INDE232/ILE232/ECON204

ENGINEERING ECONOMY
CHAPTER 1

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 Basics of Engineering Economy
by
Leland Blank and Anthony Tarquin

Chapter 1
Foundations of Engineering
Economy
 Chapter 1 - Foundations
•PURPOSE •TOPICS
– Definition and study
approach
– Interest rate, ROR, and
•Understand the MARR
fundamental concepts of – Equivalence
engineering economy – Interest – simple and
compound
– Cash flow diagrams
– Rules of 72 and 100
 Introduction
The need for engineering economy is primarily
motivated by the work that engineers do in
performing
– Analysis
– Synthesizing
– Coming to a conclusion
as they work on projects of all sizes.

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 Definition
Engineering economy is a collection of
techniques that simplify comparison of
alternatives on economic bases.

Fundamental terminology:
– Alternative -- stand-alone solution
– Cash flows -- estimated inflows (revenues) and
outflows (costs) for an alternative
– Evaluation criteria -- Basis used to select ‘best’
alternative; usually money (currency of the
country)

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Engineering economy
–is not a method or process for
determining alternatives
–begins after the alternatives are
determined
–will not point the best alternative if it
has not been recognised

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In Engineering Economy is the sole criteria for
selecting the best alternative.

– Sometimes other factors will dominate and

selecting the alternative.
• Most project decisions consider additional factors –
safety, environmental, political, public acceptance, etc.
(multi-attribute analysis)

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 Example

• Living in North Cyprus as a student

– On campus single
– On campus multi
– Off campus in a shared flat
– Off campus in a shared house

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 Example
• In economic analysis, financial units are
generally the TANGIBLE basis for evaluation
• When there are several ways to accomplish a
stated objective,
– the alternative with the lowest overall cost or
– highest overall net income
• is selected.

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 Example
• Intangible factors
– Goodwill, convenience, friendship, morale, etc.

• When the alternatives under consideration are hard to distinguish

economically, intangible factors may tilt the decision in the
direction of one of the alternative.

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 Interest Rate, ROR, MARR
 Interest is a manifestation of time value of money
 Time value of money
The change in the amount of money over a
given time period

 Calculated as difference between an ending amount

and a beginning amount of money
Interest = end amount – original amount
 Interest Rate, ROR, MARR
Interest rate is interest over specified time period
based on original amount
interest accrued per time unit
x 100%
 Interest rate (%) = original amount

 Interest rate and rate of return (ROR) have same

numeric value, but different interpretations
 Interest Rate and ROR Interpretations
•Borrower’s perspective •Investor’s perspective

•Take loan of $5,000 for •Invest (or lend) $5,000 for

one year; repay $5,350 one year; receive $5,350

•Interest paid = $350

•Interest earned = $350
•Interest rate = 350/5,000
• = 7% •Rate of return =
350/5,000
•INTEREST RATE • = 7%
•RATE OF RETURN
 ROR and MARR
• Cost of capital (COC) – interest
rate paid for funds to finance
projects ROR

• MARR – Minimum ROR needed

for an alternative to be justified
and economically acceptable.
MARR ≥ COC.
• If COC = 5% and 6% must
be realized, MARR = 11%

• Always, for acceptable projects

• ROR ≥ MARR > COC

 Time Unit

• The time unit of the interest rate is called the

Interest period
– The most common interest period is ‘one year’
– Shorter periods
• Overnight
• Day
• Week
• Month
• Quarter (3 months)
• Half year (6 months)
are also used.

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 Example

Borrow: $10,000
Repay: $10,800 (one year after)
–Interest paid : end amount – beginning
amount
–Interest paid: 10,800 – 10,000 = $800
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑖𝑑
• Interest rate: ∗ 100
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
800
• Interest rate: ∗ 100=8% per year
10,000

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 Example
Calculate the principal deposited one year ago,
when the accumulated total now is $10,000
with IR=5%
Total accrued = original + Interest
=Original + Original * IR
. $10,000 = X ( 1 + IR)
• = X ( 1+0.05) = X ( 1.05)
. Original (X) = 10,000 / 1,05 = $9,523.80

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 Example
– Calculate the interest earned over the period

– Interest earned = Ending amount – beginning amount

• Interest= 10,000 – 9,523.81 = $476.19
• Alternatively
• Interest = Original * IR
• Interest = 9523.80 * (5/100) = $476.19

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 Equivalence
Different sums of money at different times may be equal
in economic value

Interest rate = 6% per year

-1 0 1

$106 one
year from
$94.34 last year $100 now now

Interpretation: $94.34 last year, $100 now, and $106 one year
from now are equivalent only at an interest rate of 6% per year
 Equivalence
Based on 5% annual interest

$98.00 now 1.05 $102.90 next year

$200.00 last year 1.05 $210.00 now

$38.00 now 1.05 $ 39.90 one year from now

$3000.00 now was 1.05 $ 2,857.14 one year ago

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 Simple and Compound Interest
Simple interest is always based on the
original amount, which is also called the
principal

Interest per period = (principal)(interest rate)

