The course covers the concept of time value

money and equivalence; basic economy

study methods; decisions under certainty;
decisions recognizing risk; and decisions
admitting uncertainty.

ENGINEERING
ECONOMY
Course Code: ES 002

INSTRUCTORS: Engineer Frank Jey G. Pamintuan

Engineer Leomar D. Juliano

First Semester School Year 2020 - 2021

 ENGINEERING ECONOMY

COURSE OUTLINE

UNIT 1. Introduction to Engineering Economics

1.1 Definitions
1.2 Principles of Engineering Economics
1.3 Engineering Economics and the Design Process
1.4 Cost Concepts for Decision Making

UNIT 2. Money-Time Relationship and Equivalence

2.1 Interest and Time Value of Money
2.2 The Concept of Equivalence
2.3 Cash Flows

UNIT 3. Economic Study Methods

3.1 The Minimum Attractive Rate of Return
3.2 Basic Economic Study Methods:
Present Worth, Future Worth, Annual Worth, Internal Rate of Return, Eternal Rate of
Return
3.3. Discounted Payback Period, Benefit/Cost Ratio

UNIT 4. DECISIONS UNDER CERTAINTY

4.1 Evaluation of Mutually Exclusive Alternatives and Independent Projects
4.2 Effects of Inflation
4.3 Depreciation and After-Tax Economic Analysis
4.4 Replacement Analysis

GRADING SYSTEM: Quizzes/Unit Tests 30%

Seatwork/Exercises/Homework/Problem Sets 20%

Major Examination 50%

Total 100%
 ENGINEERING ECONOMY

UNIT 1.
INTRODUCTION TO ENGINEERING
ECONOMY

Learning Objective: To make fundamentally strong base for decision making skills by
applying the concepts of economics.
 ENGINEERING ECONOMY

1.1 ENGINEERING ECONOMY/ECONOMICS DEFINED

Economics is the science that deals with the production and consumption of goods and services and the
distribution and rendering of these for human welfare.

In different books, Engineering Economy is defined as;

- The body of knowledge that allows an engineer to determine which of several alternatives is
economically best—the least expensive, or perhaps the most profitable. In order to make this
determination properly, the engineer needed to understand the mathematics governing the
relationship between time and money.

- The science that deals with techniques of quantitative analysis useful for selecting a preferable
alternative from several technically viable ones.

- Involves the systematic evaluation of the economic merits of proposed solutions to engineering
problems.

The following are the economic goals.

- A high level of employment
- Price stability
- Efficiency
- An equitable distribution of income
- Growth

1.2 THE PRINCIPLES OF ENGINEERING ECONOMY

Principle 1. Develop the alternatives.

After identifying the problem, alternatives need to be developed and defined for analysis. The
choice/decision is among alternatives.

Principle 2. Focus on the differences

In order to make the decision, the differences between the future outcomes of the alternatives are
to be considered.

Principle 3. Use a consistent viewpoint.

The perspective (viewpoint) of the decision maker should be consistent in the analysis and
comparison of alternatives.

Principle 4. Use a common unit of measure.

Using a common unit of measurement of the outcomes will simplify the comparing the
alternatives.

Principle 5. Consider all relevant criteria.

Other than outcomes in monetary units, other organizational objectives you would like to achieve
with your decision should be considered and given weight in the selection of an alternative.
 ENGINEERING ECONOMY

Principle 6. Make uncertainty explicit.

Uncertainty is inherent in projecting future outcomes and should be considered in the analysis
and comparison.

Principle 7. Revisit your decisions.

Projected results and decisions should be compared with actual results to improve the decision
process.

1.3 THE ENGINEERING ECONOMIC ANALYSIS PROCEDURE

Steps:

1. Problem recognition, definition, and evaluation.

- It provides the basis for the rest of the analysis. A problem must be well understood before the project
team proceeds with the analysis.

2. Development of the feasible alternatives.

-Two primary actions in Step 2, (1) searching for potential alternatives and
(2) Screening them to select a smaller group of feasible alternatives for detailed analysis.

3. Development of the cash flows for each alternative.

-uses the basic cash-flow approach employed in engineering economy

4. Selection of a criterion (or criteria).

-The decision maker will normally select the alternative that will best serve the long-term interests of the
owners of the organization.

5. Analysis and comparison of the alternative.

-is largely based on cash-flow estimates for the feasible alternatives selected for detailed study

6. Selection of the Preferred Alternative.

-Selection of the recommended course of action

7. Performance monitoring and post evaluation results.

-Is accomplished during and after the time that the results achieved from the selected alternative are
collected.

Assignment. Read an research the following terms.

Fixed cost Overhead cost
Variable cost Standard cost
Incremental cost Cash cost
Recurring costs Book cost
Non-recurring costs Opportunity cost
Direct cost Sunk cost
Indirect cost Life cycle cost
 ENGINEERING ECONOMY

1.4 COST CONCEPTS FOR DECISION MAKING

COST TERMINOLOGIES

- Fixed cost – those that are unaffected by changes in activity level over a feasible range of operations for the
capacity or capability available.
Example: Insurance and taxes on facilities, general management and administrative salaries, license fees
and interest costs of borrowed capital.

- Variable cost – are those associated with an operation that vary in relation to changes in quantity of output
or other measures of activity level.
Example: The cost of materials and labor used in a product or service are variable costs – because they
vary with the number of output units even though the costs per unit stay the same.

- Incremental cost (incremental revenue) – refers to the additional cost or revenue that will result for
increasing the output of a system by one of more units. This is often quite difficult to determine in practice.
Thus if to produce 100 units will cost P200, and the total cost for producing 110 units is P215, then the
increment cost for additional 10 units is P15 or 1.50 per unit.

- Recurring costs – costs that are repetitive and occur where an organization produces similar goods or
services on a continuing basis. Variable cost are also recurring costs, because they repeat with each unit of
output. Fixed cost that is paid on a repeatable basis is a recurring cost (ex. office space rental)

- Non-recurring costs – are those that are not repetitive even though the total expenditures maybe
cumulative over a relatively short period of time. Usually it involves the developing or establishing a
capability or capacity to operate.

- Direct cost – those that can be reasonably measured and allocated to a specific output or work (labor and
materials).

- Indirect cost –They are costs allocated through a selected formula (such as proportional to direct labor
hours or direct materials) to the outputs or work activities (ex. Cost of common tools, general supplies
equipment maintenance).

- Overhead cost – used to mean all expenditures that are not direct cost Example(administrative, insurance,
taxes, electricity, general repairs)

- Standard cost – representation cost per unit of output that are established in advance of actual production
or service delivery.

- Cash cost – cost that involves payment of cash.

 ENGINEERING ECONOMY
- Book cost – does not involve cash transaction; non-cash. The most common example of book cost is the
depreciation. It is included in an analysis for it affects income taxes, which are cash flows.

- Opportunity cost – is incurred because of the use of limited resources such that the opportunity to use those
resources to monetary advantage in alternative use is foregone. It is the cost of the best rejected opportunity
and is often hidden or implied.

Example of opportunity cost: Consider a student who could earn P 5,000/ month or P60,000 for
working during a year but chooses instead to go to school for a year and spend P35,000 to do so. The
opportunity cost of going to school for that year is P95,000 ( the 60,000 for the income gone and the P35,000
for the school expenses).

 Sunk cost – is one that has occurred in the past and has no relevance to estimates of future costs and
revenues related to an alternative course of action. It represents money which has been invested and which
cannot be recovered due to certain reasons. A sunk cost is common to all alternatives and is not part of the
future cash flows and can be disregarded in an engineering economic analysis.

 Life cycle cost – refers to the summation of cost estimates from inception to disposal for both equipment
and projects as determined by an analytical study and estimate of total costs experienced during their life

EXAMPLE 1.1: (FIXED AND VARIABLE COST)

A contractor has to choose between two sites on which to set up the Asphalt mixing Plant equipment.
The Contractor estimates that it will cost up to ₱150 per cubic meter kilometer (m3-km) to haul the material
from mixing plant job location. Factors to the two mixing sites are as follows;

Cost Site A Site B

Average Hauling distance 4 km 3 km
Monthly Rent ₱100,000 ₱350,000
Setting and Removing of ₱750,000 ₱2.5 M
Equipment
Hauling Expense ₱150/m3-km ₱150/m3-km
Flag Person - ₱7,500/day

The job requires 50,000 cu.m of asphalt material. It is estimated that 4 months (17 weeks of five
working days/week) to finish the job. Which is better site? How many cu.m. of asphalt material should be
delivered before starting to make profit if paid ₱600/m3 delivered to job location?

Solution:

Cost Fixed Variable Site A Site B

Rent X 400, 000 140, 000
Set-up X 750, 000 2, 50, 000
Flag Person X 0 637, 550
Hauiling X 4(50, 000)(150)= 3(50, 000)(150)=
30, 000, 000 22, 500, 000
TOTAL 31, 150, 000 27,037, 500
 ENGINEERING ECONOMY

The contractor will begin to make profit when total revenue is equal to total cost as a function of the cubic
meter of asphalt delivered or;

TOTAL COST = TOTAL REVENUE; 3(150)=450/CU.M.

(1.4M + 2.5M + 637, 500) + 450X = 600X

4, 537, 000 + 450X = 600X

X = 30, 246.67

X ≈ 30 , 247 CU . M . delivered

Using site B, the contractor will begin to make profit on the jobs after delivering 30, 247 cubic meter
materials.
 ENGINEERING ECONOMY

ACITIVITY!

1. What is the difference between Fixed cost and Variable cost?

2. It is the additional cost (or revenue) that results from increasing the output of a system by one (or
more) units.
3. Differentiate Direct cost and Indirect cost. Give an example each.
4. These are costs that are repetitive and occur where an organization produces similar goods or
services on a continuing basis.
5. These are costs of materials/labor that are used to produce the product.
a) Recurring costs
b) Non-recurring costs
c) Direct cost
d) Indirect cost
6. These are costs that are not repetitive even though the total expenditures maybe cumulative over a
relatively short period of time.
a) Recurring costs
b) Non-recurring costs
c) Direct cost
d) Indirect cost
7. Example of these costs are common tools, general supplies equipment maintenance.
a) Recurring costs
b) Non-recurring costs
c) Direct cost
d) Indirect cost

Choices for items 8-10

a) Cash cost
b) Opportunity cost
c) Sunk cost
d) Standard cost
e) Book cost
f) Overhead cost

8. This cost It is included in an analysis for it affects income taxes, which are cash flows.
9. Examples of these costs are; administrative, insurance, taxes, electricity, general repairs.
10. It is the cost of the best rejected opportunity and is often hidden or implied.
 ENGINEERING ECONOMY

THE GENERAL ECONOMIC ENVIRONMENT

CONSUMER AND PRODUCER GOODS AND SERVICES

 Consumer goods and services- are those products or services that are directly used by people to satisfy
their wants.

 Producer goods and services- are used to produce consumer goods and services or other producer goods.

NECESSITIES AND LUXURIES

 Necessities- are those products or services that are required to support human life and activities that will
be purchased in somewhat the same quantity even though the price varies considerably.

 Luxuries- are those products or services that are desired by human and will be purchased if money
available after the required necessities have been obtained.

DEMAND and SUPPY

Demand- is the quantity of a certain commodity that is bought at a certain price at a given place and time.
Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is
the amount of a certain product people are willing to buy at a certain price.

Factors influencing demand

The shape of the demand curve is influenced by the following factors:
- Income of the people
- Prices of related goods
- Tastes of consumers

Law of Demand – The demand for a commodity varies inversely as the price of the commodity, though not
proportionately.

Supply - is the quantity of a certain commodity that is

offered for sale at certain price at a given place and time. It represents how much the market can offer.

The shape of the supply curve is affected by the following factors:

- Cost of the inputs
- Technology
- Weather
- Prices of related goods
 ENGINEERING ECONOMY

Law of supply - The supply of the commodity varies directly as the price of the commodity, though not
proportionately.

LAW OF SUPPLY AND DEMAND

An interesting aspect of the economy is that the demand and supply of a product are interdependent and
they are sensitive with respect to the price of that product. The interrelationships between them are shown in
Fig. 1.2. From Fig. 1.2 it is clear that when there is a decrease in the price of a product, the demand for the
product increases and its supply decreases. Also, the product is more in demand and hence the demand of the
product increases. At the same time, lowering of the price of the product makes the producers restrain from
releasing more quantities of the product in the market. Hence, the supply of the product is decreased. The point
of intersection of the supply curve and the demand curve is known as the equilibrium point. At the price
corresponding to this point, the quantity of supply is equal to the quantity of demand. Hence, this point is called
the equilibrium point.
 ENGINEERING ECONOMY

BREAK-EVEN ANALYSIS

The main objective of break-even analysis is to find the cut-off production volume from where a firm
will make profit. Let;

s = selling price per unit

v = variable cost per unit
FC = fixed cost per period
Q = volume of production

The total sales revenue (S) of the firm is given by the following formula:

S=s x Q

The total cost of the firm for a given production volume is given as

TC=Total variable cost +¿ cost

¿ v x Q+ FC

 The linear plots of the above two equations are shown in Fig.1.3
 The intersection point of the total sales revenue line and the total cost line is called the break-even
point.
 The corresponding volume of production on the X-axis is known as the break-even sales quantity.
 At the intersection point, the total cost is equal to the total revenue. This point is also called the no-loss
or no-gain situation.
 For any production quantity which is less than the break-even quantity, the total cost is more than the
total revenue. Hence, the firm will be making loss.

Profit=Sales – (¿ cost +Variable costs)

¿( s x Q) – ( FC+v x Q)

Fixedcost
Break−even quantity =
price cost
Selling −Variable
unit unit

FC
¿
(S−V )
 ENGINEERING ECONOMY
Fixedcost price
Break−even sales= (selling )
price cost unit
Selling −Variable
unit unit

The contribution is the difference between the sales and the variable costs. The margin of safety (M.S.)
is the sales over and above the break-even sales.

