The University of the West Indies

Faculty of Engineering
Notes for: ENGR1000/MENG1006 - INTRODUCTION TO ENGINEERING
Prepared by Dr T.M.Lewis

FUNDAMENTALS OF ENGINEERING PROJECT ECONOMICS

LECTURE 2

1. Principles of Project Appraisal

1.1 In general terms the projects with which engineers tend to be involved are investment projects in
which a capital expenditure is involved. This usually means that there is a current outlay of cash
in return for an anticipated future flow of benefits.

1.2 The principles employed in project appraisal are those of economic evaluation. A similar
approach is taken to a project appraisal whether it is for:
- building a school
- a transportation facility
- the development of agricultural land,
- determining the scale of a manufacturing enterprise,
- determining whether to rent or buy equipment,
- determining the economic life of machinery,
- determining the degree of protection against flooding, hurricanes and earthquakes.

1.3 In the broadest terms these principles relate to the quantification of costs and benefits over the
life of the project. However, it is not sufficient simply to examine the total amounts of these costs
and benefits because of the 'time value of money'.

2 Present Value and Future Value

2.1 Effect of Time

People who receive income and do not buy all the goods to which they are entitled save, and this
money is available for others to use in investments. The people who refrain from consumption are
compensated for this in the form of interest. Thus, interest may be defined as the amount that
has to be paid for the use of borrowed money, and it is a rate (usually a percentage of any
principal involved) for a period of time (usually a year). The existence of interest means that a
sum now is worth more than an identical sum at some time in the future, and interest is a
measure of the time value of money.

If the existing interest rate is 10% per year, for example, the choice between having $100
now and $100 after one year can be assessed in two ways:

(i) $100 now can be invested at a rate of interest of 10% per annum to yield $110 at the end of
one year. This is $10 more than you would have had if you had taken the $100 after one year.

(ii) $90.91 invested now at a rate of interest of 10% per annum will yield $100 at the end
of one year. Thus you could spend $9.09 now and still end up with $100 after a year.

The choice is clear, either way. Because of the interest, the sum now is worth more than
the sum later, whether we look at the value to us now or in the future. Thus, the choice
between cash flows which arise at different times should never be made simply by
comparing their absolute amounts. Rather, the comparison should be made by
converting the sums to their equivalent values at a common point of time, whether it be
the present or the future.

A typical engineering project, whether it is a petro-chemical plant, a power station or the

acquisition of a new piece of machinery, involves a capital investment being made at the start,
with a series of returns being earned for its working life thereafter. Because different alternative
projects have different schedules of cash flows, with money coming in and going out at different
times, it is necessary to make these flows directly comparable in order to be able to choose
between them rationally. The process of discounting cash flows to the present, to the future or to
an annuity is the method that is used to do this.

Note that cash inflows are normally considered to be positive (+) whilst cash outflows are
considered negative (-). The net cash flow during any time period is simply the difference
between the cash inflows and the outflows, and it may be either positive or negative

2.3 Present Value

For an engineering project, receipts (benefits) and expenditures (costs) are generally most
conveniently compared at the start of the project. This can be considered as ‘the end of year
zero' or ‘the start of year 1’. All cash sums can be converted to an equivalent value by working
out what sum would have to be 'invested' at the going interest rate to give that sum at that time.
The equivalent sums at the start of year 1, are termed Present Values (in the example above,
the sum of $90.91 would have to be invested now to get $100 in one year at an interest rate of
10% per annum, so $90.91 is the present value of $100 one year from now at an interest rate of
10%).

The process of converting an amount to its equivalent at an earlier date is known as

discounting, and the interest rate involved (10% per annum in this case) is called the discount
rate.

SIMPLE I NTEREST:
Where the interest on some capital (present) sum or principal is not reinvested to earn more
interest on itself.

