition
2) Monopoly
3) Monopolistic Competition
4) Oligopoly
 Each of them has its own set of characteristics and

assumptions, which in turn affect the decision making of firms
and the profits they can make.
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Market Structure
1) Perfect Competition:
Perfect competition exists when there is a large number of
producers / firms producing homogenous products (i.e; product
with same quality). The maximum output which an individual
firm can produce is relatively very small to the total demand or
the industry product so that a firm cannot affect the price by
changing its supply of output.
Features:
Large number of buyers in the market and no individual
buyer can influence market demand.
Large number of sellers and no individual seller can

influence market supply.
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Market Structure
1) Perfect Competition :(Cont.)
Homogeneous goods: Products are homogeneous in
nature. Same quality goods, but different brand name
Perfect knowledge : regarding prices of goods because

product is homogeneous
A firm is a price taker : prices are determined by market

demand and supply . Thus individual firm do not control
market price, but each individual firm uses its resources
efficiently to make profit
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Market Structure
2) Monopoly:
It is a market situation in which there are large number of
buyers but only one seller of the product. It is a situation in
which a seller of a product has no close substitute.
Example: K-electric
Features:
Only one seller : and whole market supply is fully
controlled
No close substitute
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Market Structure
2) Monopoly: (Cont.)
Price discrimination : means charging different prices
from different customers for same product like k-electric
different per unit charges for different units consumed
Full restrictions: No entry of new firms
Imperfect knowledge: regarding prices
Price maker : Under monopoly , a firm is a price maker
and not price taker.
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Market Structure
3) Monopolistic Competition:
It refers to a market situation in which there are many
producers producing goods which are close substitutes of one
another or where output is differentiated (differentiated may be
difference in quality or products for same purpose).
Features:
Large number of sellers and no individual seller can
influence market supply
Differentiated goods i.e; goods which differ in terms of
quality for e.g;; soaps and are also called product
differentiation.
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Market Structure
3) Monopolistic Competition (Cont.):
Monopolistic competitive firms follow independent price
policies
Imperfect knowledge due to differentiated goods.
Selling cost : it includes all the expenses made to
increase the sale of the product i.e.; advertisement
Few restriction : Copy right , Patent right etc.
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Market Structure
4) Oligopoly:
It is a market situation in which there are large number of
buyers but only few sellers of the product & they use their
market influence to set the prices and in turn maximize their
profits. e.g.; mobile companies , cigarette manufacture etc.
Features:
Few sellers of the product : Each seller partially controls
the market supply
Interdependence in decision making : If there is fall in
the price of one company’s product , it may lead to fall in
the price of other firms.
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Market Structure
4) Oligopoly: (Cont.)
High barriers to enter : High investment is required
Huge advertisement expense
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TYPES OF BUSINESS ORGANIZATIONS

1) A Sole Proprietorship / Sole trader
A sole trader is a business that is owned by one person . It may
have one or more employees.
ADVANTAGES
Total control of business by owner
Cheap to start up
Keep all profit
DISADVANTAGES
Unlimited liability
Difficult to raise finance
May be difficult to specialize or enjoy economies of scale
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1) A Sole Proprietorship / Sole trader (Cont.)
Problem with continuity if sole trader retires or dies
Business owner responsible for all debts of business
2) Partnership
Business where there are two or more owners of the enterprise.
ADVANTAGES
Synergy . There is clear potential for the enhancement of value
resulting from two or more individuals combining strength
Spreads the risk across more people, so if the business gets
into difficulty then there are more people to share the burden
of debt
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2) Partnership (Cont.)
Partner may bring money and resources to the business
Partner may bring other skills and ideas to the business,
complementing the work already done by the original partner
Increased credibility with potential customers and suppliers –
who may see dealing with the business as less risky than
trading with just a sole trader
DISADVANTAGES
Have to share profits
Less control of business for individual
Disputes over workload
Problems if partners disagree over of direction of business.
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DISADVANTAGES (Cont.)
Limited life : A partnership may end upon the withdrawal or
death of a partner.
3) Corporations:
A corporation is a legal entity doing business and is distinct from
the individuals within the entity. Public corporations are owned
by shareholders who elect a board of directors to oversee
primary responsibilities. Shareholders own company. Company
employs directors to control management of business. The
directors may also be shareholders (most are)/
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DISADVANTAGES (Cont.)
Limited life : A partnership may end upon the withdrawal or
death of a partner.
3) Corporations:
A corporation is a legal entity doing business and is distinct from
the individuals within the entity. Public corporations are owned
by shareholders who elect a board of directors to oversee
primary responsibilities. Shareholders own company. Company
employs directors to control management of business. The
directors may also be shareholders (most are)/
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3) Corporations: (Cont.)
ADVANTAGES
Unlimited commercial life. The corporation is an entity of its
own and does not dissolve when ownership changes
Greater flexibility in raising capital through the sale of stock
Limited liability: Limited liability means that investors can
only lose money they have invested. Those who have a claim
against company they can only recover money from existing
assets of business. They cannot claim personal assets of
shareholders to recover amounts owed by company
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3) Corporations: (Cont.)
DISADVANTAGES
Regulatory restrictions. Corporations are typically more closely
monitored by government agencies .Complying with
regulations can be costly
Higher organizational and operational cost
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Introduction
 The term capital refers to wealth in the form of money or
property that can be used to produce that can be used to
produce more wealth.
 The majority of engineering economy studies involve
commitment of capital for extended periods of time, so the
effect of time must be considered.
 In this regard, it is recognized that a dollar today is worth
more than a dollar one or more years from now because of the
interest (or profit) it can earn.
 Therefore, money has a time value.
 It has been said that often the riskiest thing a person can do
with money is nothing! Money has value, and if money
remains uninvested (like in a large bottle), value is lost.
1
Why Consider Return to Capital?

 There are two fundamental reasons why return to capital in
the form of interest and profit is an essential ingredient of
engineering economy studies.
 Return on capital is incentive as compared to consumption:
First, interest and profit pay the providers of capital for
forgoing its use during the time the capital is being used.
The fact that the supplier can realize a return on capital
acts as an incentive to accumulate capital by savings,
thus postponing immediate consumption in favor of
creating wealth in the future.
 Return on capital is payment of the investment risk:
Second, interest and profit are payments for the risk the
investor takes in permitting another person, or an
organization, to use his or her capital.
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Why Consider Return to Capital?

 Investors must decide whether the expected return on their
capital is sufficient to justify buying into a proposed project or
venture.
 If capital is invested in a project, investors would expect, as a
minimum, to receive a return at least equal to the amount
they have sacrificed by not using it in some other available
opportunity of comparable risk.
 This interest or profit available from an alternative
investment is the opportunity cost of using capital in the
proposed undertaking.
 In summary, whenever capital is required in engineering and
other business projects and ventures, it is essential that
proper consideration be given to its cost(i.e., time value).
Simple Interest
 When the total interest earned or charged is linearly
proportional to the initial amount of the loan (principal), the
interest rate, and the number of interest periods for which the
principal is committed, the interest and interest rate are said
to be simple.
 Simple interest is not used frequently in modern commercial
practice.
 When simple interest is applicable, the total interest, I ,
earned or paid may be computed using the formula
𝐼= 𝑃 𝑁 𝑖
where P = principal amount lent or borrowed;
N = number of interest periods (e.g., years);
𝑖 = interest rate per interest period.
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Simple Interest
 The total amount repaid at the end of N interest periods is
P + I.
 Thus, if $1,000 were loaned for three years at a simple
interest rate of 10% per year, the interest earned would be
𝐼 = $1,000 × 3 × 0.10 = $300
 The total amount owed at the end of three years would be
$1,000 + $300 = $1,300.
Compound Interest
 Whenever the interest charge for any interest period (a year,
for example) is based on the remaining principal amount plus
any accumulated interest charges up to the beginning of that
period, the interest is said to be compound.
 Compound interest (or compounding interest) is interest
calculated on the initial principal, which also includes all of
the accumulated interest of previous periods of a deposit or
loan.
 Compound interest is contrasted with simple interest, where
previously accumulated interest is not added to the principal
amount of the current period, so there is no compounding.
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Compound Interest
 The effect of compounding of interest can be seen in the
following table for $1,000 loaned for three periods at an
interest rate of 10% compounded each period:
 A total of $1,331 would be due for repayment at the end of the

third period.
Simple vs Compound Interest

 If the length of a period is one year,
the $1,331 at the end of three
periods(years) can be compared with
the $1,300 given earlier for the same
problem with simple interest.
 A graphical comparison of simple
interest and compound interest is
given in the figure at the right:
 The difference is due to the effect of compounding, which is
essentially the calculation of interest on previously earned
interest.
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Simple vs Compound Interest

 This difference would be much
greater for larger amounts of money,
higher interest rates, or greater
numbers of interest periods.
 Thus, simple interest does consider
the time value of money but does not
involve compounding of interest.
 the primary difference between
simple interest and compound
interest is that compound interest
includes interest on the interest
earned in the previous period, while
simple interest does not.
9
Notation and Cash-Flow Diagrams

 The following notation is utilized in formulas for compound interest
calculations:
𝑖 = interest rate per interest period
N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or
more cash flows at a reference point in time called the present;
F = future sum of money; the equivalent value of one or
more cash flows at a reference point in time called the future;
A = end-of-period cash flows (or equivalent end-of-period
values) in a uniform series continuing for a specified number
of periods, starting at the end of the first period and
continuing through the last period.
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 The use of cash-flow (time) diagrams or tables is strongly
recommended for situations in which the analyst needs to clarify or
visualize what is involved when flows of money occur at various
times.
 In addition, viewpoint is an essential feature of cash-flow diagrams.
 The difference between total cash inflows (receipts) and cash
outflows (expenditures) for a specified period of time (e.g., one
year) is the net cash flow for the period.
 Cash flows are important in engineering economy because they form
the basis for evaluating alternatives.
 The usefulness of a cash-flow diagram for economic analysis
problems is analogous to that of the free-body diagram for
mechanics problems.
11

 The cash-flow diagram employs several conventions:
1) The horizontal line is a time scale, with progression of
time moving from left to right. The period (e.g., year,
quarter, month) labels can be applied to intervals of
time rather than to points on the time scale.
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2) The arrows signify cash flows and are placed at the
end of the period. If a distinction needs to be made,
downward arrows represent expenses (negative cash
flows or cash outflows) and upward arrows represent
receipts (positive cash flows or cash inflows).
13

3) The cash-flow diagram is dependent on the point of
view. For example, the situation shown in figure were
based on cash flow as seen by the lender. If the
directions of all arrows had been reversed, the
problem would have been diagrammed from the
borrower’s viewpoint.
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Cash-Flow Diagramming
Q) Before evaluating the economic merits of a proposed
investment, the XYZ Corporation insists that its
engineers develop a cash-flow diagram of the proposal.
An investment of $10,000 can be made that will produce
uniform annual revenue of $5,310 for five years and then
have a market (recovery) value of $2,000 at the end of
year (EOY) five. Annual expenses will be $3,000 at the
end of each year for operating and maintaining the
project. Draw a cash-flow diagram for the five-year life of
the project. Use the corporation’s viewpoint.
15
Cash-Flow Diagramming
Ans)
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Present and Future Equivalent Values

of Single Cash Flows
 The following figure shows a cash-flow diagram involving a
present single sum, P, and a future single sum, F, separated
by N periods with interest at 𝑖% per period. Throughout this
chapter, a dashed arrow, such as that shown in Figure 4-5,
indicates the quantity to be determined.
17
Finding F when given P

 If an amount of P dollars is invested at a point in time and
𝑖% is the interest (profit or growth) rate per period, then by
the end of one period the amount will grow to a future
amount of
P + P𝑖 = P(1+𝑖)
 By the end of two periods, the amount will grow to
P(1 + 𝑖)(1 + 𝑖) = P(1 + 𝑖)2
 by the end of three periods, the amount will grow to
P(1 + 𝑖)2(1 + 𝑖) = P(1 + 𝑖)3
 and by the end of N periods the amount will grow to
(1 + 𝑖)  Single
payment compound
amount factor
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Future Equivalent of a Present Sum

Q) Suppose that you borrow $8,000 now, promising to repay
the loan principal plus accumulated interest in four
years at 𝑖= 10% per year. How much would you repay at
the end of four years?
Ans:
19

 Numerical values for this factor,“(1 + 𝑖) ” are given in the
second column from the left in the tables of Appendix C for a
wide range of values of 𝑖 and N.
 We shall use the functional symbol (F/P, 𝑖%,N) for (1 + 𝑖) .
 Hence,

 where the factor in parentheses is read “find F given P at 𝑖 %
interest per period for N interest periods.”
 Note that the sequence of F and P in F/P is the same as in the
initial part of the Equation.
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 Let's solve the previous question again by using Appendix C,
we have
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Discrete Cash-Flow Examples Illustrating Equivalence

 In Borrowing - Lending  In Equivalence Terminology
Terminology Q) What is the future equivalent
Q) A firm borrows $1,000 for at the end of eight years of
eight years. How much must it $1,000 at the beginning of those
repay in a lump sum at the end eight years?
of the eighth year?
 Solution
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Finding P when Given F

 Since, we have
 Solving this for P gives the relationship:
 The quantity (1 + 𝑖) is called the single payment present

worth factor.
 Numerical values for this factor are given in the third column
of the tables in Appendix C for a wide range of values of 𝑖 and
N.
23
Present Equivalent of a Future Amount of Money

 We shall use the functional symbol (P/F, 𝑖 %, N) for this factor.
Hence,
 Hence,
 Let’s solve a question:
Q) An investor (owner) has an option to purchase a

tract of land that will be worth $10,000 in six
years. If the value of the land increases at 8% each
year, how much should the investor be willing to
pay now for this property?
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 Solution through formula:  Solution through C-11 table:
Using,
Here, F = $10,000
N = 6 years
𝑖=8%
Therefore,
𝑃 = $10,000(1 + 0.08) 𝑃 = $10,000(𝑃/𝐹, 8%, 6)
𝑃 = $10,000 (0.6302) 𝑃 = $10,000 (0.6302)
𝑃 = $6,302 (Ans) 𝑃 = $6,302 (Ans)
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Discrete Cash-Flow Examples Illustrating Equivalence

 In Borrowing - Lending  In Equivalence Terminology
Terminology Q) What is the present
Q) A firm wishes to have equivalent of $2,143.60 received
$2,143.60 eight years from eight years from now?
now. What amount should be
deposited now to provide for it?
 Solution
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 The following three simple rules apply when performing
arithmetic calculations with cash flows:
 Rule A: Cash flows cannot be added or subtracted unless they

occur at the same point in time.
 Rule B: To move a cash flow forward in time by one-time unit,

multiply the magnitude of the cash flow by (1 + 𝑖), where 𝑖 is
the interest rate that reflects the time value of money.
 Rule C: To move a cash flow backward in time by one-time

unit, divide the magnitude of the cash flow by (1 + 𝑖).
27
Finding N when Given P, F, and

 Sometimes we are interested in finding the amount of time
needed for a present sum to grow into a future sum at a
specified interest rate.
Arranging the equation we
 We have get,
Q) how long would it take for

Using logarithms, $500 invested today at 15%
interest per year to be worth
$1,000? (Ans: 4.96 ≅ 5 years)
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Finding N when Given P, F, and

Q) The average price of gasoline was given as $2.31 in 2005. The
average annual rate of increase in the price of gasoline is
6.62%. If we assume that the price of gasoline will continue to
inflate at this rate, how long will it be before we are paying
$5.00 per gallon?
Ans: Here, P = $2.31 , 𝑖 = 6.62%, F = $5.00 . Now using
$5.00
log( )
$2.31
𝑁=
log(1 + 0.0662)
log(2.1645)
𝑁= = 12.05 𝑦𝑒𝑎𝑟𝑠
log(1.0662)
So, if gasoline prices continue to increase at the same rate, we
can expect to be paying $5.00 per gallon in 2017.
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Annuity
 It is a series of equal amount of cashflows (receipt or payment)
after equal interval of time.
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Relating a Uniform Series (Annuity) to Its Present

and Future Equivalent Values
 The following figure shows a general cash-flow diagram
involving a series of uniform (equal) receipts, each of amount A,
occurring at the end of each period for N periods with interest
at 𝑖 % per period. Such a uniform series is often called an
annuity.
31
Important Assumptions for Annuity A