Contribution=Sales−Variable costs

Margin of safety (M . S )= Actual sales – Break−even sales

profit
¿ ( sales )
contribution

Example1.2: (Break – even Analysis)

G & J associates has the following:

Fixed Cost = Php 2, 000, 000

Variable Cost/ Unit = Php 100

Selling Price/ Unit Php 200

Find the following:

a) The break-even sales quantity.

b) The break-even sales

c) If the actual production quantity is 60, 000, find (1) Contribution; (2) Margin of Safety

Solution:

FC 2 ,000 , 000
a) Break-even Qty = S−V = 200−100 =20 , 000 Units

FC 2 ,000 , 000
b) Break-even Sales ¿ S−V × s= 200−100 ×200=Php 4 , 000 , 000

c) (1) Contribution ¿ sales−variables cost= ( S × Q )−(V × Q)

¿ ( 200 ×60 , 000 )−(100 ×60 , 000)
 ENGINEERING ECONOMY
¿ P hp 6 , 000 ,000

(2) Margin of Safety ¿ sales−break−even sales

¿ ( 200 ×60 , 000 )−(4 , 000 ,000)

¿ Php 8 ,000 , 000

PROFIT/VOLUME RATIO (P/V RATIO)

P/V ratio is a valid ratio which is useful for further analysis. The different formulas for the P/V ratio are
as follows:

P Contribution Sales−Variable costs

ratio= =
V Sales Sales

The relationship between BEP and P/V ratio is as follows:

¿ cost
BEP=
P
ratio
V

The following formula helps us find the M.S. using the P/V ratio:

Profit
M . S .=
P
ratio
V

EXAMPLE 1.3: Consider the following data of a company for the year 1997:

Sales = Php120,000
Fixed cost = Php 25,000
Variable cost = Rs. 45,000

Find the following:

(a) Contribution
(b) Profit
(c) BEP
(d) M.S.
 ENGINEERING ECONOMY
Solution
(a) Contribution = Sales – Variable costs
= Php 1,20,000 – Php 45,000
= Php 75,000

(b) Profit = Contribution – Fixed cost

= Php 75,000 – Php 25,000
= Php 50,000

(c) BEP
Contribution
P/V ratio =
Sales

75,000
¿ x 100 = 62.50%
120 ,000

¿ cost
25000
BEP = P = x 100 = Php 40,000
ratio 62.50
V

Profit
50000
M.S. = P = x 100 = Php 80,000
ratio 62.50
V

Try Me!

1. Consider the following data of a company for the year 2020:

Sales = Php 80,000
Fixed cost = Php 15,000
Variable cost = Php 35,000
Find the following:
(a) Contribution=
(b) Profit=
(c) BEP=
(d) M.S. =

2. ABC company have the have the following details:

Fixed cost= 40,000
Variable cost/unit = 300
Selling price/unit = 500
Find the following:
a) The break-even sales quantity
b) The break-even sales
 ENGINEERING ECONOMY
c) If the actual production quantity is 120,000 find the following
1.) Contribution
2.) Margin of safety by all methods
 ENGINEERING ECONOMY

1.5 Present Economy Studies

When alternatives for accomplishing a specific task are being compared over one year or less and the
influence of time on money can be ignored, engineering economic analyses are referred to as present economy
studies. The following factors will affect the decision:
- Price of the raw material
- Transportation cost of the raw material
- Availability of the raw material
- Quality of the raw material

In this section, the concept of simple economic analysis is illustrated using suitable examples in the following
areas:
 Material selection for a product
 Making versus Purchasing (Outsourcing) Studies
 Trade-Offs in Energy Efficiency Studies
 Design selection for a product
 Design selection for a process industry
 Building material selection for construction activities
 Process planning/Process modification

Example 1.4: (Material Selection)

In the design of an engine part, the designer has a choice of either aluminum alloy casting or steel
casting. Both materials provide equal service but aluminum casting will weigh 1.2 kg while steel casting weighs
1.35 kg.
The aluminum can be cast for 800/kg and the steel for 550/kg. The cost for machining per unit is 1500
for aluminum and 1700 for the steel. Every kg of excess weight will have a penalty of 1300 due to excess fuel
consumption. Which material should be specified and what is the economic advantage per unit?

Solution:
Given:
Alloy Steel
Wt. of material 1.2 kg 1.35 kg
Cost of Making 800/kg 550/kg
Cost of Machining 1500/unit 1700/unit
Penalty 1300/ kg excess

1. (a) Total cost using aluminum

T.C= cost of making + cost of machining
= 1.2(800) + 1500
= Php 2460

(b) Total cost using steel

T.C= cost of making + cost of machining+ penalty
= 1.35(550) + 1700 + (1.35-1.2)(1300)
= Php 2637.5
2. Economic Advantage of aluminum over steel
 ENGINEERING ECONOMY
= 2637.5 – 2460
= Php 187.5

EXAMPLE 1.5: (Design Selection for a Product)

Two machines currently owned by Sheldon are being considered for the production of a part. Consider
the following table:

Machine A Machine B
Production Rate 100 parts/ hr 130 parts/hr
Production hours 7 hr/day 6 hr/day
Percent part rejected 3% 10%

The material cost is ₱300/part, and all defect free parts produced can be sold for ₱600 each. For either
machine, the operator cost is ₱800/hr and overhead is ₱200 per hour.
1. Assume that all defect-free parts can be sold with machine should Sheldon use?
2. What would be the percent of parts rejected have to be for machine B to be as profitable as machine A?

SOLUTION:
(1.) Machine A or Machine B?
(a) Machine A
Parts Hour
Product/day = 100 x7
hour day

Parts
= 700
day

Parts
Num. of defect-free= 700 (1-.03) = 679
day
Profit per Day = Revenue –Cost
= 679(600)–[679(300)+800(7)+200(7)]
= 407,400 – 210,700
= ₱196,700

(b) Machine B
Parts Hour
Product/day = 130 x6
hour day

Parts
= 780
day

Parts
Num. of defect-free= 780 (1-.10) = 702
day
Profit per Day = Revenue –Cost
= 702(600)–[702(300)+800(6)+200(6)]
= 421,200 – 216,600
= ₱204,600

Therefore, Sheldon must use Machine B.

 ENGINEERING ECONOMY

(2) Profit A = Profit B

196,700 = RevenueB - CostB

Defect free = 780(1-x) = 780 – 780x, where x= percent reject

196,700 = (780-780x)(600) – [(780-780x)(300)+(800x6)+200(6)]

X= 0.1338 or
X= 13.38%
 ENGINEERING ECONOMY
Activity:

1. A municipal solid-waste site for a city must be located at Site A or Site B. After sorting, some of the solid
refuse will be transported to an electric power plant where it will be used as fuel. Data for the hauling of refuse
from each site to the power plant are shown:

Site A Site B
Average hauling distance 4 miles 3 miles
Annual rental fee for solid-waste $50,000 $100,000
site
Hauling cost $1.50/yd3-mile $1.50/yd3-mile
If the
power plant will pay $8.50 per cubic yard of sorted solid waste delivered to the plant, where should the solid-
waste site be located? Use the city’s viewpoint and assume that 250,000 cubic yards of refuse will be hauled to
the plant for one year only.
a) How much is the Profit for Site A?
b) How much is the Profit for Site B?
c) What Site must be selected?

2. A machine part is manufactured at a unit cost of 40 ¢ for material and 15 ¢ for labor. An investment of
$500,000 in tooling is required. The order calls 3 million pieces. Halfway through the order, a new method of
manufacture can be put into effect that will reduce the unit costs to 34 ¢ and 10 ¢ labor cost, but will require
$100,000 for additional tooling. This tooling will not be useful for future orders. Other cost are allocated at 2.5
times the direct labor cost. What should be done?
 ENGINEERING ECONOMY

UNIT 2.
Money-Time Relationship and Equivalence
Section Topic Learning Objective
Interest and the Time To solve and understand problems
2.1 Value of Money involving interest and the time value of
money.
The concept of To determine the different amounts
2.2 Equivalence of money at different points in time
that is equal to economic value.
Cash Flow To understand cash flow and how to
2.3 graphically represent them.
 ENGINEERING ECONOMY

Introduction
Interest rate is the rental value of money. It represents the growth of capital per unit period. The period
may be a month, a quarter, semiannual or a year.

Simple Interest
The interest is said to be simple interest if the interest to be paid is directly proportional to the length of
time the amount or principal is borrowed. The principal is the amount of money borrowed or invested.

Total interest (I) is computed by the formula:

I =( P)(r )(t)

where: P = principal amount lent or borrowed

t = number of interest period (ex. years)
r = interest rate per interest period

Total amount to be paid F in the end of N years:

F=P+ I or F=P(1+(r)(t ))

Example 2.1:
Suppose that ₱1, 000 is borrowed at a simple interest rate of 18% per annum. At the end of one year, the
interest would be:
Solution:
I = (P) (n) (i)
I = 1,000 (1) (0.18) = ₱ 180

Example 2.2:
Harry invested ₱5000.00 in mutual fund with the interest rate of 4.8%. How much interest would she
earn after 2 years?
Solution:
P = ₱5000.00 ; i= 4.8% ; n= 2 Hence, Harry would earn ₱480 after 2
I = (P) (r) (t) years.
I = (₱5000.00)(4.8%)(2) =₱ 480.00

Try me!
Junel has one savings account with the interest rate of 3.5%, and one money market account with the
interest rate of 4.8% in a bank. If he deposits ₱1,200.00 to the savings account, and ₱1,800.00 to the money
market account, how much money will he have after 5 years?

Compound Interest
Compound interest calculations apply to investments where the amount of interest is calculated on the
present balance of the account.

Interest Period Interest Is Calculated:

 ENGINEERING ECONOMY
Semiannually Twice per year, or once every six months

Quarterly Four times a year, or once every three months

Monthly 12 times per year
Weekly 52 times per year
Daily 365 times per year
Continuous For infinitesimally small periods

Total amount to be paid F in the end of N periods:

F=P(1+i) N

Example 2.3:
1. A person deposits a sum of ₱ 20,000 at the interest rate of 18% compounded annually for 10 years.
Find the maturity value after 10 years.
Solution:
P = ₱ 20,000
i = 18% compounded annually
n = 10 years
The maturity value of Php 20,000
invested now at 18% compounded yearly
F = P(1 + i)N
is equal to Php 104,680 after 10 years.
= 20,000 (1 + 0.18)1
= 20,000 x 5.234 = ₱ 104,680

TRY ME!

2. Mr. Naru To had P10,000 stashed under his mattress for 30 years. How much money he lost by
putting it in a bank account at 8.5% annual interest compounded yearly? Ans. P105, 582.516

3. Rody invests P12000 in a bank account which pays interest at the rate of 5% per annum. Calculate the
value of her investment after 5 years. Ans. P15, 315.379

Effective and Nominal Interest Rates

Nominal interest rate, r
- Is the conventional method of stating the annual interest rate. It is calculated by multiplying the interest
rate per compounding period by the number of compounding periods per year.

r Where: Is= interest for sub-period

i s=
m r= nominal rate
m= number of sub-periods

Effective interest rate, ie

 ENGINEERING ECONOMY
- Is the actual but not usually stated interest rate, found by converting a given interest rate with an
arbitrary compounding period (normally less than a year) to an equivalent interest rate with a one-year
compounding period.
- Annual Equivalent Rate.

r m Where: Ie= effective rate

i e =(1− ) −1
m
Examples 2.4:
1. Haring Roque the loan shark lends money to clients at a rate of 6 percent interest per week! What is the
nominal interest rate for these loans? What is the effective annual interest rate?

i s=
r r m
Solution: (a) (b) i e =(1+ ) −1
m m
r =i s (m) i e =1969 %
¿ 6∗52
= 312%

TRY ME!

2. You bought a piece of land 5 years ago for P150, 000. Today it is worth P375, 000.
(a) What annual interest rate did you earn if interest is compounded yearly? Ans.0.201
(b) What monthly interest rate did you earn if interest is compounded monthly? Ans. 0.185

3. Junel has a bank deposit now worth P38, 500. A year ago, it was P35, 000. What was the nominal
monthly interest rate on his account? Ans. 9.569 %
 ENGINEERING ECONOMY

CASH-FLOW DIAGRAMS

The following notation is utilized in formulas for compound interest calculations:

I = effective interest rate per interest period;
N = number of compounding (interest) periods;
P = present sum of money; the equivalent value of one or more cash flows at a reference point in time
called the present;
F = future sum of money; the equivalent value of one or more cash flows at a reference point in time
called the future;
A = end-of-period cash flows (or equivalent end-of-period values) in a uniform series continuing for a
specified number of periods, starting at the end of the first period and continuing through the last
period.

Beginning of the month 1 F

0 1 2 3 4

P
End of the month 1

The cash-flow diagram employs several conventions:

1. The horizontal line is a time scale, with progression of time moving from left to right divided into equal
periods.
2. The arrows signify cash flows and are placed at the end of the period. Downward arrows represent cash
outflows, and upward arrows represent cash inflows.
3. The cash-flow diagram is dependent on the point of view.
 ENGINEERING ECONOMY

Example 2.5:

1. You have accumulated ₱50,000 in your savings account. You can add ₱1000 at the end of each
month to your account which pays an annual interest rate of 6% compounded monthly. What will be
the total amount of your savings after 5 years?

0 1 2 3 4 59 60

1K 1K 1K 1K 1K 1K

i= 6%
50,000

2. An Engineer plans expenditures of $1 million now and each of the next 4 years just for the
improvement of field-based pressure-release valves. Construct the cash flow diagram to find the
equivalent value of these expenditures at the end of year 4, using a cost of capital estimate for safety-
related funds of 12% per year.

Try Me!
A civil engineer wants to deposit an amount P now such that she can withdraw an equal annual amount of
A1 = ₱2000 per year for the first 5 years, starting 1 year after the deposit, and a different annual withdrawal of
A2 = ₱3000 per year for the following 3 years. How would the cash flow diagram appear if i = 6.5% per year?

INTEREST FORMULAS
 ENGINEERING ECONOMY
I.
Single-Payment Compound Amount (Finding F when given P)
Here, the objective is to find the single future sum (F) of the initial payment (P) made at time 0 after n
periods at an interest rate i compounded every period.
The formula to obtain the single-payment compound amount is

F=P(1+i)n = P (F/P, i, n)

Where (F/P, i, n) is called as single-payment compound amount factor

EXAMPLE 2.6:
1. A person deposits a sum of ₱ 20,000 at the interest rate of 18% compounded annually for 10 years.
Find the maturity value after 10 years.

