BES 125 Engineering Economics

Week 3: September 21-25, 2020

Examples: (following the steps for performing economic study, pp. 4 of Blank and Tarquin, 2012).

1. If you are looking for 1-year investment scheme to gain the most from your money, which
of the following is most advantageous to you?
A. P12,500 that yields P1125 in interest
B. P56,000 that yields P6160 in interest
C. P95,000 that yields P7600 in interest

Following the steps in performing economic study:

Steps Representation, interpretation, analysis, calculation and conclusion
1. Identify and understand Problem: Which of the three alternatives will give your money the
the problem; identify best value?
the objective of the Objective: To select which alternatives among A, B, or C will earn the
project. most for your money.

2. Collect relevant, Given: 1-year period for all

available data and A. P = 12,500; I= 1125 ; F = 13,625 ; n = 1 year
define viable solution B. P = 56,000 ; I=6160 ; F = 62,160 ; n = 1 year
alternatives C. P = 95,000 ; I = 7600 ; F = 102,600 ; n = 1 year

Viable solution alternative:

A simple or compounded interest may be used without affecting the
results provided that the compounding period is one year.

3. Make realistic cash flow

estimates 13,625

0 I= 1125
A.
1
62,160
12,500

B. 0 I= 6160
1

56,000

102,600

0 I= 7600
C.
1

95,000
Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 1
4. Identify and economic For investment alternatives, we look for those that provide the
measure of worth. highest rate of return (RoR), based on economic analysis.

5. Evaluate each Calculation: simple interest Compound interest

alternative. formula
(economic analysis)
√

(You may use either of the formula above since the compounding
period is assumed as yearly for all alternatives).

A. =0.09 9% per annum

Or
√

B. 11% per annum

Or √

C. 8% per annum
Or
√

6. Select the best With reference to step 1 and step 4:

alternative. The best alternative among A, B, and C which has the highest rate of
return (RoR) is alternative B at 11% per annum.

Example 2: Purchase or Rent?

You need a bulldozer for your new road-opening project and you are confronted with the
dilemma whether to purchase or rent for a limited time of 5 years. Assuming all bulldozers in
the scheme below has the same capacity and a uniform interest rate of 6%, which of the
following alternative is more economically feasible?

A. Purchase a brand new bulldozer. Initial cost is P7.5 million, Maintenance and operating
cost per year is P450,000 and a salvage value of P3.5 million at the end of 5 years.
B. Rent the bulldozer with rental fee plus maintenance and operating cost of P2,300,000
per year.

Solution: (following the steps described above).

I need to use a bulldozer for my project. The problem is: “Which of the alternatives will be
more economically feasible?” The objective of this study is to determine and compare the
Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 2
 total costs for each alternative. All relevant costs have been identified including: initial costs,
maintenance and operating costs and salvage value, if any at the end of 5 years. A
calculation of the future value of the costs will be a viable solution to perform the economic
analyses. The measure of economic worth would be Future Worth. The alternative that will
give the lesser cost would be the more economically feasible.

Cash flows and calculation of future worth: n=5 years; i=6% per year, compounded annually.

A. Purchase of brand new bulldozer: 3,500,000

0 1 2 3 4 5
year

A= 450,000
7,500,000

F5 = -7,500,000 (1+0.06)5 - 450,000 (F/A, 6%, 5) + 3,500,000

F5 = -7,500,000 (1.3382) – 450,000 (5.6371) + 3,500,000
F5 = -10,036,691 – 2,536,695 +3,500,000
F5 = - 9,073,386
Total cash outflow in the 5th year is P-9,073,386

B. Rent for 5 years 0 1 2 3 4 5

year

A= 2,300,000

F5 = -2,300,00 (F/A, 6%, 5)

= - 2,300,000 (5,6371)
= -12,965,330

Total cash outflow in the 5th year is P12,965,330

Select the best alternative: The more economically feasible alternative is to purchase the
equipment because it has the lesser cost.

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 3

 Solved Problems from Blank and Tarquin, 2015.

2.15/p.65
The Public Service Board (PSB) awarded two contracts worth a combined P1.07 million to
improve (i.e., deepen) a retention basin and reconstruct the spillway that was severely
damaged in a flood 2 years ago. The PSB said that, because of the weak economy, the bids
came in P950,000 lower than engineers expected. If the projects are assumed to have a 20-
year life, what is the annual worth of the savings at an interest rate of 6% per year?

Solution:
The engineers are able to proceed with the project at lower cost by P950,000. The economic
life of the project is 20 years. The objective of this problem is to determine the equivalent
annual savings incurred because of reduced project cost.

Cash flow diagram:

Savings generated will be taken as cash inflow.

950,000

A= ?

0 1 2 3 18 19 20

Calculation:
We use the capital recovery formula.

[ ] Use A/P , 6% Table on pp. 591

OR
A= 950,000 (A/P, 6%, 20)
= 950,000 (0.08718)
[ ]
A= 82,821

2.45/p.68
Acme Bricks, a masonry products company, wants to have P600,000 on hand before it
invests in new conveyors, trucks, and other equipment. If the company sets aside P80,000
per year in an account that increases in value at a rate of 15% per year, how many years will
it take before Acme can purchase the equipment?

