29/09/2010

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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