Solution
P = ₱ 20,000
i = 18% compounded annually
n = 10 years

F = P(1 + i) n
= P(F/P, i, n)
= 20,000 (F/P, 18%, 10)
= 20,000 5.234 ¿ Php104,680.

The maturity value of Php 20, 000 invested in 18% compounded annually is equal
to Php 104,680 after 10 years.
 ENGINEERING ECONOMY

II. Single-Payment Present Worth Amount (Finding P when given F)

Here, the objective is to find the present worth amount (P) of a single future sum (F) which will be received
after n periods at an interest rate of i compounded at the end of every interest period.

The formula to obtain the present worth is

F
P= = F(P/F, i, n)
( 1+i )n

where (P/F, i, n) is termed as single-payment present worth factor.

EXAMPLE 2.7:
1. A person wishes to have a future sum of ₱100,000 for his son’s education after 10 years from now.
What is the single-payment that he should deposit now so that he gets the desired amount after 10 years?
The bank gives 15% interest rate compounded annually.

Solution:
F = ₱ 100,000
i = 15%, compounded annually
n = 10 years
F
P=
( 1+i )n
= F (P/F, i, n)
= 100,000 (P/F, 15%, 10)
= 100,000 0.2472 ¿ Php24,720

The person has to invest ₱ 24,720 now so that he will get a sum of ₱ 100,000 after
10 years at 15% interest rate compounded annually.
 ENGINEERING ECONOMY

III. Equal-Payment Series Compound Amount (Finding F when given A)

In this type of investment mode, the objective is to find the future worth of n equal payments which are
made at the end of every interest period till the end of the nth interest period at an interest rate of i compounded
at the end of each interest period.

A = equal amount deposited at the end of each interest period

n = No. of interest periods i = rate of interest
F = single future amount

The formula to get F is

(1+i )n−1
F= A = A ( F / A , i ,n)
i
where
(F/A, i, n) is termed as equal-
payment series compound amount
factor.

EXAMPLE 2.8:
1. A person who is now 35 years old
is planning for his retired life. He plans to invest an equal sum of ₱ 10,000 at the end of every year for
the next 25 years starting from the end of the next year. The bank gives 20% interest rate, compounded
annually. Find the maturity value of his account when he is 60 years old.
Solution:
A = ₱ 10,000 (1+i )n−1
F= A
n = 25 years i
i = 20%
F=? ( 1+0.20 )25 −1
=(10,000)
0.20
¿ Php 4 , 719 , 810
The future sum of the annual equal payments after 25 years is equal to Php 4, 719, 810.

IV. Equal-Payment Series Sinking Fund ( Finding A when given F)

 ENGINEERING ECONOMY
In this type of investment mode, the objective is to find the equivalent amount (A) that should be deposited
at the end of every interest period for n interest periods to realize a future sum (F) at the end of the nth interest
period at an interest rate of i.

A = equal amount to be deposited at the end of each interest period

n = No. of interest periods
i = rate of interest
F = single future amount at the end of the nth period

i
A=F = A ( F / A , i ,n)
(1+i )n−1

Where (A/F, i, n) is called as equal-payment series sinking fund factor.

EXAMPLE 2.9:
1. A company has to replace a present facility after 15 years at an outlay of ₱ 500,000. It plans to deposit
an equal amount at the end of every year for the next 15 years at an interest rate of 18% compounded
annually. Find the equivalent amount that must be deposited at the end of every year for the next 15
years.

Solution:
F = ₱ 500,000
n = 15 years
i = 18%
A =?
0.18
A=(500,000)
( 1+0.18 )15−1
= 500,000(0.0164)
¿ Php 8,200

The annual equal amount which must be deposited for 15 years is Php 8,200.
 ENGINEERING ECONOMY

V. Equal-Payment Series Present Worth Amount (Finding P when given A)

The objective of this mode of investment is to find the present worth of an equal payment made at the end of
every interest period for n interest periods at an interest rate of i compounded at the end of every interest period.
P = present worth
A = annual equivalent payment
i = interest rate
n = No. of interest periods
The formula to compute P is

( 1+i )n−1
P= A n
=A (P/ A , i, n)
i ( 1+ i )

Where (P/A, i, n) is called equal-payment series present worth factor

EXAMPLE 2.10:
1. A company wants to set up a reserve which will help the company to have an annual equivalent amount
of ₱ 1,000,000 for the next 20 years towards its employee’s welfare measures. The reserve is assumed
to grow at the rate of 15% annually. Find the single-payment that must be made now as the reserve
amount.
Solution:
A = ₱ 1,000,000
i = 15%
n = 20 years
P =?
( 1+i )n−1
P= A n
=A (F / A ,i , n)
i ( 1+ i )

( 1+0.15 )20−1
¿(1,000,000)
(
0.15 ( 1+ 0.15 )20 )
¿ 1000,000(6.2593)
¿ Php 6,259,300

The amount of reserve which must be set-up now is equal to Php 62,59,300.
 ENGINEERING ECONOMY

VI. Equal-Payment Series Capital Recovery Amount (Finding A given P)

The objective of this mode of investment is to find the annual equivalent amount (A) which is to be
recovered at the end of every interest period for n interest periods for a loan (P) which is sanctioned now at an
interest rate of i compounded at the end of every interest period.

P = present worth (loan amount)

A = annual equivalent payment (recovery amount)
i = interest rate
n = No. of interest periods
i ( 1+ i )n
A=P n
=P( A/ P , i , n)
( 1+i ) −1

Where, (A/P, i, n) is called equal-payment series capital recovery factor.

EXAMPLE 2.11:
1. A bank gives a loan to a company to purchase an equipment worth ₱ 1,000,000 at an interest rate of
18% compounded annually. This amount should be repaid in 15 yearly equal installments. Find the
installment amount that the company has to pay to the bank.

Solution:
P = ₱ 1,000,000
i = 18%
n = 15 years
A =?

i ( 1+ i )n
A=P n
=P( A/ P , i , n)
( 1+i ) −1
(0.18) ( 1+0.18 )15
¿(1,000,000)
(
( 1+ 0.18 )15−1 )
¿(1,000,000)(0.1964)
¿ Php196,400

The instalment amount that the company has to pay to the bank is Php 196, 400.
VII. Uniform Gradient Series Annual Equivalent Amount
 ENGINEERING ECONOMY
The objective of this mode of investment is to find the annual equivalent amount of a series with an amount
A1 at the end of the first year and with an equal increment (G) at the end of each of the following n – 1 years
with an interest rate i compounded annually.

1 n
A=A 1 +G
( −
i ( 1+i )n−1 )
=G( A / G ,i , n)

Where (A/G, i, n) is called uniform gradient series factor.

EXAMPLE 2.12:
1. A person is planning for his retired life. He has 10 more years of service. He would like to deposit 20%
of his salary, which is ₱ 4,000, at the end of the first year, and thereafter he wishes to deposit the
amount with an annual increase of ₱ 500 for the next 9 years with an interest rate of 15%. Find the total
amount at the end of the 10th year of the above series.

Solution:
A1 = ₱ 4,000
G = ₱ 500
i = 15%
n = 10 years
A =? & F =?

1 n (1+i )n−1
A=A 1 +G
( −
i ( 1+i )n−1 )
=G( A / G ,i , n) F= A
i
1 10 ( 1+0.15 )10−1
¿ 4000+500
( −
0.15 ( 1+0.15 )10 −1 ) ¿(5691.60)
0.15
¿ 4000+500 (3.3832)
¿ 5,691.60 ( 20.304 )
¿ Php5691.60
¿ Php115,562.25

At the end of the 10th year, the compound amount of all his payments will be Php115,562.25.
 ENGINEERING ECONOMY

Continuous Compounding

Single Payment

F=P(e rn ) = P[ F /P , r , n]
P=F (e−rn ) = F [P /F ,r , n]

Uniform Series

e r−1 e rn ( er −1 )
A=F
[ ]
e rn −1
A=P
[ e rn −1 ]
e rn−1 e rn −1
F= A r
[ ]
e −1
P= A
[ e rn ( er −1 ) ]
Example 2.13: Continuous Compounding and Single Amounts
An Engineer wish to deposit P1500 on a bank that earns 12% compounded continuously. What is the
sum after 8 years from now?

Solution:
Given:
P= P1500
r= 12% compounded continuously
n=8 years
0.12 (8)
F=P(e rn ) = 1500( e )
=Php 3917. 54

Example 2. 14: Continuous Compounding and Annual Payments

Beth invested P5000 at the end of each year on her account which gives a nominal annual interest rate of
7.5% compounded continuously. Determine the total worth of his investment at the end of 15 years.

Solution:
Given:
A= 5000
r= 7.5% compounded continuously
n= 15 years

e rn−1 e(0.075)15−1
F= A
[ ]
e r−1
= 5000
[
0.075
e −1 ]
¿ Php133,545.58
 ENGINEERING ECONOMY

UNIT 3.
Economic Study Methods

Section Topic Learning Objective

The minimum Attractive State the meaning and role of
3.1 Rate of Return Minimum Attractive Rate of Return
(MARR) and opportunity costs.
Basic Economic Study Utilize different basic economic
3.2 Methods study methods to evaluate and
select alternatives.
Utilize different present worth
3.2.a Present Worth techniques to evaluate and select
alternatives.
Select the best alternative using
3.2.b Capitalized Cost
capitalized cost (CC) analysis.
Select the best alternative using
3.2.c Future Worth
future worth analysis.
Select the best alternative using an
3.2.d Annual Worth
annual worth analysis.
Understand the meaning of rate of
3.2.e Rate of Return return and perform an ROR
evaluation of a single project
3.3 Other Methods:

Determine the payback period of a

project at i = 0% and i > 0%.
3.3.a Payback Analysis
Illustrate the cautions when using
payback analysis.
Calculate the benefit/cost ratio and
3.3.b Benefit/Cost Ratio
use it to evaluate a single project.
 ENGINEERING ECONOMY

Engineers play a major role in making decisions about investment opportunities. They are the ones who
estimate the expected costs of and returns from an investment. Engineers frequently refer to investment
opportunities as projects.
Let us assume that an organization wants to invest a huge sum of money and there are three different
projects to choose from. The engineer has to select the best alternative among these three competing projects.
There are several comparison methods for comparing the worthiness of the projects. These methods are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method

3.1 Minimum Acceptable Rate of Return (MARR)

The MARR is an interest rate that must be earned for any project to be accepted. If the projects earns at
least the MARR, then it is worthy since this means that the money is earning at least as much as can be if it was
invested elsewhere. Projects that earn less than the MARR are not desirable, since investing money in these
projects denies the opportunity to use the money more profitably elsewhere.

3.2 Basic Economic Study Methods

3.2.a. PRESENT WORTH METHOD

In this method of comparison, the cash flows of each alternative will be reduced to time zero at an interest
rate that is generally the MARR. Then, depending on the type of decision, the best alternative will be selected
by comparing the present worth amounts of the alternatives.

NPW =PW of cash inflows−PW of cash outflows

Example 3.1:
An engineer has two bids for an elevator to be installed in a new building. The details of the bids for the
elevators are as follows:

Bid Engineer’s estimates

Initial cost (Php) Service Years Annual Costs (Php)
Alpha Elevator Inc. 450,000 15 27,000
Beta Elevator Inc. 540,000 15 28,500
 ENGINEERING ECONOMY
Determine which bid should be accepted, based on the present worth method of comparison assuming 15%
interest rate, compounded annually.

Solution

Bid 1: Alpha Elevator Inc.

Initial cost, P =450,000

Annual operation and maintenance cost, A = 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually.

The present worth of the above cash flow diagram is computed as follows:

PW(15%) = 450,000 + 27,000(P/A, 15%, 15)

= 450,000 + 27,000 (5.8474)
= 450,000 + 157,879.80
= Php 607,879.80

Bid 2: Beta Elevator Inc.

Initial cost, P = 540,000

Annual operation and maintenance cost, A =28,500
Life = 15 years
Interest rate, i = 15%, compounded annually.

The present worth of the above cash flow diagram is computed as follows:
PW (15%) = 540,000 + 28,500(P/A, 15%, 15)
= 540,000 + 28,500 (5.8474)
= 540,000 + 166,650.90
=Php 706,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is to be selected for
implementation. That is, the elevator from Alpha Elevator
Inc. is to be purchased and installed in the new building.

Example 3.2:
 ENGINEERING ECONOMY
Investment proposals A and B have the net cash flows as follows:

Proposal End of years

0 1 2 3 4
A (Php) -10,000 3,000 3,000 7,000 6,000
B (Php) -10,000 6,000 6,000 3,000 3,000

Compare the present worth of A with that of B at i = 18%. Which proposal should be selected?

Solution:

Proposal A

Cash-flow diagram of Proposal A

The present worth of the above cash flow diagram is computed as

PWA (18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)
+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182) + 7,000(0.6086)
+ 6,000(0.5158)
=Php 2,052.10

Proposal B

Cash-flow diagram of Proposal B

The present worth of the above cash flow diagram is calculated as

PWB (18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2)
+ 3,000(P/F, 18%, 3) + 3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182)
+ 3,000(0.6086) + 3,000(0.5158)
 ENGINEERING ECONOMY
=Php 2,767.40

At i = 18%, the present worth of proposal B is higher than that of proposal A. Therefore,
select proposal B.

Try This!
1. XYZ General Hospital is evaluating new office equipment offered by three companies. In each case the
interest rate is 15% and the useful life of the equipment is 4 years. Use NPW analysis to determine the
company from which you should purchase the equipment.

A B C
First cost $15,000 $25,000 $20,000
Maintenance Cost 1,600 400 900
Annual benefit 8,000 13,000 11,000
Salvage value 3,000 6,000 4,500

3.2.b CAPITALIZED COST

Capitalized cost is the present sum of money that would need to be set aside now, at some interest rate, to
yield the funds required to provide the service (or whatever)indefinitely.

Perpetuity

- A perpetuity is an annuity whose payment take place forever, i.e., it is an annuity whose term is
infinite
A
Formula; P=
i

Example 3.3:
What is the capitalized cost of a public works project that will cost $25,000,000 now and will require a
maintenance cost of $2,000,000 annually? The effective annual interest rate is 12%.