 It should be noted that the formulas and tables to be
presented are derived such that A occurs at the end of
each period, and thus,
1) P (present equivalent value) occurs one interest
period before the first A (uniform amount),
2) F (future equivalent value) occurs at the same time as
the last A, and N periods after P, and
3) A (annual equivalent value) occurs at the end of
periods 1 through N, inclusive.
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Finding F when Given A

 If a cash flow in the amount of A dollars occurs at the
end of each period for N periods and 𝑖 % is the interest
(profit or growth) rate per period, the future equivalent
value, F, at the end of the Nth period is obtained by
summing the future equivalents of each of the cash
flows. Thus
33

 Thus
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 The bracketed terms comprise a geometric sequence
having a common ratio of (1 + 𝑖) .
 Recall that the sum of the first N terms of a geometric
sequence is
1−𝑟
𝑆 =𝑎
1−𝑟
 Where a1 is the first term in the sequence and r is the
common ratio.
 In our case, a1 = (1 + 𝑖) and r = (1 + 𝑖)
 Now, by applying this concept on future equivalent
value equation, we get
35

1 − (1 + 𝑖)
𝐹 = 𝐴 (1 + 𝑖)
1 − (1 + 𝑖)
1
(1 + 𝑖) 1−
(1 + 𝑖)
𝐹=𝐴
(1 + 𝑖) 1
1−
(1 + 𝑖)
(1 + 𝑖) − 1
(1 + 𝑖) (1 + 𝑖)
𝐹=𝐴
(1 + 𝑖) (1 + 𝑖) − 1
(1 + 𝑖)
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(1 + 𝑖) − 1
𝐹=𝐴
𝑖
( )
 The quantity is called the uniform series compound
amount factor.
 Numerical values for the uniform series compound amount
factor are given in the fourth column of the tables in Appendix
C for a wide range of values of 𝑖 and N. We shall use the
functional symbol (F/A, 𝑖%, N) for this factor.
 Hence,
𝐹 = 𝐴(𝐹/𝐴, 𝑖% , N)
37

Q) A recent government study reported that a college
degree is worth an extra $23,000 per year in income
(A) compared to what a high-school graduate
makes. If the interest rate (𝑖) is 6% per year and
you work for 40 years (N), what is the future
compound amount (F) of this extra income?
Solution:
The viewpoint we will use to solve this problem is that of
“lending” the $23,000 of extra annual income to a
savings account (or some other investment vehicle). The
future equivalent is the amount that can be withdrawn
after the 40th deposit is made.
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Notice that the future equivalent occurs at the same

time as the last deposit of $23,000.
39
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Become a Millionaire by Saving $1.00 a Day!

Q) If you are 20 years of age and save $1.00 each day
for the rest of your life, you can become a
millionaire.” Let’s assume that you live to age 80
and that the annual interest rate is 10% ( 𝑖 =
10%).
Solution:
41
Finding P when Given A

 We know that,
( )
-----(1)
 We also know that,
-----(2)
 By substituting eq (2) in eq (1), we get
 Dividing both sides by (1 + 𝑖) , we get

𝑇ℎ𝑒 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑖𝑛
𝑏𝑟𝑎𝑐𝑘𝑒𝑡𝑠 𝑖𝑠 𝑐𝑎𝑙𝑙𝑒𝑑 𝑡ℎ𝑒
uniform 𝑠𝑒𝑟𝑖𝑒𝑠
𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑓𝑎𝑐𝑡𝑜𝑟
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Finding P when Given A

 Thus, the above equation is the relation for finding the
present equivalent value (as of the beginning of the
first period) of a uniform series of end-of-period cash
flows of amount “A” for “N” periods.
 Numerical values for this factor are given in the fifth
column of the tables in Appendix C for a wide range of
values of 𝑖 and N.
 We shall use the functional symbol (P/A, 𝑖 %, N) for this
factor.
 Hence,
43
Present Equivalent of an Annuity (Uniform Series)

Q) A micro-brewery is considering the installation of a
newly designed boiler system that burns the dried,
spent malt and barley grains from the brewing
process. The boiler will produce process steam that
powers the majority of the brewery’s energy
operations, saving $450,000 per year over the
boiler’s expected life of 10 years. If the interest rate
is 12% per year, how much money can the brewery
afford to invest in the new boiler system?
Solution: here we have, A= $450,000 per year , N= 10
years, 𝑖= 12%
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45

 Using,
𝑃 = 𝐴(𝑃/𝐴, 𝑖% , N)
𝑃 = $450,000(𝑃/𝐴, 12%, 10)
𝑃 = $450,000(5.6502)
𝑃 = $2,542,590
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Q) If you purchase a car from ABC dealership, you
expect to have four free oil changes per year
during the five years you keep the car. Each oil
change would normally cost you $30. If you save
your money in a mutual fund earning 2% per
quarter, how much are the oil changes worth to
you at the time you buy the car ?
Solution:
Acc. to the Que., here we have, A= $30 /oil change, 𝑖= 2%
&𝑁=4 × 5 𝑦𝑒𝑎𝑟 = 20 𝑞𝑢𝑎𝑟𝑡𝑒𝑟 (or 20 oil changes)
47
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49
Finding A when Given F

 By solving the equation of future equivalent of annuity we can
get the equation for Annuity A, of a uniform series of cash flows
occurring at the end of N interest periods that would be
equivalent to (have the same value as) its future value
occurring at the end of the last period:
 The quantity in brackets is called the sinking fund factor.

 Numerical values for this factor are given in the sixth column
of the tables in Appendix C for a wide range of values of 𝑖 and
N. We shall use the functional symbol (A/F,𝑖%,N) for this factor.
Hence,
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Finding A when Given P

 By solving the equation of present equivalent of annuity we can
get the equation for Annuity A, of a uniform series of cash flows
occurring at the end of each of N interest periods that would be
equivalent to, or could be traded for, the present equivalent P,
occurring at the beginning of the first period.
 The quantity in brackets is called the capital recovery factor.

 Numerical values for this factor are given in the seventh
column of the tables in Appendix C for a wide range of values of
𝑖 and N. We shall use the functional symbol (A/P,𝑖 %, N) for this
factor. Hence,
51

Q) You borrow $15,000 from your credit union to purchase a
used car. The interest rate on your loan is 0.25% per month
and you will make a total of 36 monthly payments. What is
your monthly payment?
Solution:
The cash-flow diagram shown below is drawn from the viewpoint
of the bank. Notice that the present amount of $15,000 occurs
one month (interest period) before the first cash flow of the
uniform repayment series.
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53
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Finding the Number of Cash Flows in an Annuity

Given A, P, and
 Sometimes we may have information about a present amount
of money (P), the magnitude of an annuity (A), and the interest
rate (𝑖). The unknown factor in this case is the number of cash
flows in the annuity (N).
Q) Your company has a $100,000 loan for a new security
system it just bought. The annual payment is $8,880 and
the interest rate is 8% per year for 30 years. Your company
decides that it can afford to pay $10,000 per year. After
how many payments (years) will the loan be paid off?
55

Given A, P, and
 Sometimes we may have information about a present amount
of money (P), the magnitude of an annuity (A), and the interest
rate (𝑖). The unknown factor in this case is the number of cash
flows in the annuity (N).
Q) Your company has a $100,000 loan for a new security
system it just bought. The annual payment is $8,880 and
the interest rate is 8% per year for 30 years. Your company
decides that it can afford to pay $10,000 per year. After
how many payments (years) will the loan be paid off?
Solution:
Here: P = $100,000 , Original A= $8,880 per year, 𝑖 = 8% per
year, N = 30 years , New A = $10,000 per year
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Given A, P, and
The original loan payment was found using
57

Given A, P, and
Now, instead of paying $8,880 per year, your company is going to
pay $10,000 per year. Common sense tells us that less than 30
payments will be necessary to pay off the $100,000 loan.
Using,
We can now use the interest tables provided in Appendix C to

find N. Looking down the Present Worth Factor column (P/A)
(which is equal or nearest to $10) of Table C-11, we see that
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Given A, P, and
And,
59

Given A, P, and
Therefore,
“if $10,000 is paid per year, the loan will be paid off after 21
years instead of 30. The exact amount of the 21st payment will
be slightly less than $10,000”
This question can also be solved using calculator or MS Excel.
The solution can be reached by scanning the following QR
CODE:
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Finding the Interest Rate, 𝒊, Given A, F, and N

Q) After years of being a poor, debt-encumbered college
student, you decide that you want to pay for your dream
car in cash. Not having enough money now, you decide to
specifically put money away each year in a “dream car”
fund. The car you want to buy will cost $60,000 in eight
years. You are going to put aside $6,000 each year (for
eight years) to save for this. At what interest rate must
you invest your money to achieve your goal of having
enough to purchase the car after eight years?
Solution:
Here: F = $60,000 , N = 8 years, A = $6,000
61

Using,
Now we can use the interest tables in Appendix C to help track

down the unknown value of 𝑖. What we are looking for are two
interest rates, one with an (F/A, 𝑖 %, 8) value greater than 10
and one with an (F/A, 𝑖 %, 8) less than 10.
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Using,
Thumbing through Appendix C, we find
63

which tells us that the interest rate we are looking for is
between 6% and 7% per year. Even though the function (F/A,
𝒊 %,N) is nonlinear, we can use linear interpolation to
approximate the value of 𝒊.
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We have,
X Y
0.06 9.8975
𝑖 10
0.07 10.2598
Using,
9.8975
10.2598 9.8975
65

We get,
𝑖 = 0.0628 or 6.28 % per year
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Relationships between the compound interest

factors
67
Relationships between the compound interest

factors
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Deferred Annuities (Uniform Series)

 All annuities (uniform series) discussed to this point involve
the first cash flow being made at the end of the first period,
and they are called ordinary annuities.
 If the cash flow does not begin until some later date, the
annuity is known as a deferred annuity.
 A deferred annuity is one for which the ﬁrst payment starts
some time in the future.
 If the annuity is deferred for J periods (J < N), the situation is
as portrayed in Figure:
69

 You can see in the figure that, the entire framed ordinary
annuity has been moved away from “time present,” or “time
zero,” by J periods.
 Remember that, in an annuity deferred for J periods, the first
payment is made at the end of period (J + 1), assuming that
all periods involved are equal in length.
 The present equivalent at the end of period J of an annuity
with cash flows of amount A is
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 The present equivalent at the end of period J of an annuity
with cash flows of amount A is
 The present equivalent of the single amount A(P/A, 𝑖%,N − J)

as of time zero will then be
71
Present Equivalent of a Deferred Annuity

Q) To illustrate the preceding discussion, suppose that a
father, on the day his son is born, wishes to determine
what lump amount would have to be paid into an account
bearing interest of 12% per year to provide withdrawals
of $2,000 on each of the son’s 18th, 19th, 20th, and 21st
birthdays.
Solution:
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Solution (Cont.):
One should first recognize that an ordinary annuity of four
withdrawals of $2,000 each is involved and that the present
equivalent of this annuity occurs at the 17th birthday when a
(P/A, 𝑖 %,N − J) factor is utilized.
In this problem, N = 21 and J = 17
73

Hence,
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Note the dashed arrow in the cash-flow diagram denoting P17.
Now that P17 is known, the next step is to calculate P0. With
respect to P0, P17 is a future equivalent, and hence it could also
be denoted F17. Money at a given point in time, such as the end
of period 17, is the same regardless of whether it is called a
present equivalent or a future equivalent. Hence,
75

Hence,
which is the amount that the father would have to deposit on

the day his son is born.
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Q) A series of year-end cash flows extending over eight years.
The amounts are $100 for the first year, $200 for the
second year, $500 for the third year, and $400 for each
year from the fourth through the eighth. These could
represent something like the expected maintenance
expenditures for a certain piece of equipment or
payments into a fund. For interest rate 20%, Find:
(a) Present equivalent expenditure, 𝑃
(b) Future equivalent expenditure, 𝐹
(c) Annual equivalent expenditure, A
77

Solution:
For Present equivalent expenditure, 𝑷𝟎 :
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Solution:
For Present equivalent expenditure, 𝑷𝟎 :
To find the equivalent P0, we need to sum the equivalent values
of all payments as of the beginning of the first year (time zero).
79

Solution:
For Future equivalent expenditure, 𝐹8:
To find the equivalent F8, we can sum the equivalent values of
all payments as of the end of the eighth year (time eight).
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Solution:
For Future equivalent expenditure, 𝐹8:
Figure indicates these movements of money through time.
However, since the equivalent P0 is already known to be
$1,203.82, we can directly calculate
81

Solution:
For Annual equivalent expenditure, A:
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Solution:
For Annual equivalent expenditure, A:
The equivalent A of the irregular cash flows can be calculated
directly from either P0 or F8 as
or
83
Uniform (Arithmetic) Gradient of Cash Flows

 Some problems involve receipts or expenses that are projected
to increase or decrease by a uniform amount each period, thus
constituting an arithmetic sequence of cash flows.
 For example, because of leasing a certain type of equipment,
maintenance and repair savings relative to purchasing the
equipment may increase by a roughly constant amount each
period. This situation can be modeled as a uniform gradient of
cash flows.
 The following figure is a cash-flow diagram of a sequence of
end-of-period cash flows increasing by a constant amount, G,
in each period. The G is known as the uniform gradient
amount.(i.e. the amount of 2nd year is greater than the
amount in 1st by “G” and so on.)
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Uniform (Arithmetic) Gradient of Cash Flows

 Note that the timing of
cash flows on which the
derived formulas and
tabled values are based is
as follows:
 Notice that the first uniform

gradient cash flow, G, occurs at the
end of period two.
85
Finding P when Given G

The future equivalent of arithmetic sequence of cash flow as
shown in previous figure is :
----(1)
( )
Since,
( ) ( )
∴𝑒𝑞(1)→
( ) ( )
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87
The expression in the bracket is uniform series compound

amount factor for 1 to N years. Hence,
Or
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Finding A when Given G

Since,
Dividing both sides by uniform series compound amount factor (or

sinking fund factor)
( )
( ) ( ) ( )
( )
89
Finding A when Given G
The term in brackets in Equation (4-25) is called the gradient to

uniform series conversion factor. Numerical values for this factor
are given on the right-hand side of Appendix C for a range of i and
N values. We shall use the functional symbol (A/G, i%,N) for this
factor. Thus,
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Since,
Multiplying both sides by uniform series present worth factor
91
The term in braces in Equation is called the gradient to present

equivalent conversion factor. It can also be expressed as (1/𝑖)[(P/A,
𝑖%,N) − N(P/F, 𝑖%,N)]. Numerical values for this factor are given
in column 8 of Appendix C for a wide assortment of 𝑖 and N
values. We shall use the functional symbol (P/G, 𝑖%,N) for this
factor. Hence,
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Using the Gradient Conversion Factors to Find P and A

Q) Suppose that certain EOY cash flows are expected to be
$1,000 for the second year, $2,000 for the third year, and
$3,000 for the fourth year and that, if interest is 15% per
year, it is desired to find
(a) present equivalent value at the beginning of the first year,
(b) uniform annual equivalent value at the end of each of the
four years.
SOLUTION:
G= $1000
𝑖 = 15% per year
N= 4 years
93

SOLUTION:
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Q) Suppose that we have cash flows as follows:
Also, assume that we wish to calculate their present
equivalent at i = 15% per year, using gradient conversion
factors.
SOLUTION:
G= $1000
𝑖 = 15% per year
N= 4 years
The following figure shows how the original schedule can be

broken into two separate sets of cash flows, an annuity series of
$5,000 plus an arithmetic gradient of $1,000 that fits the
general gradient model for which factors are tabled.
95
The summed present equivalents of these two separate sets of

cash flows equal the present equivalent of the original problem.
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Method 2: The annual equivalent of the original cash flows

could be calculated as follows:
97
which is the same value obtained previously (subject to round-off

error).
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Q) Three contiguous countries in Florida have agreed to pool tax
country-maintained bridge refurbishment. At a recent meeting
the country engineer estimated that a total of $500,000 will be
deposited at the end of year into an account for the repair of old
and safety-questionable bridges throughout the three-country
area . Further they estimate that the deposits will increase by
$100,000 per year for only next 9 years , thereafter then cease .
Determine :
a. Equivalent present worth
b. Annual series amounts
If country funds earn interest at a rate of 5% per year.
99