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 4

 Solution:
Acme desires to establish a sinking fund account of P80,000 per year, earning an interest of
15% per year, in order to accumulate a total of P600,000 for the outright purchase of new
conveyors, trucks and other equipment. The objective is to determine the number of years
this will take.
Cash flow diagram and calculation:
The diagram will show cash outflows (solid lines) to represent actual investments and the
dashed line in the final year to represent expected cash inflow.
600,000

0 1 2 3 n

A= 80,000
Sinking fund formula will be used.

[ ]

80,000 = 600,000 [ ]

= 5.393 years say 5.4 years

Given the above data and assumptions, Acme Brick will be able to accumulate
P600,000 in 5.4 years.

3.33/p.90
An investor just purchased property under a unique financing agreement with the
seller. The contract price is P1.6 million. The payment plan is Z pesos now, 2Z pesos
in year 2, and 3Z pesos in years 3 through 5. If the interest rate on the transaction is
10% per year, how much is the payment in year 2?

Solution:
The problem calls for the determination of the payment amount in year 2. The
objective therefore, is to calculate the value of Z given the sinking fund formula P/A.
This can be done by calculating the present value of payments equate it with the
equivalent value of P1.6 million. The relevant information to solve this problem are
given.

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 5

 Cashflow diagram of the payment scheme

1,600,000 Equivalent
Two-step process amount

(P/F, 10%, 2) (P/A, 10%, 3) 1,600,000

3Z 3Z 3Z

(P/F, 10%, 2)
≈
2Z
Z

year
0 2 3 4 5 0 5

There are several ways to calculate Z. For this problem, I will calculate Z based on
equivalent Present value, using the 10% Compound Interest Factor Table on pp. 595.

1,600,600 = Z + 2Z(P/F, 10%, 2) + 3Z(P/A, 10%, 3) (P/F, 10%, 2)

= Z + 2Z(0.8264) + 3Z(2.4869)(0.8264)
= Z(1+1.6528+ 6.1655)
Z = 181,440.87

Conclusion: Payment in the 2nd year is 2(181,440.87) = 362,881.74

3.46/p.91

For the cash flows shown, determine the value of G such that the present worth in
year 0 equals P16,000 at an interest rate of 10% per year.

Year 0 1 2 3 4 5
Cash flow
0 8000 8000 8000-G 8000-2G 8000-3G
P

Solution:

Since this is a problem in shifted decreasing gradients, we need to draw the cash
flow diagram based on the problem, then draw then separate the uniform series
amount representing the base amount using P8000. Subtract from this, the positive
gradient. Calculate the value of G given that future worth of the single and uniform
payments are equivalent to P16,000 at year 0.

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 6

 Cash flow diagram and calculations:

Cash flow of the problem

0 4
1 2 3 5

8000 - 3G
8000 - 2G
8000 - G
8000 8000

P=16,000

Cash flow diagrams to aid in the calculation of G.

3G
A= 8000
0 1 2 3 4 5 P/G
2G
– P/F
G

0 1 2 3 4 5

PA

Using 10% compounded factor table on page 595. There are many ways to solve this.
This is one solution

16,000 = 8,000 (P/A, 10%, 5) – G(P/G, 10%, 4) (P/F, 10%, 1)

= 8,000 (3.7908) – G (4.3781)(0.9091)

G = (30,326.40m- 16,000)/3.98013

G = 3599.48

The value of the constant gradient is approximately P3600.00

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 7

 Homework No. ____

Solve the following problems using the steps in performing economics studies.

1. The UP National Center for Transporation Studies (UP NCTS) raised the average
fuel efficiency standard to 15 km per 1 liter for cars and light trucks by the year
2016. The rules will cost consumers an average of P30,000 extra per vehicle in
the 2012 model year. If a person purchases a new car in 2012 and keeps it for 5
years , how much must be saved in fuel cost each year to justify the extra cost?
Use an interest rate of 8% per year.
2. Determine the present worth of a maintenance contract that has a present cost
of P50,000 in year 1, P65,000 in year 2 and an annual increase of 6% per year for
the next 5 years. Use an interest rate of 10% per year.
3. A start-up construction company believes that by investing P120,000 each year in
years 1, 2, and 3, it will avoid spending P436,500 in year 3. If the company does
make the annual investments, what rate of return will be realized?
4. 2.52/page 68 - present a solution different from those found in the Solutions
Manual.
5. Find the future worth in year 10 of P50,000 in year 0 and amounts increasing by
15% per year through year 10 at an interest rate of 10% per year.
6. What is the present worth of a monthly investment of P5,000 made 3 years ago?
Assume rate of return of 6% per year compounded monthly.
Present a unique solution (i.e., not found in the Solutions Manual).
7. 3.38/page 90
8. 3.50/page 50

Prof. Jessica Maria Paz S.Casimiro BES 125 Engineering Economics 8