Solution:
 ENGINEERING ECONOMY
A
Capitalized cost = FC +
i
2,000,000
=25,000,000+
0.12
= $41,666,667 Ans.

Example 3.4:
A city plans a pipeline to transport water from a distant watershed area to the city. The pipeline will cost $8
million and will have an expected life of 70 years. The city anticipates it will need to keep the water line in
service indefinitely. Compute the capitalized cost, assuming7% interest.

Solution:

First draw the cash flow diagram;

For us to be able to use the interest rate of 7% per year compounded annually, it is helpful to convert the $8
million disbursement at the end of 70 years into an equivalent A every year.

$8 million

n=70

From the formula of Equal-Payment Series Sinking Fund;

i
A=F = A ( F / A , i ,n)
(1+i )n−1
0.07
(
=8,000,000 )
( 1+0.07 )70−1
= $4960
Each 70-year period is identical to this one and the infinite series is shown in the figure below;
 ENGINEERING ECONOMY

Now we can compute for the capitalized cost as follows;

A
C.C = FC +
i
4,960
= 8,000,000 +
0.07
=$8,071,000 Ans.

Try this!

1. Calculate the capitalized cost of a project that has an initial cost of $300,000
And additional investment cost of $100,000 after ten years. The annual operating cost will be $10,000 for the
first four years and $16,000 after that.
It is expected that the recurring major rework costs of $30,000 every 12 years with interest rate of 6% per year.

ACTIVITY!
DPWH is planning to construct either a suspension bridge or a truss bridge to cross a river. In the east site,
the suspension bridge would have to stretch from one hill to another to span the widest part of the river, railroad
tracks, and local highways below. Its first cost will be $30millon with annual maintenance and inspection costs
of $15,000. In addition the concrete deck would have be resurfaced every ten years at cost of $50,000. The cost
of purchasing right-of-way is expected to cost $800,000.
In the south site the truss bridge will be constructed but would require a new roads construction. The first
cost of this bridge will be $10 million while the cost of the new roads will be $80,000. This bridge has to be
painted every 3 years at cost of $100,000. In Addition, this bridge would have a major reworks every ten years
at cost of $450,000. The cost of purchasing right-of-way is expected to be $11million. Determine which of these
two sites should be selected if the interest rate is 6% per year.
 ENGINEERING ECONOMY

3.2.c FUTURE WORTH METHOD

 It is based on the equivalent worth of all cash inflows and outflows at the end of the planning horizon
(study period) at an interest rate generally the MARR

 All cash inflows and outflows are compounded forward to a reference point in time called the future.

 In the future worth method of comparison of alternatives, the future worth of various alternatives will be
computed. Then, the alternative with the maximum future worth of net revenue or with the minimum
future worth of net cost will be selected as the best alternative for implementation.

FW Decision Rule: If FW (i = MARR) ≥ 0, the project is economically justified.

Example 3.5:
An investment of $10,000 can be made that will produce a uniform annual of $5,500 for five years and then
have a market (salvage) value of $2,000. Annual expenses will be $3,150 each year. The company is willing to
accept any project that will earn 10% per year or more, on all invested capital. Show whether this is a desirable
investment by using the FW method.

Solution:
FW (10%) = -10,000 (F/P, 10%, 5) + 2,350 (F/A, 10%, 5) + 2,000
= -10,000 (1.6105) + 2,350 (6.1051) + 2,000
= -16,105 + 14,347 + 2,000
=$ 242
Since FW (10%) > 0, it is a good project.

Example 3.6:
A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual
welding operation. The investment cost is $25,000, and the equipment will have a market value of $5,000 at the
end of a study period of five years. Increased productivity attributable to the equipment will amount to $8,000
per year after extra operating costs have been subtracted from the revenue generated by the additional
production. A cash-flow diagram for this investment opportunity is given below. If the firm’s MARR is 20%
per year, is this proposal a sound one? Evaluate the FW of the potential improvement project.
 ENGINEERING ECONOMY

Solution:
FW (20%) = -25,000 (F/P, 20%, 5) + 8, 000 (F/A, 20%, 5) + 5,000
=$ 2, 324.80

Since FW (10%) > 0, it is a good project.

ACTIVITY!

1. A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual
welding operation. The investment cost is $25,000, and the equipment will have a market value of $5,000 at
the end of a study period of five years. Increased productivity attributable to the equipment will amount to
$10,000 per year after extra operating costs have been subtracted from the revenue generated by the
additional production. If the firm’s MARR is 25% per year, is this proposal a sound one? Use the FW
method.
 ENGINEERING ECONOMY

3.2.d ANNUAL WORTH METHOD

Annual worth comparisons are essentially the same as present/future worth comparisons, except that all
disbursements and receipts are transformed to a uniform series at the MARR.

Assumptions:
1. Cash flows occur at time 0 and at the ends of periods 1 through N.
2. Cash flows are known; the horizon, N, is known; and there is no uncertainty.
3. The interest rate, i, is known.

AW Decision Rule: If AW (i = MARR) ≥ 0, the project is economically justified.

Example 3.7:
A certain machine costs $30,000. Expected revenues are $2500 per quarter for the next 6 years. The
quarterly operating cost is $500. The machine can be sold for $1000 at the end of the 6 years. If interest is 8%
compounded quarterly determine the equivalent quarterly worth and the EAW.

Solution:
First we can either convert all the cash flows in Present worth or Future worth before we can determine the
Equivalent Annual Worth.
Cash flows are quarterly, 6 (4) = 24 periods.

FW= 2,500(F/A, 8%, 24) + 1000 – 30,000(F/P, 8%, 24) – 500(F/A, 8%, 24)
= 76,054.656 + 1000 – 48,253.117 – 15,210.931
= $13,590.615

Now we can determine the EAW. But first convert the interest rate to effective.
Formula: (ieff – 1) = (1+j/m) m
ieff = (1+0.08/4) 4
ieff = 0.08243 or 8.243%

EAW = 13,590.615(A/F, 8.243%, 6) = $1841. 29 ≈ 1842

Since AW (8%) > 0, it is economically justified.

Activity:

Present Worth/ Future Worth

 ENGINEERING ECONOMY
1. A new bridge with a 100-year life is expected to have an initial cost of $ 20 million. This bridge must be
resurfaced every five years, at a cost of $ 1 million. The annual inspection and operating costs are estimated
to be $ 50, 000. Determine the present-worth cost of the bridge using the capitalized equivalent approach
(i.e. take the life of the bridge as infinite). The interest rate is 10% per year, compounded annually.

2. Calculate the capitalized cost of a project that has an initial cost of $300,000 and additional investment cost
of $100,000 after ten years. The annual operating cost will be $10,000 for the first four years and $16,000
after that. It is expected that the recurring major rework costs of $30,000 every 12 years with interest rate of
6% per year.

3. A used machine costs $20 000 to purchase. It has an annual maintenance cost of $20 000, a salvage value of
$5000, and a 10-year life. If the interest rate is 10% per year, compounded annually, what is the present-
worth cost of the machine?

4. Determine the purchase price of a new home if it was financed with a 10% down payment and payments of
$ 539.59 per month for 30 years at 6% interest.

5. A used machine costs $20 000 to purchase. It has an annual maintenance cost of $20 000, a salvage value of
$5000, and a 10-year life. If the interest rate is 10% per year, compounded annually, what is the future-
worth cost of the machine?

6. Determine the future worth of the following series of cash flows, given i = 15%: CF 0 = -$I0 000, CF1 = CF2
= CF3 = CF4 = $5000, CF5 = -$2000, CF6 = $3000.

7. A machine which costs $100 000 when new has a lifetime of 15 years and a salvage value equal to 20% of
its original cost. Determine the capital recovery for this machine, if the interest rate is 10% per year,
compounded annually.

8. Determine the amount of money required to generate an infinite number of annual payments of $5000 each,
if the interest rate is 1O0/0 per year, (a) compounded annually, (b) compounded continuously.

9. A used machine costs $20 000 to purchase. It has an annual maintenance cost of $20 000, a salvage value of
$5000, and a 10-year life. If the interest rate is 10% per year, compounded annually, what is the present-
worth cost of the machine?

10. Calculate the capitalized cost of a project that has an initial cost of $300,000 and additional investment cost
of $100,000 after ten years. The annual operating cost will be $10,000 for the first four years and $16,000
after that. It is expected that the recurring major rework costs of $30,000 every 12 years with interest rate of
6% per year.
 ENGINEERING ECONOMY

Annual worth Method

1. A machine that cost $ 30, 000 new has an 8-year life and a salvage value equal to 10% of its original cost.
The annual maintenance cost of this machine is $ 1, 000 the first year. With an increase of $ 200 each year
hereafter; the annual operating cost is $ 800 per year. Determine the EUAC of this machine if the interest
rate is 10% per year, compounded annually.

2. A machine cost $ 40, 000 to purchase and $ 10, 000 per year to operate. The machine has no salvage value,
and a 10 year life. If i=10% per year, compounded annually, what is the equivalent uniform annual cost of
the machine?

3. A machine costs $30 000 to purchase and $12 000 per year to operate. The machine has a 10-year life and
no salvage value. Determine the EUAC of this machine at annual interest rates of (a) 5%, (b) 15%, and (c)
20%, compounded annually.

4. The Sandwich Company may buy a new piece of equipment for $ 25, 000. The equipment’s useful life is 4
years, and its salvage value is $ 5, 000. The

5. Costs of $10 000, $20 000, and $23 000 are incurred at the ends of three successive years. Find the EUAC
for k repetitions of the cycle, if (a) i = 10% per year, (b) i = 15% per year, compounded annually.
 ENGINEERING ECONOMY

3.2.e INTERNAL RATE OF RETURN METHOD

 The internal rate of return (IRR) is based only on a project’s cash flows. It is the most widely used rate
of return method for performing engineering economic analysis.

 Also known as investor’s method, discounted cash flow method, and probability index.

 This involves solving for the interest rate, termed internal rate of return (IRR), that equates the
equivalent worth of an alternative’s cash inflows (receipts or savings) to the equivalent worth of cash
outflows (expenditures, including investments costs).

 IRR can be defined also as the interest rate that reduces the present worth amount of a series of receipts
and disbursements to zero.

IRR Decisio Rule: IRR≥ MARR, the project is economically justified.

Example 3.8:

By replacing its assembly line conveyor with an asynchronous conveyor, Golden Valley Manufacturing will
save $50,000 per year in rework, inspection, and labor costs. The asynchronous conveyor will cost $275,000,
and its life is 15 years. There is no salvage value. If Golden Valley uses a 10% interest rate, should the
asynchronous conveyor be installed?

Solution:

PW = −275,000+50,000( P / A , i ,15)

( 1+i )15−1
PW=−275,000+50,000 ( i(1+i)15 )
Solving for IRR using linear Interpolation.

Assume values of i and solve for their corresponding PW. Make a table and list the computed PW. Take note
that we find IRR @ PW=0.

( 1+0.15 )15 −1
@IRR= 15%, PW =−275,000+50,000 (
0.15(1+ 0.15)15 )
= $17368.505
 ENGINEERING ECONOMY

( 1+0.16 )15−1
@IRR= 16%, PW =−275,000+50,000 (
0.16 (1+ 0.16)15 )
= $3772.808

( 1+0.17 )15−1
@IRR= 17%, PW =−275,000+50,000 (
0.17 (1+ 0.17)15 )
= -$8790.638

i PW We find that the IRR is between 16% and 17% where PW=0.
15% $17368.505
16% 3772.808
17% -$8790.638

The next step is to interpolate for the IRR.

i PW
16% $3772.808
IRR 0
17% -$8790.638

16 %−IRR 3772.808−0
=
16 %−17 % 3772.808−(−8790.638)

IRR=16.3 %

The IRR exceeds the MARR of 10%. Thus, the asynchronous conveyor line
should be installed.
 ENGINEERING ECONOMY
Example 3.9:
A company is trying to diversify its business in a new product line. The life of the project is 10 years with
no salvage value at the end of its life. The initial outlay of the project is Php 2,000,000. The annual net profit is
Php 350,000. Find the rate of return for the new business.

Solution:
Life of the product line (n) = 10 years
Initial outlay = Php 2,000,000
Annual net profit = Php 350,000
Scrap value after 10 years = 0

The formula for the net present worth function of the situation is
PW (i) = –2,000,000 + 350,000(P/A, i, 10)

4 Assume values of i and solve for their corresponding PW. Make a table and list the computed PW. Take
note that we find IRR @ PW=0.

When i = 10%,
PW (10%) = –2,000,000 + 350,000(P/A, 10%, 10)
= –2,000,000 + 350,000(6.1446)
=Php 150,610.

When i = 11%,
PW (12%) = –2,000,000 + 350,000(P/A, 11%, 10)
= –2,000,000 + 350,000(5.8892)
=Php 61,231.204

When i = 12%,
PW (12%) = –2,000,000 + 350,000(P/A, 12%, 10)
= –2,000,000 + 350,000(5.6502)
=Php –22,430.

We find that the IRR is between 11% and 12% where PW=0.

i PW
11% 61,231.204 11%−IRR 61,231.204−0
=
IRR 0 11%−12 % 61,231.204−(– 22,430)
12% –22,430
IRR=11.73%
 ENGINEERING ECONOMY

3.3 OTHER METHODS

3.3.a PAYBACK ANALYSIS

Payback analysis is another use of the present worth technique. It is used to determine the amount of
time, usually expressed in years, required to recover the first cost of an asset or project. Payback is allied with
breakeven analysis; this is illustrated later in the section. The payback period, also called payback or payout
period, has the following definition and types.

The payback period n P is an estimated time for the revenues, savings, and any other monetary benefits to
completely recover the initial investment plus a stated rate of return i.

There are two types of payback analysis as determined by the required return.

No return; i = 0%: Also called simple payback, this is the recovery of only the initial investment.

Discounted payback; i ¿ 0%: The time value of money is considered in that some return, for example, 10%
per year, must be realized in addition to recovering the initial investment.

t=n p

No Return, i=0%; NCF, varies annually: 0=−P+ ∑ NCF t

t=1

P
No Return, i=0%; annual uniform NCF: np=
NCF
t=n p
P
Discounted, i > 0%; NCF, varies annually: 0=−P+ ∑ NCF t ( ,i , t)
t=1 A

P
Discounted, i > 0%; annual uniform NCF: 0=−P+ NCF ( , i, n p )
A
Example 3.10:
Two equivalent pieces of quality inspection equipment are being considered for purchase by Square D
Electric. Machine 2 is expected to be versatile and technologically advanced enough to provide net income
longer than machine 1.

