BULE HORA UNIVERSITY

COLLEGE OF ENGINEERING
AND TECHNOLOGY

Department of CIVIL ENGINEERING

COURSE NAME: ENGINEERING ECONOMICS

COURSE NUMBER: CEng5201

COMPILED BY: ABDI DERESA

 Course objectives

• The Course objectives are to:

– Understand the basic concepts of Engineering economics.

– Understand the time value of money.

– Understand the concepts behind benefit-cost analyses.

– Understand the concept of depreciation.

 Course Contents
1. Introduction to Economics.
2. Basic concepts
3. Annual, discrete and periodic compounding
4. Present and future worth
5. Rate of return and payback periods
6. Benefit-cost ratio
7. Depreciation and equipment replacement
• Mode of delivery:
– Lectures, Tutorials

• Mode of assessment:
– Continuous assessment = 60%

– Final Examination= 40%

 Important References
1. A Collin and William B, 1982, Engineering Cost
Analysis, Courtland Ledbetter, Harper and Row
Publishers.

2. Bill G. Eppes & Daniel E. Whitema, 1977Cost

Accounting for the Construction Firm.
 Introduction
• Economics is defined as the study of
allocation of scarce resources among
unlimited ends or wants.
• Economics is the science that deals with the
production and consumption of goods and
services and the distribution and rendering of
these for human welfare
 Cont.….
• Development Economics is a subject dealing with
the concepts, skills, methods and techniques of
economics in order to support decisions made by
investors, implementing agents, etc.; through
indicating the feasibility and priority of their
engagements in construction related businesses.
 Basic Economics Principles
 Owners generally wish to:

– Lower costs and completion times of their construction

projects; and

– Increase the benefits such as quality, life time, profit or

serviceability etc. of their construction projects.

 As a result they want their construction projects are optimally

designed, constructed and operated in order to make their
business objective viable.

 Construction Economics is useful in order to ensure such

demands of Owners.
 As a result; the following decisions need to be made in order
to fulfil such requirements:
– Deciding whether to accept a project or not;
– Deciding where to construct the project;
– Choosing how to allocate risks and responsibilities to
carry out the project
– Selecting optimal design, construction and operation
technologies: methods, materials, machineries, etc.
– Prioritizing projects to supply – demand principles and
use scarce resources
 Therefore, the following basic economics principles are vital
to support such decisions:

 Supply and Demand

– Supply and Demand
– Monopoly and Monopsony
– Economic efficiency and optimization
 Time Value of Money &

 Cash Flow Diagrams

 Engineering Economics
• Engineering economics is concerned with the monetary
consequences (or) financial analysis of the projects, products
and processes that engineers design.

• Engineering economics deals with the methods that enable

one to take economic decisions towards minimizing costs
and/or maximizing benefits to business organizations.
 Cont.…
• It deals with the concepts and techniques of analysis useful in
evaluating the worth of systems, products, and services in
relation to their costs.

• A science that involves formulating, estimating, and

evaluating the expected economic outcomes of alternatives
designed to accomplish a defined purpose.
• Discuss the importance of engineering
economics to Engineers?
• Engineering economics is important to Engineers
to:
– Understand and apply economic factors such as time value of
money, economic equivalence, cost and benefits estimation, etc.
to know if a project is feasible.
– Incorporate economic analysis into their efforts.
– Select and implement, from multiple alternatives, based on
proper economic analysis.
– Design Decision Support System (DSS) based on not only
Engineering aspects but also economic aspects
 Engineering Economy
• 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?

15
• The criterion to select an alternative in engineering
economy for a specific set of estimates is called a
measure of worth.
• The most popular measures developed and used
worldwide are:
 Present Worth (PW)  Capitalized Cost (CC)
 Future Worth (FW)  Payback Period (PP)
 Annual Worth (AW)  Economic Value Added (EVA)
 Rate of Return (ROR)  Cost Effectiveness
 Benefit/Cost (B/C)
 BASIC CONCEPTS
 Interest

 Interest Rate

 Cash flow

 Time value of money

 Equivalence technique

 Inflation

 Taxes
 Interest and Interest Rate
• Interest is the manifestation of the time value of money.

