In light of the recent calamity of the NCoV pandemic, this handout and worksheet will

serve as learning material for students taking up ES219 (Engineering Economy).

This learning material will have examples and exercises as the students progress
through. The students are advised answer the exercises first before moving on to the next
topic.The students are to answer these exercises with their complete solutions. However,
if the space provided does not suffice, the students are encouraged to use a different
sheet of paper for them to show their complete solution. This material likewise contains
definitions that would simplify explanations. The output from the students will be checked
and recorded.

After this learning material, the students can:

1. calculate the rate of return and benefit – cost ratio of a certain investment
2. differentiate internal and external interest rates
3. solve problems on annuity
4. calculate payback period

Prepared by:

Engr. Lelie Lou B. Bacalla

Instructor
 HANDOUT AND WORKSHEET FOR ENGINEERING ECONOMY

NAME:
YEAR & SECTION:
DATE:

CONTINUOUS COMPOUNDING

Suppose that money was deposited at a local bank with 4% interest and is left there for
1 years, has it ever crossed your mind how much difference would this money make if it
was compounded on a semi-annual basis than on the yearly basis? The difference in
value of the money if it was compounded at different times per year is shown on the table
below:

We take only the single payment compound amount factor for simplicity of calculations:
Compounding Frequency Single payment compound
amount factor
Annually 0.04 (1) 1.04
(1 + )
1
Semi-Annually 0.04 (2) 1.0404
(1 + )
2
Quarterly 0.04 (4) 1.0406
(1 + )
4
Bimonthly 0.04 (6) 1.04067
(1 + )
6
Biquarterly 0.04 (8) 1.040707
(1 + )
8
Monthly 0.04 (12) 1.04074
(1 + )
12
Daily 0.04 (360) 1.0408
(1 + )
360
The value of the single payment compound amount factor approaches to a constant
value, in this situation of, e0.04. Therefore, any amount of money deposited to earn interest
would have a limit. This type of compounding is called continuous compounding.

In continuous compounding, the principle is to deposit money at an infinite amount

of time. While this is technically not possible and realistically impractical, it is an important
consideration when it comes to engineering economy as it gives you a limit on how much
money your money could grow. Then it would give you an estimate on how you can
optimize the money you deposit.

DEFINITION. CONTINUOUS COMPOUNDING

If an amount P is deposited in an account paying an annual interest rate i compounded
continuously, the amount F in the account after n years is found as:
𝐹 = 𝑃𝑒 𝑖𝑡

EXAMPLE:

Talia invested 3000PhP. How much would this money be if it was invested at 5.5%,
compounded continuously for 30 years.

SOLUTION:
P = 3,000PhP
i = 5.5%
n = 30 years
𝐹 = 3000𝑒 0.055(30)
𝑭 = 𝟏𝟓, 𝟔𝟐𝟎. 𝟗𝟒𝑷𝒉𝑷
NAME:
YEAR&SECTION:
DATE:
WORKSHEET 1

1. Mary invests 4,000PhP compounded continuously. How much money will she
have in 4 years? (Use your birthday as the interest rate. Example: March 28 is
0328 then, the interest rate is 3.28%)
2. Ann aims to double her money. She put 5000PhP in a bank account that
compounds continuously. How long will it take her to double her money? (Use the
birthday of your mother as an interest rate)
3. Kim invests some money compounded continuously. In 6 years she has the
amount of 10,000PhP. How much did she initially invest? (Use the time you
answered this problem as interest rate.)
4. Kevin invests 2150PhP on a bank compounded continuously. How much time does
it take for her money to reach 5,000PhP. (Use the date you answered this
worksheet as interest rate.)
 HANDOUT AND WORKSHEET FOR ENGINEERING ECONOMY

NAME:
YEAR & SECTION:
DATE:

MINIMUM ATTRACTIVE RATE OF RETURN AND ANNUITY

Minimum Attractive Rate of Return simply called as MARR, is the minimum rate of
return that an investor is willing to accept on the money he invests. It is also called as
minimum acceptable rate of return or hurdle rate.

Factors to consider when setting hurdle rate

o Risk Premium – Assigning a risk value for the anticipated risk involved with
the project. Riskier investments generally have greater hurdle rates than
less risky ones.
o Inflation Rate – If the economy is experiencing mild inflation, that may
influence the final rate by 1-2%. There are instances when inflation may be
the most significant factor to consider
o Interest Rate – Interest rates represent an opportunity cost that could be
earned on another investment, so any hurdle rate needs to be compared to
real interest rates

Annuity – a sum of money payable at a regular interval. Common example for annuity is
paying for the car or a motorcycle bought using loan. The loaned vehicle is payed with
constant amount over a regular basis (every month or bimonthly, for example).