Solution:
The cash flow diagram from the country’s perspective is shown in
figure:
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Solution: (Cont.)
(a) Two computations must be made
and added: the first for the present
worth of the base amount PA and the
second for the present worth of the
gradient PG. The total present worth
PT occurs in year 0.
This is illustrated by the partitioned

cash flow diagram in Figure (drawn
to a scale of $1000 unit)
101

Solution: (Cont.)
The total present worth is
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Solution: (Cont.)
(b) Here, too, it is necessary to consider the gradient and the base
amount separately. The total annual series AT is found by
103
Nominal & Effective Interest Rate

 The concept of nominal and effective interest rate must used
when interest is compounded more than once each year.
For example, if an interest rate is expressed as 1% per month,
the terms nominal and effective interest rates must be
considered.
 The interest amounts for loans, mortgages, bonds, and stocks
are commonly based upon interest rates compounded more
frequently than annually.
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(a) Nominal Interest Rate

 A nominal interest rate “r” is an interest rate that does not
account for compounding. By definition,
𝐫 = 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞 𝐩𝐞𝐫 𝐭𝐢𝐦𝐞 𝐩𝐞𝐫𝐢𝐨𝐝 × 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐩𝐞𝐫𝐢𝐨𝐝𝐬
 A nominal rate may be calculated for any time period longer
than the time period stated by using above equation.
 For example, the interest rate of 1.5% per month is the same as
each of the following nominal rates.
105
(a) Nominal Interest Rate

 Note that none of these rates mention anything about
compounding of interest; they are all of the form “ r % per time
period.”
 These nominal rates are calculated in the same way that simple
rates are calculated, that is, interest rate times number of
periods.
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(b) Effective Interest Rate

 It is the actual rate that applies for a stated period of time.
 An effective interest rate is a rate 𝑖 wherein the compounding of
interest is taken into account.
 The compounding of interest during the time period of
corresponding nominal rate is accounted for the effected interest
rate.
 It is commonly expressed on annual basis as the effective
annual interest rate 𝑖 but any time can be used.
 An effective interest rate has compounding frequency attached
to the nominal rate statement. If compounding frequency is not
stated, it is assumed to be same as time period of “r” and it this
case the nominal and effective interest rate has same value.
107

 The most common form of interest rate statement when
compounding occurs over time periods shorter than 1 year is “%
per time period, compounded CP-ly”, where CP= compounding
period.
 for example, 10% per year, compounded monthly, or 12% per
year, compounded weekly.
 If the CP is not mentioned, it is understood to be the same as
the time period mentioned with the interest rate.
 All of the following are effective interest rate statements
because either they state they are effective or the compounding
period is not mentioned. In the latter case, the CP is the same
as the time period of the interest rate.
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109
Concept of APR and APY

 APR (Annual Percentage Rate) is often stated as the annual
interest rate for credit cards, loans, and house mortgages. This
is the same as the nominal rate . An APR of 15% is the same
as a nominal 15% per year or a nominal 1.25% on a monthly
basis.
 APY (Annual Percentage Yield) is a commonly stated annual
rate of return for investments, certificates of deposit, and saving
accounts. This is the same as an effective rate.
 The effective rate is always greater than or equal to the nominal
rate, and similarly APY ≥ APR.
 Based on these descriptions, there are always three time-based
units associated with an interest rate statement.
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Time-based units (interest rate statement)

 Interest / time period (t): (basic time unit of interest rate)
The period of time over which the interest is expressed. This is
the t in the statement of r % per time period (t) , for example, 1%
per month. The time unit of 1 year is by far the most common. It
is assumed when not stated otherwise.
 Compounding period (CP):
The shortest time unit over which interest is charged or earned.
This is defined by the compounding term in the interest rate
statement, for example, 8% per year, compounded monthly. If CP
is not stated, it is assumed to be the same as the interest period.
Or
The time used to calculate the effect of interest. It is defined by
compounding term in the effective interest rate statement.
111

 Compounding frequency (m):
The number of times that compounding occurs within the interest
period “t”. If the compounding period CP and the time period t
are the same, the compounding frequency is 1, for example, 1%
per month, compounded monthly.
Compounding Frequency # of Compounding period per year
Annually 1
Semi-Annually 2
Quarterly 4
Bi-monthly 6
Monthly 12
Daily 365
Weekly 52
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 Consider the (nominal) rate of 8% per year, compounded
monthly. It has an interest period t of 1 year, a compounding
period CP of 1 month, and a compounding frequency m of 12
times per year. A rate of 6% per year, compounded weekly, has
t=1 year, CP = 1 week, and m = 52, based on the standard of 52
weeks per year.
 An effective rate can be determined from a nominal rate by
using the relation
113

Q) Three different bank loan rates for electric generation
equipment are listed below. Determine the effective rate on the
basis of the compounding period for each rate.
(a) 9% per year, compounded quarterly.
(b) 9% per year, compounded monthly.
(c) 4.5% per 6 months, compounded weekly.
Solution: (Since 𝑖 = r/m)
(a) 𝑖 = 9/4 = 2.25%
(b) 𝑖 = 9/12 = 0.75%
(c) 𝑖 = 9/(52/2) = 0.173%
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115
Further Explanation
 Consider a principal amount of $1,000 to be invested for three
years at a nominal rate of 12% compounded semiannually. The
interest earned during the first six months would be $1,000 ×
(0.12/2) = $60.
 Total principal and interest at the beginning of the second six-
month period is P + Pi = $1,000 + $60 = $1,060.
 The interest earned during the second six months would be
$1,060 × (0.12/2) = $63.60
 Then total interest earned during the year is $60.00 + $63.60 =
$123.60
 Finally, the effective annual interest rate for the entire year is
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Further Explanation
2nd Method:
he relationship between effective interest, 𝑖 , and nominal
interest, r, is
117
Derivation of Effective Annual Interest Rate

 Treatment for nominal and effective interest rates parallels that
of simple and compound interest. Like compound interest, an
effective interest rate at any point during the year includes
(compounds) the interest rate for all previous compounding
periods during the year.
 Therefore, the derivation of an effective interest rate formula
directly parallels the logic used to develop the future worth
relation
 The effective rate “𝑖” per CP must be compounded through all

“m” periods to obtain the total effect of compounding by the end
of the year. This means that F can also be written as
-----(1)
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 The future worth F at the end of 1 year is the principal P plus
the interest P( 𝑖 ) through the year. Since interest may be
compounded several times during the year, use the effective
annual rate symbol 𝑖 to write the relation for F
−−−−−(2)
119

 By eq (2) in eq (1), we get
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Where,
121
Effective Annual Interest Rate

Q) Mr. Ali obtained a new credit card from national bank, with
a stated rate of 18% per year , compounded monthly . For a
$ 1000 balance at the beginning of the year. Find the
effective annual rate and the total amount owed to bank
after 1 year , provided no payments are made during the
year.
Solution:
r = 18% per year
t =1 year
m = 12
𝑖 =?
F=?
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 Firstly,
18% per year
 Now,
123

1st Method:
2nd Method:
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Q) Suppose that a $100 lump-sum amount is invested for 1-
years at a nominal interest rate of 6% compounded
quarterly . How much is it worth at the end of the tenth
year.
Solution:
r = 6% per year
t =1 year (assume)
m = 4 quarters (for 1 year) & m = 4 X 10 = 40 quarters(for ten
years)
𝑖 =?
F=?
125

 Firstly,
6% per year
 Now,
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1st Method:
2nd Method:
127
Equivalence Relations: Payment Period

and Compounding Period
 The payment period (PP) is the length of time between cash fl
ows (infl ows or outfl ows). It is common that the lengths of the
payment period and the compounding period (CP) do not
coincide. It is important to determine if PP = CP, PP < CP, or PP
> CP.
 Case for PP < CP
If a company deposits money each month into an account that
earns at the nominal rate of 8% per year, compounded
semiannually, the cash flow deposits define a payment period of 1
month and the nominal interest rate defines a compounding
period of 6 months..
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Equivalence Relations: Payment Period

and Compounding Period
 Case for PP > CP
If a person deposits a bonus check once a year into an account
that compounds interest quarterly, PP = 1 year and CP = 3
months.
 Equivalence Relation:
When frequency of cash flow does not equal to the frequency of
interest compounding, so we use equivalence relationship,
129
Effective Interest Rate for any time period

“t”
∵
 If it is compounded annually so 𝑖 = 𝑖 . At t = 1
 If compounding is done for any time “t” (e.g. 6 months , 7

months, 5 months, etc.)
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“t”
 If compounding is done quarterly or semiannually
(per CP)
Q Visteon, a spin off company of ford motor company, supplies
major automobile components to auto manufacturers worldwide
and is Ford’s largest supplier. An engineer is on a Visteon
committee to evaluate bids for new generation co-ordinate
measuring machinery to be directly linked to the automated
manufacturing of high-precision components . These vendor bids
include the interest rates , Visteon will make payments on a
semiannually basis only
131

“t”
(a) Determine the effective rate for each bid on the basis of
semiannual and construct cash flow diagram
(b) What are the effective annual rates
(c) Which bid has the lowest effective annual rate?
Solution:
First solving for effective interest rate for r-months:
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𝑟
S. Nominal Rate r% m=CP /PP , for 𝑖 = 1+ −1
Bids 𝑚
No. for 6 months 6 months
for 6 months
9% per year, 0.045

9% 𝑖 = 1+ −1
𝑟= = 4.5% 2 2
1 compounded 2 𝑚= =2
quarterly Per 6 months 1 𝑖 = 4.55%
3% per 0.06
quarter, 𝑟 = 3% / 𝑞𝑢𝑎𝑟𝑡𝑒𝑟 𝑋 2 2 𝑖 = 1+ −1
2 2
compounded r= 6% per 6 months 𝑚= =2
1 𝑖 = 6.09%
quarterly
8..8% per 0.044

8.8% 𝑖 = 1+ −1
year, 𝑟= = 4.4% 6 6
3 2 𝑚= =6
compounded 1 𝑖 = 4.48%
Per 6 months
monthly
133

“t”
(b) Now solving for effective annual interest rate 𝒊𝒂 :
(Table is on the next slide)
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𝑟
S. Nominal Rate r% m=CP for 1 𝒊𝒂 = 1 + −1
Bids 𝑚
No. for 1 year year
for 1 year
0.09
9% per year, 𝒊𝒂 = 1 + −1
𝑟 = 9% 4
1 compounded 𝑚=4
per year 𝒊𝒂 = 9.31%
quarterly
3% per 0.12
quarter, 𝑟 = 3% / 𝑞𝑢𝑎𝑟𝑡𝑒𝑟 𝑋 4 𝒊𝒂 = 1 + −1
2 𝑚=4 4
compounded r= 12% per year 𝒊𝒂 = 12.55%
quarterly
8..8% per 0.088

year, 𝑟 = 8.8% 𝒊𝒂 = 1 + −1
3 𝑚 = 12 12
compounded per year 𝒊𝒂 = 9.16%
monthly (lowest)
135
PP > CP (Single Payment)

Q An engineer working as a private consultant made deposits
in to as account as follows :
YEAR “0” YEAR “4” YEAR “6”
$1000 $3000 $1500
Find the amount in the account after 10 years at an interest
rate of 12% per year, compounded semiannually ?
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Solution:
Here r = 12% year & m = 2 (for six months)
For r%:
%
137
Solution:
𝐹 F F
𝐹 = 1000 , 6%, 10 × 2 + 3000 , 6%, 6 × 2 + 1500 , 6%, 4𝑋2
𝑃 P P
𝐹 = 1000 3.2071 + 3000 2.0122 + 1500 1.5938
𝐹 = $11,634
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Method 2:
139

“t”
Q For the past 7 years, Excelon Energy has paid $500 every 6
months for a software maintenance contract. What is the
equivalent total amount after the last payment, if these funds are
taken from a pool that has been returning 8% per year,
compounded quarterly?
Solution:
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“t”
Solution:
The payment period (6 months) is longer than the compounding
period (quarter); that is, PP > CP.
For r:
r= 8% / 2 = 4% per 6 months
For m:
m=2 quarters per semiannual period
141

“t”
Solution: (Cont.)
The relation for F is
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“t”
Q Suppose that there exists a series of 10 end-of-year receipts
of $1,000 each, and it is desired to compute their equivalent
worth at the end of the tenth year if the nominal interest rate is
12% compounded quarterly.
Solution:
1st Method:
For 𝒊 :
𝑟 12%
𝑖= = = 3% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
𝑚 4
For A (for one year):
𝐴 = 𝐹(𝐴/𝐹, 3%, 4)
𝐴 = 1000 0.2390
𝐴 = $239
143

“t”
For 𝐹 :
𝐹 = 𝐴(𝐹/𝐴, 3%, 40)
𝐹 = 239 75.4012
𝐹 = $18,021
2nd Method:
𝑟
𝑖 = 1+ −1
𝑚
0.12
𝑖 = 1+ −1
4
𝑖 = 0.1255
We calculated annual interest to use formula for annuity
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“t”
For 𝐹 :
𝐹 = 𝐴(𝐹/𝐴, 12.55%, 10)
𝐹 = 1000 18.022
𝐹 = $18,022
145
Equivalence Relation (PP < CP)

If a person deposits money each month into a savings account
where interest is compounded quarterly, do all the monthly
deposits earn interest before the next quarterly compounding
time?no!
Fundamentally there are two policies:
1) Interperiod cash flows earn no interest
2) Interperiod cash flows earn compound interest
1. Interperiod cash flows earn no interest
For a no-interperiod-interest policy, negative cash flows (deposits
or payments, depending on the perspective used for cash flows)
are all regarded as made at the end of the compounding period,
and positive cash flows (receipts or withdrawals) are all regarded
as made at the beginning.
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 As an illustration, when interest is compounded quarterly, all
monthly deposits are moved to the end of the quarter (no
interperiod interest is earned), and all withdrawals are moved
to the beginning (no interest is paid for the entire quarter).
 This procedure can significantly alter the distribution of cash
flows before the effective quarterly rate is applied to find P , F ,
or A .
 This effectively forces the cash flows into a PP = CP situation,
2. Interperiod cash flows earn compound interest
If PP < CP and interperiod compounding is earned, then the cash
flows are not moved, and the equivalent P , F , or A values are
determined using the effective interest rate per payment period.
147

Q Rob is the on-site coordinating engineer for Alcoa
Aluminum, where an under renovation mine has new ore refining
equipment being installed by a local contractor . Rob developed
the cash flow diagram (Shown in table) . Included are payments
to the contractor he has authorized for the current year and
approved advances from Alcoa’s home office . He knows that the
interest rate on equipment “field project” is 12 % per year
compounded quarterly and that Alcoa does not bother with inter-
period compounding of interest . Will Rob’s project finances be in
the “red” or “black” at the end of the year ? By how much?
Month Month Month Month Month Month Month Month
"0" "2" "4" "5" "7" "9" "10" "11"
-150K -200K -75K -100K 90K 120K -50K 45K
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Actual Cash Flow (in $ 1000):
Month Month Month Month Month Month Month Month
"0" "2" "4" "5" "7" "9" "10" "11"
-150K -200K -75K -100K 90K 120K -50K 45K
149

Moved Cash Flow: (in $ 1000)
 Shifting –ve cash flow at the end of compounding (3 months)
period.
 Shifting +ve cash flow at the beginning of compounding (3
months) period.
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Moved Cash Flow:
For 𝑖:
𝑟 12%
𝑖= = = 3% 𝑝𝑒𝑟 𝑞𝑢𝑎𝑟𝑡𝑒𝑟
𝑚 4
For 𝐹:
F = -150,000 (F/P,3%, 4) – 200,000 (F/P, 3%, 3) + (-170,000 +

90,000)(F/P,3%,2) + 165,000 (F/P,3%,1) – 50,000
F= $ -357,592
151
Financial Effectiveness & Efficiency

