BMFG 4623

Engineering Economy and Management

Introduction
Nidzamuddin Md. Yusof
Faculty of Mechanical Engineering
nidzamuddin@utem.edu.my
 Learning Outcomes (LO)
1. Define engineering economics, time value of money and describe
its role in decision making.
2. Identify the steps in an engineering economy study.
3. Identify areas in which economic decisions can present
questionable ethics.
4. Identify and use engineering economic terminology and symbols.
5. Describe cash flows and how to graphically represent them.
6. Calculate simple and compound interest amounts for one or more
time periods.
7. State the meaning and role of Minimum Attractive Rate of
Return (MARR).
8. Use spreadsheet for calculations.
LO 1

What is Engineering Economy?

• Engineering economy is the application of economic principles and
calculations to engineering problems. Many basic economic principles
may be applied in an engineering economic analysis, depending on their
applicability.

• Engineering Economy involves formulating, estimating, and evaluating

the expected economic outcomes of alternatives designed to
accomplish a defined purpose.

• Easy-to-use math techniques simplify the evaluation.

LO 1

Why Engineering Economy is important to

engineers?
1. Engineers design and create. This ideas/proposal need to make sense
economically and engineer must be able to convince others.
2. Engineers must be able to incorporate economic analysis into their
creative efforts. Often engineers must select and implement from
multiple alternatives.
3. The fundamental approach in engineering economy is to find which
among the many alternatives is the best choice in their monetary
terms, at an engineering standpoint.
4. Understanding and applying time value of money, economic
equivalence, and cost estimation are vital for engineers.
5. A proper economic analysis for selection and execution is a
fundamental task of engineering
LO 1

What do we need to know in Engineering

Economy?

The TVM explains the change in the amount of money over time for
funds that are owned (invested) or owed (borrowed).

• Time value of money (TVM).

• Estimation of cash flow.
• Commonly used symbols.
• Quantitative measurement of profitability.
• Systematic comparisons of alternatives.
LO 1

Time Value of Money (TVM)

The TVM explains the change in the amount of money over time for
funds that are owned (invested) or owed (borrowed).

• It indicates the relationship between time and money.

• That money available at the present time is worth more than the
identical sum in the future due to its potential earning capacity. A
RM 10 received today is worth more than a RM 10 to be received
tomorrow.
• This is because the money you received today can be invested to
earn interest. For example, money deposited into a savings account
earns a certain interest rate and is therefore said to be compounding
in value.
LO 1

Time Value of Money (TVM)

Example:
• If you were given RM100 today and invested it at an annual rate of
only 10%, it could be worth RM110 at the end of one year.
So, we can say, the future value of RM 100 today is RM 110 with given
a 10% interest rate a year (this also called economic equivalent that
will explain further later).

• Inflation has the reverse effect on the time value of money. Because
of the constant decline in the purchasing power of money, an
uninvested dollar is worth more in the present than the same
uninvested dollar will be in the future.
LO 1

Time Value of Money (TVM)

1995 2021 2030

RM10 in 1995, RM10 in 2021, RM10 in 2030,

you can purchase you can purchase how much you
20 roti canai 10 roti canai can purchase a
because at that because now, it roti canai?
time, it cost you cost you RM 1.00
only RM 0.50 per per unit.
unit.

The time value of money is the most important concept in

engineering economy
LO 2

General Steps for Engineering Economy Study

Identify and understand the problem - define
objectives.

Collect relevant, available information and define

viable solutions.

Make realistic cash flow estimates.

Identify the criteria for decision making.

Evaluate the alternatives and apply sensitivity

analysis.

Select the “best” alternative

Implement the alternative and monitor results

LO 3

Ethics
A system of moral principles. They affect how people make
decisions and lead their lives.