Where: i = interest rate; I = Interest earned; P = Present sum; F = Future sum

Interest earned in one year I1 = P.i
Interest earned in 2 years I2 = Pi + Pi = P.2i
Interest earned in n years In = P.ni

At end of n years the new principal (or the future sum) will be:

F = P + I = P + P.ni = P(1+ni)

F = P(1+ni)
Alternatively, by rearranging the equation, we can get an expression for the present value given
the future sum.
P = F/(1+ni)

Simple interest is quite rare in practice; it is much more common for compound interest
calculations to be required.
COMPOUND I NTEREST:
Where the interest each year is reinvested to earn more interest on itself.

Again where: i = interest rate; I = Interest earned; P = Present sum; F = Future sum

Year Amount at Interest Amount

start earned at end
of year during year of year
(a) (b) (a +b)
1 P P.i P(1+i)
2 P(1+i) P(1+i).i P(1+i)2
3 P(1+i)2 P(1+i)2.i P(1+i)3
n P(1+i)n-1 P(1+i)n-1.i P(1+i)n

Thus, the future value $F, of the principal $P, after n years at compound interest rate i, is given by
the last entry in this table:

F = P(1+i)n

Rearranging the equation also tells us that:

P= F
(1 + i)n

Thus the present value of $100 received one year from now with interest rates at 10% per year
will be:

P = $ 100 = $90.91
(1.1)1

2.3 Future Value

The future value is simply the accumulated value that a sum of money at a previous date will
appreciate to due to the effects of applying interest. The future value $F, of a sum with a present
value of $P, after n years, at a compound rate of interest i, is (as given above):

F = P(1 + i)n

Here, the future value in one year's time of $100 now, with interest rates of 10% per year will be:

F = 100(1.1)1 = $110

3 Significance of Present Value Calculations

3.1 The importance of using discounted cash flows can best be demonstrated by use of an
example. The following example relates to a particular investment project for which estimates
have been made of the expected initial cash outlay and subsequent cash receipts. This is the
typical pattern for cash flows in an engineering project.

Example 1
It is estimated that the initial cash outlay for a project is $100,000. The project will earn receipts of
$40,000, $50,000 and $40,000 at the end of the first, second and third years and then come to an
end. The interest rate is 10% per annum. Should this investment be recommended?
Analysis
At first sight, cash receipts exceed the outlay, an so the project would appear to bring in $30,000
more than it costs. This might suggest that the project should be accepted. However, what about
the interest that would be received if the money just sat in a bank earning interest?

Let us look at the project in terms of the present values of all of the cash flows.

Present value of outlay = -$100,000

Present value of receipts

1st year $40,000/1.1 = $36,363.64
2nd year $50,000/1.12 = $41,322.31
3rd year $40,000/1.13 = $30,052.59
Total present value of receipts = $107,738.54 = + $107,738.54
Net Present value = + $7,738.54

The fact that the net present value is positive, indicates a return in excess of 10% per annum. It
means that the value of having the three future income flows is greater than the value of having
$100,000 now under present conditions.

The test of acceptability when using present values is that when the net present value is positive
the test is satisfied and therefore the investment can be recommended.

This project can be looked at in another way, that is, from the perspective of the future worth of
the project cash flows. Interest at 10% per year can be earned on the cash sum of $100,000
used for this investment, so the total future value of leaving the $100,000 in the bank, after 3
years compounding the interest would be:

Fbank = 100,000(1.1)3 = 100,000x1.331 = $133,100

Now, this is more than the simple sum of the three yearly receipts ($130,000); however, their
values are all at different points in time, so they have to be made consistent by converting to one
point in time . In this case we are looking at the future value, three years from now, of these cash
flows:

Fproject = 40,000x1.21 + 50,000x1.1 + 40,000 = $143,400

This is higher than the future value of the capital sum plus interest when left in the bank, so the
project can go ahead. Once again the test of acceptability is satisfied if the net future value of the
cash flows is positive. Note that if you discount these future values back to the present you get
the same values as are given in the present value calculation above.

4 Interest Rates
4.1 Why do interest rates exist, and what determines them? Economically, interest rates
exist on the supply side because it is a necessary incentive to saving, and on the demand side
because capital investments are productive. Thus both borrowers and lenders see potential
advantages to themselves from the existence of savings and interest.
There are three major factors which influence the level of interest rates, and they are
1. the state of the economy, and
2. the risk involved.
3. the demand for investment