Machine 1 Machine 2
First Cost, $ 12, 000 8, 000
Annual NCF, $ 3, 000 1, 000 (years 1-5),
3, 000 (years 6-14)
Maximum Life, years 7 14
The quality manager used a return of 15% per year.

Solution:
 ENGINEERING ECONOMY

Machine 1: use equation, Machine 2: use equation,

P P
0=−P+ NCF ( , i, n p ) 0=−P+ NCF ( , i, n p )
A A

P P
0=−12 ,000+ 3000( , 15 % , n0=−8
A p)
(
, 000+1000
A )
,15 % , n p
P P
+3000( ,15 % , n p−5)( ,15 % ,5)
( 1+ 0.15 )n−1 A F
(
0=−12 ,000+ 3 ,000
)
0.15 ( 1+0.15 ) n

n p =9.52 years
12, 000
( 0.15 )( 1+0.15 )n=( 1+0.15 )n−1
3 ,000
0.6 ( 1.15 )n= (1.15 )n−1 Recommendation: Select machine 1, because it has
n n
0.6 ( 1.15 ) −1.15 =−1 a shorter payback period of 6.57 years at i =15%.
n
−0.4 ( 1.15 ) =−1
1
( 1.15 )n=
0.4
n ln ( 1.15)=ln (2.5)
 ENGINEERING ECONOMY

3.3.b Benefit/Cost Analysis

The benefit/cost ratio is relied upon as a fundamental analysis method for public sector projects. The
B/C analysis was developed to introduce greater objectivity into public sector economics. There are several
variations of the B/C ratio; however, the fundamental approach is the same. All cost and benefit estimates must
be converted to a common equivalent monetary unit (PW, AW, or FW) at the discount rate (interest rate). The
B/C ratio is then calculated using one of these relations:

B PW of benefits AW of benefits FW of benefits

= = =
C PW of costs AW of costs FW of costs

Present worth and annual worth equivalencies are preferred to future worth values. The sign convention for B/C
analysis is positive signs; costs are preceded by a sign. Salvage values and additional revenues to the
government, when they are estimated, are subtracted from costs in the denominator. Disbenefits are considered
in different ways depending upon the model used. Most commonly, disbenefits are subtracted from benefits
and placed in the numerator. The different formats are discussed below.

The decision guideline is simple:

If B/C ≥1.0, accept the project as economically justified for the estimates and discount rate applied.

If B/C < 1.0, the project is not economically acceptable.

If the B/C value is exactly or very near 1.0, noneconomic factors will help make the decision. The conventional
B/C ratio, probably the most widely used, is calculated as follows:

B benefits−disbenefits B−D
= =
C costs C

The modified B/C ratio includes all the estimates associated with the project, once operational. Maintenance
and operation (M&O) costs are placed in the numerator and treated in a manner similar to disbenefits. The
denominator includes only the initial investment. Once all amounts are expressed in PW, AW, or FW terms, the
modified B/C ratio is calculated as;

B benefits−disbenefits−M ∧O costs
Modifies =
C Initial investement
 ENGINEERING ECONOMY

Example 3.11:
In the past, the Afram Foundation has awarded many grants to improve the living and medical
conditions of people in war-torn and poverty-stricken countries throughout the world. In a proposal for the
foundation’s board of directors to construct a new hospital and medical clinic complex in a deprived central
African country, the project manager has developed some estimates. These are developed, so she states, in a
manner that does not have a major negative effect on prime agricultural land or living areas for citizens.

Award amount: $20 million (end of) first year, decreasing by $5 million per year for 3
additional years; local government will fund during the first year
only
Annual costs: $2 million per year for 10 years, as proposed
Benefits: Reduction of $8 million per year in health-related expenses for
citizens
Disbenefits: $0.1 to $0.6 million per year for removal of arable land and
commercial districts

Use the conventional and modified B/C methods to determine if this grant proposal is economically justified
over a 10-year study period. The foundation’s discount rate is 6% per year.

Solution:

Initially, determine the AW for each parameter over 10 years. In $1 million units,

Award: 20 − 5(A/G,6%,4) = $12.864 per year

Annual costs: $2 per year
Benefits: $8 per year
Disbenefits: Use $0.6 for the first analysis

The conventional B/C analysis

B benefits−disbenefits 8.0−0.6
= = =0.50
C costs 12.864+2.0

The modified B/C analysis

B benefits−disbenefits−M ∧O costs 8.0−0.6−2.0
Modified = = =0.42
C costs 12.864

The proposal is not justified economically since both measures are less than 1.0. If the low
disbenefits estimate of $0.1 million per year is used, the measures increase slightly, but not
enough to justify the proposal.
 ENGINEERING ECONOMY

ACTIVITY!
1. How long will you have to sell a product that has an income of $5000 per month and expenses of $1500
per month if your initial investment is $28,000 and your MARR is ( a ) 0% and ( b ) 3% per month?
Solve by formula.

2. The cost of grading and spreading gravel on a short rural road is expected to be $300,000. The road will
have to be maintained at a cost of $25,000 per year. Even though the new road is not very smooth, it
allows access to an area that previously could only be reached with off-road vehicles. The improved
accessibility has led to a 150% increase in the property values along the road. If the previous market
value of a property was $900,000, calculate the B/C ratio using an interest rate of 6% per year and a 20-
year study period.
 ENGINEERING ECONOMY

UNIT IV.
DECISIONS UNDER CERTAINTY
Section Topic Learning Objective
Evaluation of Mutually
Identify mutually exclusive and independent
4.1 Exclusive Alternatives and
projects; define revenue and cost alternatives.
Independent Projects
Present Worth Utilize different present worth techniques to
4.1.a
evaluate and select alternatives.
 Select the best of equal-life alternatives using
PW of equal-life alternatives
present worth analysis.
 Select the best of different-life alternatives using
PW of different-life alternatives
present worth analysis.
 Select the best alternative using future worth
Future Worth
analysis.
 Select the best alternative using an annual worth
Annual Worth
analysis.
Effects of Inflation Calculate the worth of cash flows with an
4.2
adjustment made for inflation.
4.3 Depreciation and after – Tax Economic Analysis
Use depreciation or depletion methods to reduce
4.3.a Depreciation the book value of a capital investment in an asset
and natural resource.
Perform an after-tax economic evaluation
4.3.b After – Tax Economic Analysis considering the impact of pertinent tax
regulations and income taxes.
Perform a replacement/retention study between
4.4 Replacement Analysis an in-place asset, process, or system and one that
could replace it.
 ENGINEERING ECONOMY

4.1 Evaluation of Mutually Exclusive Alternatives and Independent Projects

The evaluation and selection of economic proposals require cash flow estimates over a stated period of
time, mathematical techniques to calculate the measure of worth, and a guideline for selecting the best proposal.
From all the proposals that may accomplish a stated purpose, the alternatives are formulated. This progression is
detailed in Figure 4–2. Up front, some proposals are viable from technological, economic, and or legal
perspectives; others are not viable. Once the obviously nonviable ideas are eliminated, the remaining viable
proposals are fleshed out to form the alternatives to be evaluated. Economic evaluation is one of the primary
means used to select the best alternative(s) for implementation.

The nature of the economic proposals is always one of two types:

Mutually exclusive alternatives: Only one of the proposals can be selected. For terminology purposes, each
viable proposal is called an alternative.

Independent projects: More than one proposal can be selected. Each viable proposal is called a project.

The do-nothing (DN) proposal is usually understood to be an option when the evaluation is performed.

The DN alternative or project means that the current approach is maintained; nothing new is initiated. No
new costs, revenues, or savings are generated.

If it is absolutely required that one or more of the defined alternatives be selected, do nothing is not
considered. This may occur when a mandated function must be installed for safety, legal, government, or other
purposes.

Mutually exclusive alternatives and independent projects are selected in completely different ways. A
mutually exclusive selection takes place, for example, when an engineer must select the best diesel-powered
engine from several available models. Only one is chosen, and the rest are rejected. If none of the alternatives
are economically justified, then all can be rejected and, by default, the DN alternative is selected. For
independent projects one, two or more, in fact, all of the projects that are economically justified
can be accepted, provided capital funds are available. This leads to the two following
fundamentally different evaluation bases:
 ENGINEERING ECONOMY

Figure 4 – 1.
Progression from proposals to economic evaluation to selection.
 ENGINEERING ECONOMY

Mutually exclusive alternatives compete with one another and are compared pairwise.

Independent projects are evaluated one at a time and compete only with the DN project.

Since each project may be in or out of the selected group of projects, there are a total of 2^m mutually
exclusive alternatives. Another example, if the engineer has three diesel engine models (A, B, and C) and may
select any number of them, there are 2^3 8 alternatives: DN, A, B, C, AB, AC, BC, ABC. Commonly, in real-
world applications, there are restrictions, such as an upper budgetary limit, that eliminate many of the 2^m
alternatives. n
FC =PC (1+ f )
Finally, it is important to recognize the nature of the cash flow estimates before starting the computation
of a measure of worth that leads to the final selection. Cash flow estimates determine whether the alternatives
are revenue - or cost-based. All the alternatives or projects must be of the same type when the economic study is
performed. Definitions for these types follow:

Revenue: Each alternative generates cost (cash outflow) and revenue (cash inflow) estimates, and possibly
savings, also considered cash inflows. Revenues can vary for each alternative.

Cost: Each alternative has only cost cash flow estimates. Revenues or savings are assumed equal for all
alternatives; thus they are not dependent upon the alternative selected. These are also referred to as service
alternatives.

 Present Worth Analysis of Equal-Life Alternatives

The PW comparison of alternatives with equal lives is straightforward. The present worth P is renamed
PW of the alternative. The present worth method is quite popular in industry because all future costs and
revenues are transformed to equivalent monetary units NOW; that is, all future cash flows are converted
(discounted) to present amounts (e.g., dollars) at a specific rate of return, which is the MARR. This makes it
very simple to determine which alternative has the best economic advantage. The required conditions and
evaluation procedure are as follows:

If the alternatives have the same capacities for the same time period (life), the equal-service requirement is
met. Calculate the PW value at the stated MARR for each alternative.

For mutually exclusive (ME) alternatives, whether they are revenue or cost alternatives, the following
guidelines are applied to justify a single project or to select one from several alternatives.

One alternative: If PW = 0, the requested MARR is met or exceeded and the alternative is economically
justified.

Two or more alternatives: Select the alternative with the PW that is numerically largest, that is, less
negative or more positive. This indicates a lower PW of cost for cost alternatives or a larger PW of net cash
flows for revenue alternatives.
 ENGINEERING ECONOMY

Note that the guideline to select one alternative with the lowest cost or highest revenue uses the criterion of
numerically largest. This is not the absolute value of the PW amount, because the sign matters. The selections
below correctly apply the guideline for two alternatives A and B.

PW A PW S Selected
Alternative
-2300 -1500 B
-500 +1000 B
+2500 +2000 A
+4800 -400 A

For independent projects, each PW is considered separately, that is, compared with the DN project, which
always has PW = 0. The selection guideline is as follows:

One or more independent projects: Select all projects with PW ≥ 0 at the MARR.

The independent projects must have positive and negative cash flows to obtain a PW value that can exceed zero;
that is, they must be revenue projects.

All PW analyses require a MARR for use as the i value in the PW relations.

Example 4.1

A university lab is a research contractor to NASA for in-space fuel cell systems that are hydrogen and
methanol-based. During lab research, three equal-service machines need to be evaluated economically. Perform
the present worth analysis with the costs shown below. The MARR is 10% per year.
 ENGINEERING ECONOMY

Electric-Powered Gas-Powered Solar-Powered

First Cost, Php -4500 3500 -6000
Annual operating cost (AOC),
-900 -700 -50
Php/year
Salvage value S, Php 200 350 100
Life, years 8 8 8

Solution:

These are cost alternatives. The salvage values are considered a “negative” cost, so a + sign precedes them. (If it
costs money to dispose of an asset, the estimated disposal cost has a sign.) The PW of each machine is
calculated at i=10 % for n=8 years.

PW E =−4500−900 ( PA , 10 % , 8)+200 ( PF ,10 % , 8)=Php−9208

PW G=−3500−700 ( PA ,10 % , 8)+ 350 ( FP , 10 % ,8 )=Php−7071
PW S =−6000−50 ( PA , 10 % , 8 )+100( PF ,10 % , 8)=Php−6220
P= A ¿
P=F (1+i)−n

The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.

Water for Semiconductor Manufacturing Case: The worldwide contribution of semiconductor sales is
about Php 250 billion per year, or about 10% of the world’s GDP (gross domestic product). This industry
produces the microchips used in many of the communication, entertainment, transportation, and computing
devices we use every day. Depending upon the type and size of fabrication plant (fab), the need for ultrapure
water (UPW) to manufacture these tiny integrated circuits is high, ranging from 500 to 2000 gpm (gallons per
minute). Ultrapure water is obtained by special processes that commonly include reverse osmosis deionizing
resin bed technologies. Potable water obtained from purifying seawater or brackish groundwater may cost
from Php 2 to Php 3 per 1000 gallons, but to obtain UPW on-site for semiconductor manufacturing may cost
an additional Php 1 to Php 3 per 1000 gallons.

A fab costs upward of Php 2.5 billion to construct, with approximately 1% of this total, or Php 25 million,
required to provide the ultrapure water needed, including the necessary wastewater and recycling equipment.
A newcomer to the industry, Angular Enterprises, has estimated the cost profiles for two options to supply its
anticipated fab with water. It is fortunate to have the option of desalinated seawater or purified groundwater
sources in the location chosen for its new fab. The initial cost estimates for the UPW system are given below.
 ENGINEERING ECONOMY

Source Seawater (S) Groundwater (G)

Equipment first cost, Php M -20 -22
AOC, Php M per year -0.5 -0.3
Salvage value, % of first cost 5 10
Cost of UPW, Php per 1000 gallons 4 5

Angular has made some initial estimates for the UPW system.
Life of UPW equipment 10 years
UPW needs 1500 gpm
16 hours per day for 250 days
Operating time
per year

Example 4.2

Ultrapure water (UPW) is an expensive commodity for the semiconductor industry. With the options of
seawater or groundwater sources, it is a good idea to determine if one system is more economical than the other.
Use a MARR of 12% per year and the present worth method to select one of the systems.