Financial Effectiveness:
 The extent to which actual performance compared with targeted
performance.
Financial Efficiency:
𝐼𝑛𝑐𝑜𝑚𝑒
𝐹𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
It should be greater than 1
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Evaluating a Single
Project+ Comparison &
Selection of Alternatives
Objective:
✓ to discuss and critique contemporary (modern/ current) methods for
determining project profitability.
✓ to compare capital investment alternatives when the time value of money
is a key influence.
By:
Ahsan Ahmed
(Lecturer, MED)
The Present Worth Method
▪ The PW method is based on the concept of equivalent worth of
all cash flows relative to some base or beginning point in time
called the present.
▪ That is, all cash inflows and outflows are discounted to the
present point in time at an interest rate that is generally the
MARR (Minimum Attractive Rate of Return), which is also
known as “hurdle rate” (minimum acceptable rate of return)
▪ A positive PW for an investment project is a dollar amount of
profit over the minimum amount required by investors.
▪ It is assumed that cash generated by the alternative is
available for other uses that earn interest at a rate equal to
the MARR.
Decision of PW Method?
▪ To apply the PW method of determining a project’s economic
worthiness, we simply compute the present equivalent of all
cash flows using the MARR as the interest rate. If the present
worth is greater than or equal to zero, the project is
acceptable.
▪ It is important to observe that the higher the interest rate

and the farther into the future a cash flow occurs, the lower
its PW is.
Relation of 𝒊 & PW?
▪ The PW of $1,000 10 years from
now is $613.90 when 𝒊 = 5% per
year.
▪ However, if 𝒊 = 10%, that same

$1,000 is only worth $385.50 now.
▪ What will be done if there are two

or more alternative?
▪ First see whether it is dependent or
independent.
Two or more alternatives
Dependent Alternatives:
▪ Calculate PW of each alternative at the MARR.
▪ Select the alternative with the PW value i.e numerically
largest (i.e. less –ve and more +ve)
Independent Alternatives :
▪ For 1 or more independent projects, select all projects with
present worth greater or equal to zero 𝑃𝑊 ≥ 0 at the MARR
(i.e. interest 𝑖)
Project is economically justified?
Q)A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding
operation. The investment cost is $25,000, and the equipment
will have a market value of $5,000 at the end of a study period
of five years. Increased productivity attributable to the
equipment will amount to $8,000 per year after extra operating
costs have been subtracted from the revenue generated by the
additional production. If the firm’s MARR is 20% per year, is
this proposal a sound one? Use the PW method.
Solution:
𝑃0 = $25,000, Salvage Value = $5,000= 𝐹5 , MARR = 20% per
year, A = Revenue – Operating Cost= $8,000 per year ,
Project is economically justified or viable = ?
Cash Flow Diagram:
We know that:
𝑃𝑊 = 𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 − 𝑃𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑜𝑤
𝑃 𝑃
𝑃𝑊 20% = $8000 , 20%, 5 + $5000 , 20%, 5 − $25000
𝐴 𝐹
𝑃𝑊 20% = $934.29
The Future Worth Method
▪ Because a primary objective of all-time value of money
methods is to maximize the future wealth of the owners of a
firm, the economic information provided by the FW method is
very useful in capital investment decision situations.
▪ The FW is based on the equivalent worth of all cash inflows
and outflows at the end of the planning horizon (study period)
at an interest rate that is generally the MARR.
▪ Also, the FW of a project is equivalent to its PW; that is, FW =
PW(F/P, i%,N).
▪ If FW ≥ 0 for a project, it would be economically justified.
Q) Solve previous question using future worth analysis.
Solution:
𝐹𝑊 = 𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤 − 𝐹𝑊 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑙𝑜𝑤
𝐹 𝐹
𝐹𝑊 20% = −$25000 , 20%, 5 + $8000 , 20%, 5 + $5000
𝑃 𝐴
𝐹𝑊 20% = $2,324.80
The Annual Worth Method
▪ The AW of a project is an equal annual series of dollar
amounts, for a stated study period, that is equivalent to the
cash inflows and outflows at an interest rate that is generally
the MARR.
▪ Hence, the AW of a project is annual equivalent revenues or
savings (R) minus annual equivalent expenses (E), less its
annual equivalent capital recovery (CR) amount,
▪ An annual equivalent value of R , E , and CR is computed for

the study period, N, which is usually in years.
▪ In equation form, the AW, which is a function of i%, is
▪ Also, we need to notice that the AW of a project is equivalent

to its PW and FW.
▪ That is, AW = PW(A/P, i%, N), and AW = FW(A/F, i%, N).
▪ As long as the AW evaluated at the MARR is greater than or
equal to zero, the project is economically attractive; otherwise,
it is not. An AW of zero means that an annual return exactly
equal to the MARR has been earned.
Q) Solve previous question by AW.
Sol:
𝐴𝑊 𝑖% = 𝑅 − 𝐸 − 𝐶𝑅(𝑖%)
𝐴 𝐴
𝐴𝑊 20% = $8000 − $25000 , 20%, 5 + $5000( , 20%, 5)
𝑃 𝐹
𝐴𝑊 20% = $ 312.4
Because its AW(20%) is positive, the equipment more than pays for itself
over a period of five years, while earning a 20% return per year on the
unrecovered investment.
Comparing Alternatives
▪ The alternative that requires the minimum investment of
capital and produces satisfactory functional results will be
chosen unless the incremental capital associated with an
alternative having a larger investment can be justified with
respect to its incremental benefits.
▪ Under this rule, we consider the acceptable alternative that
requires the least investment of capital to be the base
alternative.
▪ If the extra benefits obtained by investing additional capital
are better than those that could be obtained from investment
of the same capital elsewhere in the company at the MARR,
the investment should be made.
Present Worth Analysis (Useful life
Equal)
Q) Perform a present worth analysis of equal service machines
with the cost shown below, if the MARR is 10% per year.
revenues for all three alternatives are expected to be the same.
Solution:
For Electric Powered Machine:
𝑃 𝑃
𝑃𝑊 10% 𝐸 = −2500 − 900 , 10%, 5 + 200 , 10%, 5
𝐴 𝐹
𝑃𝑊 10% 𝐸 = −$5788
Equal)
Solution: (Cont.)
For Gas Powered Machine:
𝑃 𝑃
𝑃𝑊 10% 𝐺 = −3500 − 700 , 10%, 5 + 350 , 10%, 5
𝐴 𝐹
𝑃𝑊 10% 𝐸 = −$5936
For Gas Powered Machine:

𝑃 𝑃
𝑃𝑊 10% 𝑆 = −6000 − 50 , 10%, 5 + 100 , 10%, 5
𝐴 𝐹
𝑃𝑊 10% 𝐸 = −$6127
So, electric powered project is good according to given
conditions because of highest value (although in –ve)
Different)
Q) The following data have been estimated for two mutually
exclusive investment alternatives A and B , associated with a
small engineering project for which revenues as well as
expenses are involved . They have useful lives for four and six
years respectively . If the MARR is 10% per year show which
alternative is more desire able by using present equivalent
worth method
A B
Capital investment 3500 5000
Annual Revenue 1900 2500
Annual Expenses 645 1020
Useful Life Years 4 6
Market Value at the end of useful life 0 0
Different
Solution:
▪ Since the useful lives of Alternatives A and B are different. So
we will use REPEATIBILITY ASSUMPTION.
▪ This assumption is appropriate if the study period is infinite (
very long in length) or a common multiple of the useful lives.
▪ Under this assumption, the cash flows for an alternative’s
initial life cycle will be repeated (i.e., they are identical) in all
subsequent replacement cycles.
▪ Now, the LCM of the useful lives of Alternatives A and B is 12
years. Using the repeatability assumption and a 12-year
study period, the first like (identical) replacement of
Alternative A would occur at EOY four, and the second would
be at EOY eight.
Different
Solution: (Cont.)
▪ For Alternative B, one like replacement would occur at EOY
six. This is illustrated in the following figure:
Different
Solution by PW: (Cont.)
For Alternative A:
𝑃𝑊 10% 𝐴
𝑃 𝑃
= −$3,500 − 3,500 , 10%, 4 − 3,500 , 10%, 8
𝐹 𝐹
𝑃
+ (1,900 − 645) , 10%, 12
𝐴
𝑃𝑊 10% 𝐴 = $1,028
Different
Solution by PW: (Cont.)
For Alternative B:
𝑃𝑊 10% 𝐵
𝑃
= −$5,000 − 5,000 , 10%, 6 + (2,500
𝐹
𝑃
− 1,020) , 10%, 12
𝐴
𝑃𝑊 10% 𝐵 = $2,262
Based on the PW method, we would select
Alternative B
FW Analysis (Useful life Different)
Solution of previous Que by FW:
▪ An assumption used for an investment alternative (when useful life
is less than the study period) is that all cash flows will be
reinvested by the firm at the MARR until the end of the study
period. This assumption applies to Alternative A, which has a four-
year useful life (two years less than the study period), and it is
illustrated in following figure:
Solution of previous Que by FW: (Cont.)
▪ We use the FW method to analyze this
situation of Alternative A:
𝐹𝑊 10%
𝐹
= ൤−$3500 , 10%, 4 + (1900
𝑃
𝐹 𝐹
− 645) , 10%, 4 ൨ × , 10%, 2
𝐴 𝑃
𝐹𝑊 10% = $847
Solution of previous Que by FW: (Cont.)
▪ For Alternative B:
𝐹 𝐹
𝐹𝑊 10% = −$5000 , 10%, 4 + (2500 − 1020) , 10%, 4
𝑃 𝐴
𝐹𝑊 10% = $2,561
Based on the FW of each alternative at the end of the six-year

study period, we would select Alternative B because it has the
larger value ($2,561).
AW Analysis (Useful life Different)
Solution of previous Que by AW:
12/9/2019
Modeling with Linear

Programming
By:
Ahsan Ahmed
(Lecturer, MED)
Operations Research
 It is a scientific approach to determine the optimum (best)
solution to a decision problem under the restriction of limited
resources, using the mathematical techniques to model,
analyze, and solve the problem.
 Operations research (OR) is an analytical method of problem-
solving and decision-making that is useful in the
management of organizations.
 The central objective of operations research is optimization,
i.e., "to do things best under the given circumstances."
 Optimization: Means maximization (of profit) or minimization
(of cost like expense).
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Linear Programming
 Most Prominent Operation Research Technique.
 Linear Programming: is a technique, which optimizes linear
objective function under limited constraints.
 It is designed for models with linear objective and constraint
function.
 It is mostly used for allocation of resources.
 Linear Programming is a technique, designed to help
operation managers and make decisions relative to the trade
offs necessary to allocate resources.
Linear Programming
Objective Function:
 A mathematical expression in linear programming that
maximizes or minimizes some quantity often profit or cost but
any goal may be used.
Constraints:
 Restrictions that limit the degree which manager can pursue
an objective.
 May be expressed as inequalities.
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Linear Programming
 A solution of the model is feasible if it satisfies all the
constraints.
 It is optimal if, in addition to being feasible, it yields the best
(maximum or minimum) value of the objective function.
 The optimum solution of a model is best only for that model. If
the model happens to represent the real system reasonably
well, then its solution is optimum also for the real situation.
 The number of constraints and decision variables in objective
function depends on the complexity of problem.
 Linear programming maximizes (or minimizes) a linear
objective function subject to one or more constraints.
Main Elements of Linear Programming

1) A set of decision variables:
If we have total revenue or profit, then it should be
maximum
If we have cost / expenses, then it should be minimum
Variables can be given any name:
For example: Prince Biscuit  𝑥 , Rio Biscuit  𝑥
2) Objective Function:
An equation that is needed to be optimized.
Example: Objective function: 𝑧 = 2𝑥 + 3𝑥 (here “z” can
be profit or revenue.
It tells how much should we produce 𝑥 and 𝑥 to
maximize “z”
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Main Elements of Linear Programming

3) A set of constraints:
Constraints are the equations that solution must
satisfy.
Constraints are available resources / condition in terms
of mathematical equations (e.g. machine hours).
4) Variable bounds:
The variable usually have 2 bound / boundaries. (-,+)
Means they are not infinite.
Methods:
1- Graphical Method (only for two variables)
2- Two or more variables
7
Maximize “z”
Q) Max
Subjected to:
i-
ii- Structural Constraints
iii-
(non negativity constraints it means
our case is in 1st quadrant)
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Maximize “z”
Solution:
Step # 1: Calculating the extreme points of each structural
constraints:
(i)
When then  (0,400)
When then  (1200, 0)
(ii)
When then  (0,500)
When then  (1000, 0)
9
Maximize “z”
Solution: (Cont.)
(iii)  (700,0)
Step # 2 : Plotting
these points in a graph
Step # 3 : Denoting the

feasible area / region
Feasible Area: “0abcd”
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Maximize “z”
Solution: (Cont.)
Step # 4 : Optimum Solution (always lies on any
one of the vertices) Optimum Point
Point Coordinate 𝑧 = 5𝑥 + 8𝑥
0 (0 , 0) 𝑧 =5 0 +8 0 =0
a (0 , 400) 𝑧 = 5 0 + 8 400 = 3200
b (600 , 200) 𝑧 = 5 600 + 8 200 = 4600
intersection of i and ii
c (700 , 150) 𝑧 = 5 700 + 8 150 = 4700
d (700 , 0) 𝑧 = 5 700 + 8 0 = 3500
11
Maximize “z”
Solution: (Cont.)
Step # 5 : Result / Conclusion
Decision: To get maximum profit of Rs. 4700,

company will produce
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The Reddy Mikks Company Model

Q) Reddy Mikks produces both interior and exterior paints from
two raw materials, M1 and M2.The following table provides the
basic data of the problem:
A market survey indicates that the daily demand for interior paint
cannot exceed that for exterior paint by more than 1 ton. Also, the
maximum daily demand for interior paint is 2 tons.
Reddy Mikks wants to determine the optimum (best) product mix
of interior and exterior paints that maximizes the total daily
profit.
13

Solution:
 Thus the variables of the model are defined as
𝑥 = Tons produced daily of exterior paint
𝑥 = Tons produced daily of interior paint
 To construct the objective function, note that the company wants

to maximize (i.e., increase as much as possible) the total daily
profit of both paints. Given that the profits per ton of exterior
and interior paints are 5 and 4 (thousand) dollars, respectively, it
follows that
Total profit from exterior paint = 5𝑥 ( thousand ) dollars
Total profit from interior paint = 4𝑥 ( thousand ) dollars
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Solution:(Cont.)
 Letting z represent the total daily profit (in thousands of
dollars), the objective of the company is
𝑧 = 5𝑥 + 4𝑥
 Next, we construct the constraints that restrict raw material

usage and product demand. The raw material restrictions are
expressed verbally as
15

Solution:(Cont.)
 The daily usage of raw material Ml is 6 tons per ton of exterior
paint and 4 tons per ton of inte rior paint. Thus
Usage of raw material M1 by exterior paint = 6𝑥 tons/day
Usage of raw material M1 by interior paint = 4𝑥 tons/day
 Hence
Usage of raw material M1 by both paints = 6𝑥 + 4𝑥 tons/day
 In a similar manner,
Usage of raw material M2 by both paints = 1𝑥 + 2𝑥 tons/day
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Solution:(Cont.)
 Because the daily availabilities of raw materials M1 and M2 are
limited to 24 and 6 tons, respectively, the associated restrictions are
given as
6𝑥 + 4𝑥 ≤ 24 (Raw material M1)
𝑥 + 2𝑥 ≤ 6 (Raw material M2)
 The first demand restriction stipulates that the excess of the
daily production of interior over exterior paint, 𝑥 − 𝑥 , should not
exceed 1ton, which translates to
𝑥 − 𝑥 ≤ 1 (Market Supply)
 The second demand restriction stipulates that the maximum daily
demand of interior paint is limited to 2 tons, which translates to
𝑥 ≤ 2 (Demand Limit)
17

Solution:(Cont.)
 An implicit (or "understood-to-be") restriction is that variables 𝑥
and 𝑥 cannot assume negative values. The nounegativity
restrictions, 𝑥 ≥ 0, 𝑥 ≥ 0, account for this requirement.
 The Complete Reddy Mikks model is
Maximize 𝑧 = 5𝑥 + 4𝑥
Subjected to
6𝑥 + 4𝑥 ≤ 24 -------------(1)
𝑥 + 2𝑥 ≤ 6 -------------(2)
𝑥 −𝑥 ≤1 -------------(3)
𝑥 ≤2 -------------(4)
𝑥 ,𝑥 ≥0 -------------(5)
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Solution:(Cont.)
 Any values of 𝑥 and 𝑥 that satisfy all five constraints constitute a
feasible solution. Otherwise, the solution is infeasible.
 But the goal of the problem is to find the best feasible solution, or
the optimum, that maximizes the total profit.
constraints:
 For eq. 1: 6𝑥 + 4𝑥 ≤ 24 when 𝑥 = 0, 𝑥 = 6  (0,6)
when 𝑥 = 0, 𝑥 = 4  (4,0)
 For eq. 2: 𝑥 + 2𝑥 ≤ 6 when 𝑥 = 0, 𝑥 = 3  (0,3)
when 𝑥 = 0, 𝑥 = 4  (6,0)
19

