EMU365 Engineering Economy

Lecture 1 – Introduction to Engineering Economy

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Why Engineering Economy is Important to Engineers?

❑ Engineers design → Designing involves economic decisions

❑ Engineers must be able to incorporate economic analysis into their efforts
❑ Understanding and applying time value of money, economic equivalence, and
cost estimation are vital for engineers
❑ Project decisions are made more on the return on investment or payback than
on technology
❑ You must communicate the basics of economy for your proposals to get
funding

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Why Engineering Economy is Important to Engineers?

❑ Decisions are commonly the result of choosing one alternative over another
▪ Decisions involve money → capital
▪ Amount of capital is usually limited → where and how to invest to add value?
▪ Engineers play a major role in capital investment decisions

❑ Engineering economy involves formulating, estimating, and evaluating the

expected economic outcomes of alternatives designed to accomplish a
defined purpose
▪ Easy-to-use math techniques simplify the formulation and evaluation
▪ Estimates of economic outcomes can be deterministic or stochastic in nature

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Why Engineering Economy is Important to Engineers?

❑ Since decisions affect what will be done, the time frame of engineering
economy is the future
❑ Numbers used in engineering economy are best estimates of what is expected
to occur
▪ cash flows →The estimated inflows (revenues) and outflows (costs) of money
▪ time of occurrence → When do cash flows occur?
▪ interest rates → The charge for using money
▪ measure of worth → criterion used to select an alternative (PW, FW, ROR etc.)

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Why Engineering Economy is Important to Engineers?

Engineering economics is applied in an extremely wide variety of situations

▪ Equipment purchases and leases
▪ Construction projects
▪ Airport design and operations
▪ Sales and marketing projects
▪ Transportation systems of all types
▪ Product design
▪ Manufacturing processes
▪ Hospital and healthcare operations
▪ …

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Accounting vs. Engineering Economy

Evaluation Evaluation and

of past prediction of
performance future events

Accounting Engineering Economy

Past Future
Present

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Time Value of Money (TVM)

❑ TVM explains the change in the amount of money over time

❑ Corporate investments are expected to earn a return
▪ Investment always involves money
▪ Money has a ‘time value’

The time value of money is the most important concept

in engineering economy

Money makes money!

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Time Value of Money (TVM)

Which would you prefer?

❑ $100 cash today
❑ Assurance of receiving $100 a year from now (You will receive it for sure!)

You want the $100 now! :

❑ You can use it for an extra year
❑ If you had no need to use it, you could let some use it
▪ There is TVM in the form of willingness of banks, businesses, and people to pay interest
for its use

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General Steps for Decision Making Processes

1. Understand the problem – define

objectives
2. Collect relevant information – e.g., cash
flows, interest rate
3. Define the set of feasible alternatives
4. Define the criteria for decision making
5. Evaluate the alternatives
6. Select the “best” alternative
7. Implement the alternative and monitor
results

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General Steps for Decision Making Processes

How to choose the best alternative (Step 6)?

Alternative A has a rate of return (ROR) of 15.2% per year and Alternative B has
an ROR of 16.9% per year. Which one to chose?
❑ If only economic factors are considered → choose B
❑ If there are noneconomic or intangible factors → it depends
▪ Market pressures (e.g., need for an international presence)
▪ Availability of resources (e.g., skilled labor force, power)
▪ Government laws (e.g., safety, environmental issues)
▪ Management’s opinion
▪ …

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General Steps for Decision Making Processes

How to choose the best alternative (Step 6)?

❑ Every day we choose between alternatives
❑ For example, when you drive to campus, you decide to take the “best” route
▪ Was the best route the safest, shortest, fastest, cheapest, most scenic, or what?
❑ In economic analysis, financial units (dollars or other currency) are generally
used as the tangible basis for evaluation

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Interest and Interest Rate

❑ In Financial World money itself is a commodity

❑ Like any other commodities that are bought and sold money costs money
❑ Cost of money is measured by interest rate

Interest : the manifestation of the time value of money

▪ Fee that one pays to use someone else’s money
▪ Difference between an ending amount of money and a beginning amount of money
Interest = amount owed now − principal

Interest rate : interest paid over a time period (a percentage of principal)

interest accrued per time unit
Interest rate (% ) = × 100%
principal

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Interest and Interest Rate

Interest paid Interest earned

Interest rate Rate of return

❑ Two perspectives to an amount of interest

▪ Interest Paid: when money is borrowed and repaid as a larger amount
▪ Interest Earned: when money is invested and obtained back as a larger value

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Interest and Interest Rate

Example 1
A person borrows $10,000 on May 1 and must repay a total of $10,700 exactly
one year later. Determine the interest amount and the interest rate paid.

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Interest and Interest Rate

Example 2
A Consulting Company plans to borrow $20,000 from a bank for 1 year at 9 %
interest rate to buy new office equipment. Compute the interest and the total
amount due after 1 year.

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Rate of Return

Interest earned over a period of time is expressed as a percentage of the original

amount (principal)
interest accrued per time unit
Rate of return (%) = × 100%
original amount

❑ Same with the formula in Slide 12

❑ But we have different perspective here
▪ Borrower’s perspective – interest rate paid
▪ Lender’s or investor’s perspective – rate of return earned

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Rate of Return

Example
Calculate the amount deposited 1 year ago to have $1000 now at an interest
rate of 5% per year. Also, calculate the amount of interest earned during this
time period.