• Interest is a fee that is charged for the use of someone

else's money.

• Whenever money is borrowed or invested, one party acts

as the Lender and another party as the Borrower.

• The size of the fee will depend upon the total amount of
money borrowed and the length of time over which it is
borrowed.
• The lender is the owner of the money, and the
borrower pays interest to the lender for the use of the
lender's money.

• The amount of interest indicates the increase between

principal amount invested or borrowed and the final
amount Received or owed.
• In case of an investment made in the past, the total amount of
interest accumulated till now is given by;
Amount of interest = Total amount to be received – original
investment
• Similarly in case of a loan taken in past, the total amount of
interest is given by;
Amount of interest = Present amount owed – original loan
• In both the cases there is a net increase over the amount of
money that was originally Invested or Borrowed.
 Examples
 An engineer wishes to borrow $20,000 in order to start his
own business. A bank will lend him the money provided he
agrees to repay $920 per month for two years. How much
interest is he being charged?

 A person deposited $100,000 in a bank for one year and got

$110,000 at the end of one year. Find out the total amount of
interest.
 Interest Rate
• When interest paid over a specific time unit is expressed
as a percentage of the principal, the result is called the
interest rate.

𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐀𝐜𝐜𝐫𝐮𝐞𝐝 𝐩𝐞𝐫 𝐭𝐢𝐦𝐞 𝐔𝐧𝐢𝐭

Interest Rate(%) = × 𝟏𝟎𝟎%
𝐏𝐫𝐢𝐧𝐜𝐢𝐩𝐚𝐥

Example
 An investor makes a loan of $5000, to be repaid in one lump
sum at the end of one year. What annual interest rate
corresponds to a lump-sum payment of $5425?
 Cash Flow
• The estimated inflow (revenues) and the outflow (Costs)
of money are called Cash flow.

• A cash flow is the difference between total Cash receipts

(inflows) and total Cash disbursements (outflows) for a
given period of time (typically, one year).

• Cash flows are very important in engineering economics

because they form the basis for Evaluating Projects,
Equipment, and Investment Alternatives.
 Cont.…
• 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.
• The easiest way to visualize a cash flow is through a cash flow
diagram, in which the individual cash flows are represented as
vertical arrows along a horizontal time scale
• Cash inflows arc the Receipts, Revenues, Incomes, and Savings
generated by project and business activity.
– A plus sign indicates a cash inflow.
• Cash outflows are Costs, Disbursements, Expenses, and Taxes
caused by projects and business Cash flow activity.
– A negative or minus sign indicates a cash outflow.
– When a project involves only costs, the minus sign may be
omitted for some techniques, such as benefit/cost analysis.
• Positive cash flows (net inflows) are represented by upward-
pointing arrows, and
• Negative cash flows (net outflows) by downward-pointing
arrows
– the length of an arrow is proportional to the magnitude of the
corresponding cash flow.
– Each cash flow is assumed to occur at the end of the respective time
period.
 Categories of Cash Flows
• 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

27
Cash Flow Diagram
• A Cash Flow Diagram is a picture of a financial problem that shows
all cash inflows and outflows along a time line.
• Cash Flow Diagrams are illustrations that show all the monetary
transactions during the time of an enterprise.
• It is a graphical representation of cash flows drawn on the y axis
with a time scale on the x axis.
• The diagram includes what is known, what is estimated, and what
is needed. That is, once the cash flow diagram is complete, another
person should be able to work the problem by looking at the
diagram.
 Cash flow is the sum of money recorded
as receipts or disbursements in a project’s
financial records.
 A cash flow diagram presents the flow of
cash as arrows on a time line scaled to the
magnitude of the cash flow, where
expenses are down arrows and receipts
are up arrows.
 Year-end convention ~ expenses occurring
during the year are assumed to occur at
the end of the year.
 A mechanical Mixer will cost $20,000
when purchased. Maintenance will cost
$1000 per year. The Mixer will generate
revenues of $5000 per year for 5 years.
The salvage value of Mixer is
$7000.draw a cash flow diagram
 A company plans to invest $500,000 to manufacture a new
product. The sale of this product is expected to provide a net
income of $70,000 per a year for 10 years, beginning at the
end of the first year. Draw a cash flow diagram
 Time value of money
• The time value of money is important when one is interested
either in investing or borrowing the money.