Solution:(Cont.)
 For eq. 3: 𝑥 − 𝑥 ≤ 1 when 𝑥 = 0, 𝑥 = 1  (0,1)
when 𝑥 = 0, 𝑥 = −1  (-1,0)
 For eq. 4: 𝑥 ≤ 2  (0,2)
Step # 2 : Plotting these points in a graph (which is available in the

next slide)
20
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21

Solution:(Cont.)
Step # 3 : Determination of the Feasible Solution Space
The feasible area is “ ABCDEF ”
Step # 4 : Determination of the Optimum Solution:
A (0 , 0) 𝑧 =5 0 +4 0 =0
B (4 , 0) 𝑧 = 5 4 + 4 0 = 20
C (3, 1.5) 𝑧 = 5 3 + 4 1.5 = 21
D (2 , 2) 𝑧 = 5 2 + 4 2 = 18
E (1 , 2) 𝑧 = 5 1 + 4 2 = 13
F (0,1) 𝑧 =5 0 +4 1 =4
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Solution:(Cont.)
Decision: To get maximum profit of Rs. $ 21,000, company will

produce a daily product mix of 3 tons of exterior paint and 1.5 tons of
interior paint.
-X-
23
Note for Considering regions
 If a𝑥 + 𝑏𝑥 ≤ 𝑐 (𝑏𝑒𝑙𝑜𝑤 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒)
 If a𝑥 + 𝑏𝑥 ≥ 𝑐 (𝑏𝑒𝑙𝑜𝑤 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒)
 If a𝑥 + 𝑏𝑥 ≤ 𝑐 (𝑎𝑏𝑜𝑣𝑒 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒 𝑝𝑎𝑠𝑠𝑖𝑛𝑔 𝑡ℎ𝑟𝑜𝑢𝑔ℎ 𝑜𝑟𝑖𝑔𝑖𝑛)
 If a𝑥 + 𝑏𝑥 ≤ 𝑐 (𝑏𝑒𝑙𝑜𝑤 𝑡ℎ𝑒 𝑙𝑖𝑛𝑒 𝑝𝑎𝑠𝑠𝑖𝑛𝑔 𝑡ℎ𝑟𝑜𝑢𝑔ℎ 𝑜𝑟𝑖𝑔𝑖𝑛)
24
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Minimization (Diet Problem) Model

Q) Ozark Farms uses at least 800 lb of special feed daily. The
special feed is a mixture of corn and soybean meal with the
following compositions:
The dietary requirements of the special feed are at least 30%

protein and at most 5% fiber.
Ozark Farms wishes to determine the daily minimum-cost feed
mix.
25

Solution:
 Thus the decision variables of the model are defined as
𝑥 = lb of corn in the daily mix
𝑥 = lb of soybean meal in the daily mix
 The objective function seeks to minimize the total daily cost (in
dollars) of the feed mix and is thus expressed as
Minimize 𝑧 = 0.3𝑥 + 0.9𝑥
 The constraints of the model reflect the daily amount needed and
the dietary requirements. Because Ozark Farms needs at least
800 lb of feed a day, the associated constraint can be ex pressed
as
𝑥 + 𝑥 ≥ 800
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Solution: (Cont.)
 As for the protein dietary requirement constraint, the amount
of protein included in 𝑥 lb of corn and 𝑥 lb of soybean meal is
(0.09𝑥 + 0.6𝑥 ) lb. This quantity should equal at least 30% of the
total feed mix (𝑥 + 𝑥 ) lb-that is,
0.09𝑥 + 0.6𝑥 ≥ 0.3(𝑥 + 𝑥 )
 In a similar manner, the fiber requirement of at most 5% is
constructed as
0.02𝑥 + 0.06𝑥 ≤ 0.05(𝑥 + 𝑥 )
 The constrain ts are simplified by moving the terms in 𝑥 and 𝑥
to the left-hand side of each inequality, leaving only a constant
on the right-hand side. The complete model thus becomes
27

Solution:(Cont.)
Minimize 𝑧 = 0.3𝑥 + 0.9𝑥
Subjected to
𝑥 + 𝑥 ≥ 800 -------------(1)
0.21𝑥 − 0.30𝑥 ≤ 0 -------------(2)
0.03𝑥 − 0.01𝑥 ≥ 0 -------------(3)
𝑥 ,𝑥 ≥0 -------------(4)

constraints:
 For eq. 1: 𝑥 + 𝑥 ≥ 800 when 𝑥 = 0, 𝑥 = 800  (0,800)
when 𝑥 = 0, 𝑥 = 800  (800,0)
28
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Solution:(Cont.)
 For eq. 2: 0.21𝑥 − 0.30𝑥 ≤ 0 (This constraint passes though the
origin so to plot the associated lines, we need one additional point,
which can be obtained by assigning a value to one of the variables
and then solving for the other variable)
Taking, 𝑥 = 0, 𝑥 = 0  (0,0)
Taking, 𝑥 = 200, 𝑥 = 140  (200,140)
 For eq. 3: 0.03𝑥 − 0.01𝑥 ≥ 0 (This constraint also passes though
the origin so to plot the associated lines, we need one additional
point, which can be obtained by assigning a value to one of the
variables and then solving for the other variable)
Taking, 𝑥 = 0, 𝑥 = 0  (0,0)
Taking, 𝑥 = 100, 𝑥 = 300  (100,300)
29

Solution:(Cont.)
Step # 2 : Plotting these points
in a graph
Step # 3 : Determination of the

Feasible Solution Space
The feasible unbounded area
has been highlighted having
corner points A and B.
30
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Solution:(Cont.)
Point Coordinate 𝑧 = 0.3𝑥 + 0.9𝑥
A (200 , 600) 𝑧 = 0.3 200 + 0.9 600 = 600
B (470.6 , 329.4) 𝑧 = 0.3 470.6 + 0.9 329.4 = 437.64
Decision: The associated minimum cost of the feed mix is $437.65 per
day at 𝑥 = 470.6 and 𝑥 = 329.4.
31
Furniture Model
Q) Aadat Company uses 03 machines to construct tables and
chairs as follows
Machine Chairs (hrs) Tables (hrs) Available hrs / week
M1 3 3 36
M2 5 2 50
M3 2 6 60
If Aadat company gets a profit of $20 / chair and $30 / table. Then
find the total no. of chairs and tables which should be sold by
Aadat company to get the maximum profit.
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Furniture Model
Solution
 The Aadat company model is
Maximize 𝑧 = 20𝑥 + 30𝑥
Subjected to
3𝑥 + 3𝑥 ≤ 30 -------------(1)
5𝑥 + 2𝑥 ≤ 50 -------------(2)
2𝑥 + 6𝑥 ≤ 60 -------------(3)
𝑥 ,𝑥 ≥0 -------------(4)
33
Furniture Model
Solution: (Cont.)
constraints:
 For eq. 1: 3𝑥 + 3𝑥 ≤ 36 when 𝑥 = 0, 𝑥 = 12  (0,12)
when 𝑥 = 0, 𝑥 = 12  (12,0)
 For eq. 2: 5𝑥 + 2𝑥 ≤ 50 when 𝑥 = 0, 𝑥 = 25  (0,25)

when 𝑥 = 0, 𝑥 = 10  (10,0)
 For eq.3: 2𝑥 + 6𝑥 ≤ 60 when 𝑥 = 0, 𝑥 = 10  (0,10)

when 𝑥 = 0, 𝑥 = 30  (30,0)
34
Ahsan Ahmed 17
12/9/2019
Furniture Model
Solution: (Cont.)
Step # 2 : Plotting these points in
a graph
Step # 3 : Determination of the

Feasible Solution Space
The feasible area : 0abcd
35
Furniture Model
Solution:(Cont.)
o (0 , 0) 𝑧 = 20 0 + 30 0 = 0
a (0 , 10) 𝑧 = 20 0 + 30 10 = 300
b (3, 9) 𝑧 = 20 3 + 30 9 = 330
c (8.67 , 3.33) 𝑧 = 20 8.67 + 30 3.33 = 273.3
d (10 , 0) 𝑧 = 20 10 + 30 0 = 200

Decision: Aadat Company can get a max. profit of $330 by selling 3
chairs and nine tables
36
Ahsan Ahmed 18
12/22/2019
Payback and Internal

Rate of Return
By:
Ahsan Ahmed
(Lecturer, MED)
Payback Period
 Payback Period is a measure of
the speed with which an
investment is recovered by the
cash inflows it produces.
 Payback period is the time in
which the initial cash outflow of
an investment is expected to be
recovered from the cash inflows 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
generated by the investment. It 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑
is one of the simplest investment

appraisal techniques.
Ahsan Ahmed 1
12/22/2019
Payback Period
 Case-I: For Even Cash Flows:
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑
 Case-II: For Uneven Cash Flows:
When cash inflows are uneven, we need to calculate the
cumulative net cash flow for each period and then use the
following formula for payback period:
𝐴
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑌 +
𝐵
Where, Y= last period with a negative cumulative cash flow,
A= absolute value of cumulative cash flow at the
end of the period Y,
B= total cash flow during the period after Y
3
Payback Period (Even Cashflows)

Q) Company C is planning to undertake a project requiring
initial investment of $105 million. The project is expected
to generate $25 million per year for 7 years. Calculate the
payback period of the project.
Solution:
𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑝𝑒𝑟 𝑃𝑒𝑟𝑖𝑜𝑑
$105 million
$25 million per year
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 4.2 𝑦𝑒𝑎𝑟𝑠 (Ans)
Ahsan Ahmed 2
12/22/2019
Payback Period (Uneven Cashflows)

Q) Company C is planning to undertake another project
requiring initial investment of $50 million and is expected
to generate $10 million in Year 1, $13 million in Year 2, $16
million in year 3, $19 million in Year 4 and $22 million in
Year 5. Calculate the payback value of the project.
Solution:
Year Net Cash Inflow Cumulative cash inflow
(in millions) (in millions)
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period (Uneven Cashflows)

Solution: (Cont.)
Here, Y = 3,
A = (−11)
B = 19
Therefore,
𝐴
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝑌 +
𝐵
11
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3 +
19
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3.6 𝑦𝑒𝑎𝑟𝑠 (𝐴𝑛𝑠)

6
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12/22/2019
Discounted Payback Period

 One of the major disadvantages of simple payback period is
that it ignores the time value of money. To counter this
limitation, an alternative procedure called discounted
payback period may be followed, which accounts for time
value of money by discounting the cash inflows of the project.
 In discounted payback period we have to calculate the present
value of each cash inflow taking the start of the first period as
zero point. For this purpose the management has to set a
suitable discount rate. The discounted cash inflow for each
period is to be calculated using the formula:
𝐴𝑐𝑡𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 =
(1 + 𝑖)
Where, 𝑖 = discount rate
n = period to which the cash inflow relates
7

 Usually the above formula is split into two components which
are
1) Actual Cash Inflow
2) Present value factor
( )
 Thus discounted cash flow is the product of actual cash flow
and present value factor.
 The rest of the procedure is similar to the calculation of
simple payback period except that we have to use the
discounted cash flows as calculated above instead of actual
cash flows. The cumulative cash flow will be replaced by
cumulative discounted cash flow.
Ahsan Ahmed 4
12/22/2019

𝐵
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐴 +
𝐶
Where,
A= Last period with a negative discounted cumulative cash
flow,
B= Absolute value of discounted cumulative cash flow at the
end of the period A,
C= Discounted cash flow during the period after A.

Q) An initial investment of $2,324,000 is expected to generate
$600,000 per year for 6 years. Calculate the discounted
payback period of the investment if the discount rate is 11%.
Solution:
Present Value Cumulative
Net Cash Discounted cash
Year 𝟏 discounted cash
Flow factor flows
𝒏
(𝟏 𝒊) flow
0 $(2,324,000) 1.000 $(2,324,000) $(2,324,000)
1 $ 600,000 0.901 $ 540,541 $(1,783,459)
2 $ 600,000 0.812 $ 486,973 $(1,296,486)
3 $ 600,000 0.731 $ 438,715 $ (857,771)
4 $ 600,000 0.659 $ 395,239 $ (462,533)
5 (A) $ 600,000 0.593 $ 356,071 $ (106,462) (B)
6 $ 600,000 0.535 $ 320,785 (C) $ 214,323
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Ahsan Ahmed 5
12/22/2019

Solution: (Cont.)
𝐵
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 𝐴 +
𝐶
−106,462
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 5 +
320,785
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 5.32 𝑦𝑒𝑎𝑟𝑠 (Ans)
11
Internal Rate of Return

 The IRR method is the most widely used rate-of-return
method for performing engineering economic analyses.
 It is sometimes called by several other names, such as the
investor’s method, the discounted cash-flow method, and the
profitability index.
 This method solves for the interest rate that equates the
equivalent worth of an alternative’s cash inflows (receipts or
savings) to the equivalent worth of cash outflows
(expenditures, including investment costs).
 The resultant interest rate is termed the Internal Rate of
Return (IRR).
 The IRR is sometimes referred to as the breakeven interest
rate.
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12/22/2019

 IRR is critical value of interest rate where net present value
will be zero.
 IRR is found by trial and error method.
 Using a PW formulation, we see that the IRR is the 𝑖′%∗ at
which
 Where, 𝑅 = 𝑛𝑒𝑡 𝑟𝑒𝑣𝑒𝑛𝑢𝑒𝑠 𝑜𝑟 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑘𝑡ℎ 𝑦𝑒𝑎𝑟;

𝐸 =
𝑛𝑒𝑡 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠, 𝑖𝑛𝑐𝑙𝑢𝑑𝑖𝑛𝑔 𝑎𝑛𝑦 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡𝑠 𝑓𝑜𝑟 𝑡ℎ𝑒 𝑘𝑡ℎ 𝑦𝑒𝑎𝑟;
N = 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑙𝑖𝑓𝑒 (𝑜𝑟 𝑠𝑡𝑢𝑑𝑦 𝑝𝑒𝑟𝑖𝑜𝑑).
13

• Once 𝑖 ′ has been calculated, it is compared with the MARR to
assess whether the alternative in question is acceptable. If
𝑖′ ≥ MARR, the alternative is acceptable; otherwise, it is not.
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 If 𝑖 < 𝑖 :
NPV > 0
PWB – PWC > 0
PWB > PWC
Hence Project is justified
 If 𝑖 > 𝑖 :
NPV < 0
PWB – PWC < 0
PWB < PWC
Hence Project is rejected
15

Let
 A% = low interest rate
= 20%
 B% = high interest rate
= 25%
 a = +ve NPV
 b = -ve NPV
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12/22/2019

𝐿𝑖𝑛𝑒 𝐵𝐴 𝐿𝑖𝑛𝑒 𝑑𝐴
=
𝐿𝑖𝑛𝑒𝐵𝐶 𝐿𝑖𝑛𝑒 𝑑𝑒
𝐵% − 𝐴% 𝑖 % − 𝐴%
=
𝑎−𝑏 𝑎−0
𝑎
𝑖 % = 𝐴% + (𝐵% − 𝐴%)
𝑎−𝑏
17

Q) Find the IRR of this case:
 A% = 5%
 B% = 15%
 a = 1568
 b = -1262
Using,
𝑎
𝑖 % = 𝐴% + (𝐵% − 𝐴%)
𝑎−𝑏
1568
𝑖 % = 5% + (15% − 5%)
1568 − (−1262)
𝑖 % = 10.54%
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12/22/2019

