Chapter 1: Foundations of

Engineering Economy

Instructor: Anshu Jalora

Objective
 How can we make better decisions?
 Understand “better” decisions.
 Identify related mathematical tools,
terminology and techniques (TTT).

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Purpose of Engineering Economy
 Value adding decisions (Value? Installing self
checkout terminals at Wal-mart vs. manual checkout)
 Decisions involve costs (salaries, equipment,…)
 Compare alternatives on economic factors (profits)
 Cash flows, timing and external factors (interest rate)
 A collection of mathematical techniques that simplify
economic comparison is ‘Engineering Economy’

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Engineering Economic Analysis
 Outcomes of decisions made in past
 Expected future outcomes of alternative
decisions yet to be made
 Involves estimates that are usually
stochastic in nature
 Role of sensitivity analysis (what if…?)

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When selecting from alternatives
1. Understand the problem and define the objective (checkout
system?)
2. Collect relevant information (?)
3. Define feasible alternatives and make realistic estimates
4. Identify selection (decision making) criteria
5. Evaluate alternatives
6. Select the best alternative
7. Implement
8. Monitor

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Six Sigma
 Steps in Six Sigma process
 Define
 Measure
 Analyze
 Implement
 Control

 Dell Makes All Its Computers Reliable (?)

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Selection Criteria
 Examples:
 Present worth (PW) Future worth (FW)
 Payback period Annual worth (AW)
 Rate of return (ROR) Economic value added
 Benefit/cost ratio (B/C) Capitalized cost (CC)
 Time value of money
 The change in the amount of money over a given
time period
 Pay credit card bills now vs. pay 6 months later

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Selecting Alternatives…
 Alternative Description
 Example: (1) Install new (2) Upgrade old
 Parameters:
 Static: Costs (purchase price, installation costs,
etc), useful life, salvage value
 Operational (stochastic, controllable) :
Estimated revenues and operating expenses
 External (stochastic, uncontrollable) : Interest
rate, taxes, inflation

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Selecting Alternatives…
 Cash Flows
 Estimated inflows (revenues) and outflows
(costs)
 Alternative Selection
 Define selection criteria (single or multiple)
 Analyze
 Select

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Interest Rate and Rate of Return
 Interest owed
= amount owed now – original amount
Interest rate (%) = ??
 Interest earned
= total amount now – original amount
Rate of return (%) = ??
ROR ~ Return on Investment (ROI)

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Interest
 Simple
 Compound
 Interest earns interest
 Interest period
 Time unit for rate of return. The most
common period is 1 year

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Inflation
 Represents a decrease in the value of a
currency over a period of time
 Reduction in purchasing power of the currency
 Increase in the consumer price index (CPI)
 Increase in the future costs (Ex. Maintenance)
 Increase in salaries (Ex. Minimum hourly rate)
 Reduction in ‘real’ rate of return on investments
 Inflation and investments
 Currency A: ROR 4%, Inflation 3%
 Currency B: ROR 3.5%, Inflation 2%

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Economic Equivalence
 $100 now and $110 a year later when
rate of interest is 10% per year.

 Equivalence between different sums of

money at different points in time by
taking into account the time value of
money

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Simple vs. Compound Interest
 Simple Interest
 Calculated using the principal amount only


Total Simple Interest
= Principal * Number of Periods * Interest Rate
 Compound Interest
 Interest is calculated on principal plus interest

accumulated in all previous periods

 Compound Interest per period
= (principle + all accrued interest) * Interest Rate
 PS: Interest Rate is expressed in decimal form (10% = 0.10)

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Compound Interest
 Example:
 Principle = $1000; Interest Rate = 10%; Time = 2yrs
 SI (Total) = 1000*2*0.1 = $200
 CI (yr 1) = 1000*0.1 = $100
 CI (yr 2) = 1100*0.1 = $110
 CI (Total) = $210
 CI (Total)
= Principle*(1+interst rate) number of years-Principle
 CI (Total) = 1000 *(1.1)2 – 1000 = $210

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Commonly Used Notation
 P: Value of money at a designated time or at
time 0 (present time).
 F: Value of money at some future time.
 A: Series of consecutive, equal, end of
period amounts of money.
 n: Number of interest periods
 i: Interest rate or rate of return per time
period
 T: Time, stated in periods.

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Examples
 1.10 – 1.14

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Using Excel
 Appendix A
 Commonly used Excel Functions:
 PV (i%, n, A, F): To find present value
 FV (i%, n, A, P): To find future value
 PMT (i%, n, P, F): To find value A
 NPER (i%, A, P, F): To find n
 RATE (n, A, P, F): To find i (assuming CI)
 IRR (first_cell:last_cell): To find i (assuming CI)
 NPV (i%, second_cell:last_cell)+first_cell: To find present
value P of any series

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Minimum Attractive Rate of Return
 MARR is the minimum rate of return for
selecting an alternative.
 aka Hurdle rate
 Higher than the rate expected from a
bank or some safe investment (Why?)
 ROR >= MARR > cost of capital
 It is selected and not computed

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Capital
 Capital (money) is required to finance
decisions
 Two ways to obtain capital:
 Equity Financing
 Use one’s own funds
 Cost of Capital is the interest being currently earned (Ex.
Bank savings rate of return)
 Debt Financing
 Borrow from outside sources
 Responsible for paying interests and principal as per
schedule
 Cost-of-Capital is the interest rate

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Cash Flows
 Two Form of flows
 Cash inflows
 Revenues; Operating cost reductions;…
 Cash outflows
 Cost of assets; Operating costs;…
 New cash flow = cash inflow – cash outflow
 These are estimates
 Point Estimates
 Distribution Estimates

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End of Period Convention
 End of period refers to end of interest
period and NOT end of calendar year
 All cash flows are assumed to occur at
the end of an interest period
 If there are multiple cash flows in an
interest period, net cash flow is
assumed to occur at the end of the
interest period

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 Cash Flow Diagram
Year 1 Year 5

0 1 2 3 4 5
Time
+
Cash Flow, $

0 1 2 3 Time

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Doubling Time: Rule of 72
 Time required for an initial single
amount to double in size with
compound interest is approximately:
72/i

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