LECTURE 3

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LECTURE 2

Formulation
Engineering Estimation
Economics
Evaluation
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 LEARNING OUTCOMES BOOK CHAPTER 1

1. Role in decision making

2. Study approach
3. Ethics and economics
4. Interest rate
5. Terms and symbols
6. Cash flows
7. Economic equivalence
8. Simple and compound interest rates
9. WACC and Minimum attractive rate of ret
urn MARR
10. Spreadsheet functions 1-4
 QUESTION FROM THE LAST CLASS
•A company plans to borrow $20,000 from a bank for one year at 9%
interest for a new recording equipment
•Required
•Draw the Cashflow Diagram

TERMS AND SYMBOLS

•Compute the interest and the total amount due after 1 year
•Solution
•The total interest accrued:
Interest = $20,000 × 0.09 = $1,800

•The total amount due is the sum of principal and interest:

Total due = $20,000 + $1,800 = $21,800
$20,000

P 𝒊=9% n=1
0 1 Yr
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F $21,800
 INVESTMENT OPPORTUNITY

$21,800
𝑹𝒐𝑹=9%
0 1

$20,000

$210,000

-1 0

𝑹𝒐𝑹=5%

$200,000
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 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

• Cost of Equity > Benchmark > Risk free Rate > T-bills
• Cost of Debt > Interest Rate
 COST OF CAPITAL ( WACC ) EXAMPLE
Suppose the Alpha Company has a capital structure
composed of the following, in millions:
▪ Debt = 10
▪ Common equity = 40
Required
if the cost of debt is 9%, the cost of equity is 15%, what is
Alpha’s weighted average cost of capital?

Solution:
WACC = [(0.20)(0.09) + [(0.8)(0.15)]
= 0.018 + 0.120
= 0.138, or 13.8%

IF an investment gives us 13.8% of Rate of Return, should we accept the

project ? WHY ?
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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
For an economically justified project

ROR ≥ MARR > WACC

 INVESTMENT OPPORTUNITY

$21,800
𝑹𝒐𝑹=9%
0 1

𝑾𝑨𝑪𝑪=9%
$20,000

$210,000

-1 0

𝑹𝒐𝑹=5%

$200,000 𝑾𝑨𝑪𝑪=3%

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ROR ≥ MARR > WACC
 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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 QUESTION
• A company loaned money to an engineering staff member for a
radio-controlled model airplane.
• The loan is for $1,000 for 3 years at 5% per year
• Required
• Draw the Cashflow Diagram
• Calculate How much money will the engineer repay at the end of 3
years? P=$1,000
• Solution
1 2 3
I1=$50.00 I2=$50.00 I3=$50.00

• The interest for each of the 3 years is:

Interest per year = $1,000 × 0.05 = $50
F=$1,150
Total interest for 3 years is $1,000 × 0.05 × 3 = $150
The amount due after 3 years is $1,000 + $150 = $1,150
 REPAYMENT PLAN(SIMPLE INTEREST)

• The $50 interest accrued in the first year and the $50
accrued in the second year do not earn interest

• The interest due each year is calculated only on the

$1,000 principal
End of Amount Interest Amount Amount
Year Borrowed Owed Paid
0 $1,000 0 0 0
1 - $50 $1,050 0
2 - $50 $1,100 0
3 - $50 $1,150 $1,150
 REPAYMENT PLAN(COMPOUND INTEREST)

• The $50 interest accrued in the first year and the $50
accrued in the second year do not earn interest

• The interest due each year is calculated on the Amount

Owed
End of Amount Interest Amount Amount
Year Borrowed Owed Paid
0 $1,000 0 0 0
1 - $50 $1,050 0
2 - $52.5 $1,102.5 0
3 - $55.13 $1,157.63 $1,157.63
SIMPLE AND COMPOUND INTEREST

•Two “types” of interest calculations

• Simple Interest
• Compound Interest
•Compound Interest is more common worldwide
and applies to most analysis situations

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE

• Demonstrate the concept of equivalence using the different

loan repayment plans described below. Each plan repays a
$5,000 loan in 5 years at 8% interest per year

• Plan 1: Simple interest, pay all at end. No interest or principal is

paid until the end of year 5. interest accumulates each year on
the principal only
• Plan 2: Compound interest, pay all at end. No interest or
principal is paid until the end of year 5. interest accumulates
each year on the total of principle and all accrued interest
• Plan 3: Simple interest paid annually, principal repaid at end.
The accrued interest is paid each year, and the entire principal
is repaid at the end of year 5
• Plan 4: Compound interest and portion of principal repaid
annually. The accrued interest and one-fifth of the principal is
repaid each year

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 PAYMENT PLAN

End of Amount Interest Amount Amount

Year Borrowed Owed Paid
0
1
2
3
4

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 1

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 2

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 3

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 EXAMPLE [2]
THE CONCEPT OF EQUIVALENCE – PLAN 4

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 TERMINOLOGY AND SYMBOLS

P = value or amount of money at a time designated as t

he present or time 0.
F = value or amount of money at some future time.
A = series of consecutive, equal, end-of-period amounts
of money.
n = number of interest periods; years
i = interest rate or rate of return per time period; perce
nt per year, percent per month
t = time, stated in periods; years, months, days, etc

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 RULE OF 72 FOR INTEREST

• A common question most often asked by investo

rs is:
•How long will it take for my investment to dou
ble in value?
•Must have a known or assumed compound int
erest rate in advance
•Assume a rate of 13%/year to illustrate….

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 RULE OF 72 FOR INTEREST

• The Rule of 72 states:

•The approximate time for an investment to do
uble in value given the compound interest rate
is:
•Estimated time (n) = 72/i
•For i = 13%: 72/13 = 5.54 years

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 OPPORTUNITY COST
▪Definition: Largest rate of return of all
projects not accepted (forgone) due to a
lack of capital funds
▪ If no MARR is set, the ROR of the first project not
undertaken establishes the opportunity cost
Example: Assume MARR = 10%. Project A, not funded due to
lack of funds, is projected to have RORA = 13%. Project B
has RORB = 15% and is funded because it costs less than A
Opportunity cost is 13%, i.e., the opportunity to make an
additional 13% is forgone by not funding project A

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 CHAPTER SUMMARY
• Engineering Economy fundamentals
❖Time value of money
❖Economic equivalence
❖Introduction to capital funding and MARR
❖Spreadsheet functions
• Interest rate and rate of return
❖Simple and compound interest
• Cash flow estimation
❖Cash flow diagrams
❖End-of-period assumption
❖Net cash flow
❖Perspectives taken for cash flow estimation
• WACC & MARR
• Rule 72
• Opportunity Cost

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 ASSIGNMENT NO. 1

•Book Chapter 1 End Questions

•Q. no.1, 4, 11, 13,, 16, 19, 22, 24, 40,
41
•Submission : Handwritten converted
in to PDF to be uploaded on LMS.

•DEADLINE : NEXT WEEK Same day

(late submission or LMS Enrollment
issues will not be compensated)
2/23/2024
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Thank You
Again
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