ENGINEERING ECONOMICS

MUHAMMAD LABEEB FA21-BME-023

DATE March 06, 2024
SECTION BME-6/A
COURSE INSTRUCTOR Mr. Meiraj
Assignment Number 1
Due Date: Friday, 1st March, 2024
1. What is overhead cost/expense. Explain in 3-4 lines with example.
2. How would you differentiate between fixed cost and variable cost.
3. How would you differentiate between direct cost and indirect cost.
4. How would you define opportunity cost. Explain in 3-4 lines with example.
5. Assume you have a business idea where the investor will have to invest 100,000 upfront and
he will earn 20,000 for 3 years at the end of each year and then 60,000 at the end of 4th year.
a. Make a cashflow diagram from above information.
b. Calculate if the investment is favorable or not. Assume, i. Interest rate is 10% compounded
annually (no compounding) ii. Interest rate is 10% compounded semi-annually.

1.
Overhead costs or expenses refer to the ongoing operational expenses incurred by a business that
are not directly attributable to the production of goods or services. These costs are necessary for
the functioning of the business but are not directly tied to specific products or services. Examples
include rent for office space, utilities, administrative salaries, and depreciation of equipment.
For instance, consider a manufacturing company: while direct costs such as raw materials and
labor are directly related to producing goods, overhead costs like rent for factory space,
maintenance expenses, and managerial salaries are essential but not directly tied to any specific
product. Overhead costs are vital for the business to operate smoothly and are typically spread
across all products or services, influencing pricing decisions and overall profitability. Efficient
management of overhead costs is crucial for maintaining a healthy bottom line.

2.
Fixed costs and variable costs are two key components of a company's total expenses, and they
differ in how they behave with changes in production levels or business activity.
Fixed costs remain constant regardless of the level of production or sales volume. These costs are
incurred regularly and are not directly influenced by changes in output. Examples include rent
for office space, salaries of permanent staff, and insurance premiums. Regardless of whether the
company produces one unit or a thousand units, fixed costs remain unchanged.
In contrast, variable costs fluctuate in direct proportion to changes in production levels or
business activity. These costs increase as production increases and decrease as production
decreases. Examples include raw materials, direct labor, and utilities directly tied to production.
For instance, if a bakery produces more loaves of bread, the cost of flour and labor will increase
accordingly.
Understanding the distinction between fixed and variable costs is crucial for businesses in
making decisions related to pricing, production levels, and overall cost management strategies.

3.
Direct costs and indirect costs are classifications used to categorize expenses based on their
relationship to the production of goods or services and their traceability to specific cost objects.
Direct costs are expenses that can be directly attributed to a specific product, project, or
department. These costs are incurred solely because of the production process and vary with the
level of output. Examples include raw materials, labor directly involved in production, and
specific equipment used for a particular project.
On the other hand, indirect costs are expenses that cannot be easily traced back to a specific cost
object and are incurred for the general operation of the business. These costs are typically shared
across multiple products, projects, or departments. Examples include rent for shared facilities,
utilities, administrative salaries, and depreciation of shared equipment.
For instance, in a manufacturing company, the cost of raw materials used in a particular product
line is a direct cost, while the salary of the factory manager overseeing multiple product lines is
an indirect cost. Understanding the distinction between direct and indirect costs is crucial for
accurate cost allocation, pricing decisions, and overall cost management strategies.

4.
Opportunity cost refers to the value of the next best alternative forgone when a decision is made.
It represents the potential benefits that are lost when one alternative is chosen over another. In
essence, it highlights the trade-offs inherent in decision-making, where choosing one option
means giving up the benefits of another.
For example, consider a student who has to decide between studying for an exam or going to a
movie with friends. If the student chooses to study, the opportunity cost is the enjoyment and
social interaction gained from going to the movie. Conversely, if the student chooses to go to the
movie, the opportunity cost is the potential higher grade or deeper understanding of the subject
that could have been achieved through studying.
Understanding opportunity cost is crucial in various contexts, including business decisions,
personal finance, and resource allocation, as it helps individuals and organizations make
informed choices by weighing the benefits and drawbacks of different alternatives.

