ENGINEERING ECONOMICS Lecture 1 - Introduction

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COURSE SYLLABUS AND SCHEDULE
Week Lecture & Assessment Tasks Date
1-2 Introduction to Engineering Economics
3 Time value of Money
4 Variable Interest Rate & Effects of Inflation - Class Assignment 1 Within Week #4
5 Nominal and Effective Interest Rates - Quiz 1 Within Week #5
Jan 12, 2023
6 Mid-term Exam (Thursday)
7 Equivalent Worth Analysis
8 Rate of Return (e.g., IRR, ERR and EROR) and Minimum Attractive
Rate of Return (MARR)
9 Depreciation - Class Assignment 2 Within Week #9
10 Break-even Analysis and Comparison Analysis - Quiz 2 Within Week #10
11 Class Assignment 3 / Revision Within Week #11
As Scheduled by
12 - 13 Final Exam the College
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 GRADING SYSTEM

No Assessment Tasks Frequency Points Weights

Allocated (% from total grade)

1 Class Assignments 3 5 15

2 Quizzes 2 10 20

3 Mid Term Exam 1 25 25

4 Final Exam 1 40 40
Foundations of
Engineering
Economics
 5
Introduction to Economics

▰ Economics is the science of

scarcity.

▰ Scarcity is the basic economic

problem that Economics attempts
to overcome.
 6
Introduction to Economics

Scarcity means there

is NOT enough for
everyone
Introduction to Economics
7

What is Scarcity in Economics?

▰ Scarcity is the condition in which our
wants are greater than our limited
resources.

▰ Scarcity arises when something is both

limited in quantity yet desired.
 What makes something scarce? 8

▰Nobody needs diamonds, yet they are

considered extremely valuable! Why?
▰The answer lies in the fact that
economic value is derived from
scarcity
▪ The more scarce an item is, the more valuable
it is!
▪ The less scarce, the less value it has in society!
 Scarcity vs. Shortage

SCARCITY SHORTAGE

Natural limitation in the Temporary & man-

quantity of resources made unavailability of
needed to meet unlimited goods or services
wants & needs
What is Economics?
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▰ Since we are unable to have everything we

desire, we must make choices on how we will
use our resources.
▰ In economics, we study the choices of
individuals, firms, and governments.
▰ Economics is the study of CHOICE.
 What is Economics?

Study of how people and Economics Economists study the

organizations use their choices we make and
limited resources to the consequences of
satisfy unlimited wants these choices
and needs.

Microeconomics Macroeconomics
➢ Study of small individual economic ➢ Study of the entire economy as a whole
units e.g., households, firms, labour or in its basic subdivisions e.g., ex:
market, etc. unemployment, inflation, GDP, etc.
 Fundamental Concepts of Economics

Scarcity Resources
Economics is about the allocation Economics is about the allocation of
of scarce resources among resources among society’s various
society’s various needs and needs and wants.
wants.

Economics
Tradeoffs Opportunity Cost
Individuals and society as whole are constantly “The opportunity cost is the opportunity lost”.
making choices involving tradeoff between In other words, every economic decision
alternatives. Whether it’s what goods to consume, involves giving up something.
what goods to produce, how to produce them, NOTHING IS FREE!!
and so on.
Economic Resources (Factors of Production)

Natural resources available for

production
Land

Labour The human input into the

production process
Economic
Resources
Man-made resources used to
Capital
produce goods & services

Intellectual resource that involves the

Enterprise
decision making & risk taking of
entrepreneurs
Fundamental Economic Questions

For Whom to Produce?

Who will consume the goods
& services after they have
been produced?

How to Produce?
Who will do the production
and which method of
production will be used?

What to Produce?

What mix of goods & services

to produce?
ENGINEERING

Engineering is the profession in which the knowledge of the

mathematical and natural sciences gained by study,
experience and practice are employed to utilize effectively
the available resources for the benefit of mankind.

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ENGINEERING ECONOMICS

Engineering Economics is a subset of economics for

application to engineering. Engineers seek economic viable
solution ,for each engineering problem, that is normally
considered along with the technical aspects.

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WHY STUDY ENGINEERING ECONOMICS?