Payment Period – interval between payments (a month, a quarter, a year)

 Types of Annuity

1. Contingent annuity – the payments are made for a fixed period of time until
som event happens.
For example: monthly pension continues until the pensioner dies
2. Ordinary Annuity – the payment is paid immediately after the payment period
passes.
For example: a vehicle is loaned at the 15th of this month, the first payment
is done on the 15th of the next month. The loan is paid every 15th of the
month until the loan is paid off, usually indicated on the loan contract.
3. Annuity Due – the payment is made at the beginning of every payment period.
For example: the loan is made today, the first payment is made today until
the beginning of the last payment period
4. Deferred Annuity – the initial payment is made sometime in the future
For example: the loan is made today, the first payment is made 3 months
after, depending on the contract.

FORMULA. ORDINARY ANNUITY

PRESENT WORTH:
𝐴[(1 + 𝑖)𝑛 − 1]
𝑃=
𝑖(1 + 𝑖)𝑛
[(1+𝑖)𝑛 −1]
Where: is uniform series present worth factor
𝑖(1+𝑖)𝑛

i is the interest rate

n is the number of payment periods
A is the payment per payment period

FUTURE WORTH
𝐴[(1 + 𝑖)𝑛 − 1]
𝐹=
𝑖
[(1+𝑖)𝑛 −1]
Where: 𝑖
is uniform series compound amount factor
 i is the interest rate
n is the number of payment periods
A is the payment per payment period

EXAMPLE. ORDINARY ANNUITY.

A man purchased on monthly installment a 100,000PhP worth of land. The interest rate
is 12% nominal and payable in 20 years. What is the monthly amortization?

SOLUTION
P = 100,000PhP
r = 12 %
m = 12
𝐴[(1 + 𝑖)𝑛 − 1]
𝑃=
𝑖(1 + 𝑖)𝑛

0.12 12(20)
𝐴[(1 + ) − 1]
100,000 = 12
0.12
𝑖(1 + 12 )12(20)

A=1,108.08PhP

EXAMPLE. ANNUITY DUE

You promised to pay 1000PhP for 5 years starting today. The interest rate is 5%. What
is the present value of the payment?
SOLUTION:

For annuity dues. The payment starts immediately. If taking into account the payment
today, the formula will be converted to:
𝐴[(1 + 𝑖)𝑛−1 − 1]
𝑃=𝐴+
𝑖(1 + 𝑖)𝑛−1
The addition of A to the formula is because of the first payment. The second term is the
formula for ordinary annuity excluding the frist payment since it has been taken into
account on the first term, hence the n-1 on the exponent.
1000[(1 + 0.05)5−1 − 1]
𝑃 = 1000 +
0.05(1 + 0.05)5−1
1000[(1 + 0.05)4 − 1]
𝑃 = 1000 +
0.05(1 + 0.05)4
𝑃 = 𝟐, 𝟓𝟖𝟗. 𝟒𝟏

EXAMPLE. DEFERRED ANNUITY

A man loan s 187,400PhP from a bank with interest at 5% compounded annually. He

agrees to pay his obligations by paying 8 equal annual payments, the first being due at
the end of 10 years. Find the annual payments.

SOLUTION:
To solve deferred annuity, convert the payments A to one single payment then convert.
In this case, we convert all payments from year 10 to year 18 to a single payment at
year 9.
𝐴[(1 + 0.05)8 − 1]
𝑃9 =
0.05(1 + 0.05)8

𝑃9 = 6.643𝐴
After converting to one single payment, use compound interest formula to convert the
money to present worth at year 1
 𝑃9 = 𝑃1 (1 + 𝑖)𝑛
6.643𝐴 = 187,400(1 + 0.05)9
𝑨 = 𝟒𝟒, 𝟗𝟖𝟐. 𝟎𝟒𝑷𝒉𝑷
NAME:
YEAR&SECTION:
DATE:
WORKSHEET 2

1. Auto loan requires payments of 30,000PhP per month for 3 years at a nominal
annual rate of 9% compounded monthly. What is the present value of this loan and
the accumulated value at its conclusion?
2. The cash price of an automobile is 100,000PhP. The buyer is willing to finance the
purchase at 18% convertible monthly and to make payments of 2500PhP at the
end of each month for four years. Find the down payment that will be necessary.
3. Starting on her 30th birthday, a woman invests x dollars every year on her birthday
in an account that grows at an annual effective interest rate of 7%. What should x
be if she wants this fund to grow to 3,000,000PhP just before her 65th birthday?
4. Find the future value at the end of the last payment period. Payments of 1000PhP
each are made at the beginning of each year for 3 years with interest at 5%
compounded annually.
5. A four-year lease agreement requires payments of 10,000PhP at the beginning of
every year. If the interest rate is 6% compounded monthly, what is the cash value
of the lease?
 HANDOUT AND WORKSHEET FOR ENGINEERING ECONOMY

NAME:
YEAR & SECTION:
DATE:

INTERNAL AND EXTERNAL RATE OF RETURN

INTERNAL RATE OF RETURN

This method solves for the interest rate that equates the equivalent worth of an
alternative’s cash inflows (receipts or savings) to the equivalent worth of cash outflows
(expenditures, including investment costs). Equivalent worth may be computed using any
of the three methods discussed earlier. The resultant interest rate is termed the Internal
Rate of Return (IRR). The IRR is sometimes referred to as the breakeven interest rate.