Different levels/types of ethics:

• Universal morals or ethics – Fundamental beliefs: stealing, lying,
harming or murdering another are wrong.
• Personal morals or ethics – Beliefs that an individual has and maintains
over time; how a universal moral is interpreted and used by each
person.
• Professional or engineering ethics – Formal standard or code that
guides a person in work activities and decision making.
LO 4

Interest

Interest:
• The manifestation of the time value of money.
• Fee that one pays to use someone else’s money (original amount/
principal)
• The difference between an ending amount of money and a beginning
amount of money.
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑎𝑚𝑜𝑢𝑛𝑡 𝑜𝑤𝑒𝑑 𝑛𝑜𝑤 – 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
LO 4

Interest Rate vs Rate of Return (ROR)

Interest Rate:
• Interest paid over a time period expressed as a percentage of the
principal.
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 % = ×100%
𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙

Rate of Return:
• Interest earned over a period of time is expressed as a percentage of
the original amount (principal).
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑢𝑛𝑖𝑡
𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 % = ×100%
𝑜𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡
LO 4

Interest Rate Rate of Return

Loan Loan

Repayment Repayment
+ interest + interest
Bank Borrower Investor Corporation

Interest paid Interest earned

LO 4

Commonly used Symbols

P = value or amount of money at a time t designated as present
or time 0.
F = value or amount of money at some future time, such as at t =
n periods in the future.
A = series of consecutive, equal, end-of-period amounts of money.
n = number of interest periods; years, months.
i = interest rate or rate of return per time period; percent per
year or month.
t = time, usually in periods such as years or months.
LO 4

Commonly used Symbols (Example)

Ali borrowed RM 5,000 to purchase second-hand Kancil. He can repay the loan in
two ways below:
a) Five equal annual installments with interest based on 5% per year.
b) One payment 3 years from now with interest based on 7% per year.
Determine the engineering economy symbols and their value for each option.

Answer:
a) P = RM 5000 i = 5% per year n = 5 years A=?
b) P = RM 5000 i = 7% per year n = 3 years F=?
LO 5

Cash Flows: Terms

The amounts of money estimated for future projects or observed for
project events that have taken place.
Cash Inflows:
• Revenues (R), receipts, incomes, savings generated by projects and
activities that flow in. Plus sign (+) is used.

Cash Outflows:
• Disbursements (D), costs, expenses, taxes caused by projects and
activities that flow out. Minus sign (-) is used.
𝑁𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 − 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠
𝑁𝐶𝐹 = 𝑅 − 𝐷
End-of-period èFunds flow at the end of a given interest period
LO 5

Cash Flows: Estimating

An attempt to predict the future.
Point estimate:
• A single-value estimate of a cash flow element of an alternative.
• Cash inflow: Income = RM 150,000 per month.
Range estimate:
• Min and max values that estimate the cash flow.
• Cash inflow: Revenue between RM 1 million to RM 2.5 million.

Point estimates are commonly used; however, range estimates

with probabilities attached provide a better understanding of
variability of economic parameters used to make decisions.
LO 5

Cash Flows: Diagrams

Very important tool in an economic analysis, especially when
the cash flow series is complex.

Draw a timeline: Always assume end-of-

Time (yearly, monthly, etc.) period cash flows

0 One time 1 2 ... ... ... n-1 n

period

Show the cash flows (to approximate scale): P = RM 100

0 1 2 ... ... ... n-1 n

Cash flows are shown as directed arrows: + (up) for inflow
P = - RM 80 - (down) for outflow
LO 5

Cash Flows: Diagrams Example

From the table below, plot the observed cash flows over the last 7 years and the estimated
sale of the next year for RM150. Show present worth (P) arrow at present time, t = 0.

End of Income Cost Net Cash Flow P=?

Year (RM) (RM) (RM)
RM650
RM625 RM625
-7 0 2500 -2500 RM600
RM575
-6 750 100 650 RM550
RM525
RM500
-5 750 125 625
-4 750 150 600
-3 750 175 575
-7 -6 -5 -4 -3 -2 -1 0 1 Year
-2 750 200 550
-1 750 225 525
0 750 250 500
1 750 + 150 275 625
-RM2500
LO 6

Economic Equivalence
Definition:
Combination of interest rate (or rate of return) and time value of
money to determine different amounts of money at different points in
time that are economically equivalent.

