Sheila

Sheila Belayutham
Belayutham

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Sheila
Sheila Belayutham
Belayutham

 It deals with the concepts and

techniques of analysis useful in
evaluating the worth of systems,
products, and services in relation to their
costs.

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Sheila
Sheila Belayutham
Belayutham

 It is used to answer many different

questions
› Which engineering projects are worthwhile?
 Has the mining or petroleum engineer shown
that the mineral or oil deposits is worth
developing?
› Which engineering projects should have a
higher priority?
 Has the industrial engineer shown which factory
improvement projects should be funded with
the available dollars?
› How should the engineering project be
designed?
 Has civil or mechanical engineer chosen the
best thickness for insulation? 3
Sheila
Sheila Belayutham
Belayutham

 Cash flow
 Interest Rate and Time value of money
 Equivalence technique

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Sheila
Sheila Belayutham
Belayutham

 Engineering projects generally have

economic consequences that occur over
an extended period of time
› For example, if an expensive piece of machinery
is installed in a plant were brought on credit, the
simple process of paying for it may take several
years.
› The resulting favorable consequences may last
as long as the equipment performs its useful
function.
 Each project is described as cash receipts
or disbursements (expenses) at different
points in time

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Sheila
Sheila Belayutham
Belayutham

 The expenses and receipts due to

engineering projects usually fall into one
of the following categories:
› First cost: expense to build or to buy and
install
› Operations and maintenance (O&M): annual
expense, such as electricity, labor, and minor
repairs
› Salvage value: receipt at project termination
for sale or transfer of the equipment (can be
a salvage cost)
› Revenues: annual receipts due to sale of
products or services
› Overhaul: major capital expenditure that
occurs during the asset’s life
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Sheila
Sheila Belayutham
Belayutham

 Cash flow diagrams are a mean of visualizing

(and simplifying) the flow of receipts and
disbursements (for the acquisition and
operation of items in an enterprise).
 The diagram convention is as follows:
› Horizontal Axis : The horizontal axis is marked off in
equal increments, one per period, up to the duration
of the project.

› Revenues : Revenues (or receipts) are represented

by upward pointing arrows.

› Disbursements : Disbursements (or payments) are

represented by downward pointing arrows.
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Sheila
Sheila Belayutham
Belayutham

 All disbursements and receipts (i.e. cash flows) are

assumed to take place at the end of the year in
which they occur. This is known as the "end-of-year"
convention.

 Arrow lengths are approximately proportional to the

magnitude of the cash flow.

 Expenses incurred before time = 0 are sunk costs, and

are not relevant to the problem.

 Since there are two parties to every transaction, it is

important to note that cash flow directions in cash
flow diagrams depend upon the point of view taken.
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Sheila
Sheila Belayutham
Belayutham

Figure shows cash flow diagrams for a transaction spanning five years. The
transaction begins with a $1000.00 loan. For years two, three and four, the
borrower pays the lender $120.00 interest. At year five, the borrower pays the
lender $120.00 interest plus the $1000.00 principal.

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Sheila
Sheila Belayutham
Belayutham

 A man borrowed $1,000 from a bank at 8%

interest. Two end-of-year payments: at the
end of the first year, he will repay half of the
$1000 principal plus the interest that is due.
At the end of the second year, he will repay
the remaining half plus the interest for the
second year.
 Cash flow for this problem is:
End of year Cash flow
0 +$1000
1 -$580 (-$500 - $80)
2 -$580 (-$500 - $80)

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Sheila
Sheila Belayutham
Belayutham

$1,000

1 2

$580
$580

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Sheila
Sheila Belayutham
Belayutham

 The time-value of money is the

relationship between interest and time.
i.e.

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Sheila
Sheila Belayutham
Belayutham

 Money has value

› Money can be leased or rented
› The payment is called interest
› If you put $100 in a bank at 9% interest for one
time period you will receive back your original
$100 plus $9

Original amount to be returned = $100

Interest to be returned = $100 x .09 = $9

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Sheila
Sheila Belayutham
Belayutham

 Interest is a rental amount charged by

financial institutions for the use of money.
 Called also the rate of capital growth, it is
the rate of gain received from an
investment.
 It is expressed on an annual basis.
 For the lender, it consists, for convenience,
of (1) risk of loss, (2) administrative expenses,
and (3) profit or pure gain.
 For the borrower, it is the cost of using a
capital for immediately meeting his or her
needs.
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Sheila
Sheila Belayutham
Belayutham

Simple Interest
 Simple Interest : I = Pni.
P = Principal
i = Interest rate
n = Number of years (or periods)
I = Interest

 Interest is due at the end of the time period. For fractions of a

time period, multiply the interest by the fraction.