Engineers are not limited to their conventional activities.

Now, they are actively involved in strategic and
operational decision making processes. Therefore,
engineering economics can help them to analyze the
economic perspective of a project.

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 EXAMPLE
A child tricycle could be built with an aluminum frame or a
composite frame. Some may argue that the composite frame
will be stronger and lighter, it is a better choice.

Regardless of the engineering discipline, economic factors

are important and engineering economics must be
integrated within the design process.

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 EXAMPLES OF ENGINEERING DECISIONS

1. Should a highway bypass be constructed around a city?

2. Should a computer-vision system replaces the human inspector

in performing quality tests?

3. Should 3d printer acquired by the biomechanics materials

departments?

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DECISION IN ENGINEERING
Decisions often reflect a person’s educated choice of how to
best invest funds; capital Amount of capital is usually restricted
(how to invest to add value?) Engineers play a major role in
capital investment decisions based on their analysis

Fundamentally, engineering economy involves formulating,

estimating and evaluating the economic outcomes when
alternatives to accomplish a defined purpose are available.

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DECISION IN ENGINEERING
General Steps for Decision Making Processes

1. Understand the problem – define objectives

2. Collect relevant information

3. Define the set of feasible alternatives

4. Identify the criteria for decision making

5. Evaluate the alternatives and apply sensitivity analysis

6. Select the “best” alternative

7. Implement the alternative and monitor results

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 COMMONLY USED SYMBOLS
t = time, usually in periods such as years or months
P = value of money at a time t designated as present or time 0
F = value 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 FLOW TERMS
1. Cash Inflows – Revenues (R), receipts, incomes, savings
generated by projects and activities that flow in. Plus
sign used

2. Cash Outflows – Disbursements (D), costs, expenses,

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

3. Net Cash Flow (NCF) – for each time period:

NCF = cash inflows – cash outflows = R – D

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CASH FLOW EXAMPLES

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DECISION IN ENGINEERING
Cash Flows
The estimated Cash-inflows and
Cash-outflows of money

Analysis
Computations considering the time
value of money on cash flows to
obtain a measure of worth

Time Value of Money

Cash flows occur over a
substantial period of time. How
can we treat the same amount of
money available at different
times?
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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

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RATE OF RETURN / INTEREST RATE
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

• Borrower’s perspective – interest rate paid

• Lender’s or investor’s perspective – rate of return earned

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RATE OF RETURN / INTEREST RATE –CASH
FLOW EXAMPLE

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MARR
❖For any investment to be profitable, the investor expects to
receive more money than the amount of capital invested i.e., a
fair rate of return, or return on investment, must be realizable.
❖

❖The Minimum Attractive Rate of Return (MARR) is a reasonable

rate of return established for evaluating and selecting
alternatives.
❖The MARR is established by (financial) managers and is used as
a criterion against which an alternative’s ROR is measured when
making the accept/reject investment decision.
❖A project is not economically viable unless it is expected to
return at least the MARR.
❖MARR is also referred to as the hurdle rate, cutoff rate,
benchmark rate, and minimum acceptable rate of return.
CAPITAL DEVELOPMENT

❖Capital Development is a process by which

engineering companies and corporations raise
funds from different sources for engineering
projects and other types of projects.
❖The sources of this capital are basically divided
into 2:
➢Equity Financing
➢Debt Financing

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 Capital
Development

Equity Financing Debt Financing

• Company uses its own funds • Company borrows from outside
from cash on hand, stock sources and repays the principal
sales, or retained earnings. and interest according to some
• schedule.
• Individuals can use their own • Sources of debt capital may be
cash, savings, or investments. bonds, loans, mortgages,
venture capital pools, & many
• In the example above, using others.
money from the 5% savings • Individuals, too, can utilize debt
account is equity financing. sources, such as the credit card
(15% rate) and bank options
(9% rate) described above.
COST OF CAPITAL
❖It always costs money in the form of interest to raise capital.
❖The interest, expressed as a percentage rate per year is called the
cost of capital.
❖If you want to purchase a new excavator but do not have sufficient
money, you could obtain a bank loan for, say, a cost of capital of 9%
per year and pay for the excavator in cash now.
❖Alternatively, you might choose to use your credit card and pay off the
balance on a monthly basis. This approach will probably cost you at
least 15% per year.
❖Alternatively, you could use funds from your savings account that earns
5% per year and pay cash. This approach means that you also forgo
future returns from these funds.
❖The 9%, 15%, and 5% rates are your cost of capital estimates to
raise the capital for the system by different methods of capital
financing.
COST OF CAPITAL
Example
 If the excavator mentioned in the previous slide was purchased
with 40% credit card money at 15% per year and 60% savings
account funds earning 5% per year, what was the weighted
average cost of capital?

