Chapter 1

Foundations Of
Engineering
Economy

Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

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 LEARNING OUTCOMES

1. Role in decision 7. Economic equivalence

making 8. Simple and compound
2. Study approach interest

3. Interest rate 9. Minimum attractive

rate of return
4. Terms and symbols
10. Spreadsheet
5. Cash flows functions

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Why Engineering Economy is Important to
Engineers

 Engineers design and create

 Designing involves economic decisions
 Engineers must be able to incorporate economic
analysis into their creative efforts
 Often engineers must select and implement from
multiple alternatives
 Understanding and applying time value of money,
economic equivalence, and cost estimation are vital
for engineers
 A proper economic analysis for selection and
execution is a fundamental task of engineering
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Why Engineering Economy is
Important to Engineers

Decision made by engineers,

manger, individuals…..etc are
the result of choosing one
alternative over others.

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 Role of Engineering Economy in
Decision making

The time frame of engineering economy is

primarily in the future.
The estimate involve four essential element
1. cash flow.
2. Time of occurrence of cash flow.
3. Interest rates for time value of money.
4. Measuring of economic worth for selecting
an alternative.
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 Role of Engineering Economy in
Decision making

The estimate will be somewhat different than

what actually occurs due to :
 Changing circumstances
 Unplanned for events

As result, sensitivity analysis is important

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 Sensitivity analysis

Sensitivity analysis : is used to explore what

happens to a project profitability when the
estimated value of study factors are changed.

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General Steps for Decision Making Processes

1. Understand the problem – define objectives

2. Collect relevant information
3. Define the set of feasible alternatives
4. Identify the criteria for decision making
5. Evaluate the alternatives and apply
sensitivity analysis
6. Select the “best” alternative
7. Implement the alternative and monitor
results
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 Time Value of Money (TVM)
Description: TVM explains the change in the
amount of money over time for funds owed
(borrowed) by or owned (invested) by a
corporation (or individual)

 Corporate investments are expected to earn a return

 Investment involves money
 Money has a ‘time value’
The time value of money is the most
important concept in engineering
economy
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 Interest and 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 expressed

as a percentage of principal

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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 (%) = x 100%
original amount

 Borrower’s perspective – interest rate paid

 Lender’s or investor’s perspective – rate of return earned

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Interest paid Interest earned

Interest rate Rate of return

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 Interest rates

Interest rates reflect two things:

1. Real rate of return

2. The expected inflation rate

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 Interest Rate

Inflation contributes to the following :

1. A reduction in purchasing power of the currency
2. An increase in the cost of equipment and its
maintenance
3. An increase in the cost of salaries for
professionals and hourly employee
4. A reduction in the real rate of return on personal
savings and certain corporate investment.

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Example

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Example

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Example

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 Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month

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 Cash Flows: Terms
 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: Estimating
 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 are commonly used; however, range estimates
with probabilities attached provide a better understanding of
variability of economic parameters used to make decisions

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 Cash Flow Diagrams
What a typical cash flow diagram might look like
Draw a time line Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow
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 Cash Flow Diagram Example
Plot observed cash flows over last 8 years and estimated sale next
year for $150. Show present worth (P) arrow at present time, t = 0

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 Chapter 1
Foundations Of Engineering
Economy
 Interest and 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 expressed

as a percentage of principal

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 Commonly used Symbols
t = time, usually in periods such as years or months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time period;
percent per year or month

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 Cash Flows: Terms
 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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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 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 rate i and time t in upcoming

relations to move money (values of P, F and A)
between time points t = 0, 1, …, n to make
them equivalent (not equal) at the rate i

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 Example of Equivalence
Different sums of money at different times may
be equal in economic value at a given rate
$110

Year

0 1
Rate of return = 10% per year

$100 now

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year.

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 Simple and Compound Interest

 Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = Pni

Example: $100,000 lent for 3 years at simple i = 10%

per year. What is repayment after 3 years?
Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

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 Simple and Compound Interest
 Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time

Interest = (principal + all accrued interest) (interest rate)

Interest for time period t is

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 Compound Interest Example
Example: $100,000 lent for 3 years at i = 10% per
year compounded. What is repayment after 3
years?
Interest, year 1: I1 = 100,000(0.10) = $10,000
Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000
Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100
Compounded: $133,100 Simple: $130,000
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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 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
 Also termed hurdle rate,
benchmark rate and cutoff
rate

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 MARR Characteristics
 MARR is established by the financial
managers of the firm
 MARR is fundamentally connected to the cost
of capital
ROR ≥ MARR > Cost of Capital
 Cost of Capital : how much it costs to obtain
the needed capital funds.
MARR usually considers the risk inherent to a
project

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 Types of Financing

 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
For an economically justified project
ROR ≥ MARR > WACC
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 Types of Financing

Example:
A company has debt of 200million and equity
of 300 million . The after tax cost of debt is 6%
and the cost of equity is 14%. What is the cost
of capital ?
%debt = 200/(200+300) = 40%
%equity = 300/(200+300) = 60%

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Types of Financing

The cost of capital , weighted average cost of

capital is used (WACC)

WACC = 40%*60%+60%*14% =10.8%

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 Chapter 2
Factors : How Time and Interest
AffectMoney
 Single Amount Factors(F/P and P/F)

One of the most fundamental factors in

engineering economy which is the one that
determine the amount of money F
accumulated after n years from single present
P with interest compounded one time per year.

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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Uniform series present worth factor

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 Opportunity Cost
 Definition: Largest rate of return of all projects not
accepted (forgone) due to a lack of capital funds
 If no MARR is set, the ROR of the first project not undertaken
establishes the opportunity cost

Example: Assume MARR = 10%. Project A, not

funded due to lack of funds, is projected to
have RORA = 13%. Project B has RORB = 15%
and is funded because it costs less than A
Opportunity cost is 13%, i.e., the opportunity to
make an additional 13% is forgone by not
funding project A
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 Introduction to Spreadsheet Functions
Excel financial functions
Present Value, P: = PV(i%,n,A,F)
Future Value, F: = FV(i%,n,A,P)
Equal, periodic value, A: = PMT(i%,n,P,F)
Number of periods, n: = NPER((i%,A,P,F)
Compound interest rate, i: = RATE(n,A,P,F)
Compound interest rate, i: = IRR(first_cell:last_cell)
Present value, any series, P: = NPV(i%,second_cell:last_cell) + first_cell

Example: Estimates are P = $5000 n = 5 years i = 5% per year

Find A in $ per year
Function and display: = PMT(5%, 5, 5000) displays A = $1154.87

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 Chapter Summary
 Engineering Economy fundamentals
 Time value of money
 Economic equivalence
 Introduction to capital funding and MARR
 Spreadsheet functions
 Interest rate and rate of return
 Simple and compound interest

 Cash flow estimation

 Cash flow diagrams
 End-of-period assumption
 Net cash flow
 Perspectives taken for cash flow estimation
 Ethics
 Universal morals and personal morals
 Professional and engineering ethics (Code of Ethics)
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