5.
Year 0: -100,000 (Initial Investment)
Year 1: +20,000 (End of Year 1)
Year 2: +20,000 (End of Year 2)
Year 3: +20,000 (End of Year 3)
Year 4: +60,000 (End of Year 4)
i. Interest rate is 10% compounded annually (no compounding): Using the formula for present
value of annuity:
PV = PMT × [(1 - (1 + r)^-n) / r]
Where: PV = Present Value PMT = Payment (annuity) r = interest rate per period n = number of
periods
For the annuity payments of 20,000 for 3 years: PV_annuity = 20,000 × [(1 - (1 + 0.10)^-3) /
0.10] ≈ 20,000 × 2.48685 ≈ 49,737
For the single payment of 60,000 at the end of the 4th year: PV_single_payment = 60,000 / (1 +
0.10)^4 ≈ 41,322
Total Present Value = PV_annuity + PV_single_payment ≈ 49,737 + 41,322 ≈ 91,059
Since the initial investment is 100,000, and the present value of the future cash flows is less than
the initial investment, the investment is not favorable.
ii. Interest rate is 10% compounded semi-annually: The calculation would involve adjusting the
interest rate (r) and the number of periods (n) accordingly for semi-annual compounding. After
recalculating the present value of the cash flows, we compare it with the initial investment to
determine favorability.
Comparing the two scenarios, the investment would be more favorable when the interest rate is
compounded semi-annually if the present value of the future cash flows exceeds the initial
investment.
Assignment (Continued)
1. You plan to receive $15,000 in 4 years. If the discount rate is 6% annually, what is the present
value of this amount?
2. If you invest $3,000 at an annual interest rate of 5% for 7 years, what will be the future value?
3. You will receive $800 each year for the next 6 years. If the discount rate is 8%, what is the
present value of this annuity?
4. If you deposit $250 each month into a savings account that pays 3% interest compounded
monthly, what will be the future value after 4 years?
5. You will receive $500 in one year, $1,200 in three years, and $1,800 in five years. If the
discount rate is 5%, what is the present value of these cash flows?
6. If you invest $1,500 today and expect to receive $300 in one year and $800 in three years,
what will be the future value at the end of three years, assuming a 4% interest rate?
7. You plan to receive $1,000 each year for the next 8 years. If the discount rate is 7%, what is
the present value of this annuity?
8. If you invest $4,500 at an annual interest rate of 4% for 10 years, what will be the future
value?
9. You plan to receive $700 each quarter for the next 3 years. If the discount rate is 6%, what is
the present value of this quarterly annuity?
10. You deposit $600 per year into an account that earns an annual interest of 5%. If you plan to
keep making deposits for the next 6 years, what will be the future value?

1.
To calculate the present value of $15,000 received in 4 years with a discount rate of 6%
annually, you can use the formula for the present value of a single future cash flow:
PV = FV / (1 + r)^n
Where: PV = Present Value FV = Future Value r = discount rate per period n = number of
periods
Substituting the given values: PV = 15,000 / (1 + 0.06)^4
Calculating the denominator: (1 + 0.06)^4 = (1.06)^4 ≈ 1.262476
Now, divide the future value by the denominator: PV ≈ 15,000 / 1.262476 ≈ 11,875.55
So, the present value of receiving $15,000 in 4 years with a discount rate of 6% annually is
approximately $11,875.55.

2.
To calculate the future value of an investment with compound interest, you can use the formula:
FV = PV × (1 + r)^n
Where: FV = Future Value PV = Present Value (initial investment) r = annual interest rate (in
decimal) n = number of periods
Substituting the given values: PV = $3,000 r = 5% or 0.05 n = 7 years
Now, plug these values into the formula: FV = 3000 × (1 + 0.05)^7
Calculating the value inside the parentheses: (1 + 0.05)^7 = (1.05)^7 ≈ 1.407100
Now, multiply the present value by this result: FV ≈ 3000 × 1.407100 ≈ 4221.30
So, the future value of investing $3,000 at an annual interest rate of 5% for 7 years would be
approximately $4,221.30.

3.
To calculate the present value of an annuity, where you receive a fixed amount of money each
period for a specified number of periods, you can use the formula:

\[ PV = PMT \times \left( \frac{1 - (1 + r)^{-n}}{r} \right) \]

Where:
- \( PV \) = Present Value of the annuity
- \( PMT \) = Payment received each period (annuity)
- \( r \) = Discount rate per period
- \( n \) = Number of periods

Given:
- \( PMT \) = $800 (received each year for the next 6 years)
- \( r \) = 8% or 0.08
- \( n \) = 6 years

Now, plug these values into the formula:

\[ PV = 800 \times \left( \frac{1 - (1 + 0.08)^{-6}}{0.08} \right) \]

First, calculate the value inside the parentheses:

\[ (1 + 0.08)^{-6} = (1.08)^{-6} \approx 0.6270 \]

\[ 1 - 0.6270 \approx 0.3730 \]

Now, divide this by the discount rate:

\[ \frac{0.3730}{0.08} \approx 4.6625 \]

Now, multiply the payment by this result:

\[ PV \approx 800 \times 4.6625 \approx 3,730 \]

So, the present value of receiving $800 each year for the next 6 years with a discount rate of 8%
is approximately $3,730.

