Hanoi University of Science and Technology

School of Economics and Management

Chapter 2: Engineering
Economy Projects

Instructor: Nguyen Tai Vuong

Chapter Outlines
2.1 Engineering Economy Projects and Capital
Budgeting
2.2 EE Project Fundamentals
2.3 Simple and Compound Interest
2.4 Nominal and Effective Interest Rate
2.5 Minimum Attract Rate of Return
2.6 Types of Financing
2.7 Calculating Practices

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2.1 Engineering Economy Projects
and Capital Budgeting

• Engineering Economy Projects involves

– Formulating, Estimating, and Evaluating
expected economic outcomes of alternatives
designed to accomplish a defined purpose
(project)
• Capital budgeting: describes decisions
where
– Expenditures and Receipts for a particular
undertaking will continue over a period of time.

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Types of Engineering Economy Projects

• Expansion of facilities
– Expansion of high way Phap Van – Cau Gie from 4
lanes to 6 lanes
– Expansion of factory from 1,000m2 to 1,300m2

• New or improved products

– New Nescafe rang xay (roasted and ground)
– New bonding technique incorporated into the
manufacture of automobile brake pads

• Replacement
– Computer-vision system replaces the human inspector
in performing quality tests on an automobile welding
line

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Types of Engineering Economy Projects

• Lease or buy
– Car leasing or purchase new one
– Concrete mixer

• Make or buy
– Keyboard
– Machine components

• Safety or environmental protection equipment

– Wastewater treatments

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2.2 EE Project Fundamentals

• Time value of money

• Interest and interest rate

• Cash flows

• Economic equivalence

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Time Value of Money (TVM)

• The time value of money is the most important

concept in EE Projects

• TVM explains the change in the amount of money

over time for funds owed by (or owned by) a
corporation (or individual)
– Corporate investments are expected to earn a
return
– Investment involves money
– Money has a ‘time value’

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Interest and Interest Rate
• Interest – the manifestation of the time value of
money
• Fee that one pays to use someone else’s money
• Difference between an ending amount of money and a
beginning amount of money

 Interest = amount owed now – principal

• Interest rate – Interest paid over a time period

expressed as a percentage of principal

𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (%) = × 100%

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Rate of Return
• Interest earned over a period of time is
expressed as a percentage of the original
amount (principal)
interest accrued per time unit
Rate of return (%) = x 100%
original amount

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Interest Rate vs Rate of Return

Interest paid Interest earned

Interest rate Rate of return

 Borrower’s perspective – interest rate paid
 Lender’s or investor’s perspective – rate of return earned

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Commonly used Symbols

t = time, usually in periods such as years or
months
P = value or amount of money at a time t
designated as present or time 0
F = value or amount of money at some future
time, such as at t = n periods in the future
A = series of consecutive, equal, end-of-period
amounts of money
n = number of interest periods; years, months
i = interest rate or rate of return per time
period; percent per year or month

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Cash Flows: Terms
• Cash Inflows – Revenues (R), receipts,
incomes, savings generated by projects and
activities that flow in. Plus sign used

• Cash Outflows – Disbursements (D), costs,

expenses, taxes caused by projects and
activities that flow out. Minus sign used

• Net Cash Flow (NCF) for each time period:

NCF = cash inflows – cash outflows = R – D

• End-of-period assumption:
Funds flow at the end of a given interest period

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Cash Flows: Estimating

 Point estimate – A single-value estimate of a
cash flow element of an alternative
Cash inflow: Income = $150,000 per month

 Range estimate – Min and max values that

estimate the cash flow
Cash outflow: Cost is between $2.5 M and $3.2 M

– Point estimates are commonly used;

– However, range estimates with probabilities attached
provide a better understanding of variability of economic
parameters used to make decisions.

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Cash Flow Diagrams
What a typical cash flow diagram might look like

Draw a time line

Always assume end-of-period cash flows

Time
0 1 2 … … … n-1 n
One time
period
F = $100
Show the cash flows (to approximate scale)

0 1 2 … … … n-1 n
Cash flows are shown as directed arrows: + (up) for inflow
P = $-80
- (down) for outflow

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Cash Flow Diagram Example

- Plot observed net cash flows over last 8 years.
- Show present worth (P) arrow at present time, t = 0

End Year Income Cost Net Cash Flow

-7 $0 $ 2,500
-6 750 100
-5 750 125
-4 750 150
-3 750 175
-2 750 200
-1 750 225
0 750 250
1 900 275

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 2-17

Economic Equivalence
• Definition:
– Combination of interest rate (rate of return)
and time value of money to determine
different amounts of money at different points
in time that are economically equivalent

• How it works:
– Use rate i and time t in upcoming relations to
move money (values of P, F and A) between
time points t = 0, 1, …, n to make them
equivalent (not equal) at the rate i

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 Example of Equivalence
Different sums of money at different times may
be equivalent in economic value at a given rate
$110

Year

0 1
Rate of return = 10% per year

$100 now

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year.

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Exercise
Use economic equivalence to determine the amount
of money or value of i that makes the following
statements correct.

a. $5000 today is equivalent to $4275 exactly 1 year

ago at i = ___% per year.
b. A car that costs $28,000 today will cost $____ a
year from now at i = 4% per year.
c. At i = 4% per year, a car that costs $28,000 now,
would have cost $____ one year ago.