When calculating for the IRR, expected cash flows for a project or investment are
given and the net present value (cash inflow – cash outflow) equals zero. Put another
way, the initial cash investment for the beginning period will be equal to the present value

of the future cash flows of the investment.

 EXAMPLE.

A company is deciding whether to purchase new equipment that costs 500,000PhP.

Management estimates the life of the new asset to be four years and expects it to
generate an additional 160,00PhP annual profits. In the fifth year, the company plans
to sell the equipment for its salvage value of 50,000PhP. Meanwhile, another similar
investment option can generate a 10% return. This is higher than the company’s current
hurdle rate of 8%. The goal is to make sure the company is making best use of its cash.

SOLUTION:

Using the formula above to calculate for the IRR

𝐶𝐹1 𝐶𝐹2 𝐶𝐹3 𝐶𝐹4 𝐶𝐹5
0 = 𝐶𝐹0 + + + + +
1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)3 (1 + 𝐼𝑅𝑅)4 (1 + 𝐼𝑅𝑅)5
160,000 160,000 160,000 160,000 50,000
0 = −500,000 + + + + +
1 + 𝐼𝑅𝑅 (1 + 𝐼𝑅𝑅)2 (1 + 𝐼𝑅𝑅)3 (1 + 𝐼𝑅𝑅)4 (1 + 𝐼𝑅𝑅)5
𝑰𝑹𝑹 = 𝟏𝟑. 𝟐𝟕%

The company should purchase the new equipment.

EXTERNAL RATE OF RETURN

The method of external rate of return equates the future worth of the positive cash flows
using the minimum attractive rate of return (MARR) to the future worth of negative cash
flow using the ERR. The ERR takes into account the interest rate external to a project at
which the net cash flows generated by the project over its life can be reinvested. If this
external reinvestment rate, which is usually the firm’s MARR, happens to equal the
project’s IRR, then the ERR methods produce identical results to those of the IRR Method.

The formula for the ERR Method is:

 𝑛 𝑛
𝑛−𝑡
∑ 𝐶𝐹𝐼 (1 + 𝑀𝐴𝑅𝑅) = ∑ 𝐶𝐹𝑜 (1 + 𝐸𝑅𝑅)𝑛−𝑡
𝑡=0 𝑡=0

Where: 𝐶𝐹𝐼 is the cash inflow

𝐶𝐹𝑜 is the cash outfloe
n is the period of analysis
t is the time the cash inflow/outflow has occurred
To illustrate this principle, refer to the example below

EXAMPLE.
A project has cash flows of $2500 now, –$12500 in one year and $15 000 in two years. If the
MARR is 25%, find the approximate ERR.

SOLUTION.
𝑛 𝑛
𝑛−𝑡
∑ 𝐶𝐹𝐼 (1 + 𝑀𝐴𝑅𝑅) = ∑ 𝐶𝐹𝑃 (1 + 𝐸𝑅𝑅)𝑛−𝑡
𝑡=0 𝑡=0

2,500(1 + 0.25)2−0 + 15,000(1 + 0.25)2−2 = 12,500(1 + 𝐸𝑅𝑅)2−1

ERR = 0.5125
NAME:
YEAR&SECTION:
DATE:
WORKSHEET 3
1. Robert owns Company ABC and must decide whether to purchase a new
equipment for 300,000PhP. The equipment would only last three years, but it is
expected to generate 150,000PhP of additional annual revenue during those
years. Company ABC sell the equipment for scrap afterward for about 10,000PhP.
Using IRR, Company ABC can determine if the equipment purchase is a better
use of its cash than its other investment options, which should return about 10%.
Should Robert agree to buy the equipment?
2. Find the internal rate of return for a $10,000 investment that will pay $1,000/year
for 20 years.
3. You started with $11,000 and one year later you have $12,500. What was your
internal rate of return?
4. Using a MARR of 12%, find the external rate of return (ERR) for the following
cash flow. With and without using Excel
Year Cash Flow
0 -$25,000
1 $20,000
2 -$20,000
3 $15,000
4 $17,000
 HANDOUT AND WORKSHEET FOR ENGINEERING ECONOMY

NAME:
YEAR & SECTION:
DATE:

PAYBACK PERIOD AND BENEFIT-COST RATIO

PAYBACK PERIOD

Payback considers the initial investment costs and the resulting annual cash flow.
The payback period is the amount of time (usually measured in years) to recover the initial
investment in an opportunity. Unfortunately, the payback method doesn’t account for
savings that may continue from a project after the initial investment is paid back from the
profits of the project, but this method is helpful for a “first-cut” analysis of a project.

