Lecture # 4

Engineering Economics (MS-291)

Ch1: Foundations of Engineering Economy

Dr. Maazullah Khan

PhD, MSc, MBA
Associate Professor of Practice
Department of Management Sciences GIKI
Recap
• Time Value of Money: You need compensation for;
– postponing consumption
– losing an opportunity to invest
• Cash Flow Diagram
– Cash Inflows represented by + sign and upward arrow
– Cash outflows represented by – sign and downward arrows
Economic Equivalence
•Definition:
  Combination of interest rate (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 and time in upcoming relations to move
money (values of P, F and A) between time points to make them equivalent
at the rate .
Example: Economic Equivalence
• Different
  sums of money at different times may be equal in economic value at a given rate of interest.
=> Numerically, but they are economically equivalent.

$12

0 Rate of return = 20% per year 1

$10
• $10 now is economically equivalent to $12 one year from now, if the $10 are invested at a rate of 20%
per year.
Example: Economic Equivalence
•There
  exists a value which is economically equivalent to all the cash flows.
Types of Interest
• Simple Interest
=> Interest is earned only on PRINCIPAL

• Compound Interest
=> Interest is earned on PRINCIPAL and INTEREST previously earned
Simple Interest
•  Simple Interest is calculated using Principal only.
• Suppose a company XYZ borrows for years carrying a simple interest rate of .
• The total simple interest (in $) on principal over a period of having an interest rate of is
given by;

• At the end of years, XYZ will pay back principal and the accumulated simple interest
Example: Simple Interest
• HBL
  lends an engineering company Rs. 1,000,000 to install solar panels in their main
office. The loan is for 4 years at 10% simple interest rate per year.
• Q: How much money will company pay at the end of 4 years?
• Solution1:

• Solution2:
Compound Interest
• Interest is calculated on PRINCIPAL and INTEREST previously earned.
• In other words, interest on interest.
• It is the result of reinvesting interest, rather than paying it out.
• So, that interest in the next period is then earned on the principal sum plus previously
accumulated interest.
• In practice Compound Interest Rate is used.
• Whenever, you are required to calculate interest and it’s not specified; it always mean
compound interest.
Compound Interest
•   Suppose you invest $100 today @ 10% at time
After one year, at ;

After one year, at ;

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As you can see, the basis of calculation for is $110 which is composed of $100 principal
and $10 interest previously earned.
Simple and Compound Interest Comparison
Simple Interest Graph Compound Interest Graph
Power of Compounding
Future value of $1 invested for various time periods at an 8% annual interest rate

Source: Fundamentals of Financial Management by Van Horne

Minimum Attractive Rate of Return
• Minimum Attractive Rate of Return (MARR): is 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.
• MARR is also termed hurdle rate, benchmark rate or cutoff rate.
Characteristics of MARR

• MARR is established by the financial managers of the firm.

• MARR is fundamentally connected to the cost of capital.

• 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.

Size of MARR relative to other rate of
return values
Sources of Capital
Mainly two sources of capital
1.Equity Capital:
– not paid to investors in the normal course of business
– equity capital is provided by owners or shareholders
– equity capital is also called equity financing or share capital
2. Debt Capital:
– capital raised through bank loans and corporate bonds
– loans are repayable in future
– dividends to shareholders are only paid after interest on debt capital is paid
Weighted Average Cost of Capital (WACC)
• If capital is used from more than one sources; then we need to calculate
WACC.
• For example, a combination of debt and equity then the cost of capital is a
weighted average cost of capital (WACC).
• While making business decisions, firms compare weighted average cost of
capital with the expected rate of return.
• Return on project should be higher that weighted average cost of capital
for being accepted.
Problem 1.41 (p.34)
Managers from different departments in Zenith Trading, a large multinational corporation,
have offered six projects for consideration by the corporate office. A staff member for the
chief financial officer used key words to identify the projects and then listed them in order
of projected rate of return as shown below. If the company wants to grow rapidly through
high leverage and uses only 10% equity financing that has a cost of equity capital of 9%
and 90% debt financing with a cost of debt capital of 16%, which projects should the
company undertake?
Solution
Solution
•   Undertake those project where the

Decision: Projects having more than 15.3% ROR will be undertaken.

=> Inventory, Technology and Warehouse projects will be accepted/undertaken
=> Please note that typically
Using Returns for Decision Making
•  

• Accept a project if expected

• MARR should be greater than WACC.
• If ⇒ it means that all project returns go to the capital providers and thus there is no
value addition.
• If ⇒ it means that the project return are not enough even to meet the expectations of
capital providers and thus there is negative value addition. i.e. the company shrunk.
 Thank You

Any Questions?
Email: maazullah@giki.edu.pk

Teaching Assistant: Ms. Sabahat Orakzai

sabahat@giki.edu.pk
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin [ISBN-
10: 0073376302]

• Videos from Dragon’s Den are copy righted. We are using it only for educational
purposes.

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