• If a person invests his money today in bank savings, by next

year he will definitely accumulate more money than his
investment. This accumulation of money over a specified time
period is called as time value of money.
 Cont.….
• Since money has the ability to earn interest, its value
increases with time.
• Time value of money because: -
– Buying power of future money is less than today’s money due to
inflation
– Today’s money can be used for investment and most likely brings profit
depending of the Rate of Return upon different businesses
– Comparison of today’s and future money can be made in order to
support decision when to invest money
– Comparison of different investment options whose expenditures differ
in time using the same time framework
– Future money can only provide savings through Deposit Interests;
however borrowing for investment purposes will overcome them
• 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

Simple interest:
• The interest is said to simple, when the interest is charged only on the
principal amount for the interest period.

• No interest is charged on the interest amount accrued during the

preceding interest periods.

IT  P  n  i
Where,
IT =Total amount of Interest
P= Principal amount
n= Number of interest periods
– It is understood that n and i refer to the same unit of time (e.g., the year).
• Simple interest reflects the effect of time value of money only on the principal
amount.
• Normally, when a simple interest loan is made, nothing is
repaid until the end of the loan period; then, both the
principal and the accumulated interest are repaid.
• The total amount due can be expressed as:
F  P  I  P  Pni
F  P (1  ni )
 A student borrows $3000 from his uncle in order to finish school.
1
His uncle agrees to charge him simple interest at the rate of 5 % per
2
year. Suppose the student waits two years and then repays the entire
loan. How much will he have to repay?
 A student deposits $1000 in a savings account that pays
interest at the rate of 6% per year. How much money will
the student have after one year?
Compound interest:
• The interest is said to be compound, when the interest for
any interest period is charged on principal amount plus
the interest amount accrued in all the previous interest
periods.

• Interest that is computed on the original unpaid debt and

the unpaid interest

• Compound interest is most commonly used in practice

• Compound interest takes into account the effect of time
value of money on both principal as well as on the
accrued interest also.

Fn  P (1  i ) n

Where,

F= Future amount, P= Principal amount, i=interest

rate, number of interest period
 Mr. Robsan deposits $2000 in a savings account
that pays interest at the rate of 9% per year,
compounded annually. If all of the money is
allowed to accumulate, how much will Mr. Robsan
have after 15 years?
 Person has taken a loan of amount of $10,000 from a bank for
a period of 5 years. Estimate the amount of money, the person
will repay to the bank at the end of 5 years for the following
cases;

a. Considering simple interest rate of 8% per year.

b. Considering compound interest rate of 8% per year.

 Equivalence technique
• 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 the interest rate

• Compound Interest formulas can be used to facilitate

equivalence computations

• In economic analysis, "equivalence" means "the state of being

equal in value."
• Economic equivalence is a combination of interest rate and
time value of money to determine the different amounts of
money at different points in time that are equal in economic
value.
• The concept is primarily applied in the comparison of
different Cash Flows.
• Money changes value with time; therefore, one of the main
factors when considering equivalence is;
– To determine at which point(s) in time the money
transactions occur.
– The specific amounts of money involved in the
transactions.
– The interest rate at which the equivalence is evaluated
must also be considered
 Equivalence as a basis for determining time value of money
– Equivalence does not mean money today and money in the future are
equal.

– Equivalence do not consider risks but can be made to consider if

quantifiable and could be framed / estimated time wise

– Equivalence can make different scenarios comparable at different

times

– Non – equivalency indicates an initiative for choice depending on

which provides better value for money

– For construction related business often today’s money is much more

important; specifically in our country context
• The equivalent value of an amount that is borrowed now, at
future time period at a given interest rate depends on: -
– The type of interest whether simple or compound and
– The different loan repayment arrangements like;
 Payment of accumulated interest annually and
principal at the end of the stipulated interest periods
 Payment of both the principal and interest at the end
interest periods
 Payment of uniform amounts annually that comprises
a portion towards the payment of principal amount
and remaining for the accumulated interest
throughout the interest periods
• Equivalence indicates that different amount of money at
different time periods are equivalent by considering the time
value of money.