Solution:

An important first calculation is the cost of UPW per year. The general relation and estimated costs for the two
options are as follows:

Php cost∈ Php gallons minutes hours days

UPW cost relation : = (
year 1000 gallons )( minutes )( hour )( day )( year )
4
Seawater := ( 1000 )( 1500 )( 60 ) ( 16 ) ( 250)−Php 1.44 M per year
5
Seawater := ( 1000 )( 1500 )( 60) ( 16) ( 250)−Php 1.80 M per year
Calculate the PW at i = 12% per year and select the option with the lower cost (larger PW value). In Php 1
million units:

PW relation: PW =first cost−PW of AOC −PW of UWP+ PW of Salvage Value

PW S =−20−0.5 ( PA , 12 % , 10 )−1.44 ( PA , 12% ,10 )+0.05 ( 20 ) ( PF , 12% ,10)

PW S =−20−0.5 (5.65020 )−1.44 ( 5.6502 ) +0.05 ( 20 ) ( 0.3220 )

PW S =Php−30.64

PW G=−22−0.3 ( PA , 12% ,10)−1.80 ( PA , 12 % , 10)+ 0.10( 22) ( PF , 12% ,10)

 ENGINEERING ECONOMY
PW G=−20−0.3 ( 5.65020 ) −1.80 ( 5.6502 ) +0.10 ( 20 ) ( 0.3220 )

PW G=Php−33.16

Based on this present worth analysis, the seawater option is cheaper by Php 2.52 M.

 Present Worth Analysis of Different-Life Alternatives

When the present worth method is used to compare mutually exclusive alternatives that have different lives, the
equal-service requirement must be met. The procedure of Section 3.2 is followed, with one exception:

The PW of the alternatives must be compared over the same number of years and must end at the same time
to satisfy the equal-service requirement.

This is necessary, since the present worth comparison involves calculating the equivalent PW of all future cash
flows for each alternative. A fair comparison requires that PW values represent cash flows associated with equal
service. For cost alternatives, failure to compare equal service will always favor the shorter-lived mutually
exclusive alternative, even if it is not the more economical choice, because fewer periods of costs are involved.
The equal-service requirement is satisfied by using either of two approaches:

LCM: Compare the PW of alternatives over a period of time equal to the least common multiple (LCM) of
their estimated lives.

Study period: Compare the PW of alternatives using a specified study period of n years. This approach does
not necessarily consider the useful life of an alternative. The study period is also called the planning horizon.
For either approach, calculate the PW at the MARR and use the same selection guideline as that for equal-life
alternatives. The LCM approach makes the cash flow estimates extend to the same period, as required. For
example, lives of 3 and 4 years are compared over a 12-year period.

The first cost of an alternative is reinvested at the beginning of each life cycle, and the estimated salvage value
is accounted for at the end of each life cycle when calculating the PW values over the LCM period.
Additionally, the LCM approach requires that some assumptions be made about subsequent life cycles.

The assumptions when using the LCM approach are that

1. The service provided will be needed over the entire LCM years or more.
2. The selected alternative can be repeated over each life cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same for each life cycle.
Example 4.3

National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two manufacturers offered the
estimates below.

Vendor A Vendor B
First cost, Php - 15, 000 -18, 000
AOC, Php per year - 3, 500 - 3, 100
 ENGINEERING ECONOMY
Salvage value, Php 1, 000 2, 000
Life, years 6 9

a) Determine which vendor should be selected on the basis of a present worth comparison, if the MARR is
15% per year.
b) National Homebuilders has a standard practice of evaluating all options over a 5-year period. If a study
period of 5 years is used and the salvage values are not expected to change, which vendor should be
selected?

Solution

a) Since the equipment has different lives, compare them over the LCM of 18 years. For life cycles after
the first, the first cost is repeated in year 0 of each new cycle, which is the last year of the previous
cycle. These are years 6 and 12 for vendor A and year 9 for B. The cash flow diagram is shown in
Figure 5–2. Calculate PW at 15% over 18 years.
P P P
( )
PW A =−15 , 000−15 , 000 , 15 % , 6 + 1, 000
F F( )
, 15 % , 6 −15 , 000
F(, 15 % , 12 )
P P P
+1 , 000 ( F )
,15 % ,12 +1 ,000
F ( )
, 15 % , 18 −3 , 500
A ( ,15 % ,18 )
¿ Php−45 , 036

PW B =−18 , 000−18 , 000 ( PF , 15 % , 9 )+2 ,000 ( PF , 15 % , 9)+2 , 000( FP ,15 % ,18)

−3 , 100 ( PA , 15 % , 18)
 ENGINEERING ECONOMY
¿ Php−41 ,384Figure 4.2 Cash flow diagram for different-life alternatives

Vendor B is selected, since it costs less in PW terms; that is, the PW B value is numerically
larger than PW A .

b) For a 5-year study period, no cycle repeats are necessary. The PW analysis is
P P
PW B =−15 , 000−3,500 ( A )
, 15 % , 5 +1 , 000
F (
, 15 % , 5 )
¿ Php−26 , 236

PW B =−18 , 000−3,100 ( PA , 15 % , 5)+2 , 000 ( PF , 15 % , 5)

¿ Php−27 , 397

Vendor A is now selected based on its smaller PW value. This means that the shortened study
period of 5 years has caused a switch in the economic decision. In situations such as this, the
standard practice of using a fixed study period should be carefully examined to ensure that the
appropriate approach, that is, LCM or fixed study period, is used to satisfy the equal-service
requirement.
 ENGINEERING ECONOMY
 3.2.b Future Worth Analysis

The future worth (FW) of an alternative may be determined directly from the cash flows, or by multiplying the
PW value by the FP factor, at the established MARR. The n value in the FP factor is either the LCM value or a
specified study period. Analysis of alternatives using FW values is especially applicable to large capital
investment decisions when a prime goal is to maximize the future wealth of a corporation’s stockholders.

Future worth analysis over a specified study period is often utilized if the asset (equipment, a building,
etc.) might be sold or traded at some time before the expected life is reached. Suppose an entrepreneur is
planning to buy a company and expects to trade it within 3 years. FW analysis is the best method to help with
the decision to sell or keep it 3 years hence. Example 5.5 illustrates this use of FW analysis. Another excellent
application of FW analysis is for projects that will come online at the end of a multiyear investment period, such
as electric generation facilities, toll roads, airports, and the like. They are analyzed using the FW value of
investment commitments made during construction.

The selection guidelines for FW analysis are the same as for PW analysis; FW ≥ 0 means the MARR is met
or exceeded. For two or more mutually exclusive alternatives, select the one with the numerically largest FW
value.

Example 3.4

A Filipino food distribution conglomerate purchased a Korean food store chain for Php 75 million 3 years ago.
There was a net loss of Php 10 million at the end of year 1 of ownership. Net cash flow is increasing with an
arithmetic gradient of Php +5 million per year starting the second year, and this pattern is expected to continue
for the foreseeable future. This means that breakeven net cash flow was achieved this year. Because of the
heavy debt financing used to purchase the Canadian chain, the international board of directors expects a MARR
of 25% per year from any sale.

a) The Filipino conglomerate has just been offered Php 159.5 million by a French company wishing to
get a foothold in Korea. Use FW analysis to determine if the MARR will be realized at this selling
price.
b) If the Filipino conglomerate continues to own the chain, what selling price must be obtained at the
end of 5 years of ownership to just make the MARR?

Solution:

a) Set up the future worth relation in year 3 ( FW 3) at I = 25% per year and an offer price of Php 159.5
million. Figure 5–4 a presents the cash fl ow diagram in million Php units.

PW B =−75 ( FP , 25 % , 3)−10 ( FP , 25 % , 2)−5 ( FP ,25 % ,1)+159.5

¿ Php−8.86 million

No, the MARR of 25% will not be realized if the Php 159.5 million offer is accepted.
 ENGINEERING ECONOMY

Figure 4-3 Cash flow diagrams

b) Determine the future worth 5 years from now at 25% per year. Figure 3-4 (b) presents the cash flow
diagram. The A/G and F/A factors are applied to the arithmetic gradient.
F F A F
(P ) (
PW B =−75 , 25 % , 5 −10
P ) (
,25 % , 5 +5
G )(
, 25 % , 5
A )
, 25 % , 5

¿ Php−246.81 million

The offer must be for at least Php 246.81 million to make the MARR. This is
approximately 3.3 times the purchase price only 5 years earlier, in large part based on
the required MARR of 25%.
 ENGINEERING ECONOMY

 Annual Worth Analysis

The annual worth method is typically the easiest to apply of the evaluation techniques when the MARR is
specified. The AW is calculated over the respective life of each alternative, and the selection guidelines are the
same as those used for the PW method. For mutually exclusive alternatives, whether cost- or revenue-based, the
guidelines are as follows:

One alternative: If AW ≥ 0, the requested MARR is met or exceeded and the alternative is economically
justified.

Two or more alternatives: Select the alternative with the AW that is numerically largest, that is, less
negative or more positive. This indicates a lower AW of cost for cost alternatives or a larger AW of net cash
flows for revenue alternatives.

Example 4.5
Luby’s Cafeterias is in the process of forming a separate business unit that provides meals to facilities for the
elderly, such as assisted care and long-term care centers. Since the meals are prepared in one central location
and distributed by trucks throughout the city, the equipment that keeps food and drink cold and hot is very
important. Michele is the general manager of this unit, and she wishes to choose between two manufacturers of
temperature retention units that are mobile and easy to sterilize after each use. Use the cost estimates below to
select the more economic unit at a MARR of 8% per year.

Hamilton (H) Infinity Care (IC)

Initial Cost P, Php - 15, 000 -20, 000
Annual M and O, Php/year - 6, 000 - 9, 000
Refurbishment cost, Php 0 -2, 000 every 4 years
Trade-in value S, % or P 20 40
Life, years 4 12

Solution
The best evaluation technique for these different-life alternatives is the annual worth method, where AW is
taken at 8% per year over the respective lives of 4 and 12 years.

AW H =−annual equivalent of P−annual M ∧O+ annual equivalent of S

AW H =−15 , 000 ( AP ,8 % , 4)−6000+ 0.2 ( 15 , 000) ( FA , 8 % , 4 )

¿ Php−9 , 863

AW IC=−annual equivalent of P−annual M ∧O−annual equuivalent of refurbishment

+annual equivalent of S
 ENGINEERING ECONOMY

AW IC=−20 , 000 ( AP , 8 % , 12)−9000−2 , 000[ ( PF , 8 % , 4)+( PF , 8 % , 8)]( PA ,8 % ,12)

A
+0.4 ( 20 ,000 )( , 8 % , 12)
F

¿ Php−11, 571

The Hamilton unit is considerably less costly on an annual equivalent basis.

4.2 EFFECTS OF INFLATION

Inflation means that cost and revenue cash flow estimates increase over time. This increase is due to the
changing value of money that is forced upon a country’s currency by inflation, thus making a unit of currency
(such as the dollar)worth less relative to its value at a previous time.

INFLATION CONTRIBUTES TO

• A reduction in purchasing power of the currency

• An increase in the CPI (consumer price index)

• An increase in the cost of equipment and its maintenance

• An increase in the cost of salaried professionals and hourly employees

• A reduction in the real rate of return on personal savings and certain corporate investments

Where: FC = future cost of a commodity

PC = present worth of the same a commodity
f = annual inflation rate
n = number of years
Example 4.5

An item presently costs Php 1, 000. I inflation is at the rate of 8% per year, what will be the cost of the
item in two years?

Solution:
 ENGINEERING ECONOMY
2
FC =Php 1 , 000 (1+ 0.08 ) =Php1 , 166.40

In an Inflationary economy, the buying power of money decreases as costs increase. Thus,

P
F=
( 1+ f )n

Where: F = future worth, measured in today’s pesos

PC = present worth
f = annual inflation rate
n = number of years
Example 4.6

An economy is experiencing inflation at an annual rate of 8%. If this continues, what will be Php 1, 000
worth two years from now in terms of today’s pesos?

Solution:
Php 1 ,000
FC = =Php 857.34
( 1+0.08 )2

If interest is being compounded at the same time that inflation is occurring, the future worth will be,

P ( 1+i )n ( 1+i )n
F=
( 1+ f )n
=P
( )
( 1+ f )n
Where: F = future worth, measured in today’s pesos
PC = present worth
f = annual inflation rate
n = number of years
 ENGINEERING ECONOMY
Example 4.7

A man invested Php 10, 000 at an interest rate of 10% compounded annually. What will be the final
amount of investment, in terms of today’s pesos, after five years, if inflation remains the same at the rate of 8%
per year?
Solution:

( 1+0.1 )5
FC =Php 1 , 000
(
( 1+ 0.08 )5)=Php 10 , 960.86

4.3 DEPRECIATION AND AFTER – TAX ECONOMIC ANALYSIS

4.3.a DEPRECIATION

Depreciation is the decrease in the value of physical property with the passage of time.
An asset starts to lose value as soon as it is purchased. For example, a car bought for Php 1 200 000
today may be worth Php 1 000 000 next week, Php 950 000 next year, and Php 500 000 in 10 years. This loss in
value, called depreciation, occurs for several reasons.
Use-related physical loss: As something is used, parts wear out. An automobile engine has a limited life
span because the metal parts within it wear out. This is one reason why a car diminishes in value over time.
Often, use-related physical loss is measured with respect to units of production, such as thousands of kilometers
for a car, hours of use for a light bulb, or thousands of cycles for a punch press.
Time-related physical loss: Even if something is not used, there can be a physical loss over time. This
can be due to environmental factors affecting the asset or to endogenous physical factors. For example, an
unused car can rust and thus lose value over time. Time-related physical loss is expressed in units of time, such
as a 10-year-old car or a 40-year-old sewage treatment plant.
Functional loss: Losses can occur without any physical changes. For example, a car can lose value over
time because styles change so that it is no longer fashionable. Other examples of causes of loss of value include
legislative changes, such as for pollution control or safety devices, and technical changes. Functional loss is
usually expressed simply in terms of the particular unsatisfied function.
 Value of an Asset
Models of depreciation can be used to estimate the loss in value of an asset over time, and also to determine the
remaining value of the asset at any point in time. This remaining value has several names, depending on the
circumstances.