Solution
WACC = Debt Financing + Equity Financing

WACC = 0.4(15%) + 0.6(5%) = 9% annually

COST OF CAPITAL
OPPORTUNITY COST
❖Often, there are many alternatives that are expected to yield a
ROR higher than the MARR but there may not be sufficient capital
available for all, or the project’s risk may be estimated as too
high to take the investment chance.

❖Therefore, new projects that are undertaken usually have an

expected return at least as great as the return on another
alternative that is not funded.

❖The expected rate of return on the unfunded project is called the

opportunity cost.
OPPORTUNITY COST
❖The opportunity cost is the rate of return of a forgone
opportunity caused by the inability to pursue a project.

❖Numerically, it is the largest rate of return of all the projects not

accepted (forgone) due to the lack of capital funds or other
resources.

❖When no specific MARR is established, the default MARR is the

opportunity cost, i.e., the ROR of the first project not undertaken
due to unavailability of capital funds.
OPPORTUNITY COST
Example
As an illustration of opportunity cost, assume a MARR of 12% per
year. Further, assume that a proposal A with an expected ROR =
13% is not funded due to a lack of capital. Meanwhile, proposal
B has a ROR = 14.5% and is funded from available capital.

Solution
Since proposal A is not undertaken due to the lack of capital, its
estimated ROR of 13% is the opportunity cost i.e., the opportunity
to make an additional 13% return is forgone.
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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 ECONOMIC EQUIVALENCE - EXAMPLE
Different sums of money at different times
may be equal in economic value at a
given rate

For example, $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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SIMPLE INTEREST

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SIMPLE INTEREST - EXAMPLE

Question:

$100,000 lent for 3 years at simple i = 10% per year.

What is repayment (Total Amount Due) after 3 years?

Solution:
Interest = 100,000(3)(0.10) = $30,000
Total due = 100,000 + 30,000 = $130,000

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SIMPLE INTEREST - EXAMPLE

▰ GreenTree Financing lent an engineering company

$100,000 to retrofit an environmentally unfriendly
building. The loan is for 3 years at 10% per year simple
interest. How much money will the firm repay at the end
of 3 years?

▰ Solution
The amount due after 3 years is;

= $100,000 (1+ 0.1 x 3) = $130,000

COMPOUNDED INTEREST

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COMPOUND INTEREST - EXAMPLE

Question:

$100,000 lent for 3 years at simple i = 10% per year.

What is repayment (Total Amount Due) after 3 years?

Solution:
Interest = 100,000[(1+0.1)^3-1] = $33,100
Total due = 100,000 + 33,100 = $133,100

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SIMPLE VS. COMPOUND INTEREST
Example: $100,000 lent for 3 years at interest rate i = 10%
per year. What is repayment after 3 years ?
Simple Interest CompoundInterest

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

❑ Total due, year 1: F1 = 100,000 + 10,000
P=$100,000
=$110,000
n= 3
i= 10% ❑ Interest, year 2:2 I = 110,000(0.10) = $11,000
Simple interest = PX n x i ❑ Total due, year 2: F2 = 110,000 + 11,000
= $121,000
Interest = 100,000(3)(0.10)
= $30,000 ❑ Interest, year 3: I3 = 121,000(0.10) = $12,100
Total due = 100,000 + 30,000 ❑ Total due, year 3: F3 = 121,000 + 12,100
= $133,100
= $130,000