1. Payback with Equal Annual Savings

If annual cash flows are equal, the payback period is found by dividing the
initial investment by the annual savings.
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑎𝑛𝑛𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑠𝑎𝑣𝑖𝑛𝑔𝑑

EXAMPLE.
A shop is evaluating the purchase of a still to recycle its waste solvent. The shop
manager analyzes both his current operation and the option of using a still. He sees
that installation of a still will cost 77,000PhP, but provide a net annual operational
savings of $14,700PhP. Find the payback period.

SOLUTION
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
𝑎𝑛𝑛𝑢𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑠𝑎𝑣𝑖𝑛𝑔𝑑
 77,000
𝑃𝑎𝑦𝑏𝑎𝑐𝑘 𝑝𝑒𝑟𝑖𝑜𝑑 =
14,700
𝑷𝒂𝒚𝒃𝒂𝒄𝒌 𝒑𝒆𝒓𝒊𝒐𝒅 = 𝟓. 𝟐𝟒 𝒚𝒆𝒂𝒓𝒔

2. Payback with Unequal Annual Savings

The previous example assumes that the annual cash flow is the same each
year. In reality, there are significant costs such as depreciation and taxes that
will cause cash flows to vary each year. If the annual cash flow differs from year
to year, the payback period is determined when the accrued cash savings equal
the initial investment costs (i.e., when the cumulative cash flow balance equals
zero).
EXAMPLE.
The initial investment in a pollution prevention project is $10,000. The projected savings
is $4,000 for the first year, $4,000 for the second year, $2,500 for the third year, $2,000
in the fourth year, and $2,000 for the fifth year.

SOLUTION:

Year Annual Cashflow Cumulative Cash

Balance
0 -10,000 0 -10,000
1 4,000 -10,000 + 4,000 -6,000
2 4,000 -6,000 + 4,000 -2,000
3 2,500 -2,000+2,500 500
4 2,000 500+2,000 2,500
5 2,000 2,500+2,000 4,500

The cumulative cash balance zeroes in between year 2 and year 3. The rate of change
from year 2 to year 3 is constant, therefore, the method of interpolation may be used.
By letting x be equal the number of years the amount be paid back.
 3−𝑥 500 − 0
=
𝑥 − 2 0 − (−2000)
𝒙 = 𝟐. 𝟖 𝒚𝒆𝒂𝒓𝒔
Therefore, the payback period is 2.8 years

BENEFIT-COST RATIO

The benefit-cost ratio is an indicator showing the relationship between the relative costs
and benefits of a proposed project expressed in monetary or qualitative terms. If a project
has a BCR of greater than 1, the project is expected to deliver a positive net present value
to a firm and its investors. If a project's BCR is less than 1.0, the project's costs outweigh.
To illustrate the benefit cost-ratio, the example below is provided.

EXAMPLE

Assume company ABC wishes to assess the profitability of a project that involves
renovating an apartment building over the next year. The company decides to
lease the equipment needed for the project for 50,000PhP rather than
purchasing it. The inflation rate is 2%, and the renovations are expected to
increase the company's annual profit by 100,000PhP for the next three years.

SOLUTION:

Recall: from the IRR section, the formula for NPV was presented but was equated to
zero.
IRR may be substituted with the inflation rate

100000 100000 100000

𝑁𝑃𝑉 = + 2
+ = 288388.32
1 + 0.02 (1 + 0.02) (1 + 0.02)3

288388.32
𝐵𝐶𝑅 =
50000

𝐵𝐶𝑅 = 5.77

Therefore, the company must consider renovating.

NAME:
YEAR&SECTION:
DATE:
WORKSHEET 4

1. A businessman invests P100,000 in an equipment that it projects will

yield P500,000 in profit. It will take two years to create and inflation is estimated at
three percent. Should the company push through with the investment? Use the
BCR method
2. The Stan Company is planning to purchase a lot. The lot would cost P2,500,000
and would have a useful life of 10 years with zero salvage value. The expected
annual cash inflow of the machine is P100,000. Calculate the payback period.
3. JJ Inc. wants to install new machines. Two types of machines are available in the
market – machine 1 and machine 2. Machine 1 would cost P180,000 while
machine 2 would cost P150,000. Both the machines can reduce annual labor cost
by P3,000. Calculate which machine to purchase using payback period.
4. Company Jan wants to replace an equipment. The equipment costs P625,000.
The inflation is 3 percent, upgrading the equipment is expected to boost your
profits by $220,000 a year for each of the next three years. Should they replace
the equipment with a new one?