4.
To find the future value of regular monthly deposits into a savings account with compound
interest, you can use the future value of an annuity formula:

\[ FV = PMT \times \left( \frac{(1 + r)^{nt} - 1}{r} \right) \]

Where:
- \( FV \) = Future Value
- \( PMT \) = Payment per period (monthly deposit)
- \( r \) = Interest rate per period (monthly interest rate)
- \( n \) = Number of times the interest is compounded per period (monthly compounding)
- \( t \) = Total number of periods (in months)

Given:
- \( PMT \) = $250 (monthly deposit)
- \( r \) = 3% per year or 0.03/12 per month
- \( n \) = 12 (monthly compounding)
- \( t \) = 4 years = 4 * 12 = 48 months

Now, plug these values into the formula:

\[ FV = 250 \times \left( \frac{(1 + \frac{0.03}{12})^{12 \times 4} - 1}{\frac{0.03}{12}} \right)

\]

Calculate the value inside the parentheses first:

\[ (1 + \frac{0.03}{12})^{12 \times 4} = (1.0025)^{48} \approx 1.13144 \]

\[ (1.13144 - 1) \approx 0.13144 \]

Now, divide this by the monthly interest rate:

\[ \frac{0.13144}{\frac{0.03}{12}} \approx 5.56158 \]

Now, multiply the payment by this result:

\[ FV \approx 250 \times 5.56158 \approx 1,390.40 \]

So, the future value of depositing $250 each month into a savings account with 3% interest
compounded monthly, after 4 years, will be approximately $1,390.40.
5.
To find the present value of these cash flows, we'll use the formula for calculating the present
value of multiple future cash flows:

\[ PV = \frac{FV_1}{(1 + r)^1} + \frac{FV_2}{(1 + r)^2} + \frac{FV_3}{(1 + r)^3} \]

Where:
- \( PV \) = Present Value
- \( FV_1, FV_2, FV_3 \) = Future cash flows at respective time periods
- \( r \) = Discount rate

Given:
- \( FV_1 \) = $500 (received in one year)
- \( FV_2 \) = $1,200 (received in three years)
- \( FV_3 \) = $1,800 (received in five years)
- \( r \) = 5% or 0.05

Now, plug these values into the formula:

\[ PV = \frac{500}{(1 + 0.05)^1} + \frac{1200}{(1 + 0.05)^3} + \frac{1800}{(1 + 0.05)^5} \]

Calculate the values inside the parentheses:

\[ (1 + 0.05)^1 = 1.05 \]

\[ (1 + 0.05)^3 = (1.05)^3 \approx 1.15763 \]

\[ (1 + 0.05)^5 = (1.05)^5 \approx 1.27628 \]

Now, calculate the present value:

\[ PV = \frac{500}{1.05^1} + \frac{1200}{1.15763} + \frac{1800}{1.27628} \]

\[ PV = \frac{500}{1.05} + \frac{1200}{1.15763} + \frac{1800}{1.27628} \]

\[ PV = 476.19 + 1036.76 + 1411.60 \]

\[ PV \approx 2924.55 \]

So, the present value of receiving $500 in one year, $1,200 in three years, and $1,800 in five
years with a discount rate of 5% is approximately $2,924.55.

6.
To find the future value of these cash flows, we can use the formula for calculating the future
value of multiple future cash flows:

\[ FV = PV \times (1 + r)^n + FV_1 + FV_2 \]

Where:
- \( FV \) = Future Value
- \( PV \) = Present Value (initial investment)
- \( r \) = Interest rate per period
- \( n \) = Number of periods
- \( FV_1, FV_2 \) = Future cash flows at respective time periods

Given:
- \( PV \) = $1,500 (initial investment)
- \( FV_1 \) = $300 (received in one year)
- \( FV_2 \) = $800 (received in three years)
- \( r \) = 4% or 0.04
- \( n \) = 3 years

Now, plug these values into the formula:

\[ FV = 1500 \times (1 + 0.04)^3 + 300 + 800 \]

Calculate the value inside the parentheses:

\[ (1 + 0.04)^3 = (1.04)^3 \approx 1.124864 \]

Now, calculate the future value:

\[ FV = 1500 \times 1.124864 + 300 + 800 \]

\[ FV = 1687.30 + 300 + 800 \]

\[ FV \approx 2787.30 \]

So, the future value of investing $1,500 today, expecting to receive $300 in one year and $800 in
three years, with a 4% interest rate, at the end of three years will be approximately $2,787.30.