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Simple and Compound Interest

❑ For more than one interest period, the terms simple interest and compound
interest become important
❑ Simple Interest
▪ Interest is calculated using principal only
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = (𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙)(𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑝𝑒𝑟𝑖𝑜𝑑𝑠)(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒)
𝐼 = 𝑃𝑛𝑖

Example 1
$100,000 lent for 3 years at simple i = 10% per year. What is repayment after 3
years?

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Simple and Compound Interest

❑ Compound Interest
▪ Interest is based on principal plus all accrued interest
▪ That means interest earns interest and compounds over time
Interest = (principal + all accrued interest) (interest rate)
 j = t −1

Interest for time period t → It =  P +  I J  (i)
 j =1 
Total due at the end of time period t → P(1+i)𝑡

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Simple and Compound Interest

Example 2
$100,000 lent for 3 years at i = 10% per year compounded. What is repayment
after 3 years?

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Simple and Compound Interest

Example 3
Calculate the interest and payment amounts for a $5,000 loan which will be
repaid in 5 years at 8% per year compound interest under the following plans:
Plan1 : Pay all at end

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Simple and Compound Interest

Example 3
Calculate the interest and payment amounts for a $5,000 loan which will be
repaid in 5 years at 8% per year compound interest under the following plans:
Plan2 : Pay interest annually, principal paid at end

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Simple and Compound Interest

Example 3
Calculate the interest and payment amounts for a $5,000 loan which will be
repaid in 5 years at 8% per year compound interest under the following plans:
Plan3 : Pay interest and portion of principal ($1,000) annually

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Simple and Compound Interest

Example 3
Calculate the interest and payment amounts for a $5,000 loan which will be
repaid in 5 years at 8% per year compound interest under the following plans:
Plan4 : Pay equal amount of interest and principal

We used the following formula

(but we come back to its
derivation in next weeks)

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Commonly used Symbols

t = time, usually in periods such as years, months, days

P = value or amount of money at a time designated as present or time 0
▪ Present Worth (PW)
▪ Present Value (PV)
▪ Net Present Value (NPV)
F = value or amount of money at some future time, such as at t = n
▪ Future Worth (FW)
▪ Future Value (FV)
A = series of consecutive, equal, end-of-period amounts of money
n = number of interest periods; years, months, days
i = interest rate or rate of return per time period; percent per year or month
▪ compound unless otherwise stated
▪ expressed as percent per interest period
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Cash Flows

Cash Inflows – Revenues (R), receipts, incomes, savings generated by projects

and activities that flow in. Plus sign used

Cash Outflows – Disbursements (D), costs, expenses, taxes caused by projects

and activities that flow out. Minus sign used

Net Cash Flow (NCF) for each time period:

NCF = cash inflows − cash outflows = R − D

End-of-period assumption:
Funds flow at the end of a given interest period
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Cash Flows

Point estimate – A single-value estimate of a cash flow element of an alternative

Cash inflow: Income = $150,000 per month

Range estimate – Min and max values that estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M

Point estimates (a constant) are commonly used; however, range

estimates with probabilities assigned provide a better understanding of the
variability and sensitivity of economic parameters used to make decisions.

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Cash Flows

A typical cash flow diagram:

❑ Draw a timeline
Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period

❑ Show the cash flows

$100
$50

0 1 2 … … … n-1 n

P = $80 Cash flows are shown as directed arrows: + (up) for inflow F=?
- (down) for outflow
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Cash Flows

Example 1
You want to deposit an amount P now such that you can withdraw an equal
annual amount of A1 = $2000 per year for the first 5 years, starting 1 year after
the deposit, and a different annual withdrawal of A2 = $3000 per year for the
following 3 years. Plot the cash flows if i = 8.5% per year?

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Cash Flows

Example 2
A rental company spent $2500
on a new air compressor 7
years ago. The annual rental
income from the compressor
has been $750. The $100 spent
on maintenance the first year
has increased each year by
$25. The company plans to sell
the compressor at the end of
next year for $150. Construct
the cash flow diagram from the
company’s perspective.

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Economic Equivalence

❑ 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
❑ Different sums of money at different times may be equal in economic value at a
given rate
▪ $100 now is economically equivalent to $110 one year from now, if the $100 is invested at
a rate of 10% per year
$110

Year

0 1

Rate of return = 10% per year

$100 now

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Economic Equivalence

Example
Ali wants to borrow $10,000 now and repay it over the next 2 years. He received
2-year repayment options from banks A and B. If the interest rate is 5% per year,
which bank should be selected?

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Minimum Attractive Rate of Return (MARR)

❑ 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

❑ Also termed hurdle rate,

benchmark rate, cutoff rate and
minimum acceptable rate of return

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Minimum Attractive Rate of Return (MARR)

❑ MARR is established by the financial managers

❑ MARR is related to the cost of capital
▪ Equity Financing: Funds either from retained earnings, new stock issues, or owner’s
infusion of money
▪ Debt Financing: Borrowed funds from outside sources – loans, bonds, mortgages, venture
capital pools, etc. Interest is paid to the lender on these funds
▪ Weighted average cost of capital (WACC): Weighted average of Equity and Debt financing
❑ For an economically justified project → 𝐑𝐎𝐑 ≥ 𝐌𝐀𝐑𝐑 > 𝐖𝐀𝐂𝐂
❑ MARR usually considers the risk inherent to a project (the higher the risk
means the higher the MARR)

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