Q)A capital investment of $ 10,000 can be made in a
project that will produce a uniform annual revenue of
$5310 for five years and then have a salvage value of $
2000 . Annual expenses will be $3000 . The company is
willing to accept any project that will earn at least 10%
per year before income taxes on all invested capital .
Calculate whether it is acceptable by using the IRR
method.
Solution:
NPV= PWB – PWC = $5,310 − $3,000 , 𝑖%, 5 +
$2,000 , 𝑖%, 5 − $10,000
19

By using hit and trial method,
Let 𝑖=5%
𝑁𝑃𝑉 % = $2,310 , 5%, 5 + $2,000 , 5%, 5 − $10,000
𝑁𝑃𝑉 % = $1,568
Let 𝑖=15%
𝑁𝑃𝑉 %
𝑃 𝑃
= $2,310 , 15%, 5 + $2,000 , 15%, 5 − $10,000
𝐴 𝐹
𝑁𝑃𝑉 % = −$1,262
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12/22/2019

For i %:
𝑎
𝑖 % = 𝐴% + (𝐵% − 𝐴%)
𝑎−𝑏
1568
𝑖 % = 5% + (15% − 5%)
1568 − (−1262)
𝑖 % = 10.5%
Decision: Since IRR (10.5%) > 10%, therefore accept the

project.
21
Incremental Cash flow

Sanderson Meat processor has asked its lead process engineer
to evaluate two different types of conveyors for the bacon
curing line . Type A has an initial cost of $ 70,000 and a life of 8
years .Type B has an initial cost of $ 95,000 and a life
expectancy of 12years. The annual operating cost for type A is
expected to be $ 9000 , while the AOC for type B is $7000. If the
salvage value are $ 5000 and $ 10,000 for type A and type B
respectively . Tabulate the incremental cash flow using their
LCM.
Solution:
Alternative with high initial cost = B = Challenger
Alternative with low initial cost = A = Defender
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12/22/2019
Incremental Cash flow

Cash Flow Incremental Cashflow
Year
Type A Type B B-A
0 -$70,000 -$95,000 -$25,000
1-7 -$9,000 -$7,000 $2,000
-$70,000 - $9,000 +
8 -$7,000 $67,000
$5,000
9-11 -$9,000 -$7,000 $2,000
-$95,000 -
12 -$9,000 -$83,000
$7,000+$10,000
13-15 -$9,000 -$7,000 $2,000
-$70,000 - $9,000 +
16 -$7,000 $67,000
$5,000
17-23 -$9,000 -$7,000 $2,000
24 -$9000 + $5000 -$7,000+$10,000 $7,000
Total -$411,000 -$388,000 $73,000
23
Mutually Exclusive Project Analysis

 The phrase mutually exclusive means that the selection of one
solution excludes the selection of any other. Use of
incremental analysis is the correct method to solve mutually
exclusive projects
 Steps :
1) The alternative with the smaller initial investment is
the defender.
2) The alternative with the greater initial
investment is the challenger.
3) Subtract the defender cash flow from the
challenger cash flow to find the incremental
cash flow.
24
Ahsan Ahmed 12
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4) Find the IRR of the incremental cash flow.
5) If IRR ≥ MARR accept the increment and
choose the challenger , otherwise reject the
increment and choose the defender.
After understanding following steps, lets move to the prob.
25

Two companies Bell Atlantic and GTE merged to form a giant
telecommunication corporation named Verizon Communication
.As expected , some equipment incompatibilities had to be
rectified ,especially for long distance and international wireless
and video services . One item had two suppliers Supplier A-
U.S. firm and Supplier B- Asian firm . Approximately 3000
units of this equipment were needed .Estimates for vendors A
and B are given for each unit .Use MARR=15%.
Solution:
26
Ahsan Ahmed 13
12/22/2019

Incremental
Cash Flow
Year Cashflow
Type A Type B B-A
0 -$8,000 -$13,000 -$5,000
1-5 -$3,500 -$1,600 $1,900
5 - $2000 - $13000 -$11,000
6-10 -$3,500 -$16,000 $1,900
10 - $2000 $2,000
Total -$43,000 -$38,000 $5,000
27

Solution: (Cont.)
𝑁𝑃𝑉 = 𝑃𝑊𝐵 − 𝑃𝑊𝐶

𝑁𝑃𝑉
𝑃 𝑃
= $1,900 , 𝑖%, 10 + $2,000 , 𝑖%, 10
𝐴 𝐹
𝑃
− $11,000 , 𝑖%, 5 − $5,000
𝐹
28
Ahsan Ahmed 14
12/22/2019

Solution: (Cont.)
𝑁𝑃𝑉 %
𝑃 𝑃
= $1,900 , 10%, 10 + $2,000 , 10%, 10
𝐴 𝐹
𝑃
− $11,000 , 10%, 5 − $5,000
𝐹
𝑁𝑃𝑉 %
= $1,900 6.1446 + $2,000 0.3855 − $11,000 0.6209
− $5,000
𝑁𝑃𝑉 % = 615.84
29

Solution: (Cont.)
𝑁𝑃𝑉 %
𝑃 𝑃
= $1,900 , 15%, 10 + $2,000 , 15%, 10
𝐴 𝐹
𝑃
− $11,000 , 15%, 5 − $5,000
𝐹
𝑁𝑃𝑉 %
= $1,900 5.0188 + $2,000 0.2472 − $11,000 0.4972
− $5,000
𝑁𝑃𝑉 % = −439.08
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12/22/2019

Solution: (Cont.)
Using,
𝑎
𝑖 % = 𝐴% + (𝐵% − 𝐴%)
𝑎−𝑏
Here, A= 10% ; B= 15% ; a=615.84 ; b= −439.08 ,
therefore
615.84
𝑖 % = 10% + (15% − 10%)
615.84 + 439.08
𝑖 % = 12.3%
Since 𝑖 < 𝑀𝐴𝑅𝑅, so reject the challenger and accept the
defender.
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1/12/2020
Replacement Decision
By:
Ahsan Ahmed
(Lecturer, MED)
Types of lives of Asset

1) Economic Life:
 Economic life is the period of time (years) that results in the
minimum equivalent uniform annual cost (EUAC) of owning
and operating an asset.
𝐸𝑈𝐴𝐶 𝑖% = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑖% + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
Where,
𝐴 𝐴
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑖% = 𝐼 , 𝑖%, 𝑁 − 𝑆 , 𝑖%, 𝑁
𝑃 𝑃
2) Ownership Life:
 Period between date of acquisition and date of disposal by an
owner
Ahsan Ahmed 1
1/12/2020
Types of lives of Asset

3) Physical life:
 Period between date of acquisition and final disposal of asset
over its succession of owners. For example, the car just
described may have several owners over its existence.
4) Useful life:
 Period that an asset is kept in productive service (Primary or
backup) and generates income. It is an estimate of how long
an asset is expected to be used in a trade or business to
produce income
Replacement Analysis Using PW

(Before Taxes)
Q) A firm owns a pressure vessel that it is contemplating
replacing. The old pressure vessel has annual operating and
maintenance expenses of $60,000 per year and it can be kept
for five more years, at which time it will have zero MV (Current
Market Value). It is believed that $30,000 could be obtained for
the old pressure vessel if it were sold now.
A new pressure vessel can be purchased for $120,000. The new
pressure vessel will have an MV of $50,000 in five years and
will have annual operating and maintenance expenses of
$30,000 per year. Using a before-tax MARR of 20% per year,
determine whether or not the old pressure vessel should be
replaced. A study period of five years is appropriate.
Ahsan Ahmed 2
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 The first step in the analysis is to determine the investment
value of the defender (old pressure vessel).
 Using the outsider viewpoint, the investment value of the
defender is $30,000, its present MV.
 We can now compute the PW of each alternative and decide
whether the old pressure vessel should be kept in service or
replaced immediately.
Defender (Old Pressure Vessel):

Challenger (New Pressure Vessel):
Decision:
The present worth of challenger is greater than present worth
of defender. Thus the old pressure vessel should be replaced
immediately.
Ahsan Ahmed 3
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Replacement Analysis Using EUAC

Q) The manager of a carpet manufacturing plant became
concerned about the operation of a critical pump in one of the
processes. After discussing this situation with the supervisor of
plant engineering, they decided that a replacement study
should be done, and that a nine-year study period would be
appropriate for this situation. The company that owns the plant
is using a before-tax MARR of 10% per year for its capital
investment projects.
The existing pump, Pump A, including driving motor with
integrated controls, cost $17,000 five years ago. An estimated
MV of $750 could be obtained for the pump if it were sold now.
Some reliability problems have been experienced with Pump A,
including annual replacement of the impeller and bearings at
a cost of $1,750. Annual operating and maintenance expenses
7

have been averaging $3,250. Annual insurance and property
tax expenses are 2% of the initial capital investment. It
appears that the pump will provide adequate service for
another nine years if the present maintenance and repair
practice is continued. It is estimated that if this pump is
continued in service, its final MV after nine more years will be
about $200.
An alternative to keeping the existing pump in service is to sell
it immediately and to purchase a replacement pump, Pump B,
for $16,000. An estimated MV at the end of the nine-year study
period would be 20% of the initial capital investment.
Operating and maintenance expenses for the new pump are
estimated to be $3,000 per year. Annual taxes and insurance
would total 2% of the initial capital investment.
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Based on these data, should the defender (Pump A) be kept
[and the challenger (Pump B) not purchased], or should the
challenger be purchased now (and the defender sold)? Use a
before-tax analysis and the outsider viewpoint in the
evaluation.

Solution:
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Solution: (Cont.)
For Defender: (Study period : 9 years)
𝐴 𝐴
𝐸𝑈𝐴𝐶 10% = −5,340 − 750 , 10%, 9 + 200 , 10%, 9
𝑃 𝐹
𝐸𝑈𝐴𝐶 10% = −5,340 − 750 0.1736 + 200 0.0736
𝐸𝑈𝐴𝐶 10% = −$5,455
11

Solution: (Cont.)
For Challenger: (Study period : 9 years)
𝐴 𝐴
𝐸𝑈𝐴𝐶 10% = −16,000 , 10%, 9 − 3,320 + 3,200 , 10%, 9
𝑃 𝐹
𝐸𝑈𝐴𝐶 10% = −16,000 0.1736 − 3,320 + 3,200 0.0736
𝐸𝑈𝐴𝐶 10% = −$5,862
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Solution: (Cont.)
Decision:
Because Pump A has the smaller EUAC ($5,455 < $5,862), the
replacement pump is apparently not justified, and the defender
should be kept.
13
ECONOMIC LIFE OF A NEW ASSET

(CHALLENGER)
 The minimum cost life of any new (or existing) asset is the
number of years at which the Equivalent uniform annual cost
(EUAC) of ownership is minimized.
 This minimum cost life is often shorter than either the
physical or useful life of the asset due to increasing operating
and maintenance costs in the later years of asset ownership.
1) Challenger’s economic life is determined by the minimum
EUAC
2) For any new asset ,perform a cash flow analysis and create
a table finding the EUAC for each year
3) Identify lowest EUAC value - - - Year of lowest EUAC
corresponds to economic life of the asset
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(CHALLENGER)
 A piece of machinery costs $ 7500 and has no salvage value
after it is installed. The manufacturer's warranty will pay the
first years maintenance and repair costs. In the second year,
maintenance costs will be $900 and this item will increase on
a $900 arithmetic gradient in subsequent years. Also
operating expenses for the machinery will be $ 500 the first
year and will increase on a $ 400 arithmetic gradient in the
following years . If interest rate is 8%. Compute the useful life
of the machinery that results in a minimum EUAC. That is
find its minimum cost life.
 Solution:
15

(CHALLENGER)
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(CHALLENGER)
17

(CHALLENGER)
 From either the tabulation or the figure, we see hat the
minimum cost life (Economic Useful Life) of the machinery is
4 years, with a minimum EUAC of $4589 for each of those 4
years.
 The total EUAC curve of most assets tends to follow this
concave shape--high at the beginning due to capital recovery
costs, and high at the end due to increased
maintenance/repair and operating expenses.
 The minimum EUAC occurs somewhere between these high
points.
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Depreciation
By:
Ahsan Ahmed
(Lecturer, MED)
Depreciation
 Depreciation is the decrease in value of physical properties
with the passage of time and use.
 More specifically, depreciation is an accounting concept that
establishes an annual deduction against before-tax income
such that the effect of time and use on an asset’s value can be
reflected in a firm’s financial statements.
Basic Requirement for Depreciation Properties:
In general property is depreciable if it meets the following basic
requirements:
 It must be used in business or held to produce income.
 It must have a determinable useful life, and the life must be
longer than one year.
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Depreciation
 It must be something that wears out, decays, gets used up,
becomes obsolete, or loses value from natural causes.
 It is not inventory, stock in trade, or investment property
Depreciable Property:
 Tangible property can be seen or touched, and it includes
two main types called personal property and real property.
Personal property includes assets such as machinery, vehicles,
equipment, furniture, and similar items. In contrast, real
property is land and generally anything that is erected on,
growing on, or attached to land. Land itself, however, is not
depreciable, because it does not have a determinable life.
 Intangible property is personal property such as a
copyright, patent, or franchise.
3
Additional Definitions for

Depreciation
Cost Basis (B):
 The initial cost of acquiring an assets (purchasing price +
sales tax) including transportation expenses and other normal
cost of making the assets serviceable for its intended use. It is
also called as unadjusted cost basis.
Adjusted (cost) basis:
 The original cost basis of the asset, adjusted by allowable
increases or decreases, is used to compute depreciation
deductions. For example, the cost of any improvement to a
capital asset with a useful life greater than one year increases
the original cost basis, and a casualty or theft loss decreases
it. If the basis is altered, the depreciation deduction may need
to be adjusted.
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Depreciation
Book value (BV):
 The worth of a depreciable property as shown on the
accounting records of a company. It is the original cost basis of
the property, including any adjustments, less all allowable
depreciation deductions. It thus represents the amount of
capital that remains invested in the property and must be
recovered in the future through the accounting process. The
BV of a property may not be an accurate measure of its
market value. In general, the BV of a property at the end of
year k is

Depreciation
Market value (MV):
 The amount that will be paid by a willing buyer to a willing
seller for a property, where each has equal advantage and is
under no compulsion to buy or sell. The MV approximates the
present value of what will be received through ownership of
the property, including the time value of money (or profit).
Recovery period:
 The number of years over which the basis of a property is
recovered through the accounting process. For the classical
methods of depreciation, this period is normally the useful
life.
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Depreciation
Recovery rate:
 A percentage (expressed in decimal form) for each year of the
MACRS (Modified Accelerated Cost Recovery System)
recovery period that is utilized to compute an annual
depreciation deduction.
Salvage value (SV)
The estimated value of a property at the end of its useful life. It
is the expected selling price of a property when the asset can no
longer be used productively by its owner. The term net salvage
value is used when the owner will incur expenses in disposing
of the property, and these cash outflows must be deducted from
the cash inflows to obtain a final net SV. Under MACRS, the
SV of a depreciable property is defined to be zero.