 Example : Suppose that $50,000 is borrowed at a simple interest

rate of 8% per annum. At the end of two years the interest owed
would be:
 I = $ 50,000 * 0.08 * 2
= $ 8,000

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Sheila
Sheila Belayutham
Belayutham

 Interest that is computed on the

original unpaid debt and the unpaid
interest.
 Compound interest is most commonly
used in practice.
 Total interest earned = In = P (1+i)n - P
› Where,
 P – present sum of money
 i – interest rate
 n – number of periods (years)
I2 = $100 x (1+.09)2 - $100 = $18.81

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Sheila
Sheila Belayutham
Belayutham

 Amount of money due at the end of a

loan
› F = P(1+i)1(1+i)2…..(1+i)n or F = P (1 + i)n
› Where,
 F = future value and P = present value
 Referring to slide #10, i = 9%, P = $100 and say
n= 2. Determine the value of F.

F = $100 (1 + .09)2 = $118.81

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Sheila
Sheila Belayutham
Belayutham

 Formula:
F=P(1+i)n is the
single payment compound amount
factor.

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Sheila
Sheila Belayutham
Belayutham

 Example 1 : Let the principal P = $1000,

the interest rate i = 12%, and the number
of periods n = 4 years. The future sum is:
› F = $1000 [1 + 0.12] ^ 4
= $1,573.5

Cash Flow for Single Payment

Compound Amount

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Sheila
Sheila Belayutham
Belayutham

 P=(F/(1+i)n )
single payment present worth factor.
 Example 1 : Let the future sum F = $1000,
interest rate i = 12%, and number of periods
n = 4 years. The single payment present-
worth factor is:

P= F = $1000 = $635.50
[1 + i]^n [ 1 + 0.12 ]^4

 The present worth P = $635.50.

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Sheila
Sheila Belayutham
Belayutham

Given a future amount F, the equal payments compound-amount

relationship is:
i
A = F * ---------------
[ 1 + i ]^n - 1

A = required end-of-year payments to accumulate a future amount F.

Example 1: Let F = 1000, i = 12%, and n = 4 years.

0.12
A = 1000 * ------------------ = 209.2
[ 1 + 0.12 ]^4 - 1

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Sheila
Sheila Belayutham
Belayutham

This can be described as

[ 1 + i ]^n - 1
P = A * ---------------
i * [ 1 + i ]^n

Example 1: Let A = 100, i = 12%, and n = 4 years.

[ 1 + 0.12 ]^4 - 1
P = 100 * --------------------- = 303.7
0.12 * [ 1 + 0.12 ]^4

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Sheila
Sheila Belayutham
Belayutham

 Example 3-5: If you wished to have

$800 in a savings account at the end
of four years, and 5% interest we paid
annually, how much should you put
into the savings account?
 n = 4, F = $800, i = 5%, P = ?
 P = PV(5%,4,,800,0) = -$658.16
 You should use P = $658.16

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Sheila
Sheila Belayutham
Belayutham

 Example: If $500 were deposited in a

bank savings account, how much
would be in the account three years
hence if the bank paid 6% interest
compounded annually?
 Given P = 500, i = 6%, n = 3, use F =
FV(6%,3,,500) = -595.91
 Note that the spreadsheet gives a
negative number to find equivalent of
P. If we find P using F = -$595.91, we
get P = 500.

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Sheila
Sheila Belayutham
Belayutham

 Relative attractiveness of different

alternatives can be judged by using the
technique of equivalence
 We use comparable equivalent values
of alternatives to judge the relative
attractiveness of the given alternatives
 Equivalence is dependent on interest
rate
 Compound Interest formulas can be
used to facilitate equivalence
computations

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Sheila
Sheila Belayutham
Belayutham

 Determine a single equivalent value

at a point in time for plan 1.
 Determine a single equivalent value
at a point in time for plan 2.

Both at the same interest rate and at the same time point.