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

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SINGLE PAYMENT COMPOUND AMOUNT FACTOR(SPCAF)
If an amount “P” is invested at time “t=0” the amount
accumulated after a year is given as
F1 = P+ Pi
= P(1 + i) ………. (1)
At the end of second year, the accumulated amount F2 is
given as;
F2 = F1 + F1 I To generalize the
= P(1+i) + P(1+i)i process for period “n”
= P+ Pi + Pi+ Pi2 we can write as;
= P(1+i)2 …………(2) F= P(1+i)n
Similarly at the end of the third year F3 is given as;
F3 = F2 + F2 i
= P(1+i)3 ………..(3)
SPCAF 46
SPCAF AND SPPWF “Single Payment Present Worth Factor”

Discounting

SPPWF
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EXAMPLE – PV AND FV

Question:
Find the present value of $25,000 to be received 8 years
from now at a discount rate of 12%

Solution:
We use the compounding formula ➔P=F/(1+i)^n
➔P=25000/(1.12)^8
➔P=$10,097.1

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 CLASS WORKED EXAMPLES

Question 1:
Find the Future value of $40,000
after 15 years from now at an
interest rate of 8%

Solution:
F=P*(1+i)^n
F=40,000*(1.08)^15
P=$126,887
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Class Worked Examples

2. Suppose you borrow SR10,000 which you

will pay back at the end of 5 years. If you
must pay a 12% interest rate annually, how
much money will you have to pay back
using the simple interest & compound
interest concept?
➢ Simple Interest

Column 0 Column 1 Column 2 Column 3

Original Principal x 12% Column 1 + Column 2

Period (Year) Amount Owed at Interest Amount for Amount Owed at End
Beginning of Period Period of Period

1 SR10,000 SR1,200 SR11,200

2 SR11,200 SR1,200 SR12,400

3 SR12,400 SR1,200 SR13,600

4 SR13,600 SR1,200 SR14,800

5 SR14,800 SR1,200 SR16,000

SR6,000
➢ Compound Interest

Column 0 Column 1 Column 2 Column 3

Column 2 x 12% Column 1 + Column 2

Period (Year) Amount Owed at Interest Amount for Amount Owed at End
Beginning of Period Period of Period

1 SR10,000 SR1,200.00 SR11,200.00

2 SR11,200 SR1,344.00 SR12,544.00

3 SR12,544 SR1,505.28 SR14,049.28

4 SR14,049.28 SR1,685.91 SR15,735.19

5 SR15,735.19 SR1,888.22 SR17,623.41

SR7,623.41
➢ Class Worked Examples LOGO

3. What is the weighted average cost of capital for

a corporation that finances an expansion project
using 30% retained earnings and 70% venture
capital? Assume the interest rates are 8% for
the equity financing and 13% for the debt
financing.

Solution

WACC = 0.30(8%) + 0.70(13%) = 11.5%

➢ Class Worked Examples LOGO

❖
➢ Class Worked Examples LOGO

5. An engineering company got a loan of $900,000. The

conditions of the loan stated that the company could pay
interest only at the end of each year for up to 5 years,
after which the company would have to pay the entire
amount due. If the interest rate on the loan was 12% per
year and the company paid only the interest for 4 years,
calculate the following:
(a) The amount of each of the four interest payments
(b) The amount of the final payment at the end of year 5

❖ Solution
(a) Amount paid first four years = 900,000(0.12) = $108,000
(b) Final payment = 900,000 + 900,000(0.12) = $1,008,000
➢ Class Worked Examples LOGO

6. An engineer started a consulting business. He got a loan of

SR23,800 for 1 year to buy his office furniture and furnish
the office. The loan amount had an interest rate of 10%
per year. The engineer had to buy loan-default insurance
that cost 5% of the loan amount as part of the conditions
of the loans. Also, the bank charged him a loan setup fee
of SR300. Calculate the actual interest rate the engineer
paid for the loan.

❖ Solution
Interest on loan = 23,800(0.10) = SR2,380
Loan-default insurance = 23,800(0.05) = SR1,190
Set-up fee = SR300

Total amount paid = 2380 + 1190 + 300 = SR3,870

Effective interest rate = (3,870/23,800)*100 = 16.3%
THANK YOU
SEE YOU NEXT WEEK

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