7.
To calculate the present value of an annuity, we can use the formula:

\[ PV = PMT \times \left( \frac{1 - (1 + r)^{-n}}{r} \right) \]

Where:
- \( PV \) = Present Value of the annuity
- \( PMT \) = Payment received each period (annuity)
- \( r \) = Discount rate per period
- \( n \) = Number of periods

Given:
- \( PMT \) = $1,000 (received each year for the next 8 years)
- \( r \) = 7% or 0.07
- \( n \) = 8 years

Now, plug these values into the formula:

\[ PV = 1000 \times \left( \frac{1 - (1 + 0.07)^{-8}}{0.07} \right) \]

Calculate the value inside the parentheses first:

\[ (1 + 0.07)^{-8} = (1.07)^{-8} \approx 0.50815 \]

\[ 1 - 0.50815 \approx 0.49185 \]

Now, divide this by the discount rate:

\[ \frac{0.49185}{0.07} \approx 7.025 \]

Now, multiply the payment by this result:

\[ PV \approx 1000 \times 7.025 \approx 7025 \]

So, the present value of receiving $1,000 each year for the next 8 years with a discount rate of
7% is approximately $7,025.

8.
To calculate the future value of an investment with compound interest, you can use the formula:

\[ FV = PV \times (1 + r)^n \]

Where:
- \( FV \) = Future Value
- \( PV \) = Present Value (initial investment)
- \( r \) = Interest rate per period
- \( n \) = Number of periods

Given:
- \( PV \) = $4,500 (initial investment)
- \( r \) = 4% or 0.04
- \( n \) = 10 years

Now, plug these values into the formula:

\[ FV = 4500 \times (1 + 0.04)^{10} \]

Calculate the value inside the parentheses first:

\[ (1 + 0.04)^{10} = (1.04)^{10} \approx 1.48024 \]

Now, multiply the present value by this result:

\[ FV = 4500 \times 1.48024 \]

\[ FV \approx 6661.08 \]

So, the future value of investing $4,500 at an annual interest rate of 4% for 10 years will be
approximately $6,661.08.

9.
To find the present value of a quarterly annuity, we use the formula for the present value of an
annuity:

\[ PV = PMT \times \left( \frac{1 - (1 + r)^{-nt}}{r} \right) \]

Where:
- \( PV \) = Present Value of the annuity
- \( PMT \) = Payment received each period (annuity)
- \( r \) = Discount rate per period
- \( n \) = Number of periods

Given:
- \( PMT \) = $700 (received each quarter for the next 3 years)
- \( r \) = 6% or 0.06 (discount rate per quarter)
- \( n \) = 3 years, so \( nt = 12 \) quarters (since there are 4 quarters in a year)

Now, plug these values into the formula:

\[ PV = 700 \times \left( \frac{1 - (1 + 0.06)^{-12}}{0.06} \right) \]

Calculate the value inside the parentheses first:

\[ (1 + 0.06)^{-12} \approx 0.58590 \]

\[ 1 - 0.58590 \approx 0.41410 \]

Now, divide this by the discount rate:

\[ \frac{0.41410}{0.06} \approx 6.9017 \]

Now, multiply the payment by this result:

\[ PV \approx 700 \times 6.9017 \approx 4831.19 \]

So, the present value of receiving $700 each quarter for the next 3 years with a discount rate of
6% is approximately $4,831.19.

10.
To find the future value of regular deposits into an account with compound interest, we can use
the formula for the future value of an annuity:

\[ FV = PMT \times \left( \frac{(1 + r)^n - 1}{r} \right) \times (1 + r) \]

Where:
- \( FV \) = Future Value
- \( PMT \) = Payment per period (annual deposit)
- \( r \) = Interest rate per period
- \( n \) = Number of periods

Given:
- \( PMT \) = $600 (annual deposit)
- \( r \) = 5% or 0.05
- \( n \) = 6 years

Now, plug these values into the formula:

\[ FV = 600 \times \left( \frac{(1 + 0.05)^6 - 1}{0.05} \right) \times (1 + 0.05) \]

Calculate the value inside the parentheses first:

\[ (1 + 0.05)^6 = (1.05)^6 \approx 1.3401 \]

\[ \frac{1.3401 - 1}{0.05} \approx 6.8018 \]

Now, multiply by (1 + 0.05):

\[ FV \approx 600 \times 6.8018 \times 1.05 \]

\[ FV \approx 4081.08 \times 1.05 \]

\[ FV \approx 4285.12 \]

So, the future value of depositing $600 per year into an account earning an annual interest rate of
5%, for the next 6 years, will be approximately $4,285.12.