•Judge the relative attractiveness of the

two alternatives from the comparable
equivalent values.
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Sheila
Sheila Belayutham
Belayutham

Year Plan 1 Plan 2

0 $5,000
1 $1,000
2 $1,000
3 $1,000
4 $1,000
5 $1,000
Total $5,000 $5,000
To make a choice the cash flows must be altered
so a comparison may be made.
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Sheila
Sheila Belayutham
Belayutham

 P = $1,000(P|A,10%,5)
 P = $1,000(3.791) =
$3,791

 P = $5,000
 Alternative 2 is better
than alternative 1
since alternative 2 has
a greater present
value

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Sheila
Sheila Belayutham
Belayutham

 Generally involves compound interest

formulas (factors)
 Compound interest formulas (factors)
can be evaluated by using one of the
three methods
› Interest factor tables
› Calculator
› Spreadsheet

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Sheila
Sheila Belayutham
Belayutham

 Three commonly used economic analysis

methods are
› Present Worth Analysis
› Annual Worth Analysis
› Rate of Return Analysis

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Sheila
Sheila Belayutham
Belayutham

 Steps to do present worth analysis for

selecting a single alternative
(investment) from among multiple
alternatives
› Step 1: Select a desired value of the return
on investment (i)
› Step 2: Using the compound interest formulas
bring all benefits and costs to present worth
for each alternative
› Step 3: Select the alternative with the largest
net present worth (Present worth of benefits –
Present worth of costs)

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Sheila
Sheila Belayutham
Belayutham

 A construction enterprise is investigating the

purchase of a new dump truck. Interest rate
is 9%. The cash flow for the dump truck are
as follows:
 First cost = $50,000, annual operating cost =
$2000, annual income = $9,000, salvage
value is $10,000, life = 10 years. Is this
investment worth undertaking?
 P = $50,000, A = annual net income = $9,000
- $2,000 = $7,000, S = 10,000, n = 10.
 Evaluate net present worth = present worth
of benefits – present worth of costs
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Sheila
Sheila Belayutham
Belayutham

 Present worth of benefits =

$9,000(P|A,9%,10) = $9,000(6.418) = $57,762
 Present worth of costs = $50,000 +
$2,000(P|A,9%,10) - $10,000(P|F,9%,10)=
$50,000 + $2,000(6..418) - $10,000(.4224) =
$58,612
 Net present worth = $57,762 - $58,612 < 0 ⇒
do not invest
 What should be the minimum annual
benefit for making it a worthy of investment
at 9% rate of return?

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Sheila
Sheila Belayutham
Belayutham

 Present worth of benefits = A(P|A,9%,10) =

A(6.418)
 Present worth of costs = $50,000 +
$2,000(P|A,9%,10) - $10,000(P|F,9%,10)=
$50,000 + $2,000(6..418) - $10,000(.4224) =
$58,612
 A(6.418) = $58,612 ⇒ A = $58,612/6.418 =
$9,312.44

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Sheila
Sheila Belayutham
Belayutham

 Present and future benefits (income) and

costs need to be estimated to determine
the attractiveness (worthiness) of a new
product investment alternative

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Sheila
Sheila Belayutham
Belayutham

 Annual product total cost is the sum of

annual material, labor, and overhead
(salaries, taxes, marketing expenses,
office costs, and related costs), annual
operating costs (power, maintenance,
repairs, space costs, and related
expenses), and annual first cost minus
the annual salvage value.
 Annual income generated through the
sales of a product = number of units sold
annually x unit price

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Sheila
Sheila Belayutham
Belayutham

 Single alternative case

 In this method all revenues and costs of
the alternative are reduced to a single
percentage number
 This percentage number can be
compared to other investment returns
and interest rates inside and outside the
organization

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Sheila
Sheila Belayutham
Belayutham

 Steps to determine rate of return for a

single stand-alone investment
› Step 1: Take the dollar amounts to the same
point in time using the compound interest
formulas
› Step 2: Equate the sum of the revenues to
the sum of the costs at that point in time and
solve for i

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Sheila
Sheila Belayutham
Belayutham

 An initial investment of $500 is being

considered. The revenues from this
investment are $300 at the end of the
first year, $300 at the end of the second,
and $200 at the end of the third. If the
desired return on investment is 15%, is the
project acceptable?
 In this example we will take benefits and
costs to the present time and their
present values are then equated

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Sheila
Sheila Belayutham
Belayutham

 $500 = $300(P|F, i, n=1) + 300(P|F, i, n=2) +

$200(P|F, i, n=3)
 Now solve for i using trial and error method
 Try 10%: $500 = ? $272 + $247 + $156 = $669
(not equal)
 Try 20%: $500 = ? $250 + $208 + $116 = $574
(not equal)
 Try 30%: $500 = ? $231 + $178 + $91 = $500
(equal) ⇒ i = 30%
 The desired return on investment is 15%, the
project returns 30%, so it should be
implemented

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