Depreciation
Useful life:
 The expected (estimated) period that a property will be used
in a trade or business to produce income. It is not how long
the property will last but how long the owner expects to
productively use it.
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Types of Depreciation
There are following major types of depreciation:
1) Normal Depreciation
a) Physical depreciation
b) Functional depreciation
2) Monetary Depreciation
a) Physical Depreciation:
 Physical depreciation is due to decrease in the physical ability
if the property or asset to produce desire results and the main
cause of physical depreciation is wear and tear.
Types of Depreciation
b) Functional Depreciation:
 Functional depreciation is due to decrease in demand for the
function of asset (that the property was designed to serve).
The main cause of functional depreciation are change in
technology and change in taste or fashion.
2) Monetary Depreciation:
 During the inflation, when the price of the property increases,
then recovery of capital is too difficult, and the recovered
capital will not be sufficient to provide an identical
replacement due to increase in price limit and decrease in
worth of capital.
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Methods of Depreciation
There are following methods of depreciation that apply
(directly and indirectly) to the depreciation of property :
1) Straight-Line (SL) Method
2) Sum of Year Digit (SYD)
3) Declining Balance (DB)
4) Double Declining Balance (DDB) Depreciation
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Straight-Line (SL) Method

 SL depreciation is the simplest depreciation method.
 It assumes that a constant amount is depreciated each year
over the depreciable (useful) life of the asset.
 The SL (cumulative) depreciation is determined by:
𝑃−𝑆
𝐷 = ×𝑛
𝑁
Where,
𝐷 = 𝐷𝑒𝑝𝑟𝑖𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑖𝑛 "n" 𝑦𝑒𝑎𝑟𝑠
𝑛 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝑁 = 𝑇𝑜𝑡𝑎𝑙 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒 𝑜𝑟 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑝𝑒𝑟𝑖𝑜𝑑 𝑜𝑟 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑙𝑖𝑓𝑒
𝑆 = 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
𝑃 = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 or Book Value
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 Also the annual SL depreciation “D” is
determined by:
𝑃−𝑆
𝐷= ×1
𝑁
 Since the asset is depreciated by the same
amount each year, the book value after “n” years
of service, denoted by 𝐵𝑉 , will be equal to the
first cost “P” minus the depreciation of nth year
“𝐷 ”.
𝐵𝑉 = 𝑃 − 𝐷
13

Q) A new electric motor cost $ 4,000 and has a ten year
depreciable life. The estimated savage value of the motor is
zero at the end of 10 years. Calculate the annual depreciable
amounts and the book value of the motor at the end of each
year by straight line (SL) method.
Data:
P = $ 4,000
N =10 years
SV= 0
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Solution:
The annual SL depreciation “D” is determined by:
𝑃−𝑆
𝐷=
𝑁
4,000 − 0
𝐷=
10
𝐷 = $400
15

Solution: (Cont.)
End of Year D B.V
0 - $4,000
1 $400 $3,600
2 $400 $3,200
3 $400 $2,800
4 $400 $2,400
5 $400 $2,000
6 $400 $1,600
7 $400 $1,200
8 $400 $800
9 $400 $400
10 $400 $0
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Q) Recall data of previous question and calculate total
depreciation and its book value, at the end of 5th year.
Solution:
 The total SL depreciation at the end of 5th years is determined
by:
𝑃−𝑆
𝐷 = ×𝑛
𝑁
$4,000 − 0
𝐷 = ×5
10
𝐷 = $2,000
17

Solution: (Cont.)
 The book value at the end of 5th years is determined by:
𝐵𝑉 = 𝑃 − 𝐷
𝐵𝑉 = $4,000 − $2,000
𝐵𝑉 = $2,000
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Sum of the Year Digit (SYD) Method

 This method provide larger depreciation during the early
years of ownerships, then in the later years. And the book
value curve follows convex of original shape.
𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑃 − 𝑆 × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝐹𝑎𝑐𝑡𝑜𝑟𝑠

And
𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 = 𝑃 − 𝑃 − 𝑆 × 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑅𝑒𝑣𝑒𝑟𝑠𝑒
 Depreciation factor for any year is the reverse digit for that
year divided by the sum of the digit years.
n 0 1 2 3 4 5
Reverse digit - 5 4 3 2 1
19

 Depreciation Reverse is the sum of the reverse digits upto the
required year divided by the sum of digits.
n 0 1 2 3 4 5
Reverse digit - 5 4 3 2 1
For year 3 (n=3) : (5+4+3) / 15 = 12/15

 Total depreciation at the end of “n” years:
(𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝑃 − 𝐵𝑉
(𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛) = 𝐷
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Q Repeat previous question with SYD.
Yearly Depression Book Value
Reverse Depreciation Depreciation
Year =(P-S)X Depreciation = P-(P-S)X
Digit Factor Reverse
Factor Depreciation reverse
0 - - - - 4,000
1 10 10/55 10/55 727.27 3272.73
2 9 9/55 19/55 654.55 2618.18
3 8 8/55 27/55 581.82 2036.36
4 7 7/55 34/55 509.09 1527.27
5 6 6/55 40/55 436.36 1090.91
6 5 5/55 45/55 363.64 727.27
7 4 4/55 49/55 290.91 436.36
8 3 3/55 52/55 218.18 218.18
9 2 2/55 54/55 145.45 72.73
10 1 1/55 55/55 72.73 0.00
21

Depreciation for any year can also be solved by using formula:
×( )
( )
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Declining Balance Method

 The important feature of this method is that salvage value is
not zero.
 In this method, depreciation charge for any years can easily
be calculated by multiplying the fixed percentage of salvage
value to the book value of that time.
 Depreciation for any year can also be solved by using formula:
𝐷 = 𝐾 × (𝐵𝑉)
Where,
K= depreciation rate = 1 − ; N = total life

 Also,
(𝐵𝑉) = 𝑃(1 − 𝐾)
23

 Since,
𝐷 = 𝐾 × (𝐵𝑉)
So,
If n=1  𝐷 = 𝐾 × (𝐵𝑉) = 𝐾𝑃(1 − 𝐾) = 𝐾𝑃

If n=2  𝐷 = 𝐾 × (𝐵𝑉) = 𝐾𝑃(1 − 𝐾) = 𝐾𝑃(1 − 𝐾)
If n=3  𝐷 = 𝐾 × (𝐵𝑉) = 𝐾𝑃(1 − 𝐾) = 𝐾𝑃 (1 − 𝐾)
If n=4  𝐷 = 𝐾 × (𝐵𝑉) = 𝐾𝑃(1 − 𝐾) = 𝐾𝑃 (1 − 𝐾)
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Q) If P = $20,000, salvage value = $350, useful life = 8 years.
Using declining balance, tabulate depreciation and BV at the
end of each year.
Solution:
For K:
𝑆
𝐾 = 1−
𝑃
$350
𝐾 =1−
$20,000
𝐾 = 0.3969
25

Book Value Yearly Depreciation
Years
(𝐵𝑉) = 𝑃(1 − 𝐾) 𝐷 = 𝐾 × (𝐵𝑉)
0 $20,000.00 -
1 $12,062.00 $7,938.00
2 $7,274.59 $4,787.41
3 $4,387.31 $2,887.29
4 $2,645.98 $1,741.32
5 $1,595.79 $1,050.19
6 $962.42 $633.37
7 $580.44 $381.99
8 $350.06 $230.38
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Double Declining Balance Method

In this method depreciation method is permitted double or
200% of the straight line weight i.e. (K=2/N), rest is same as
declining balance method.
Q) Solve Q1 With Double Declining method

Solution:
2
𝐾=
𝑁
2
𝐾=
10
𝐾 = 0.2
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Double Declining Balance Method

Book Value Yearly Depreciation
Years
(𝐵𝑉) = 𝑃(1 − 𝐾) 𝐷 = 𝐾 × (𝐵𝑉)
0 $4,000 -
1 $3,200 $800
2 $2560 $640
3 $2048 $512
4 $1638.4 $409.6
5 $1316.7 $209.71
6 $1048.5 $327.68
7 $838.86 $209.7
8 $671.08 $167.6
9 $536.87 $134.22
10 $429.50 $107.37
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Declining Balance with switch over to

straight line method
In this method depreciation is calculated using declining
balance for early years & switch to the straight line method.
Here, BV at end of previous year = BV at beginning of this year
Q) Repeat Q1 with declining balance switch over to SL method.
Solution:
29
Declining Balance with switch over to

straight line method
Straight Line
200% DB Method Yearly Method Yearly Depreciation
Book Value at the
Depreciation Depreciation Amount
Year beginning of the
2 Selected
year 𝐷 = 𝐾(𝐵𝑉) = (𝐵𝑉) 𝑃−𝑆
𝑁 𝐷= (Max Value)
𝑁
0 - - - -
1 $4,000.00 $800.00 $400.00 $800.00
2 $3,200.00 $640.00 $355.56 $640.00
3 $2,560.00 $512.00 $320.00 $512.00
4 $2,048.00 $409.60 $292.57 $409.60
5 $1,638.40 $327.68 $273.07 $327.68
6 $1,310.72 $262.14 $262.14 $262.14
7 $1,048.58 $209.72 $262.14 $262.14
8 $786.43 $157.29 $262.14 $262.14
9 $524.29 $104.86 $262.14 $262.14
10 $262.14 $52.43 $262.14 $262.14
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Modified Accelerated Cost Recovery

Method (MACRS)
 MACRS applies to most tangible depreciable property.
 Under MACRS, however, SV is defined to be zero, and useful
life estimates are not used directly in calculating depreciation
amounts.
 Under MACRS, tangible depreciable property is categorized
(organized) into asset classes.
 The recovery rates for the six personal property classes that
we will use in our depreciation calculations are listed in Table
7-3 (16th Edition Sullivan).
 MACRS determines annual depreciation amounts using the
relation
𝐷 =𝑑 ×𝑃
31

Method (MACRS)
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Method (MACRS)
Q ) Repeat Q1 by using MACRS
Selecting
Depreciation Rates
From table 7-3 for
10 years (useful
life)
33

Method (MACRS)
Depreciation Yearly Depreciation Book Value at the
Year Rates from table Expense end of year
7-3 for 10 years 𝐷 =𝑑 ×𝑃 𝐵𝑉 = 𝐵𝑉 −𝐷
0 - - 4000
1 0.1000 $400.0 $3,600.0
2 0.1800 $720.0 $2,880.0
3 0.1440 $576.0 $2,304.0
4 0.1152 $460.8 $1,843.2
5 0.0922 $368.8 $1,474.4
6 0.0737 $294.8 $1,179.6
7 0.0655 $262.0 $917.6
8 0.0655 $262.0 $655.6
9 0.0656 $262.4 $393.2
10 0.0655 $262.0 $131.2
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Method (MACRS)
Homework (Depreciation: MACRS)
Q) Cost basis of an asset=$17,000 and its recovery period is 5

years . Calculate yearly depreciation and book value at the end
of each year by using MACRS .
Suggested Source: Internet and Library.
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Cost Concepts and Design

Economics
By:
Ahsan Ahmed
(Lecturer, MED)
Cost
 Cost: The value of the sacrifice made to acquire goods or
services. All costs of a manufacturing organization may be
divided according to functional areas into:
1) Manufacturing cost: These are related to the production of
an item. They are the sum of direct material , direct labor
and factory overhead cost.
2) Marketing cost: These are incurred in promoting a product
or service.
3) Administrative cost: These are incurred in directing,
controlling and operating a company and includes salaries
paid to management and staff.
4) Financing cost: These are related to obtaining funds for
the operation of the company. They include the cost of
interest that the company must pay on loans, as well as
the cost of providing credit to customer.
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Elements of a Product
 Expense : A cost that has given benefit and is now expired.
 Elements of a Product: The cost elements of a product or its
integral components are direct materials, direct labor and
factory overhead.
 Materials : These are the principal substances used in
production that are transformed into finished goods by the
addition of direct labor and factory overhead. The cost of
materials may be classified into direct and indirect materials
as follows:
Direct materials: All materials that can be identified with
the production of a finished product, that can be easily
traced to the product and that represent a major material
cost of producing that product. An example of direct material
is wood to build a basketball bat.
Direct materials: All materials involved in the production
of a product that are not direct materials . Indirect materials
are included as a part of factory overhead. An example of
indirect material is the glue used to make furniture.
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 Labor cost: Labor is the physical or mental effort expended
in the production of a product. Labor costs may be divided
into direct and indirect labor as follows:
Direct Labor: All labor directly involved in the

production of a finished product that can by easily
traced to the product and that represents a major labor
cost of producing that product. The work of machine
operators in a manufacturing company would be
considered direct labor.
Indirect Labor : All labor involved in the production of
a product that is not considered direct labor. Indirect
labor is included as part of factory overhead. The work
of a plant supervisor is an example of indirect labor.
5
 Factory Overhead:
This all inclusive cost pool is used to accumulate indirect
materials, indirect labor and all other indirect manufacturing
costs which cannot be directly identified with specified
products. Examples of factory overhead costs beside indirect
materials and indirect labor are rent , light and heat for the
factory and depreciation of factory equipment.
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 Factory Overhead:
This all inclusive cost pool is used to accumulate indirect
materials, indirect labor and all other indirect manufacturing
costs which cannot be directly identified with specified
products. Examples of factory overhead costs beside indirect
materials and indirect labor are rent , light and heat for the
factory and depreciation of factory equipment.
 Prime Cost : Prime cost are direct materials and direct labor.
Prime costs are directly related to production.
 Conversion cost : These are costs concerned with
transforming direct materials into finished products.
Conversion cost are direct labor and factory overhead.
 Fixed cost : Those costs which in total remain constant over
a relevant range of output while the cost per unit varies
inversely with output. Beyond the relevant range of output ,
fixed cost will vary. Upper management controls the volume of
production and is therefore responsible for fixed costs.
 Variable cost : Variable costs are those in which the total
cost changes in direct proportion to change in volume or
output within the relevant range ,while the unit cost remains
constant. Variable cost are controlled by the department head.
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Those costs which change in total in direct proportion to
changes in volume and whose unit cost remains constant,
within the relevant range.
Terminologies
 Differential cost : A differential cost is the difference
between the costs of alternative courses of action on an item
by item basis. If the cost is increasing from one alternative to
another , it is called as incremental cost ; if the cost is
decreasing from one alternative to another it is called a
decrement cost.
 Opportunity Cost : Where a decision to pursue one
alternative is made , the benefits of other options are forgone.
Benefits lost from rejecting the next best alternative are the
opportunity cost of the chosen action. They are relevant costs
for decision-making purposes and must be considered in
evaluating a proposed alternative.
This concept is often encountered in replacement decision.
Opportunity cost is a comparative term we should have.
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Terminologies
 Sunk cost : Cost that has already been incurred and that
cannot be changed by any decision made now or in future. It
is a consequence of past decision and now irretrievable and
irrelevant in the analysis and comparison. However, its
existence can assist to make better decision.
 Standard cost or Average cost or budgeted cost:
Standard cost are those which should be incurred in a
particular production process under normal conditions.
Standard costing is usually concerned with per unit cost for
direct materials, direct labor and factory overhead.
 Controllable costs : Controllable costs are those which may
be directly influenced by unit managers in a given time
period. Most variable costs are considered as controllable cost.
11
Terminologies
 Non-controllable costs: Non-controllable costs are those
costs which are not directly administered at a given level of
management authority. Most fixed cost are non-controllable
costs.
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Cost Estimation Approaches

 Bottom Up Approach:
Treats the final cost as an independent
(output) variable and the associated cost as
input or dependent variable.
Cost components are first identified
Required Price = Direct cost + total indirect
cost + desired Profit
Traditional costing approach
Applied in industries where competition is
not the dominant factor in pricing the
product or the service or It is used for new
product.
13
Cost Estimation Approaches

 Top Down Approach:
Treats the competitive cost as an input
variable and the associated cost estimates as
the output variables.
It is used for competitive market or applied
in the early stages of new or enhanced
product design.
It is also called “Design-to-cost” approach
Price estimates are conducted to set “target”
values.
Target Price = Direct cost + total indirect
cost + Allowed Profit
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Total Revenue Function

 The total revenue, TR, that will result from a business
venture during a given period is the product of the selling
price per unit, p, and the number of units sold, D. Thus,
𝑇𝑅 = 𝑝𝑟𝑖𝑐𝑒 × 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑃. 𝐷
 If the relationship between price and demand is
𝑃 = 𝑎 − 𝑏𝐷
Then,
𝑇𝑅 = 𝑎 − 𝑏𝐷 𝐷 = 𝑎𝐷 − 𝑏𝐷
From calculus, the demand,𝐷 , that will produce maximum
total revenue can be obtained by solving
𝑑𝑇𝑅
=0
𝑑𝐷
15

𝑑(𝑎𝐷 − 𝑏𝐷 )
=0
𝑑𝐷
𝑎 − 2𝑏𝐷 = 0
Thus
𝑎
𝐷=
2𝑏
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For max TR:
(𝑇𝑅) = 𝑎𝐷 − 𝑏𝐷
𝑎 𝑎
(𝑇𝑅) =𝑎 −𝑏
2𝑏 2𝑏
𝑎
(𝑇𝑅) =
4𝑏
17
Cost, Volume, and Breakeven Point

Relationships
 Fixed costs remain constant over a wide range of activities,
but variable costs vary in total with the volume of output.
Thus, at any demand D, total cost is
𝐶 =𝐶 +𝐶
 Where 𝐶 and 𝐶 denote fixed and variable costs, respectively.
For the linear relationship assumed here,
𝐶 = 𝑐 .𝐷
 Where 𝑐 is the variable cost per unit.
 In this section, we consider two scenarios for finding
breakeven points. In the first scenario, demand is a function
of price. The second scenario assumes that price and demand
are independent of each other.
18
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Relationships
Scenario 1:
 At breakeven point 𝐷 , total revenue
is equal to total cost, and an increase
in demand will result in a profit for
the operation.
 Then at optimal demand, 𝐷∗ , profit
is maximized.
 At breakeven point 𝐷 , total revenue
and total cost are again equal, but
additional volume will result in an
operating loss instead of a profit.
19