 Market value is usually taken as the actual value an asset can be sold for in an open market. Of course,
the only way to determine the actual market value for an asset is to sell it. Consequently, the term
market value usually means an estimate of the market value. One way to make such an estimation is by
using a depreciation model that reasonably captures the true loss in value of an asset.

 Book value is the depreciated value of an asset for accounting purposes, as calculated with a
depreciation model. The book value may be more or less than market value. The depreciation model
 ENGINEERING ECONOMY
used to arrive at a book value might be controlled by regulation for some purposes, such as taxation, or
simply by the desirability of an easy calculation scheme. There might be several different book values
for the same asset, depending on the purpose and depreciation model applied.

 Scrap value can be either the actual value of an asset at the end of its physical life (when it is broken up
for the material value of its parts) or an estimate of the scrap value calculated using a depreciation
model.

 Salvage value can be either the actual value of an asset at the end of its useful life (when it is sold) or an
estimate of the salvage value calculated using a depreciation model.

 Fair value is the value which is usually determined by a disinterested third party in order to establish a
price that is fair to both seller and buyer.

 The utility or use value of a property is what the property is worth to the owner as an operating unit.
It is desirable to be able to construct a good model of depreciation in order to state a book value of an asset for a
variety of reasons:
1. In order to make many managerial decisions, it is necessary to know the value of owned assets. For
example, money may be borrowed using the firm’s assets as collateral. In order to demonstrate to the
lender that there is security for the loan, a credible estimate of the assets’ value must be made. A
depreciation model permits this to be done. The use of depreciation for this purpose is explored more
thoroughly in the second part of this chapter.
2. One needs an estimate of the value of owned assets for planning purposes. In order to decide whether to
keep an asset or replace it, you have to be able to judge how much it is worth. More than that, you have
to be able to assess how much it will be worth at some time in the future.
3. Government tax legislation requires that taxes be paid on company profits. Because there can be many
ways of calculating profits, strict rules are made concerning how to calculate income and expenses.
These rules include a particular scheme for determining depreciation expenses.
 Purpose of Depreciation
a) To provide for the recovery of capital which have been invested in physical property.
b) To enable the cost of depreciation to be changed to the cost of producing products or services that
results from the use of the property.

 Types of Depreciation

1. Normal Depreciation
o Physical Depreciation is the result of deterioration of an asset due to age and wear. It results
from use, decay and the action of the elements. Physical depreciation is a constant factor. It
begins as soon as an asset is exposed to the action of the elements or is put into use.
o Functional depreciation is the depreciation provided as a result of lack of adaptation of an
asset to function. It results from change of conditions and surroundings which render the asset ill
adapted to its work, from the growth of business which renders the asset inadequate, or to the
decline of business.
 ENGINEERING ECONOMY

2. Depreciation due to changes in price levels is atmost impossible to predict and therefore is not
considered in economy studies.
3. Depletion refers to the decrease in the value of a property due to the gradual extraction of its
contents.

 Physical and Economic Life

Physical Life of a property is the length of time during which it is capable of performing the function for
which it is designed and manufactured.

Economic Life is the length of time during which the property may be operated at a profit.

Requirement of a Depreciation Method

1. It should be simple
2. It should recover capital
3. The book value will be reasonably close to the market value at any time.
4. The method should be accepted by the Bureau of Internal Revenue
 ENGINEERING ECONOMY
 Depreciation Method

We shall use the following symbols for the different depreciation methods.

L=useful life of the property∈ years

C o=the original cost , purchase cost , freight cost ,initialization cost

C L =the valueat the end of the life ,the scrap value (including gain or loss due to

removal)

d=theannual cost of depreciation

C n=the book value at the end of n years

D n=depreciation up ¿ age n years

 The Straight Line Method

This method assumes that the loss in value is directly proportional to the age of the property.

C o−C L n( Co −C L )
d= D n= C n=C o−Dn
L L
Example 4.8

An electric balance costs Php 90, 000 and has an estimated salvage value of Php 8, 000 at the end of its
10 years life time. What would be the book value after three years, using the straight line method in solving for
the depreciation?

Solution:

C o=Php 90 , 000 C L =Php 8 ,000 L=10 n=3

C o−C L Php 90 , 000−Php 8 , 000

d= = =Php 8 ,200
L 10

n(C o −C L )
D 3= =( n ) ( d )=3 ( Php8 ,200 ) =Php24 ,600
L

C 3=C o−D 3=Php 90 , 000−Php 24 , 600=Php65 , 400

 The Sinking Fund Method

 ENGINEERING ECONOMY
This method assumes that sinking fund is established in which funds will accumulate for replacement. The
total depreciation that has taken place up to any given time is assumed to be equal to the accumulated amount in
the sinking fund at that time.

( 1+ i ) L −1 Co −C L
F
A
, i % , L= [ i ] d=
F
A
,i %, L
C n=C o−Dn

F
D n=d ( , i% ,n)
A

( 1+i )n−1
F
A
, i % , n= [ i ]
Example 4.9

A broadcasting corporation purchased an equipment for Php 53, 000 and paid Php 1, 500 for freight and
delivery charges to the job site. The equipment has a normal life of 10 years with a trade in value of Php 5, 000
against the purchase of a new equipment at the end of the life.

a) Determine the annual depreciation cost by the straight line method.

b) Determine the annual depreciation cost by the sinking fund method. Assume interest at 6.5%
compounded annually.

Solution: C o=Php 53 ,000+ Php 1 ,500=Php54 ,500

C L =Php5 , 000 L=10 n=10

a)
C o−C L Php 54 , 500−Php 5 , 000
d= = =Php 4 , 900
L 10

b)
Co −C L Php 54 , 500−Php 5 , 000
d= = =Php 3 , 668
F F
,i %, L
Example ,6.5 % ,10
A 4.10 A
A firm bought an equipment for Php 5, 000. Other expenses including installation amounted to Php 4,
000. The equipment is expected to have a life of 16 years with a salvage value of 10% of the original cost.
Determine the book value at the end of 12 years by,

a) the straight line method.

 ENGINEERING ECONOMY
b) sinking fund method at 12% interest.

Solution:

Given: C o=Php 56 , 000+ Php 4 , 000=Php 60 , 000

C L =Php 60 ,000 ( 0.10 ) =Php6 ,000

L=16 n=12 i=12%

a) Straight line method
C o−C L Php 60 , 000−Php 6 , 000
d= = =Php3 ,375
L 16

n(C o−C L )
D12= =( n )( d ) =12 ( Php 3 ,375 )=Php 40 ,500
L

C 12=Co −D 12=Php60 , 000−Php 40 ,500=Php19 , 500

b) Sinking Fund Method
Co −C L Php 60 , 000−Php 6 , 000
d= = =Php1 , 263
F F
,i %, L ,12 % ,16
A A

D 12=d ( FA ,i % , n)=Php 1 ,263( FA , 12% ,12)=Php 30 , 480

C 12=Co −D 12=Php60 , 000−Php30 , 480=Php29 , 520

 Declining Balance Method

In this method, sometimes called the constant percentage method or the Matheson Formula, it is assumed
that the annual cost of depreciation is a fixed percentage of the salvage value at the beginning of the year. The
ratio of the depreciation in any year to the book value at the beginning of that year is constant throughout the
life of the property and is designated by k, the rate of depreciation.

Book value at beginning Depreciation

Year Book value at the end of year
of year during the year

1 CO d 1=k C O C 1=CO −d 1=C 0 (1−k)

2 C O (1−k) d 2=k C 1 C 2=C1 −d 2=C 0 ( 1−k )2

3 C O ( 1−k )2 d 3=k C2 C 3=C 2−d 3=C 0 ( 1−k )3

... ... ... ...

 ENGINEERING ECONOMY
n C O ( 1−k )n d n=k Cn−1 C n=C n−1−d n=C 0 (1−k )n

... ... ... ...

L C O ( 1−k ) L−1 d L=k C L−1 C L =C L−1 −d L =C 0 ( 1−k ) L

d n=depreciation during the nth year

d n=Co ( 1−k )n−1 k C L =C o ( 1−k ) L

n Cn L C
n
C n=C o ( 1−k ) =C o
CL
CO[ ] L
k ¿ 1− √
n

Co
=1− L
√
Co

This method does not apply, if the salvage value is zero, because k will be equal to one and d 1 will be equal to
C o.

Example 4.11

A certain type of machine loses 10% of its value each year. The machine costs Php 2, 000 originally.
Make out a schedule showing the yearly depreciation, the total depreciation and the book value at the end of
each year for 5 years.

Solution:

Year Book value at Depreciation during Total depreciation at Book value at the end
beginning of year the year 10% end of year of year

1 ₱ 2,000.00 ₱ 200.00 ₱ 200.00 ₱ 1,800.00

 ENGINEERING ECONOMY
2 ₱ 1,800.00 ₱ 180.00 ₱ 380.00 ₱ 1,620.00

3 ₱ 1,620.00 ₱ 162.00 ₱ 542.00 ₱ 1,458.00

4 ₱ 1,458.00 ₱ 145.80 ₱ 687.80 ₱ 1,312.20

5 ₱ 1,312.20 ₱ 131.22 ₱ 819.02 ₱ 1,180.98

 Double Declining Balance (DDB) Method

This method is very similar to the declining balance method except that the rate of depreciation k is replaced
by 2/L.

n−1 n
2 2 2
(
d n=Co 1−
L ) L ( )
C n=C o 1−
L C L =C o 1−( )2
L
L

When the DDB method is used, the salvage value should not be subtracted from the first cost when calculating
the depreciation charge.

Example 4.12

Determine the rate of depreciation, the total depreciation up to the end of the 8 th year and the book value
at the end of 8 years for an asset that costs Php 15, 000 new and has an estimated scrap value of Php 2, 000 at
the end of 10 years by (a) the declining balance method and (b) the double declining balance method.

Solution:
C o=¿Php 15, 000 C L =¿Php 2, 000 L=¿10 n ¿8
(a) Declining Balance Method
CL Php 2 , 000
k ¿ 1−
√
L

Co √
=1−10
Php 15 , 000
= 0.1825 or 18.25%

C 8=C o ( 1−k )8=Php 15 , 000 (1−0.1825 )8=Php 2 , 992

D 8=C o −C8 =Php 15 , 000−Php 2 , 992=Php12 , 008

(b) Double Declining Balance Method

2 2
Rate of depreciation ¿ L = 20 =0.20∨20 %
 ENGINEERING ECONOMY

 The Sum-of-the-Years’ Digital (SYD) Method

Let d n =depreciation charge during thenth year

d n=(depreciation factor)(total depreciation)

reverse digit
d n= (C ¿ ¿ o−C L )¿
∑ of digits
For example, for a property whose life is 5 years.

Year Year Reverse Order Depreciation Factor Depreciation During the Year

1 5 5/15 (5/15) (C ¿ ¿ o−C L )¿

2 4 4/15 (4/15) (C ¿ ¿ o−C L )¿

3 3 3/15 (3/15) (C ¿ ¿ o−C L )¿

4 2 2/15 (2/15) (C ¿ ¿ o−C L )¿

_5_ 1 1/15 (1/15) (C ¿ ¿ o−C L )¿

15 = Σ of digits

Example 4.13

A structure costs Php 12, 000 new. It is estimated to have a life of 5 years with a salvage value at the end
of life of Php 1, 000. Determine the book value at the end of each year of life.

Solution:

C o−C L =¿Php 12, 000 - Php 1000 = Php 11, 000

 ENGINEERING ECONOMY

Year Year Reverse Order Depreciation During the Year Book Value at End of Year

1 5 5/15 (11, 000) = Php 3, 667 Php 8, 333

2 4 4/15 (11, 000) = Php 2, 933 Php 5, 400

3 3 3/15 (11, 000) = Php 2, 200 Php 3, 200

4 2 2/15 (11, 000) = Php 1, 467 Php 1, 733

_5_ 1 1/15 (11, 000) = Php 733 Php 1, 000

15
 ENGINEERING ECONOMY

Try Me!

1. A plant bought a calciner for Php 220, 000 and used it for 10 years, the life span of the equipment.
What is the book value of the calciner after 5 years of use? Assume a scrap value of Php 20, 000 for
straight line method; Php 22, 000 for textbook declining balance method and Php 20,000 for the
double declining balance method .
2. A consortium of international telecommunication companies contracted for the purchase and
installation of a fiber optic cable linking two major cities at a total cost of Php 960 Million. This
amount includes freight and installation charges estimated at 10% of the above contract price. If the
cable shall be depreciated over a period of 15 years with zero savage value:
a) Given the sinking fund deposit factor of 0.0430 at 6% interest where n = 15, what is the annual
depreciation charge?
b) What is the depreciation charge during the 8th year during the sum-of-the-year-digits method?

4.3.b AFTER– TAX ECONOMIC ANALYSIS

Taxes are fees paid by individuals or businesses to support their government. Taxes are generally the
primary source of government revenue, and are used to provide public goods and services such as highways and
dams, police services, the military, water treatment, education, health care, and other social programs.

Taxes can have a significant impact on the economic viability of a project because they change the
actual cash flows experienced by a company. A vital component of a thorough economic analysis will therefore
include the tax implications of an investment decision.

Income tax is the amount of the payment (taxes) on income or profit that must be delivered to a federal
(or lower-level) government unit. Taxes are real cash flows; however, for corporations tax computation requires
some noncash elements, such as depreciation. Corporate income taxes are usually submitted quarterly, and the
last payment of the year is submitted with the annual tax return.

The required after-tax MARR is established using the market interest rate, the corporation’s effective tax
rate, and its weighted average cost of capital. The CFAT (cash flow after taxes) estimates are used to compute
the PW or AW at the after-tax MARR. When positive and negative CFAT values are present, a PW or AW < 0
indicates the MARR is not met.

One project. PW or AW ≥ 0, the project is financially viable because the after-tax MARR is met or
exceeded.

Two or more alternatives. Select the alternative with the best (numerically largest) PW or AW value.