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 Exercise
d. Last year, Jackson borrowed $20,000 to buy a
preowned boat. He repaid the principal of the loan
plus $2750 interest after only 1 year. This year, his
brother Henri borrowed $15,000 to buy a car and
expects to pay it off in only 1 year plus interest of
$2295. The rate that each brother paid for his loan
is ___ % for Jackson and ___ % per year for Henri.

e. Last year, Sheila turned down a job that paid

$75,000 per year. This year, she accepted one that
pays $81,000 per year. The salaries are equivalent
at i = ____% per year.

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2.3 Simple and Compound Interest

• Simple Interest
Interest is calculated using principal only
Interest = (principal)(number of periods)(interest rate)
I = P.n.i

Example: $100,000 lent for 3 years at simple i = 10%

per year. What is repayment after 3 years?

Interest = 100,000(3)(0.10) = $30,000

Total due = 100,000 + 30,000 = $130,000

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Simple and Compound Interest
• Compound Interest
Interest is based on principal plus all accrued interest
That is, interest compounds over time

Interest = (principal + all accrued interest)(interest rate)

Interest for time period t is

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Compound Interest Example

• 100,000 lent for 3 years at i = 10% per year
compounded. What is repayment after 3 years?

Interest, year 1: I1 = 100,000(0.10) = $10,000

Total due, year 1: T1 = 100,000 + 10,000 = $110,000
Interest, year 2: I2 = 110,000(0.10) = $11,000
Total due, year 2: T2 = 110,000 + 11,000 = $121,000
Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due, year 3: T3 = 121,000 + 12,100 = $133,100

Compounded: $133,100 Simple: $130,000

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Exercise

A company that manufactures general-purpose

transducers invested $2 million 4 years ago in high-
yield junk bonds. If the bonds are now worth
$2.8 million, what rate of return per year did the
company make on the basis of

(a) simple interest, and

(b) compound interest?

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2.4 Nominal and Effective Interest Rate

The terms ‘nominal’ and ‘effective’ enter into consideration

when the interest period is less than one year.

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed. For example,
1% per month.

Compounding period (CP) – Shortest time unit over which interest is charged or earned.
For example,10% per year compounded monthly.

Compounding frequency (m) – Number of times compounding occurs within the interest
period t. For example, at i = 10% per year, compounded
monthly, interest would be compounded 12 times during the
one year interest period.

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 Understanding Interest Rate Terminology
A nominal interest rate (r) is obtained by multiplying an interest rate that
is expressed over a short time period by the number of compounding
periods in a longer time period:
That is:
r = interest rate per period x number of compounding periods
Example: If i = 1% per month, nominal rate per year is
r = (1)(12) = 12% per year

Effective interest rates (i) take compounding into account (effective

rates can be obtained from nominal rates via a formula to be discussed
later).

IMPORTANT: Nominal interest rates are essentially simple interest rates.

Therefore, they can never be used in interest formulas.
Effective rates must always be used hereafter in all interest formulas.

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More About Interest Rate Terminology

There are 3 general ways to express interest rates as shown below

Sample Interest Rate Statements Comment

i = 2% per month When no compounding period
(1)
i = 12% per year is given, rate is effective

i = 10% per year, comp’d semiannually When compounding period is given

(2)
i = 3% per quarter, comp’d monthly and it is not the same as interest
period, it is nominal

i = effective 9.4%/year, comp’d semiannually When compounding period is given

(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period

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Effective Annual Interest Rates
Nominal rates are converted into effective annual rates via the equation:

ia = (1 + i)m – 1
where ia = effective annual interest rate
i = effective rate for one compounding period
m = number times interest is compounded per year
Example: For a nominal interest rate of 12% per year, determine
the nominal and effective rates per year for (a) quarterly, and
(b) monthly compounding

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Effective Interest Rates

Nominal rates can be converted into effective rates
for any time period via the following equation:

i = (1 + r / m)m – 1
where i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i

Example: For an interest rate of 1.2% per month, determine the

nominal and effective rates (a) per quarter, and (b) per year

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Minicase

• The Pawnshop Advertisement:

Easy Funding: Interest only 1,000 vnd per
day for 1,000,000 vnd of debt.

• Find effective interest rate per year

compounded monthly, weekly, and daily?
(financial year: 360 days)

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2.5 Minimum Attractive Rate of

Return
 MARR is a reasonable
rate of return (percent)
established for evaluating
and selecting alternatives
 An investment is
justified economically if it
is expected to return at
least the MARR
 Also termed hurdle rate,
benchmark rate and
cutoff rate

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MARR Characteristics
• MARR is established by the financial
managers of the firm
• MARR is fundamentally connected to the
cost of capital
• Both types of capital financing are used to
determine the weighted average cost of
capital (WACC) and the MARR
• MARR usually considers the risk inherent
to a project

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2.6 Types of Financing

• Equity Financing
– Funds either from retained earnings, new stock
issues, or owner’s infusion of money.
• Debt Financing
– Borrowed funds from outside sources – loans,
bonds, mortgages, venture capital pools, etc.
Interest is paid to the lender on these funds

For an economically justified project

ROR ≥ MARR > WACC

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