Relationships
 First, at any volume (demand), D,
𝑃𝑟𝑜𝑓𝑖𝑡 (𝑙𝑜𝑠𝑠) = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
𝑃𝑟𝑜𝑓𝑖𝑡 (𝑙𝑜𝑠𝑠) = (𝑎𝐷 − 𝑏𝐷 ) − (𝐶 +𝑐 . 𝐷)
𝑃𝑟𝑜𝑓𝑖𝑡 𝑙𝑜𝑠𝑠 = −𝑏𝐷 + 𝑎 − 𝑐 𝐷 − 𝐶

 In order for a profit to occur, two conditions
must be met:
1) (a − 𝑐 ) > 0; that is, the price per unit
that will result in no demand has to be
greater than the variable cost per unit.
(This avoids negative demand.)
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Relationships
2) Total revenue (TR) must exceed
total cost ( 𝐶 ) for the period
involved i.e. 𝑇𝑅 − 𝐶 > 0
If these conditions are met, we can find
the optimal demand at which maximum
profit will occur by taking the first
derivative of Profit Equation with respect
to D and setting it equal to zero:
21

Relationships
 The optimal value of D that maximizes
profit is
 An economic breakeven point for an

operation occurs when total revenue
equals total cost.
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Relationships
 This is a quadratic equation with one

unknown (D), we can solve for the
breakeven points 𝐷 and 𝐷 (the roots of
the equation):.
23

Relationships
Q) A company produces an electronic timing switch that is used
in consumer and commercial products. The fixed cost (𝐶 ) is
$73,000 per month, and the variable cost (𝑐 ) is $83 per unit.
The selling price per unit is p = $180 − 0.02(D).
(a) Determine the optimal volume for this product and confirm
that a profit occurs (instead of a loss) at this demand.
(b) Find the volumes at which breakeven occurs; that is, what
is the range (domain) of profitable demand?
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Relationships
25

Relationships
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Relationships
27
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Evaluating Projects with

the Benefit-Cost Ratio
Method
By:
Ahsan Ahmed
(Lecturer, MED)
Public Projects
 Public projects are those authorized, financed, and operated
by federal, state, or local governmental agencies.
 Such public works are numerous, and although they may be
of any size, they are frequently much larger than private
ventures.
 Since they require the expenditure of capital, such projects
are subject to the principles of engineering economy with
respect to their design, acquisition, and operation.
 Because they are public projects, however, a number of
important special factors exist that are not ordinarily found in
privately financed and operated businesses.
 The differences between public and private projects are listed
in Table on the next slide.
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Private v/s Public Projects
Benefits-Cost Ratio Method (Intro)

 The benefit–cost ratio method, which is normally used for the
evaluation of public projects, has its roots in federal
legislation.
 B–C analysis is a systematic method of assessing the
desirability of government projects or policies when it is
important to take a long-term view of future effects and a
broad view of possible side effects.
 B–C ratio method evolved into the calculation of a ratio of
project benefits to project costs.
 Most governmental agencies require the use of the B–C
method.
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 In conducting an engineering economic analysis of any
project, whether it is a public or a private undertaking, the
proper perspective is to consider the net benefits to the
owners of the enterprise considering the project.
 For example, a project involving the expansion of a section of
a highway (e.g. I-80 : Interstate Highway) from four to six
lanes. This project is paid through the funds, originated from
taxes-thus, the true owners of the project are the taxpayers.
 Project benefits are defined as the favorable consequences
of the project to the public.
 Project costs represent the monetary disbursement(s)
required of the government.

 It is entirely possible, however, for a project to have
unfavorable consequences to the public. Considering again
the widening of I-80, some of the owners of the project—
farmers along the interstate—would lose a portion of their
arable land, along with a portion of their annual revenues.
Because this negative financial consequence is borne by (a
segment of) the public, it cannot be classified as either a
benefit or a cost.
 The term disbenefits is generally used to represent the
negative consequences of a project to the public.
 The term self-liquidating project is applied to a
governmental project that is expected to earn direct revenue
sufficient to repay its cost in a specified period of time.
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 It is entirely possible, however, for a project to have
unfavorable consequences to the public. Considering again
the widening of I-80, some of the owners of the project—
farmers along the interstate—would lose a portion of their
arable land, along with a portion of their annual revenues.
Because this negative financial consequence is borne by (a
segment of) the public, it cannot be classified as either a
benefit or a cost.
 The term disbenefits is generally used to represent the
negative consequences of a project to the public.

Self-Liquidating Project:
 The term self-liquidating project is applied to a
governmental project that is expected to earn direct revenue
sufficient to repay its cost in a specified period of time.
 Most of these projects provide utility services—for example,
the fresh water, electric power, irrigation water, and sewage
disposal provided by a hydroelectric dam.
 Other examples of self-liquidating projects include toll bridges
and highways.
 As a rule, self-liquidating projects are expected to earn direct
revenues that offset their costs, but they are not expected to
earn profits or pay income taxes.
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Multiple-Purpose Projects
 An important characteristic of public-sector projects is that
many such projects have multiple purposes or objectives.
 One example of this would be the construction of a dam to
create a reservoir on a river. This project would have multiple
purposes: (1) assist in flood control, (2) provide water for
irrigation, (3) generate electric power, (4) provide recreational
facilities, and (5) provide drinking water.
Benefits-Cost Ratio Method

 As the name implies, the B–C ratio method involves the
calculation of a ratio of benefits to costs.
 Whether evaluating a project in the private sector or in the
public sector, the time value of money must be considered to
account for the timing of cash flows (or benefits) occurring
after the inception of the project. Thus, the B–C ratio is
actually a ratio of discounted benefits to discounted costs.
 The B–C ratio is defined as the ratio of the equivalent worth
of benefits to the equivalent worth of costs.
 The B–C ratio is also known as the savings-investment ratio
(SIR) by some governmental agencies.
 Two of the more commonly used formulations are presented
below.
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11

 The numerator of the modified B–C ratio expresses the
equivalent worth of the benefits minus the equivalent worth
of the operating and maintenance costs, and the denominator
includes only the initial investment costs (less any market
value).
 A project is acceptable when the B–C ratio, as defined in
either Equation (10-1) or (10-2), is greater than or equal to
1.0.
 Equations (10-1) and (10-2) can be rewritten in terms of
equivalent annual worth, as follows:
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13
Equivalence of the B−C Ratio

Formulations
Question:
 The city of Columbia is considering extending the runways of
its municipal airport so that commercial jets can use the
facility. The land necessary for the runway extension is
currently a farmland that can be purchased for $350,000.
Construction costs for the runway extension are projected to
be $600,000, and the additional annual maintenance costs for
the extension are estimated to be $22,500. If the runways are
extended, a small terminal will be constructed at a cost of
$250,000. The annual operating and maintenance costs for
the terminal are estimated at $75,000. Finally, the projected
increase in flights will require the addition of two air traffic
controllers at an annual cost of $100,000. Annual benefits of
the runway extension have been estimated as follows:
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Formulations
Question: (Cont.)
Apply the B–C ratio method with a study period of 20 years

and a MARR of 10% per year to determine whether the
runways at Columbia Municipal Airport should be extended.
Solution:
15

Formulations
Using Conventional B-C Method :Equation (10-1)
𝑃𝑊 (𝐵)
𝐵−𝐶 =
𝐼 − 𝑃𝑊 𝑀𝑉 + 𝑃𝑊(𝑂&𝑀)
Here, PW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
I = 350,000 + 600,000 + 250,000 = $1,200,000
PW(MV) = 0
PW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000 (𝑃/𝐴, 10%, 20)

𝐵−𝐶 =
$1,200,000 − 0 + $197,500(𝑃/𝐴, 10%, 20)
𝐵 − 𝐶 = 1.448 > 1; 𝑒𝑥𝑡𝑒𝑛𝑑 𝑟𝑢𝑛𝑤𝑎𝑦𝑠
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Formulations
Using Modified B-C Method :Equation (10-2)
𝑃𝑊 𝐵 − 𝑃𝑊(𝑂&𝑀)
𝐵−𝐶 =
𝐼 − 𝑃𝑊 𝑀𝑉
Here, PW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
I = 350,000 + 600,000 + 250,000 = $1,200,000
PW(MV) = 0
PW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000 𝑃/𝐴, 10%, 20 − $197,500(𝑃/𝐴, 10%, 20)

𝐵−𝐶 =
$1,200,000 − 0
17

Formulations
Using Conventional B-C Method :Equation (10-3)
𝐴𝑊 (𝐵)
𝐵−𝐶 =
𝐶𝑅 + 𝐴𝑊(𝑂&𝑀)
Here, AW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
CR = 350,000 + 600,000 + 250,000-0 = $1,200,000
AW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000
𝐵−𝐶 =
1,200,000(𝐴/𝑃, 10%, 20)+$197,500
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Formulations
Using Modified B-C Method :Equation (10-4)
𝐴𝑊 𝐵 − 𝐴𝑊(𝑂&𝑀)
𝐵−𝐶 =
𝐶𝑅
Here, AW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
CR = 350,000 + 600,000 + 250,000-0 = $1,200,000
AW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000−$197,500
𝐵−𝐶 =
1,200,000(𝐴/𝑃, 10%, 20)
19
Disbenefits in the B−C Ratio

 Disbenefits were defined as negative consequences to the public
resulting from the implementation of a public-sector project.\
 The traditional approach for incorporating disbenefits into a B–C
analysis is to reduce benefits by the amount of disbenefits (i.e., to
subtract disbenefits from benefits in the numerator of the B–C
ratio).
 Alternatively, the disbenefits could be treated as costs (i.e., add
disbenefits to costs in the denominator). Equations (10-5) and
(10-6) illustrate the two approaches for incorporating disbenefits
in the conventional B–C ratio, with benefits, costs, and
disbenefits in terms of equivalent AW.
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21

Q) Refer back to Previous Question. In addition to the benefits and
costs, suppose that there are disbenefits associated with the
runway extension project. Specifically, the increased noise level
from commercial jet traffic will be a serious nuisance to
homeowners living along the approach path to the Columbia
Municipal Airport. The annual disbenefit to citizens of Columbia
caused by this noise pollution is estimated to be $100,000. Given
this additional information, reapply the conventional B–C ratio,
with equivalent annual worth, to determine whether this
disbenefit affects your recommendation on the desirability of this
project.
Solution:
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Conventional B–C ratio with AW, benefits reduced by amount of
disbenefits:
𝐴𝑊 𝐵 − 𝐴𝑊(𝐷)
𝐵−𝐶 =
𝐶𝑅 + 𝐴𝑊(𝑂&𝑀)
Here, AW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
CR = 350,000 + 600,000 + 250,000-0 = $1,200,000
AW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000 − 100,000
𝐵−𝐶 =
1,200,000(𝐴/𝑃, 10%, 20)+$197,500
23

Conventional B–C ratio with AW, costs increased by amount of
disbenefits:
𝐴𝑊 𝐵
𝐵−𝐶 =
𝐶𝑅 + 𝐴𝑊 𝑂&𝑀 + 𝐴𝑊(𝐷)
Here, AW (B) = 325,000 + 65,000 + 50,000 +50,000 = $490,000/yr
CR = 350,000 + 600,000 + 250,000-0 = $1,200,000
AW(O&M) = 22,500 + $75,000 + $100,000 = $197,500 / yr
$490,000
𝐵−𝐶 =
1,200,000 𝐴/𝑃, 10%, 20 +$197,500 + 100,000
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Comparison of Mutually Exclusive

Projects by B−C Ratios
 A group of mutually exclusive projects was defined as a group of
projects from which, at most, one project may be selected.
 When using an equivalent-worth method to select from among a
set of mutually exclusive alternatives (MEAs), the best
alternative can be selected by maximizing the PW (or AW, or
FW).
 Because the B–C method provides a ratio of benefits to costs
rather than a direct measure of each project’s profit potential,
selecting the project that maximizes the B–C ratio does not
guarantee that the best project is selected.
 An evaluation of mutually exclusive alternatives by the B–C
ratio requires that an incremental B–C analysis be conducted.
25
Comparison of Mutually Exclusive

Projects by B−C Ratios
 When comparing mutually exclusive alternatives with the B–C
ratio method, they are first ranked in order of increasing
total equivalent worth of costs.
 The do-nothing alternative is selected as a baseline alternative.
 The B–C ratio is then calculated for the alternative
having the lowest equivalent cost.
 If the B–C ratio for this alternative is equal to or greater than
1.0, then that alternative becomes the new baseline; otherwise,
do-nothing remains as the baseline.
 The next least equivalent cost alternative is then selected, and
the difference (△) in the respective benefits and costs of this
alternative and the baseline is used to calculate an incremental
B–C ratio (△B/ △C).
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B−C Analysis with Unequal Project

Lives
Question:
Two mutually exclusive alternative public-works projects are
under consideration. Their respective costs and benefits are
included in the table that follows. Project I has an anticipated life
of 35 years, and the useful life of Project II. has been estimated to
be 25 years. If the MARR is 9% per year, which, if either, of these
projects should be selected? The effect of inflation is negligible.
27

Lives
Solution:
Since AW (Cost, II) is the alternative, having the lowest equivalent

cost. So the B-C ratio is calculated for Project II (having lowest
equivalent cost.)
Therefore, Project II is acceptable.
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Lives
Solution:
For an incremental B-C Ratio:
Therefore, increment required for Project I is not acceptable.
Decision: Project II should be selected.
29

Lives
Question:
Three mutually exclusive alternative public-works projects are
currently under consideration. Their respective costs and benefits
are included in the table that follows. Each of the projects has a
useful life of 50 years, and MARR is 10% per year. Which, if any, of
these projects should be selected?
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Lives
Solution:
31

Lives
Solution:
Therefore, Project A is acceptable.
Therefore, increment required for Project B is not acceptable.
Therefore, increment required for Project C is acceptable.

Decision: Recommend Project C.
32
Ahsan Ahmed 16

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11/3/2020

Applied Economics MF-303

Introduction to the instructor

Instructor: Ahsan Ahmed (Lecturer, MED)

Course CLOs and PLOs

Key Discussion for the semester?

Factors of Production / Resources

Wants and Desires

 Sociological (Family, Society , Social Interactions etc.)

 Biological (free from pain, fear, comfortable living condition, etc.)

 Psychological (which make life just a little more enjoyable)

Do resources fullfil desires/wants?

Product & Resources

Two Dimensions of Economics

Engineering Economics (Def)

promote the well-being and survival of an organization,

Economic Environment / Behavior

 Constraints from Buyer Side:

 Constraints from Producer Side:

Economic Environment / Behavior

 Consumer Goods and Services:

 Producer Goods and Services:

Classification of Consumer and

Theory of Supply and Demand

Supply Function / Equation

Supply Function / Equation

Demand Function / Equation

Price Elasticity of Demand

Price Elasticity of Demand

Price Elasticity of Demand

 Note: -ve sign represents inverse relation according to the law

Price Elasticity of Demand

Price Elasticity of Demand

Elasticity & Revenue

When demand is price-inelastic, a price decrease

Special Cases of Elasticity

 Each of them has its own set of characteristics and

Large number of sellers and no individual seller can

Perfect knowledge : regarding prices of goods because

A firm is a price taker : prices are determined by market

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

TYPES OF BUSINESS ORGANIZATIONS

Why Consider Return to Capital?

Why Consider Return to Capital?

 A total of $1,331 would be due for repayment at the end of the

Simple vs Compound Interest

Simple vs Compound Interest

Notation and Cash-Flow Diagrams

Notation and Cash-Flow Diagrams

Notation and Cash-Flow Diagrams

Notation and Cash-Flow Diagrams

Notation and Cash-Flow Diagrams

Present and Future Equivalent Values

Finding F when given P

Future Equivalent of a Present Sum

Future Equivalent of a Present Sum

Future Equivalent of a Present Sum

Discrete Cash-Flow Examples Illustrating Equivalence