If only cost CFAT amounts are estimated, calculate the after-tax savings generated by the operating expenses
and depreciation. Assign a plus sign to each saving and apply the guidelines above.
 ENGINEERING ECONOMY
Remember, the equal-service assumption requires that the PW analysis be performed over the least common
multiple (LCM) of alternative lives. This requirement must be met for every analysis—before or after taxes.

Example 4.14

Paul is designing the interior walls of an industrial building. In some places, it is important to reduce noise
transmission across the wall. Two construction options—stucco on metal lath (S) and bricks (B)—each have
about the same transmission loss, approximately 33 decibels. This will reduce noise attenuation costs in
adjacent office areas. Paul has estimated the first costs and after-tax savings each year for both designs. Use the
CFAT values and an after-tax MARR of 7% per year to determine which is economically better.

PLAN S PLAN B
Year CFAT $ Year CFAT $
0 -28, 000 0 - 50, OOO
1–6 5, 400 1 14, 200
7 – 10 2, 040 2 13, 300
10 2, 792 3 12, 400
4 11, 500
5 10, 600
Solution:

[
AW S = −28 ,000+5400 ( PA , 7 % , 6)+2040( PA ,7 % , 4)( PF ,7 % , 6)+ 2792( FP , 7 % ,10)]( AP ,7 % , 10)

AW S =$ 422

AW B=$ 327

Both plans are financially viable; select plan S because AW S is larger

 ENGINEERING ECONOMY

[
AW B= −50 , 000+14 ,200 ( FP , 7 % ,1)+13 ,300 ( PF , 7 % ,2)+12 , 400( FP ,7 % ,3)+11 , 500( PF , 7 % , 4)+10 , 600( PF

AW B=$ 327
Both plans are financially viable; select plan S because AW S is larger

4.4 REPLACEMENT STUDY

The need for a replacement study can develop from several sources:

Reduced performance. Because of physical deterioration, the ability to perform at an expected

level of reliability (being available and performing correctly when needed) or productivity (performing
at a given level of quality and quantity) is not present. This usually results in increased costs of
operation, higher scrap and rework costs, lost sales, reduced quality, diminished safety, and larger
maintenance expenses.

Altered requirements. New requirements of accuracy, speed, or other specifications cannot be

met by the existing equipment or system. Often the choice is between complete replacement or
enhancement through retrofitting or augmentation.

Obsolescence. International competition and rapidly changing technology make currently used
systems and assets perform acceptably but less productively than equipment coming available. The ever-
decreasing development cycle time to bring new products to market is often the reason for premature
replacement studies, that is, studies performed before the estimated useful or economic life is reached.

Replacement studies use some terminology that is closely related to terms in previous chapters.

Defender and challenger are the names for two mutually exclusive alternatives. The defender is
the currently installed asset, and the challenger is the potential replacement. A replacement study
compares these two alternatives. The challenger is the “best” challenger because it has been selected as
the best one to possibly replace the defender. (This is the same terminology used earlier for incremental
ROR and BC analysis, but both alternatives were new).

Market value is the current value of the installed asset if it were sold or traded on the open
market. Also called trade-in value , this estimate is obtained from professional appraisers, resellers, or
liquidators familiar with the industry. As in previous chapters, salvage value is the estimated value at the
 ENGINEERING ECONOMY
end of the expected life. In replacement analysis, the salvage value at the end of one year is used as the
market value at the beginning of the next year.

AW values are used as the primary economic measure of comparison between the defender and
challenger. The term equivalent uniform annual cost ( EUAC) may be used in lieu of AW, because often
only costs are included in the evaluation; revenues generated by the defender or challenger are assumed
to be equal. (Since EUAC calculations are exactly the same as for AW, we use the term AW.) Therefore,
all values will be negative when only costs are involved. Salvage or market value is an exception; it is a
cash inflow and carries a plus sign.

Economic service life (ESL) for an alternative is the number of years at which the lowest AW of
cost occurs . The equivalency calculations to determine ESL establish the life n for the best challenger
and the lowest cost life for the defender in a replacement study. The next section explains how to find
the ESL.

Defender first cost is the initial investment amount P used for the defender. The current market
value ( MV ) is the correct estimate to use for P for the defender in a replacement study. The estimated
salvage value at the end of one year becomes the market value at the beginning of the next year,
provided the estimates remain correct as the years pass. It is incorrect to use the following as MV for the
defender fi rst cost: trade-in value that does not represent a fair market value , or the depreciated book
value taken from accounting records. If the defender must be upgraded or augmented to make it
equivalent to the challenger (in speed, capacity, etc.), this cost is added to the MV to obtain the
estimated defender fi rst cost.

Challenger first cost is the amount of capital that must be recovered (amortized) when replacing
a defender with a challenger. This amount is almost always equal to P , the fi rst cost of the challenger.

If an unrealistically high trade-in value is offered for the defender compared to its fair market
value, the net cash fl ow required for the challenger is reduced, and this fact should be considered in the
analysis. The correct amount to recover and use in the economic analysis for the challenger is its fi rst
cost minus the difference between the trade-in value (TIV) and market value (MV) of the defender. In
equation form, this is P – (TIV – MV).

A sunk cost is a prior expenditure or loss of capital (money) that cannot be recovered by a
decision about the future. The replacement alternative for an asset, system, or process that has incurred a
nonrecoverable cost should not include this cost in any direct fashion; sunk costs should be handled in a
realistic way using tax laws and write-off allowances.

The nonowner’s viewpoint , also called the outsider’s viewpoint or consultant’s viewpoint,
provides the greatest objectivity in a replacement study. This viewpoint performs the analysis without
bias; it means the analyst owns neither the defender nor the challenger. Additionally, it assumes the
services provided by the defender can be purchased now by making an “initial investment” equal to the
market value of the defender.

The fundamental assumptions for a replacement study parallel those of an AW analysis. If the planning horizon
is unlimited , that is, a study period is not specified, the assumptions are as follows:
 ENGINEERING ECONOMY
1. The services provided are needed for the indefinite future.
2. The challenger is the best challenger available now and in the future to replace the defender. When
this challenger replaces the defender (now or later), it will be repeated for succeeding life cycles.
3. Cost estimates for every life cycle of the defender and challenger will be the same as in their first
cycle.

Example 4.15

Only 2 years ago, Techtron purchased for $275,000 a fully loaded SCADA (supervisory control and data
acquisition) system including hardware and software for a processing plant operating on the Houston ship
channel. When it was purchased, a life of 5 years and salvage of 20% of fi rst cost were estimated. Actual M&O
costs have been $25,000 per year, and the book value is $187,000. There has been a series of insidious malware
infections targeting Techtron’s command and control software, plus next-generation hardware marketed only
recently could greatly reduce the competitiveness of the company in several of its product lines. Given these
factors, the system is likely worth nothing if kept in use for the fi nal 3 years of its anticipated useful life.

Model K2-A1, a new replacement turnkey system, can be purchased for $300,000 net cash, that is, $400,000
first cost and a $100,000 trade-in for the current system. A 5-year life, salvage value of 15% of stated first cost
or $60,000, and an M&O cost of $15,000 per year are good estimates for the new system. The current system
was appraised this morning, and a market value of $100,000 was confirmed for today; however, with the current
virus discovery, the appraiser anticipates that the market value will fall rapidly to the $80,000 range once the
virus problem and new model are publicized.

Using the above values as the best possible today, state the correct defender and challenger estimates for P,
M&O, S, and n in a replacement study to be performed today.

Solution:

Defender: Use the current market value of $100,000 as the fi rst cost for the defender. All others—original cost
of $275,000, book value of $187,000, and trade-in value of $100,000—are irrelevant to a replacement study
conducted today. The estimates are as follows:

First cost P = $100,000

M&O cost A = $25,000 per year

Expected life n = 3 years

Salvage value S=0

Challenger: The $400,000 stated first cost is the correct one to use for P, because the trade-in and market values
are equal.

First cost P = $400,000

 ENGINEERING ECONOMY
M&O cost A = $15,000 per year

Expected life n = 5 years

Salvage value S = $60,000

If the replacement study is conducted next week when estimates will have changed, the defender’s first cost will
be $80,000, the new market value according to the appraiser. The challenger’s first cost will be $380,000, that
is, P – (TIV – MV) = 400,000 – (100,000 – 80,000).

o Performing a Replacement Study

Replacement studies are performed in one of two ways: without a study period specified or with one defined.
Figure 4–4 gives an overview of the approach taken for each situation. The procedure discussed in this section
applies when no study period (planning horizon) is specified. If a specific number of years is identified for the
replacement study, for example, over the next 5 years, with no continuation considered after this time period in
the economic analysis.

A replacement study determines when a challenger replaces the in-place defender. The complete study is
finished if the challenger (C) is selected to replace the defender (D) now. However, if the defender is retained
now, the study may extend over a number of years equal to the life of the defender n D , after which a challenger
replaces the defender. Use the annual worth and life values for C and D determined in the ESL analysis in the
following procedure. Assume the services provided by the defender could be obtained at the AW D amount.

The replacement study procedure is:

New replacement study:

1. On the basis of the better AW C or AW D value, select the challenger C or defender D. When the
challenger is selected, replace the defender now, and expect to keep the challenger for nC years. This
replacement study is complete. If the defender is selected, plan to retain it for up to n D more years. (This
is the leftmost branch of Figure 4–4.) Next year, perform the following steps.

One-year-later analysis:

2. Determine if all estimates are still current for both alternatives, especially first cost, market value, and
AOC. If not, proceed to step 3. If yes and this is year n D , replace the defender. If this is not year n D ,
retain the defender for another year and repeat this same step. This step may be repeated several times.
3. Whenever the estimates have changed, update them and determine new AW C and AW D values. Initiate a
new replacement study (step 1).
 ENGINEERING ECONOMY
Figure 4 – 4. Overview of replacement study approaches.

If the defender is selected initially (step 1), estimates may need updating after 1 year of retention (step 2).
Possibly there is a new best challenger to compare with D. Either significant changes in defender estimates or
availability of a new challenger indicates that a new replacement study is to be performed. In actuality, a
replacement study can be performed each year or more frequantly to determine the advisability of replacing or
retaining any defender, provided a competitive challenger is available.
 ENGINEERING ECONOMY
ACTIVITY!

ALTENATIVE COMPARISON

1. Polypropylene wall caps, used for covering exterior vents for kitchen cooktops, bathroom fans, dryers,
and other building air exhausts, can be made by two different methods. Method X will have a first cost
of Php 75,000, an operating cost of Php 32,000 per year, and a Php 9000 salvage value after 4 years.
Method Y will have a first cost of Php 140,000, an operating cost of Php 24,000 per year, and a Php
19,000 salvage value after its 4-year life. At an interest rate of 10% per year, which method should be
used on the basis of an annual worth analysis?

2. The cash flows for two small raw water treatment systems are shown. Determine which should be
selected on the basis of an annual worth analysis at 10% per year interest.

MF UF
First Cost , Php - 33, 000 - 51, 000
Annual cost, Php - 8, 000 - 3, 000
Salvage Value, Php 4, 000 11, 000
Life Years 3 6

3. The maintenance and operation (M&O) cost of front-end loaders working under harsh environmental
conditions tends to increase by a constant $1200 per year for the first 5 years of operation. For a loader
that has a first cost of $39,000 and first-year M&O cost of $17,000, compare the equivalent annual
worth of a loader kept for 4 years with one kept for 5 years at an interest rate of 12% per year. The
salvage value of a used loader is $23,000 after 4 years and $18,000 after 5 years.

DEPRECIATION

1. Pneumatics Engineering purchased a machine that had a first cost of Php 40,000, an expected useful
life of 8 years, a recovery period of 10 years, and a salvage value of Php 10,000. The operating cost
of the machine is expected to be Php 15,000 per year. The inflation rate is 6% per year and the
company’s MARR is 11% per year. Determine ( a ) the depreciation charge for year 3, ( b ) the
present worth of the third-year depreciation charge in year 0, the time of asset purchase, and ( c ) the
book value for year 3 according to the straight line method.

2. Lee Company of Westbrook, Connecticut, manufactures pressure relief inserts for thermal relief and
low-flow hydraulic pressure relief applications where zero leakage is required. A machine purchased
3 years ago has been book-depreciated by the straight line method using a 5-year useful life. If the
book value at the end of year 3 is Php 30,000 and the company assumed that the machine would be
worthless at the end of its 5-year useful life, ( a ) what is the book depreciation charge each year and
( b ) what was the first cost of the machine?

3. A cooling-water pumping station at the LCRA plant costs Php 600,000 to construct, and it is
projected to have a 25-year life with an estimated salvage value of 15% of the construction cost.
However, the station will be book-depreciated to zero over a recovery period of 30 years. Calculate
 ENGINEERING ECONOMY
the annual depreciation charge for years 4, 10, and 25, using ( a ) straight line depreciation and ( b )
DDB depreciation. ( c ) What is the implied salvage value for DDB? ( d ) Use a spreadsheet to build
the depreciation and book value schedules for both methods to verify your answers.

4. A video recording system was purchased 3 years ago at a cost of Php 30,000. A 5-year recovery
period and DDB depreciation have been used to write off the basis. The system is to be replaced this
year with a trade-in value of Php 5000. What is the difference between the book value and the trade-
in value?

5. A European manufacturing company has new equipment with a first cost of Php 12,000, an
estimated salvage value of Php 2000, and a recovery period of 8 years. Use the SYD method to
tabulate annual depreciation and book value.

EFFECT OF INFLATION

1. An environmental testing company needs to purchase equipment 2 years from now and expects to
pay Php 50,000 at that time. At a real interest rate of 10% per year and inflation rate of 4% per year,
what is the present worth of the cost of the equipment?

2. How much can the manufacturer of superconducting magnetic energy storage systems afford to
spend now on new equipment in lieu of spending Php 75,000 four years from now? The company’s
real MARR is 12% per year, and the inflation rate is 3% per year.

3. Carlsbad Gas and Electric is planning to purchase a degassing tower for removing CO 2 from
acidified saltwater. The supplier quoted a price of Php125, 000 if the unit is purchased within the
next 3 years. Your supervisor has asked you to calculate the present worth of the tower when
considering inflation. Assuming the tower will not be purchased for 3 years, calculate the present
worth at an interest rate of 10% per year and an inflation rate of 4% per year.