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Outline Module 1
What is Economics?
What is Engineering Economy?
The Role of Engineering in Shaping the Economic
Environment
Project Life Cycle
Some Concepts, Definitions and Terminologies
Module 1: Introduction Time Value of Money
Interest and Interest Rate
SI-4251 Ekonomi Teknik Cash Flow
Muhamad Abduh, Ph.D.
1-2 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.
What is Economics? What is Engineering Economy?
The study of how limited resources are used to satisfy Engineering and the Economy
unlimited human wants. Any endeavor, including engineering, will always have consequences
Engineering endeavor
The study of how individual and societies choose to use Add value betterment of effectiveness, efficiency, changing conditions
and utilize scarce resources Add economic value the most common comparable measurement
Resources: Example:
LAND all gifts of nature that can be applied to the process Economic decisions
A piece of equipment has been used for 10 years as part of important
(production) process. Current condition indicates that service level is slightly decrease,
LABOR efforts, skills, expertise, knowledge of people which often breaks down. On the other hand the demand for product is in
can be applied to the process constant increase, at least for the next 5 years.
Alternatives:
CAPITAL human, tools/machineries, financial Replaced with a new one or to be repaired
Current and future technology (?)
Future demand (?)
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The Role of Engineering in Shaping the
Engineering Economy Economic Environment
Deals with the concepts and techniques of analysis useful Engineering Options
for evaluating the worth of goods, services, system in There are many (engineering) alternative solution for any
relation to cost problem or challenge
What solution is best to satisfy? For now or anytime in the
For engineers, it is used to answer questions such as: future
Which engineering projects are worthwhile? How do we compare one to another?
Which engineering projects should have higher priority? Engineering Steps
How should an engineering project be designed? 1. Determine objectives
The answers based on the concepts of: 2. Identification of strategic factors
Cash flows (cash in and cash out) 3. Determine means engineering proposals
Interest rate and time value of money 4. Evaluation of engineering proposals cash flow of
alternatives
Equivalent techniques
5. Decision making economic evaluation
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Project Life Cycle Time Value of Money
Concept &
Definition Phase Purchasing or earning power of money
Next Cycle Funds borrowed for the prospects of gain are commonly
Design Phase
exchanged for goods, services or instruments of production,
Construction Phase that ultimately leads to increase earning
Level of Change Operation & Maintenance Phase Time value of money
What you could buy with Rp. 1 million a year ago will not be
the same with the ones you buy today.
scope cost
Rp. 1 million you invested in a bank a year ago will yield more
when you draw today.
Rp 1 million today is worth more than a year latter.
Concept of equivalence different sums of money at different
time can be equal in economic value.
Rp. 1 Mill P F Rp. 1 Mill
+ interest
Time
0 1 2 3 n-1 n
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Interest and Interest Rate Basic Calculation of Interest
Interest is defined as a rental amount charged by financial institution F
of the use of money Rp. 1 Mill P Rp. 1 Mill
+ interest
Interest rate (also known as rate of capital growth) is defined as the
rate gain received from an investment measured in % 0 1 2 3 n-1 n
Interest rate is determined mutual agreement between the
borrower and the lender, or by market forces involving supply and
demand market value. Original investment present value (P)
From lender’s point of view:
Involves risk of default Total accumulated amount future value (F)
Compensate for not taking other alternative (including for own use) Interest , I = F – P
Cost of investigating borrower and other administrative expenses
To make up for inflation Interest rate, i = (interest accrued per unit time) /
From borrower’s point of view: (original amount)
Based in one’s utility, for personal use
Based on expected return, for financing operation or investment
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Simple Interest Compound Interest
Simple interest = (principal)(number of periods)(interest rate), I = P.n.i Compound interest interest will be charged for all unpaid amount
Accumulated amount, F = P + I = P(1+ni) Accumulated amount, F = P(1+i)n
End of Amount Owed at Interest Charged Amount Owed at Amount Paid at
Period Beginning of Period (C) = (B) x i End of Period End of Period
(A) (B) = (C)n-1 (D) = (B) + (C) (E)
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 0,-
End of Amount Owed at Interest Amount Owed at Amount Paid at
Period Beginning of Period Charged End of Period End of Period 2 Rp. 1.120. 000,- Rp. 134.400,- Rp. 1.254.400,- Rp. 0,-
(A) (B) (C) = (B) x i (D) = (B) + (C) 3 Rp. 1.254.400,- Rp. 150.528,- Rp. 1.404,928- Rp. 0,-
1 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 120.000,- 4 Rp. 1.404.928,- Rp. 168.592,- Rp. 1.573.519,- Rp. 1.573.519,-
2 Rp. 1.000. 000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 120.000,-
End of Amount Owed at Interest Amount Owed at End of Period
3 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 120.000,- Period Beginning of Period Charged
1 P Pi P + Pi = P (1+i)1
4 Rp. 1.000.000,- Rp. 120.000,- Rp. 1.120.000,- Rp. 1.120.000,-
2 P(1+i) P(1+i) i P(1+i) 1 + P(1+i)i = P (1+i) 2
3 P(1+i) 2 P(1+i) 2i P(1+i) 2 + P(1+i) 2.i = P (1+i) 3
EXCEL n P(1+i) n-1
P(1+i) n-1i
P(1+i) n-1
+ P(1+I) n-1i
= P(1+i) n
EXCEL
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Exercise for Concept of Equivalence Cash Flows
Loan: $ 5,000, i = 8%, n = 5 Any undertaking and/or business endeavor (including
Repayment plans: engineering projects) generally have economic consequences
that occur over an extended period of time.
Plan 1: Simple interest, pay all at end.
Each project is described as cash received (inflow – cash in) or
Plan 2: Compound interest, pay all at end.
disbursement or expenses (outflow – cash out) at different
Plan 3: Simple interest paid annually, principal repaid at end.
point in time.
Plan 4: Compound interest and portion of principal repaid
Cash Flow Diagram (CFD) summarizes the costs and benefits
annually.
of engineering project over time. CFD illustrates the size, sign
Plan 5: Equal payments of compound interest and principal
and timing of individual cash flows and form as the basis for
made annually.
engineering economic analysis
EXCEL
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Cash Flows Diagram Homework #1
In a CFD the end of period t is the same as the 1. What will be the accumulated amount of Rp 750.000,-
compounded annually for three years at the rate of 10% p.a?
beginning of next period t+1
2. How much do you have to save now if you’d like to have
The choice of time 0 is arbitrary. It can be when the Rp. 15.500.000,- to start a new company 2 years from now at
project is analyzed, when funding is approved or when the interest rate of 1.5% compounded monthly?
the construction begins 3. What is the rate of return of an initial investment worth Rp.
35 millions that yield Rp. 42.500.000,- after 18 months?
4. An initial investment of Rp. 50 millions is being considered.
The revenues from this investment are Rp 25 millions at the
end of first year, Rp 20 millions and Rp 15 millions at the end
of second and third years. If the alternative will give a
revenue of Rp 57,5 millions at the end of the third year, which
investment would you recommend? The interest rate is set at
11% annually.
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