Total interest = (principal)(n periods)(interest rate)
Example: Invest $250,000 in a bond at 5% per year
simple
Interest each year = 250,000(0.05) = $12,500
Interest over 3 years = 250,000(3)(0.05) = $37,500
 Simple and Compound Interest
Compound interest is based on the principal
plus all accrued interest
Interest per period = (principal + accrued interest)(interest rate)
Total interest = (principal)(1+interest rate)n periods - principal

Example: Invest $250,000 at 5% per year compounded

Interest, year 1 = 250,000(0.05) = $12,500
Interest, year 2 = 262,500(0.05) = $13,125
Interest, year 3 = 275,625(0.05) = $13,781
Interest over 3 years = 250,000(1.05)3 – 250,000 = $39,406
 Example

$5000 borrowed at interest rate=8% per year for 5

years.
Compare various interest applications/repayment
a) Simple interest, pay all at the end
b) Compound interest, pay all at the end

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 Example

a) Loan: 5000, ir=8% simple

End of year Interest for Total owed end of End of year Total owed
year year payment after pay
0 5000
1 400 5400 5400
2 400 5800 5800
3 400 6200 6200
4 400 6600 6600
5 400 7000 7000 0000

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 Example
b) Loan: 5000, ir=8%, Compound interest pay all at the end
End of year Interest for Total owed end End of year Total owed
year of year payment after pay
0 5000
1 400 5400 5400
2 432 5832.00 5832.00
3 466.56 6298.56 6298.56
4 503.88 6802.44 6802.44
5 544.20 7346.64 7346.64 0000

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 Terminology and Symbols
 t = time index in periods; years, months,
etc.
 P = present sum of money at time t = 0; $
 F = sum of money at a future time t; $
 A = series of equal, end-of-period cash
flows; currency per period, $ per year
 n = total number of periods; years, months
 i = compound interest rate or rate of return;
% per year
 Terminology and Symbols
• P = Present worth, PW
• Present Value, PV
• Net Present Value, NPV
• Discounted cash Flow, DCF
• Capitalised cost, CC
• F = Future worth, FW
• Future value, FV
• A = Annual worth, AW
• Equivalent uniform Annual worth, EUAW

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 Terminology and Symbols
A new college graduate has a job with Boeing
Aerospace. She plans to borrow $10,000 now to
help in buying a car. She has arranged to repay the
entire principal plus 8% per year interest after 5
years. Identify the engineering economy symbols
involved and their values for the total owed after 5
years.
Solution
The future amount F is unknown.
P=$10,000 i=8% per year n=5 years F=?
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 Terminology and Symbols
Example: Borrow $5,000 today and repay
annually for 10 years starting next year at 5% per
year compounded. Identify all symbols.
Given: P = $5,000 Find: A = ? per year
i = 5% per year
n = 10 years
t = year 1, 2, …, 10
(F not used here)
 Terminology and Symbols
You plan to make a lump-sum deposit of $5000 now into
an investment account that pays 6% per year, and you
plan to withdraw an equal end-of-year amount of $1000
for 5 years, starting next year. At the end of the sixth year,
you plan to close your account by withdrawing the
remaining money. Define the engineering economy
symbols involved.

i= 6% per year
F =? at end of year 6
A = $1000 per year for 5 years
P= $5000

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 Cash Flow Estimates
Cash inflow – receipt, revenue, income, saving
Cash outflows – cost, expense, disbursement, loss

Net cash flow (NCF) = inflow – outflow

End-of-period convention: all cash flows and NCF

occur at the end of an interest period
 Cash Flow Diagrams
Year 1 Year 5
Typical time
scale or 5
0 1 2 Time, t 3 4 5
years
+ Cash flow

P=? Find P in
year 0,
given 3
0 1 2 3 4 5
cash flows

- Cash flow
 Cash Flow Diagrams
Example: Find an amount to deposit 2 years from
now so that $4,000 per year can be available for 5
years starting 3 years from now. Assume i = 15.5% per
year
 Exmaple
P=$10,000 is borrowed at 8% per year and F is
sought after 5 years. Construct the cash flow
diagram.
Solution

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 Example
Each year Exxon-Mobil expends large amounts of
funds for mechanical safety features throughout its
worldwide operations.
Carla Ramos, a lead engineer for Mexico and Central
American operations, plans expenditures of $1
million now and each of the next 4 years just for the
improvement of field-based pressure release valves.
Construct the cash flow diagram to find the
equivalent value of these expenditures at the end of
year 4, using a cost of capital estimate for safety-
related funds of 12% per year.

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Example

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 Rule of 72
Approximate n = 72 / i
Estimates # of years (n) for an amount to double (2X) at a
stated compound interest rate

E.g. at i = 10%, $1,000 doubles to $2,000 in ~7.2 years

Solution for i estimates compound rate to double in n years

•Approximate i = 72 / n
 Rule of 72
• Number of Years Required for Money to Double

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Introduction to Spreadsheet Functions
To display Excel Function
Present value, P = PV(i%,n,A,F)
Future value, F = FV(i%,n,A,P)
Annual amount, A = PMT(i%,n,P,F)
# of periods, n = NPER(i%,A,P,F)
Compound rate, i = RATE(n,A,P,F)
i for input series = IRR(first_cell:last_cell)