How it works:
Use interest rate (i) and time (t) in upcoming relations to move money
(values of P, F and A) between time points t = 0, 1, ..., n to make them
equivalent (not equal) at the rate i.
LO 6

Economic Equivalence
Different sums of money at different times may be equal in
economic value at a given rate.
RM110

Simple or Compound
0
Interest?
Rate of return = 10% 1per year Year

RM100 now

RM100 now is economically equivalent to RM110 one year from

now, if the RM100 is invested at a rate of 10% per year.
LO 6
Simple Interest Compound Interest
• Interest is calculated using principal • Interest is based on principal plus all
only. accrued interest.

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)(𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠)(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒) 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 + 𝑎𝑙𝑙 𝑎𝑐𝑐𝑟𝑢𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡)(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)
𝐼 = 𝑃𝑛𝑖 !"$%#

Example: RM100,000 lent for 3 years at
simple i = 10% per year. What is the
repayment after 3 years?
Calculation:
Interest = 100,000(3)(0.10) = RM30,000
Total due = 100,000 + 30,000 = RM130,000
𝑇𝑜𝑡𝑎𝑙 𝑑𝑢𝑒 𝑎𝑓𝑡𝑒𝑟 𝑛 𝑦𝑒𝑎𝑟𝑠 = 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙(1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)! "#$%&
= 𝑃(1 + 𝑖)&
𝐼 = 𝑃 + ' 𝐼! 𝑖
!"#
Example: RM100,000 lent for 3 years at i = 10%
per year compounded. Determine the repayment
after 3 years?
Calculation:
Interest, year 1: I1 = 100,000(0.10) = RM10,000
Total due, year 1: T1 = 100,000 + 10,000 = RM110,000
Interest, year 2: I2 = 110,000(0.10) = RM11,000
Total due, year 2: T2 = 110,000 + 11,000 = RM121,000

Interest, year 3: I3 = 121,000(0.10) = RM12,100

Total due, year 3: T3 = 121,000 + 12,100 = RM133,100
LO 7
Minimum Attractive Rate of Return (MARR)
Definition:
• A reasonable rate of return
(percent) established for
evaluating and selecting
alternatives.
• An investment is justified
economically if it is expected to
return at least the MARR.
• Also termed as hurdle rate,
benchmark rate and cutoff rate.
Rate of return,
percent
Expected rate of return on a
new proposal.
Range for the rate of return
on accepted proposals, if
other proposals were
rejected for some reason.
All proposals must offer at
least MARR to be considered.
MARR
Rate of return om
“safe investment”.
LO 7

MARR Characteristics
• MARR is established by the financial managers of the firm.
• MARR is fundamentally connected to the cost of capital.
• The capital is developed in two ways:
Ø Equity financing – Uses its own funds from cash on hand, savings,
investments, etc.
Ø Debt financing – Borrows from outside sources and repays the
principal and interest.
• Both types of capital financing are used to determine the weighted
average cost of capital (WACC) and the MARR.
• MARR usually considers the risk inherent to a project.
LO 8

Introduction to Spreadsheet Functions

• Present Value, P: = PV(i%,n,A,F)

• Future Value, F: = FV(i%,n,A,P)

• Equal, periodic value, A: = PMT(i%,n,P,F)

• Number of periods, n: = NPER((i%,A,P,F)

• Compound interest rate, i: = RATE(n,A,P,F)

• Compound interest rate, i: = IRR(first_cell:last_cell)

• Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell

 Chapter Summary
• Engineering economy fundamentals:
ü Time value of money.
ü Economic equivalence.
ü Introduction to capital funding and MARR.
ü Spreadsheet functions.

• Interest rate and rate of return:

ü Simple and compound interest.
• Cash flow estimation:
ü Cash flow diagrams.
ü End-of-period assumption.
ü Net cash flow.
ü Perspectives taken for cash flow estimation.

• Ethics:
ü Universal morals and personal morals.