 What are the equivalent amounts of $15,000 (today) at an

interest rate of 9% per year for the following cases?

a. 1 year from now

b. 1 year before
 Manufacturers make backup batteries for computer systems
available to Batteries+ dealers through privately owned
distributorships. In general, batteries are stored throughout
the year, and a 5% cost increase is added each year to cover
the inventory carrying charge for the distributorship owner.
Assume you own the City Center Batteries + outlet. Make
the calculations necessary to show which of the following
statements are True and which are False about battery
costs.
i. The amount of $98 now is equivalent to a cost of $105.60 one
year from now.
ii. A truck battery cost of $200 one year ago is equivalent to $205
now.
iii. A $38 cost now is equivalent to $39.90 one year from now.
iv. A $3000 cost now is equivalent to $2887.14 one year earlier.
v. The carrying charge accumulated in 1 year on an investment of
$20,000 worth of batteries is $1000.
 Inflation
• By definition, inflation represents a decrease in the value of a
given currency
• When inflation occurs, the value of a dollar/money in the
future is reduced as compared to a dollar/money today
• In simple terms, interest rates reflect two things: a so-called
real rate of return plus the expected inflation rate.
• The real rate of return allows the investor to purchase more
than he or she could have purchased before the investment,
while inflation raises the real rate to the market rate that we
use on a daily basis.
• We see the effect of inflation in that money purchases less
now than it did at a previous time.
• Inflation contributes to:-
– A reduction in purchasing power of the currency
– An increase in the CPI (consumer price index)
– An increase in the cost of equipment and its maintenance
– An increase in the cost of salaried professionals and hourly
employees
– A reduction in the real rate of return on personal savings
and certain corporate investments
• National economies frequently experience inflation, in which
the cost of goods and services increases from one year to the
next.
• Normally, inflationary increases are expressed in terms of
percentages which are compounded annually.
• Thus, if the present cost of a commodity is PC, its future cost,
FC, will be
FC  PC (1   ) n

where
= annual inflation rate (expressed as a decimal)
n = number of years
 An economy is experiencing inflation at the rate of
6% per year. An item presently costs $100. If the 6%
inflation rate continues, what will be the price of
this item in five years?
• In an inflationary economy, the value (buying
power) of money decreases as costs increase.
Thus,
FC F 1
 
PC P (1   ) n

P
F
(1   ) n

• where F is the future worth, measured in today's dollars,

of a present amount P.
• If interest is being compounded at the same time that
inflation is occurring, then the future worth can be
determined by combining Inflation rate and interest rate

 1  i n   1 i 
n

F  P
 1   n
  P
 
  1  
defining the composite interest rate,
i
 
1 

F  P (1   ) n

Observe that  may be negative.

 An engineer has received $10,000 from his employer for a
patent disclosure. He has decided to invest the money in a
15-year savings certificate that pays 8% per year,
compounded annually. What will be the final value of his
investment, in terms of today's dollars, if inflation continues
at the rate of 6% per year?
 TAXES
• In most situations, the interest that is received from an
investment will be subject to taxation.
• Suppose that the interest is taxed at a rate t, and that the
period of taxation is the same as the interest period (e.g., one
year). Then the tax for each period will be T = tiP, so that the
net return to the investor (after taxes) will be;
I '  I  T  iP  tiP
I '  1  t iP
 If the effects of taxation and inflation are both
included in a compound interest calculation, the
formula used to relate present and future values
will be used as the composite interest rate

 
1  t i  
1 

F  P (1   ) n
 Refer to previous example on slide 53, Suppose the engineer
is in the 32% tax bracket, and is likely to remain there
throughout the lifetime of the certificate. If inflation
continues at the rate of 6% per year, what will be the value
of his investment, in terms of today's dollars, when the
certificate matures?
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